CAPITAL
BUDGETING
TECHNIQUES OR
NET PRESENT
VALUE & OTHER
INVESTMENT
CRITERIA
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
1
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Outcomes
LO.1 Describe the importance of capital
budgeting decisions and the general
process that is followed when making
decisions about investing in fixed
(capital) assets.
LO.2 Describe how the net present value
(NPV) technique and the internal rate of
return (IRR) technique are used to make
investment (capital budgeting) decisions.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
2
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Outcomes (cont.)
LO.3 Compare the NPV technique with the
IRR technique, and discuss why the two
techniques might not always lead to the
same investment decisions.
LO.4 Describe how conflicts that might arise
when using the NPV and IRR techniques
can be resolved using the modified
internal rate of return (MIRR) technique.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
3
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Outcomes (cont.)
LO.5 Describe other capital budgeting
techniques used by businesses to make
investment decisions and which
techniques are used most often in
practice.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
4
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What is Capital Budgeting?
○ The process of planning and evaluating
expenditures on assets whose cash flows
are expected to extend beyond one year.
Analysis of potential additions to fixed assets.
Long-term decisions generally involve large
expenditures.
Very important to firm’s future.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
5
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Generating Ideas for Capital
Projects
○ Both a firm’s growth and its ability to
remain competitive depend on a constant
flow of ideas for new products, ways to
make existing products better, and ways to
produce output at a lower cost.
○ Procedures must be established for
evaluating the worth of such projects.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
6
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Project Classifications
○ Replacement Decisions—whether to
purchase capital assets to take the place of
existing assets primarily to maintain
existing operations.
○ Expansion Decisions—whether to purchase
additional capital projects to increase
existing operations (grow the firm).
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
7
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Project Classifications (cont.)
○ Independent Projects—projects whose cash
flows are not affected by decisions made
about other projects.
○ Mutually Exclusive Projects—a set of
projects where the acceptance of one
project means the others cannot be
accepted.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
8
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Post-Audit
○ Compares actual results with those
predicted by the project’s sponsors and
explains why any differences occurred
○ Two main purposes:
To improve forecasts
To improve operations
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
9
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Similarities between Capital Budgeting and
Asset Valuation
1. Estimate the cash flows expected from the
project.
2. Evaluate the riskiness of cash flows.
3. Compute the present value of the expected cash
flows to obtain an estimate of the asset’s value to
the firm.
4. Compare the present value (PV) of the future
expected cash flows (CF) with the initial
investment. If (PV of CF) > (Initial Investment),
purchase the asset.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
10
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Net Present Value: Sum of the PVs of
Inflows and Outflows
NPV Decision Rule:
A project is acceptable if NPV > $0
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
11
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Net Cash Flows for
Project S and Project L
Expected After-Tax
Net Cash Flows,xxx
CF t
Year (t) Project SProject L
0 $(3,000) $(3,000)
1 1,500 400
2 1,200 900
3 800 1,300
4 300 1,500
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
12
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cash Flow Timelines for
Project S and Project L
Project S: 0 1 2 3 4
Net cash flow (3,000) 1,500 1,200 800 300
Project L: 0 1 2 3 4
Net cash flow (3,000) 400 900 1,300 1,500
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
13
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What is Project S’s NPV?
0 1 2 3 4
r = 10%
Cash Flows:(3,000.00) 1,500 1,200 800 300
1,363.64
991.74
601.05
204.90
NPVS = 161.33
Project S is acceptable, because its NPV is positive.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
14
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Rationale for the NPV method:
○ NPV = (PV future CFs) – Cost
= Net gain in wealth (value)
○ Accept project if NPV > 0.
○ Choose between mutually exclusive
projects on basis of higher NPV.
○ Which adds most value?
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
15
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Using NPV method: Which project(s)
should be accepted?
○ NPVS = 161.33 and NPVL = 108.67
○ If Projects S and L are mutually exclusive,
accept Project S because NPVS > NPVL
○ If Projects S and L are independent, accept
both, because both have NPV > 0.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
16
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Internal Rate of Return (IRR)
○ IRR is the rate of return that will be earned
if a project is purchased and held for its
entire life.
○ IRR Decision Rule: A project is acceptable if
IRR > (firm’s required rate of return, r)
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
17
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Calculating IRR
A project is acceptable if IRR > r
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
18
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Calculating the IRR for Project S
0 1 2 3 4
IRRS = ?
