PC Ch. 11 Techniques of Capital Budgeting

Capital investment
decision criteria:
Evaluating Cash Flows
Financial Management-II
CCBMDO Batch-15
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Topics
 Overview and “vocabulary”
 Methods
 NPV
 IRR, MIRR
 Benefit Cost ratio
 Payback, discounted payback
 Accounting rate of return
 Unequal lives
 Economic life
 Optimal capital budget
2
The Big Picture:
The Net Present Value of a Project
Project’s Cash Flows

(CFt)
CF1 CF2 CFN

NPV = + + ··· + − Initial cost
(1 + r )1 (1 + r)2 (1 + r)N
Market Project’s
interest rates debt/equity capacity
Project’s risk-adjusted
cost of capital
(r)
Market Project’s
risk aversion business risk
What is capital budgeting?
 Analysis of potential projects.
 Long-term decisions; involve large
expenditures.
 Very important to firm’s future.
4
11.1 Capital budgeting process
 Identification of potential invt opportunities
 Assembling proposed investments
 Decision making
 Preparation of capital budget
 Preparation of budget and appropriations
 Implementation
 Performance review
5
 Identification of potential invt opportunities
 Planning body develops sales estimates  serves
as basis for setting pdn targets 
 Identify required investments in plant & eqpt.,
R&D, distribution, …
 How to identify the investment ideas?
 Monitoring external environment to scout opportunities
 Formulate a well defined corp stgy based on SWOT analysis
 Sharing the corp stgy and perspectives with persons involved in
the process of capital budgeting
 Motivate the employees to make suggestions
6
 Assembling proposed investments
 Operating departments submits the capital investment
proposals in a standardized proposal form.
 Each dept route the proposals through several persons to
ensure that it is viewed from different angles 
 Helps in creating a climate for bringing about coordination of
interrelated activities.
 Investment proposals are usually classified into
various categories for facilitation decision-making,
budgeting and control. (list to follow)
7
Capital Budgeting Project
Categories
1. Replacement to continue profitable
operations
2. Replacement to reduce costs
3. Expansion of existing products or markets
4. Expansion into new products/markets
5. Contraction decisions
6. Safety and/or environmental projects
7. Mergers
8. New product investments and Others
8
Steps in Capital Budgeting
 Estimate cash flows (inflows &
outflows).
 Assess risk of cash flows.
 Determine r = WACC for project.
 Evaluate cash flows.
9
Independent versus Mutually
Exclusive Projects
 Projects are:
 independent, if the cash flows of one are
unaffected by the acceptance of the other.
 mutually exclusive, if the cash flows of one
can be adversely impacted by the
acceptance of the other.
10
Cash Flows for A, B and C
0 12% 1 2 3
A’s CFs:
-15000 11,000 7,000 4,800
0 1 2 3
B’s CFs: 12%
-15,000 3,500 8,000 13,000
0 1 2 3
12%
C’s CFs:
-15,000 42,000 -4,000 0
11
NPV: Sum of the PVs of All
Cash Flows
N CFt
NPV = Σ
(1 + r)t
t=0
Cost often is CF0 and is negative.

N CFt
NPV = Σ – CF0
(1 + r)t
t=1
12
What’s A’s NPV?
0 1 2 3
L’s CFs: 12%
-15,000 11,000 7,000 4,800
9,821
5,580
3,417
3,818 = NPVA NPVB = 3,756
13
Rationale for the NPV Method
 NPV = PV inflows – Cost
 This is net gain in wealth, so accept

project if NPV > 0.
 Choose between mutually exclusive

projects on basis of higher positive NPV.
Adds most value.
14
Using the NPV measure, which
franchise(s) should be accepted?
 If A and B are mutually exclusive,

accept A because NPVA > NPVB.
 If A & B are independent, accept
both; NPV > 0.
 NPV is dependent on cost of capital.
15
Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3

Cost Inflows
IRR is the discount rate that forces PV inflows =
cost. This is the same as forcing NPV = 0.
N CF
Σ =0
t
(1 + IRR)t
t=0
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 16
IRR: Enter NPV = 0, Solve for IRR
N CFt N CFt
Σ (1 + IRR)t
=0
Σ (1 + IRR)t
-P=0
t=0 t=1
IRR is an estimate of the project’s rate of return

 it is comparable to the YTM on a bond.
17
What’s A’s IRR?
0 1 2 3
IRR = ?
-15,000 11,000 7,000 4,800

