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Capital

Capital Budgeting

Budgeting

Techniques

Techniques

© Pearson Education Limited 2004

Fundamentals of Financial Management, 12/e

Created by: Gregory A. Kuhlemeyer, Ph.D.

Carroll College, Waukesha, WI

3-1

After studying Chapter 13,

you should be able to:

◆ Understand the payback period (PBP) method of project evaluation and

selection, including its: (a) calculation; (b) acceptance criterion; (c)

advantages and disadvantages; and (d) focus on liquidity rather than

profitability.

◆ Understand the three major discounted cash flow (DCF) methods of

project evaluation and selection – internal rate of return (IRR), net

present value (NPV), and profitability index (PI).

◆ Explain the calculation, acceptance criterion, and advantages (over the

PBP method) for each of the three major DCF methods.

◆ Define, construct, and interpret a graph called an “NPV profile.”

◆ Understand why ranking project proposals on the basis of IRR, NPV, and

PI methods “may” lead to conflicts in ranking.

◆ Describe the situations where ranking projects may be necessary and

justify when to use either IRR, NPV, or PI rankings.

◆ Understand how “sensitivity analysis” allows us to challenge the single-

point input estimates used in traditional capital budgeting analysis.

◆ Explain the role and process of project monitoring, including “progress

reviews” and “post-completion audits.”

3-2

Capital

Capital Budgeting

Budgeting

Techniques

Techniques

◆ Project Evaluation and Selection

◆ Potential Difficulties

◆ Capital Rationing

◆ Project Monitoring

◆ Post-Completion Audit

3-3

Project

Project Evaluation:

Evaluation:

Alternative

Alternative Methods

Methods

◆ Internal Rate of Return (IRR)

◆ Net Present Value (NPV)

◆ Profitability Index (PI)

3-4

Proposed

Proposed Project

Project Data

Data

Julie Miller is evaluating a new project

for her firm, Basket Wonders (BW).

She has determined that the after-tax

cash flows for the project will be

$10,000; $12,000; $15,000; $10,000;

and $7,000, respectively, for each of

the Years 1 through 5. The initial

cash outlay will be $40,000.

3-5

Independent Project

◆ For this project, assume that it is

independent of any other potential

projects that Basket Wonders may

undertake.

◆ Independent -- A project whose

acceptance (or rejection) does not

prevent the acceptance of other

projects under consideration.

3-6

Payback

Payback Period

Period (PBP)

(PBP)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

required for the cumulative

expected cash flows from an

investment project to equal

the initial cash outflow.

3-7

Payback

Payback Solution

Solution (#1)

(#1)

0 1 2 3 (a) 4 5

10 K 22 K 37 K(c) 47 K 54 K

Cumulative

Inflows PBP =a+(b-c)/d

= 3 + (40 - 37) / 10

= 3 + (3) / 10

= 3.3 Years

3-8

Payback

Payback Solution

Solution (#2)

(#2)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

-40 K -30 K -18 K -3 K 7K 14 K

Cumulative Years

Cash Flows

Note: Take absolute value of last

negative cumulative cash flow value.

3-9

PBP

PBP Acceptance

Acceptance Criterion

Criterion

The management of Basket Wonders

has set a maximum PBP of 3.5

years for projects of this type.

Should this project be accepted?

initial cash outlay in less than 3.5

years. [3.3 Years < 3.5 Year Max.]

3-10

PBP

PBP Strengths

Strengths

and

and Weaknesses

Weaknesses

Strengths: Weaknesses:

◆Easy to use and ◆ Does not account

understand for TVM

◆Can be used as a ◆ Does not consider

measure of liquidity cash flows beyond

◆Easier to forecast the PBP

ST than LT flows ◆ Cutoff period is

subjective

3-11

Internal

Internal Rate

Rate of

of Return

Return (IRR)

(IRR)

present value of the future net cash

flows from an investment project with

the project’s initial cash outflow.

