Chapter 10

Capital-Budgeting
Techniques
and Practice
 Learning Objectives

1. Discuss the difficulty encountered in finding profitable

projects in competitive markets and the importance of the
search.

2. Determine whether a new project should be accepted or

rejected using the payback period, net present value, the
profitability index, and the internal rate of return.

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 FINDING PROFITABLE
PROJECTS

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 Capital Budgeting

Meaning: The process of decision making

with respect to investments in fixed assets
that is, should a proposed project be
accepted or rejected.
It is easier to evaluate profitable projects
than to find them

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 Source of Ideas for Projects

R&D: Typically, a firm has a research &

development (R&D) department that
searches for ways of improving existing
products or finding new projects.
Other sources: Employees, Competition,
Suppliers, Customers.

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 CAPITAL-BUDGETING
DECISION CRITERIA

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 Capital-Budgeting
Decision Criteria

The Payback Period

Net Present Value
Internal Rate of Return

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 The Payback Period

Meaning: Number of years needed to

recover the initial cash outlay related to an
investment.
Decision Rule: Project is considered feasible
or desirable if the payback period is less
than or equal to the firms maximum desired
payback period. In general, shorter payback
period is preferred while comparing two
projects.

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 Payback Period Example
Example: Project with an initial cash outlay of $20,000 with following free cash flows for 5 years.

Payback is 4 years.

YEAR CASH BALANCE

FLOW
1 $ 8,000 ($ 12,000)
2 4,000 ( 8,000)
3 3,000 ( 5,000)
4 5,000 0
5 10,000 12,000

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 Trade-Offs

Benefits:
Uses cash flows rather than accounting profits
Easy to compute and understand
Useful for firms that have capital constraints
Drawbacks:
Ignores the time value of money
Does not consider cash flows beyond the
payback period

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 Discounted Payback Period

The discounted payback period is similar to

the traditional payback period except that it
uses discounted free cash flows rather than
actual undiscounted cash flows.
The discounted payback period is defined as
the number of years needed to recover the
initial cash outlay from the discounted free
cash flows.

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 Discounted Payback Period

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 Table 10-2

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 Payback Period Example

Table 10-2 shows the difference between

traditional payback and discounted payback
methods.
With undiscounted free cash flows,
the payback period is only 2 years,
while with discounted free cash flows (at
17%), the discounted payback period is
3.07 years.

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 Net Present Value (NPV)

NPV is equal to the present value of all

future free cash flows less the investments
initial outlay. It measures the net value of a
project in todays dollars.

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 NPV Example

Example: Project with an initial cash

outlay of $60,000 with following free cash
flows for 5 years.
Year FCF Year FCF
Initial outlay 60,000 3 13,000
1 25,000 4 12,000
2 24,000 5 11,000
The firm has a 15% required rate of return.

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 NPV Example

PV of FCF = $60,764
Subtracting the initial cash outlay of
$60,000 leaves an NPV of $764.
Since NPV > 0, project is feasible.

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 NPV in Excel

Input cash flows for initial outlay and free

cash inflows in cells A1 to A6.
In cell A7 type the following formula:
=A1+npv(0.15,A2:A6)
Excel will give the result NPV = $764.

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 NPV Trade-Offs

Benefits
Considers all cash flows
Recognizes time value of money
Drawbacks
Requires detailed long-term forecast of cash
flows
NPV is generally considered to be the most
theoretically correct criterion for evaluating
capital budgeting projects.

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 Internal Rate of Return (IRR)

IRR is the discount rate that equates the

present value of a projects future net cash
flows with the projects initial cash outlay
(IO).

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 Internal Rate of Return

Decision Rule:
If IRR Required Rate of Return, accept
If IRR < Required Rate of Return, reject

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 Figure 10-1

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 IRR and NPV

If NPV is positive, IRR will be greater than

the required rate of return
If NPV is negative, IRR will be less than
required rate of return
If NPV = 0, IRR is the required rate of
return.

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 IRR Example

Initial Outlay: $3,817

Cash flows: Yr. 1 = $1,000, Yr. 2 =
$2,000, Yr. 3 = $3,000
Discount rate NPV
15% $4,356
20% $3,958
22% $3,817
IRR is 22% because the NPV equals the
initial cash outlay at that rate.

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 IRR in Excel

IRR can be easily computed in Excel.

In the previous example, input cash outflow
and three yearly cash inflows in cells A1:A4.
In cell A5 input
=IRR(A1:A4)
Excel will give the result IRR = 22%.

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 Multiple IRRs

A normal cash flow pattern for project is

negative initial outlay followed by positive
cash flows (, +, +, + )
However, if the cash flow pattern is not
normal (such as , +, ) there can be more
than one IRR.
Figure 10-2 is based on cash flows of
1,600, +10,000, 10,000 in years 0, 1, 2.

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 Multiple IRRs (Figure 10-2)

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 CAPITAL RATIONING

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 Capital Rationing

Capital rationing refers to situation where

there is a limit on the dollar size of the
capital budget. This may be due to:
a) temporary adverse conditions in the market;
b) shortage of qualified personnel to direct new
projects; and/or
c) other factors such as not being willing to take
on excess debt to finance new projects.

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 Capital Rationing

How to select? Select a set of projects with

the highest NPVsubject to the capital
constraint.

Note, using NPV may preclude accepting the

highest ranked project in terms of PI or IRR.

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 Figure 10-4

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 Table 10-7

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 RANKING MUTUALLY
EXCLUSIVE PROJECTS

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 Ranking Mutually
Exclusive Projects

Size Disparity
Time Disparity
Unequal Life

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 Size Disparity

This occurs when we examine mutually

exclusive projects of unequal size.
Example: Consider the following cash flows
for one-year Project A and B, with required
rates of return of 10%.
Initial Outlay: A = $200; B = $1,500
Inflow:A = $300; B = $1,900

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 Table 10-8

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 Size-Disparity
Ranking Problem

Project A Project B
NPV 72.73 227.28
PI 1.36 1.15
IRR 50% 27%

Ranking Conflict:
Using NPV, Project B is better;
Using PI and IRR, Project A is better.

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 Size-Disparity
Ranking Problem

Which technique to use to select the

project?
Use NPV whenever there is size disparity. If
there is no capital rationing, project with the
largest NPV will be selected. When capital
rationing exists, rank and select set of
projects based on NPV.

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 The Time-Disparity Problem

Time-disparity problem arises because of

differing reinvestment assumptions made by
the NPV and IRR decision criteria.
How are cash flows reinvested?
According to NPV: Required rate of return
According to IRR: IRR

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 The Time-Disparity Problem

Example: Consider two projects, A and B,

with initial outlay of $1,000, cost of capital
of 10%, and following cash flows in years 1,
2, and 3:
A: $100 $200 $2,000
B: $650 $650 $650

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 The Time-Disparity Problem

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 The Time-Disparity Problem

Project A Project B
NPV 758.83 616.45
PI 1.759 1.616
IRR 35% 43%

Ranking Conflict:
Using NPV or PI, A is better
Using IRR, B is better
Which technique to use to select the superior
project?
Use NPV

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 Key Terms

Capital budgeting
Capital rationing
Discounted payback period
Equivalent annual annuity (EAA)
Internal rate of return (IRR)
Modified internal rate of return (MIRR)
Mutually exclusive projects
Net present value (NPV)
Net present value profile
Payback period
Profitability index (PI) or benefit-cost ratio

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 Table 10-1

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 Table 10-3

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 Table 10-4

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 Table 10-5

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 Table 10-6

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 Table 10-10

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