PV1
PV2
PV3
0 = NPV
Enter CFs in CFLO, then press IRR:
IRRA = 28.83%. IRRB = 23.43%.
18
Rationale for the IRR Method
 If IRR > r, then the project’s rate of return is
greater than its cost-- some return is left over
to boost stockholders’ returns.
 Example: r= 10%, IRR = 15%.
 So this project adds extra return to

shareholders.
19
Decisions on A and B per IRR
 If A and B are independent, accept
both: IRRA > r and IRRB > r.
 If A and B are mutually exclusive,
accept A because IRRA > IRRB.
 IRR is not dependent on the cost of
capital used.
20
SUMMARY
 Capital budgeting is the process of analyzing potential projects.
 These are probably most important decisions that managers must make.
 NPV) method discounts all cash flows at the project’s cost of
capital and then sums those cash flows.
 Accept positive-NPV project as it increases shareholders’ value.
 IRR is that discount rate that forces a project’s NPV to zero.
 The project should be accepted if the IRR > WACC
 The NPV and IRR methods make the same accept–reject
decisions for independent projects, but
 If projects are mutually exclusive then ranking conflicts can
arise  the NPV method should generally be relied upon.
21
Construct NPV Profiles
Chart Title
r A B C ₹8,000
Crossover
5% ₹ 5,972 ₹ 6,819 ₹ 21,372 ₹6,000
Point = 11.44%
10% ₹ 4,391 ₹ 4,560 ₹ 19,876 ₹4,000
15% ₹ 3,014 ₹ 2,640 ₹ 18,497 ₹2,000

IRRA = 28.83%
20% ₹ 1,806 ₹ 995 ₹ 17,222 ₹0

0% 5% 10% 15% 20% 25% 30% 35% 40%
25% ₹ 738 ₹ -424 ₹ 16,040
(₹2,000)
30% ₹ -212 ₹ -1,657 ₹ 14,941 IRRB = 23.43%

(₹4,000)
35% ₹ -1,060 ₹ -2,734 ₹ 13,916 Series1 Series2
22
NPV and IRR: No conflict for
independent projects.
NPV ($)
IRR > r r > IRR

and NPV > 0 and NPV < 0.
Accept. Reject.
r (%)
IRR
Mutually Exclusive Projects
NPV ($) r < 11.44%: NPVB> NPVA , IRRA > IRRB
CONFLICT
B
r > 11.44%: NPVA> NPVB , IRRB > IRRA
NO CONFLICT
A IRRA
11.44
IRRB r (%)
24
To Find the Crossover Rate
 Find cash flow differences between the projects. See data
at beginning of the case.
 Enter these differences in CFLO register, then press IRR.
Crossover rate = 11.44%, rounded to 11.4%.
 Can subtract A from B or vice versa and consistently, but
easier to have first CF negative.
 If profiles don’t cross, one project dominates the other.
25
Two Reasons NPV Profiles Cross
 Size (scale) differences. Smaller project frees
up funds at t = 0 for investment. The higher
the opportunity cost, the more valuable these
funds, so high r favors small projects.
 Timing differences. Project with faster
payback provides more CF in early years for
reinvestment. If r is high, early CF especially
good, NPVA > NPVB.
26
Modified Internal Rate of Return
(MIRR)
 MIRR is the discount rate that causes the PV of
a project’s terminal value (TV) to equal the PV
of costs.
 TV is found by compounding inflows at WACC.
 Thus, MIRR assumes cash inflows are
reinvested at WACC.
27
MIRR for Project A: First, find
PV and TV (r = 12%).
0 1 2 3
10%
-15,000 11,000 7,000 4,800

12%
7,840
12%
13,798
-15,000 26,438
PV outflows TV inflows
28
Second, find discount rate that
equates PV and TV.
0 1 2 3
MIRR = 20.79%
-15,000 26,438
PV outflows TV inflows
15,000 = 26,438
(1+MIRRA)3
MIRRA = 20.79%
29
To find TV with financial calculator:
Step 1, Find PV of inflows.
 First, enter cash inflows in CFLO register:
CF0 = 0, CF1 = 11000, CF2 = 7000, CF3 = 4,800
 Second, enter I/YR = 12.
 Third, find PV of inflows:

Press NPV = 18,818
30
Step 2, Find TV of inflows.
 Enter PV = -18,818, N = 3, I/YR = 12,
PMT = 0.
 Press FV = 26,438 = FV of inflows.
31
Step 3, Find PV of outflows.
 For this problem, there is only one
outflow, CF0 = -15,000, so the PV of
outflows is -15,000.
 For other problems there may be
negative cash flows for several years,
and you must find the present value for
all negative cash flows.
32
Step 4, Find “IRR” of TV of
inflows and PV of outflows.
 Enter FV = 26438, PV = -15,000,
PMT = 0, N = 3.
 Press I/YR = 20.79% = MIRR.
33
Benefit Cost Ratio (BCR)
 The profitability index (PI) is the present
value of future cash flows divided by the
initial cost.
 It measures the “bang for the buck.”
34
Pjt A’s PV of Future Cash Flows
Project L:
0 1 2 3
12%
11,000 7,000 4,800
9,821
5,580
3,417
18,818
35
Project A’s Profitability Index
PV future CF 18,818
PIL = =
Initial cost 15,000
PIA = 1.2546
PIB = 1.2504
36
What is the payback period?
 The number of years required to
recover a project’s cost,
 or how long does it take to get the

business’s money back?
37
Payback period for Project A
0 1 1.57 2 3
CFt -15,000 11,000 7,000 80