ICO = + +...+

(1+IRR) (1+IRR)2

1

(1+IRR)n

3-12

IRR

IRR Solution

Solution

+ +

(1+IRR)1 (1+IRR)2

$15,000 $10,000 $7,000

+ +

(1+IRR)3 (1+IRR)4 (1+IRR)5

discounted cash flows to equal $40,000.

3-13

IRR

IRR Solution

Solution (Try

(Try 10%)

10%)

$40,000 = $10,000(PVIF10% ,1) + $12,000(PVIF10% ,2) +

$15,000(PVIF10% ,3) + $10,000(PVIF10% ,4) + $

7,000(PVIF10% ,5)

$40,000 = $10,000(.909) + $12,000(.826) +

$15,000(.751) + $10,000(.683) + $ 7,000(.621)

$40,000 = $9,090 + $9,912 + $11,265 + $6,830 +

$4,347 = $41,444 [Rate is too low!!]

3-14

IRR

IRR Solution

Solution (Try

(Try 15%)

15%)

$40,000 = $10,000(PVIF15% ,1) + $12,000(PVIF15% ,2) +

$15,000(PVIF15% ,3) + $10,000(PVIF15% ,4) + $

7,000(PVIF15% ,5)

$40,000 = $10,000(.870) + $12,000(.756) +

$15,000(.658) + $10,000(.572) + $ 7,000(.497)

$40,000 = $8,700 + $9,072 + $9,870 + $5,720 +

$3,479 = $36,841 [Rate is too high!!]

3-15

IRR

IRR Solution

Solution (Interpolate)

(Interpolate)

.10 $41,444

X $1,444

.05 IRR $40,000 $4,603

.15 $36,841

X $1,444

.05 = $4,603

3-16

IRR

IRR Solution

Solution (Interpolate)

(Interpolate)

.10 $41,444

X $1,444

.05 IRR $40,000 $4,603

.15 $36,841

X $1,444

.05 = $4,603

3-17

IRR

IRR Solution

Solution (Interpolate)

(Interpolate)

.10 $41,444

X $1,444

.05 IRR $40,000 $4,603

.15 $36,841

X = ($1,444)(0.05) X = .0157

$4,603

IRR = .10 + .0157 = .1157 or 11.57%

3-18

IRR

IRR Acceptance

Acceptance Criterion

Criterion

The management of Basket Wonders

has determined that the hurdle rate

is 13% for projects of this type.

Should this project be accepted?

each dollar invested in this project at

a cost of 13%. [ IRR < Hurdle Rate ]

3-19

IRRs on the Calculator

cash flow registry

to solve the IRR

for this problem

quickly and

accurately!

3-20

Actual

Actual IRR

IRR Solution

Solution Using

Using

Your

Your Financial

Financial Calculator

Calculator

Step 1: Press CF key

Step 2: Press 2nd CLR Work keys

Step 3: For CF0 Press -40000 Enter ↓ keys

Step 4: For C01 Press 10000 Enter ↓ keys

Step 5: For F01 Press 1 Enter ↓ keys

Step 6: For C02 Press 12000 Enter ↓ keys

Step 7: For F02 Press 1 Enter ↓ keys

Step 8: For C03 Press 15000 Enter ↓ keys

3-21 Step 9: For F03 Press 1 Enter ↓ keys

Actual

Actual IRR

IRR Solution

Solution Using

Using

Your

Your Financial

Financial Calculator

Calculator

Steps in the Process (Part II)

Step 10:For C04 Press 10000 Enter ↓ keys

Step 11:For F04 Press 1 Enter ↓ keys

Step 12:For C05 Press 7000 Enter ↓ keys

Step 13:For F05 Press 1 Enter ↓ keys

Step 14: Press ↓ ↓ keys

Step 15: Press IRR key

Step 16: Press CPT key

3-22

IRR

IRR Strengths

Strengths

and

and Weaknesses

Weaknesses

Strengths: Weaknesses:

◆ Accounts for ◆ Assumes all cash

TVM flows reinvested at

the IRR

◆ Considers all

cash flows ◆ Difficulties with

project rankings and

◆ Less

subjectivity Multiple IRRs

3-23

Net

Net Present

Present Value

Value (NPV)

(NPV)

investment project’s net cash

flows minus the project’s initial

cash outflow.