Cash Flows:(3,000) 1,500 1,200 800 300
4
CF3,000
t 1
t
NPVS = 0
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
19
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Calculating the IRR for Project S
1,500 1,200 800 300
(3,000 ) 1
2
3
4
0
(1 IRR ) (1 IRR ) (1 IRR ) (1 IRR )
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
20
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Financial Calculator Method
○ Enter the cash flows sequentially into the
CF register, and then press the IRR button
○ For Project S, IRRS = 13.1%.
○ For Project L, IRRL = 11.4%.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
21
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Rationale for the IRR Method
○ If (project’s rate of return, IRR) > (firm’s
required rate of return, r), then some
return is left over to boost stockholders’
returns.
Example: IRR = 13% > r = 10%; profitable
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
22
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Decisions on Projects S and L per
IRR
○ If Project S and Project L are independent,
accept both. IRRS = 13.1% > IRRL = 11.4% > r
= 10%.
○ If Project S and Project L are mutually
exclusive, based on IRR, Project S is more
acceptable because IRRS > IRRL
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
23
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
NPV Profiles for Project S and
Project L
Discount Rate NPVS NPVL
0% $800.00 $1,100.00
5 454.89 554.32
10 161.33 108.67
15 ( 90.74) (259.24)
20 (309.03) (565.97)
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
24
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
NPV Profiles for Projects S and L
NPV
1,200($)
1,000
800
600 Crossover Rate = 8.1%
400
268 ● IRRS = 13.1%
200
0 ● ● r (%)
5 10 8.1 15 20
-200 Project S’s
IRRL = 11.4%
-400 NPV Profile
-600
Project L’s
-800 NPV Profile
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
25
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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; thus, high r favors
small projects.
○ Timing differences: Project with faster
payback provides more CF in early years for
reinvestment.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
26
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Reinvestment Rate Assumptions
○ NPV assumes reinvest at r.
○ IRR assumes reinvest at IRR.
○ Reinvest at opportunity cost, r, is more
realistic, so NPV method is better.
○ NPV should be used to choose between
mutually exclusive projects; ensures value is
maximized.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
27
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Multiple IRRs
○ Suppose a project exists with the following
cash flow pattern:
Year Cash Flow
0 $(1,600,000)
1 10,000,000
2 (10,000,000)
o Two IRRs exist for this project.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
28
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
NPV Profile for Project M
NPV ($ million)
1.5 $10 $10
NPV $1.6
(1 r)1 (1 r)1
1.0
0.5 IRR2 = 400%
0.0 ● ●
100 200 300 400 500
-0.5 IRR1 = 25% Required Rate of Return (%)
-1.0
-1.5
-2.0
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
29
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Modified Internal Rate of Return
○ A better indicator of relative profitability; better
for use in capital budgeting
○ MIRR Rule: A project is acceptable if MIRR > r
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
30
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Traditional Payback Period
○ The length of time it takes to recover the
original cost of an investment from its
expected cash flows
The ye a r jus t prior to the
Payback ye a r of full re cove ry
period of initia l inve s tme nt
Amount of the initial investment that is
unrecovered at the start of the recov ery year
Total cash flow generated
during the recovery year
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
31
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Traditional Payback Period
(cont.)
○ PB Decision Rule: A project is acceptable if
PB < n*
○ n* = years determined by the firm
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
32
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Payback Period (PB) for Project S
PBS = 2.4
0 1 2 3 4
Net cash flow(3,000) 1,500 1,200 800 300
Cumulative CF (3,000) (1,500) (300) 500 800
300
Payback , PB S 2 2.4 years
800
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
33
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Discounted Payback Period
(DPB)
○ The traditional payback period does not
consider the time value of money; the
discounted payback period does.
○ DPB = the length of time it takes for a
project’s discounted (PV of) cash flows to
repay the cost of the investment.
○ DPB Decision Rule: A project is acceptable
if DPB < Project’s useful life.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
34
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Discounted Payback Period
(DPB) for Project S
DPBS = 3.2
0 1 2 3 4
Net cash flow (3,000) 1,500.00 1,200.00 800.00 300.00
Discounted CF (3,000) 1,363.64 991.74 601.05 204.90
Cumulative DCF (3,000) (1,636.36) (644.62) (43.57) 161.33
43.57
DPBS 3 3.2 years
204.90
DPBS < 4 years, thus the project is acceptable.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
35
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Capital Budgeting Methods Used in
Practice
○ Companies use more sophisticated capital
budgeting techniques today than in the
past (20 – 30 years ago).
○ Companies use multiple capital budgeting
techniques when making investment
decisions.
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
36
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