Cumulative -15,000 -4,000 0 3,000 50
PaybackL = 1 + $40/$70 = 1.57 years
38
Payback period for Project B
0 1 2 2.3 3
CFt -15,000 3,500 8,000 13,000
Cumulative -15,000 -11,500 -3,500 0 9,500
PaybackS = 2 + 3500/13,000 = 2.27 years

39
Strengths and Weaknesses of PBP
 Strengths:
 Provides an indication of a project’s risk
and liquidity.
 Easy to calculate and understand.
 Weaknesses:
 Ignores the TVM.
 Ignores CFs occurring after the payback
period.
 No specification of acceptable payback.
40
Discounted Payback: Uses
Discounted CFs
0 1 2 3
12%
CFt -15,000 11,000 7,000 4,800

PVCFt -15,000 9,821 5,880 3,417
Cumulative -15,000 -5179 402 3,818
Discounted
payback = 1 + 5179/5880 = 1.93 yrs
Recover investment + capital costs in 1.9 yrs.

41
Normal vs. Nonnormal Cash
Flows
 Normal Cash Flow Project:
 Cost (negative CF) followed by a series of positive
cash inflows.
 One change of signs.
 Nonnormal Cash Flow Project:
 Two or more changes of signs.
 Most common: Cost (negative CF), then string of
positive CFs, then cost to close project.
 For example, nuclear power plant or strip mine.
42
Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
43
Pavilion Project: NPV and IRR?
0 1 2
r = 12%
-15,000 42,000 -4,000
Enter CFs in CFLO, enter I/YR = 10.

NPV = 19,311
IRR = ERROR. Why?
44
Nonnormal CFs—Two Sign
Changes, Two IRRs
NPV ($) NPV Profile
IRR2 = 170%
450
0
0 60 120 170 r (%)
IRR1 = -90%
-800
45
Logic of Multiple IRRs
 At very low discount rates, the PV of
CF2 is large & negative, so NPV < 0.
 At very high discount rates, the PV of
both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
 In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
 Result: 2 IRRs.
46
Finding Multiple IRRs with
Calculator
1. Enter CFs as before.

2. Enter a “guess” as to IRR by storing
the guess. Try 10%:
10 STO
IRR = -90% = lower IRR
(See next slide for upper IRR)
47
Finding Upper IRR with
Calculator
Now guess large IRR, say, 200:

200 STO
IRR = 170% = upper IRR
48
When there are nonnormal CFs and
more than one IRR, use MIRR.
0 1 2
12%
-15,000 42,000 -4,000
PV outflows @ 12% = -18,189

TV inflows @ 12% = 37,500.
MIRR = 5.6%
49
Accept Project P?
 YES. ACCEPT because
MIRR = 5.6% > r = 12%.
 Also, if MIRR < r, NPV will be negative:

NPV = -$386,777.
50
Review
 A project to have more than one IRR if cash
flows change signs more than once.
 A project never has more than one MIRR.
 Find the terminal value (TV) of the cash inflows,
compounding them at the firm’s cost of capital,
 Determine the discount rate that forces the PV of
the TV to equal the present value of the outflows.
51
Review
 BCR (PI) measures relative profitability—that is, the
amount of PV per dollar of investment.
 The regular payback period method has three flaws:
 It ignores cash flows beyond the payback period,
 it does not consider the time value of money, and
 it doesn’t give a precise acceptance rule.
 PBP provide an indication of a project’s risk and
liquidity how long the invested capital will be tied up.
 Discounted PBP payback considers the time value of money,
but it still ignores cash flows beyond the payback period.
52
Projects T (for two years) and F (for four
years) are mutually exclusive and will be
repeated; r = 10%.
0 1 2 3 4
T: -100 60 60
F: -100 33.5 33.5 33.5 33.5