NPV = + +...+ - ICO

(1+k)1 (1+k)2 (1+k)n

3-24

NPV

NPV Solution

Solution

Basket Wonders has determined that the

appropriate discount rate (k) for this

project is 13%.

NPV = $10,000 +$12,000 +$15,000 +

(1.13)1 (1.13)2 (1.13)3

$10,000 $7,000

4 + 5 - $40,000

(1.13) (1.13)

3-25

NPV

NPV Solution

Solution

NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +

$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +

$ 7,000(PVIF13%,5) - $40,000

NPV = $10,000(.885) + $12,000(.783) +

$15,000(.693) + $10,000(.613) +

$ 7,000(.543) - $40,000

NPV = $8,850 + $9,396 + $10,395 +

$6,130 + $3,801 - $40,000

= - $1,428

3-26

NPV

NPV Acceptance

Acceptance Criterion

Criterion

The management of Basket Wonders

has determined that the required

rate is 13% for projects of this type.

Should this project be accepted?

that the project is reducing shareholder

wealth. [Reject as NPV < 0 ]

3-27

NPV on the Calculator

flow registry to solve

the NPV for this

problem quickly and

accurately!

cleared the cash flows

from your calculator, then

you may skip to Step 15.

3-28

Actual

Actual NPV

NPV Solution

Solution Using

Using

Your

Your Financial

Financial Calculator

Calculator

Step 1: Press CF key

Step 2: Press 2nd CLR Work keys

Step 3: For CF0 Press -40000 Enter ↓ keys

Step 4: For C01 Press 10000 Enter ↓ keys

Step 5: For F01 Press 1 Enter ↓ keys

Step 6: For C02 Press 12000 Enter ↓ keys

Step 7: For F02 Press 1 Enter ↓ keys

Step 8: For C03 Press 15000 Enter ↓ keys

3-29 Step 9: For F03 Press 1 Enter ↓ keys

Actual

Actual NPV

NPV Solution

Solution Using

Using

Your

Your Financial

Financial Calculator

Calculator

Steps in the Process (Part II)

Step 10:For C04 Press 10000 Enter ↓ keys

Step 11:For F04 Press 1 Enter ↓ keys

Step 12:For C05 Press 7000 Enter ↓ keys

Step 13:For F05 Press 1 Enter ↓ keys

Step 14: Press ↓ ↓ keys

Step 15: Press NPV key

Step 16: For I=, Enter 13 Enter ↓ keys

Step 17: Press CPT key

Result: Net Present Value = -$1,424.42

3-30

NPV

NPV Strengths

Strengths

and

and Weaknesses

Weaknesses

Strengths: Weaknesses:

◆ Cash flows ◆ May not include

assumed to be managerial

reinvested at the options embedded

hurdle rate. in the project. See

Chapter 14.

◆ Accounts for TVM.

◆ Considers all

3-31

cash flows.

Net

Net Present

Present Value

Value Profile

Profile

$000s Sum of CF’s Plot NPV for each

15 discount rate.

Net Present Value

Thre

e of th

10 e se p

oint

s ar

e ea

sy n

5 IRR ow!

NPV@13%

0

-4

0 3 6 9 12 15

Discount Rate (%)

3-32

Creating NPV Profiles

Using the Calculator

do not “clear” the

cash flows from the

registry, simply start

at Step 15 and enter

a different discount

rate. Each resulting

NPV will provide a

“point” for your NPV

Profile!

3-33

Profitability

Profitability Index

Index (PI)

(PI)

a project’s future net cash flows to

the project’s initial cash outflow.

Method #1:

CF1 CF2 CFn

PI = + +...+ ICO

(1+k)1 (1+k)2 (1+k)n

<< OR >>

Method #2:

PI = 1 + [ NPV / ICO ]

3-34

PI

PI Acceptance

Acceptance Criterion

Criterion

PI = $38,572 / $40,000

= .9643 (Method #1, 13-34)

means that the project is not profitable.

[Reject as PI < 1.00 ]

3-35

PI

PI Strengths

Strengths

and

and Weaknesses

Weaknesses

Strengths: Weaknesses:

◆ Same as NPV ◆ Same as NPV

◆ Allows ◆ Provides only

comparison of relative profitability

different scale ◆ Potential Ranking

projects Problems

3-36

Evaluation Summary

Method Project Comparison Decision

PBP 3.3 3.5 Accept

IRR 11.47% 13% Reject

NPV -$1,424 $0 Reject

PI .96 1.00 Reject

3-37

Other Project

Relationships

◆ Dependent -- A project whose

acceptance depends on the

acceptance of one or more other

projects.

◆ Mutually Exclusive -- A project

whose acceptance precludes the

acceptance of one or more

alternative projects.

3-38

Potential

Potential Problems

Problems

Under

Under Mutual

Mutual Exclusivity

Exclusivity

Ranking of project proposals may

create contradictory results.

A. Scale of Investment

B. Cash-flow Pattern

C. Project Life

3-39

A.

A. Scale

Scale Differences

Differences

Compare a small (S) and a

large (L) project.

END OF YEAR Project S Project L

0 -$100 -$100,000

1 0 0

2 $400 $156,250

3-40

Scale

Scale Differences

Differences

Calculate the PBP, IRR, NPV@10%,

and PI@10%.

Which project is preferred? Why?

Project IRR NPV PI

L 25% $29,132 1.29

3-41

B.

B. Cash

Cash Flow

Flow Pattern

Pattern

Let us compare a decreasing cash-flow (D)

project and an increasing cash-flow (I) project.

END OF YEAR Project D Project I

0 -$1,200 -$1,200

1 1,000 100

2 500 600

3 100 1,080

3-42

Cash

Cash Flow

Flow Pattern

Pattern

Calculate the IRR, NPV@10%, and

PI@10%.

Which project is preferred?

D 23% $198 1.17

I 17% $198 1.17

3-43

600 Examine

Examine NPV

NPV Profiles

Profiles

Plot NPV for each

Net Present Value ($)

project at various

Project I discount rates.

400

NPV@10%

200

IRR

Project D

0

-200

0 5 10 15 20 25

Discount Rate (%)

3-44

600

Net Present Value ($)

Fisher’s

Fisher’s Rate

Rate of

of Intersection

Intersection

Intersection

-200 0 200 400

At k>10%, D is best!

0 5 10 15 20 25

Discount Rate ($)

3-45

C.

C. Project

Project Life

Life Differences

Differences

Let us compare a long life (X) project

and a short life (Y) project.

END OF YEAR Project X Project Y

0 -$1,000 -$1,000

1 0 2,000

2 0 0

3 3,375 0

3-46

Project

Project Life

Life Differences

Differences

Calculate the PBP, IRR, NPV@10%,

and PI@10%.

Which project is preferred? Why?

Project IRR NPV PI

Y 100% $ 818 1.82

3-47

Another Way to

Look at Things

1. Adjust cash flows to a common terminal

year if project “Y” will NOT be replaced.

Compound Project Y, Year 1 @10% for 2 years.

Year 0 1 2 3

CF -$1,000 $0 $0 $2,420

*Lower IRR from adjusted cash-flow stream. X is still Best.

3-48

Replacing Projects

with Identical Projects

2. Use Replacement Chain Approach (Appendix B)

when project “Y” will be replaced.