Note: CFs shown in $ Thousands
53
NPVF > NPVT, but which is
better? T can be repeated!
T F
CF0 -100 -100
CF1 60 33.5
NJ 2 4
I/YR 10 10
NPV 4.132 6.190
54
Equivalent Annual Annuity
Approach (EAA)
 Convert the PV into a stream of annuity
payments with the same PV.
 T: N=2, I/YR=10, PV=-4.132, FV = 0.
Solve for PMT = EAAT = $2.38.
 F: N=4, I/YR=10, PV=-6.190, FV = 0.
Solve for PMT = EAAF = $1.95.
 T has higher EAA, so it is a better
project.
55
Replacement Chain
 Note that Project T could be repeated after 2
years to generate additional profits.
 Use replacement chain to put on common life.
56
Replacement Chain Approach: f with
Replication ($ thousands)
0 1 2 3 4
T: -100 60 60
-100 60 60
-100 60 -40 60 60
NPV = $7.547.
57
Or, Use NPVs
0 1 2 3 4
4.132 4.132
10%
3.415
7.547
The repeated NPV of Project T is bigger

than F’s NPV ($7.514 > $6.190).
58
Suppose the cost to repeat T in two
years rises to $105,000?
0 1 2 3 4
10%
T: -100 60 60
-105 60 60
-45
NPVT = $3.415 < NPVT = $6.190.
Now choose T.
59
Economic Life vs. Physical Life
 Consider another project with a 3-year
life.
 If terminated prior to Year 3, the
machinery will have positive salvage
value.
 Should you always operate for the full
physical life?
 See next slide for cash flows.
60
Economic Life vs. Physical Life
(Continued)
Year CF Salvage Value
0 -$5,000 $5,000
1 2,100 3,100
2 2,000 2,000
3 1,750 0
61
CFs Under Each Alternative
(000s)
Years: 0 1 2 3
1. No termination -5 2.1 2 1.75
2. Terminate 2 years -5 2.1 4
3. Terminate 1 year -5 5.2
62
NPVs under Alternative Lives (Cost of
Capital = 10%)
 NPV(3 years) = -$123.

 NPV(2 years) = $215.
 NPV(1 year) = -$273.
63
Conclusions
 The project is acceptable only if
operated for 2 years.
 A project’s engineering life does not
always equal its economic life.
64
Review
 If ME projects have unequal lives, it may be
necessary to adjust the analysis to put the projects
on an equal-life basis. This can be done using the
 replacement chain (common life) approach or
 the equivalent annual annuity (EAA) approach.
 A project’s true value may be greater than the NPV
based on its physical life if it can be terminated at the
end of its economic life.
65
Review
 Flotation costs and increased risk associated with
unusually large expansion programs can cause the
marginal cost of capital to increase as the size of the
capital budget increases.
 Capital rationing occurs when management places a
constraint on the size of the firm’s capital budget
during a particular period.
66

PC Ch. 11 Techniques of Capital Budgeting

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PC Ch. 11 Techniques of Capital Budgeting

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Capital investment

Project’s Cash Flows

CF1 CF2 CFN

Cost often is CF0 and is negative.

-15,000 11,000 7,000 4,800

 This is net gain in wealth, so accept

 Choose between mutually exclusive

 If A and B are mutually exclusive,

CF0 CF1 CF2 CF3

IRR is an estimate of the project’s rate of return

-15,000 11,000 7,000 4,800

 Example: r= 10%, IRR = 15%.

 So this project adds extra return to

15% ₹ 3,014 ₹ 2,640 ₹ 18,497 ₹2,000

20% ₹ 1,806 ₹ 995 ₹ 17,222 ₹0

30% ₹ -212 ₹ -1,657 ₹ 14,941 IRRB = 23.43%

35% ₹ -1,060 ₹ -2,734 ₹ 13,916 Series1 Series2

IRR > r r > IRR

-15,000 11,000 7,000 4,800

 Second, enter I/YR = 12.

 Third, find PV of inflows:

 Press FV = 26,438 = FV of inflows.

 Press I/YR = 20.79% = MIRR.

11,000 7,000 4,800

 or how long does it take to get the

CFt -15,000 11,000 7,000 80

PaybackL = 1 + $40/$70 = 1.57 years

CFt -15,000 3,500 8,000 13,000

Cumulative -15,000 -11,500 -3,500 0 9,500

PaybackS = 2 + 3500/13,000 = 2.27 years

CFt -15,000 11,000 7,000 4,800

Recover investment + capital costs in 1.9 yrs.

-15,000 42,000 -4,000

Enter CFs in CFLO, enter I/YR = 10.

NPV ($) NPV Profile

1. Enter CFs as before.

Now guess large IRR, say, 200:

PV outflows @ 12% = -18,189

 Also, if MIRR < r, NPV will be negative:

F: -100 33.5 33.5 33.5 33.5

NPV 4.132 6.190

The repeated NPV of Project T is bigger

1. No termination -5 2.1 2 1.75

2. Terminate 2 years -5 2.1 4

3. Terminate 1 year -5 5.2

 NPV(3 years) = -$123.

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