0 1 2 3

-$1,000 $2,000

-1,000 $2,000

-1,000 $2,000

-$1,000 $1,000 $1,000 $2,000

Results: IRR = 100% NPV* = $2,238.17

*Higher NPV, but the same IRR. Y is Best.

Best

3-49

Capital Rationing

Capital Rationing occurs when a

constraint (or budget ceiling) is placed

on the total size of capital expenditures

during a particular period.

Example: Julie Miller must determine what

investment opportunities to undertake for

Basket Wonders (BW). She is limited to a

maximum expenditure of $32,500 only for

this capital budgeting period.

3-50

Available Projects for BW

Project ICO IRR NPV PI

A $ 500 18% $ 50 1.10

B 5,000 25 6,500 2.30

C 5,000 37 5,500 2.10

D 7,500 20 5,000 1.67

E 12,500 26 500 1.04

F 15,000 28 21,000 2.40

G 17,500 19 7,500 1.43

H 25,000 15 6,000 1.24

3-51

Choosing by IRRs for BW

Project ICO IRR NPV PI

C $ 5,000 37% $ 5,500 2.10

F 15,000 28 21,000 2.40

E 12,500 26 500 1.04

B 5,000 25 6,500 2.30

Projects C, F, and E have the

three largest IRRs.

The resulting increase in shareholder wealth

is $27,000 with a $32,500 outlay.

3-52

Choosing by NPVs for BW

Project ICO IRR NPV PI

F $15,000 28% $21,000 2.40

G 17,500 19 7,500 1.43

B 5,000 25 6,500 2.30

Projects F and G have the

two largest NPVs.

The resulting increase in shareholder wealth

is $28,500 with a $32,500 outlay.

3-53

Choosing by PIs for BW

Project ICO IRR NPV PI

F $15,000 28% $21,000 2.40

B 5,000 25 6,500 2.30

C 5,000 37 5,500 2.10

D 7,500 20 5,000 1.67

G 17,500 19 7,500 1.43

Projects F, B, C, and D have the four largest PIs.

The resulting increase in shareholder wealth is

$38,000 with a $32,500 outlay.

3-54

Summary of Comparison

Method Projects Accepted Value Added

PI F, B, C, and D $38,000

NPV F and G $28,500

IRR C, F, and E $27,000

shareholder wealth when a limited capital

budget exists for a single period.

3-55

Single-Point

Single-Point Estimate

Estimate

and

and Sensitivity

Sensitivity Analysis

Analysis

Sensitivity Analysis:

Analysis A type of “what-if”

uncertainty analysis in which variables or

assumptions are changed from a base case in

order to determine their impact on a project’s

measured results (such as NPV or IRR).

◆ Allows us to change from “single-point” (i.e.,

revenue, installation cost, salvage, etc.) estimates

to a “what if” analysis

◆ Utilize a “base-case” to compare the impact of

individual variable changes

◆ E.g., Change forecasted sales units to see

impact on the project’s NPV

3-56

Post-Completion Audit

Post-completion Audit

A formal comparison of the actual costs and

benefits of a project with original estimates.

◆ Develop a possible set of corrective actions

◆ Provide appropriate feedback

Result: Making better future decisions!

3-57

Multiple

Multiple IRR

IRR Problem*

Problem*

Let us assume the following cash flow

pattern for a project for Years 0 to 4:

-$100 +$100 +$900 -$1,000

How many potential IRRs could this

project have?

Two!! There are as many potential

IRRs as there are sign changes.

* Refer to Appendix A

3-58

NPV

NPV Profile

Profile --

-- Multiple

Multiple IRRs

IRRs

75 Multiple IRRs at

Net Present Value

50

($000s)

25

-100

0 40 80 120 160 200

Discount Rate (%)

3-59

NPV Profile -- Multiple IRRs

will only find ONE

IRR – even if there

are multiple IRRs. It

will give you the

lowest IRR. In this

case, 12.95%.

3-60

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