A Comparison of Capital Budgeting Techniques

Capital budgeting deals with setting the criteria and prescribing the process required for making capital
investment choices. Choosing an investment project, that is, making a capital investment choice is
ultimately a cost/benefit analysis. It requires valuing the project by comparing the payoff to its costs.

Problem

Value, rank and select investment projects

Example 1.
Project A Project B Project C

Required rate 7.7% 3% 6%

year 1: $400 $100.00 $5,200
year 2 $1,250 $200 $4,000
year 3 $900.00 $150.00 $1,000
year 4 $3,000.00 $100 $200
year 5 $1,000 $50 $100
Initial Cost $5,045 $490.67 $9,687.23

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Capital Budgeting Techniques

A collection of methods allowing the manager to choose among a variety of investment projects.

Methods:

Average Accounting Return

Payback
Discounted payback
Internal Rate of Return
Modified Internal Rate of Return
Net Present Value
Profitability Index

Average Accounting Return (AAR)

AAR is the ratio of the Average Net Income to the Average Book Value.
Decision rule: Take the project if AAR is greater than some target ratio set by accountants.
Disadvantages: It has too many flaws, don't ever use it.

Payback period

Payback is the time it takes to recover the initial cost of the investment. Payback is usually measured in
years.

Decision rule: Take the project with the shortest payback period

Disadvantages
It ignores time value of money
It ignores risk
It ignores cash inflows beyond the cutoff point

Project A: Payback calculation

Period Cash flow Amount left to recover
0 -$5,045.00 -$5,045.00
1 $400 $4,645.00
2 $1,250 $3,395.00
3 $900.00 $2,495.00
0.83 $3,000.00 $0.00
Notice that in the fourth year, there is $2,495 left to recuperate, and the annual cash flow equals $3,000

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Obviously, $2,495/$3,000 = 0.83
Payback here is interpreted as follows: It takes between three and four years to recuperate the initial
cost of the project.

Project B: Payback calculation

Period Cash flow Amount left to recover
0 -$490.67 -$490.67
1 $100.00 $390.67
2 $200 $190.67
3 $150.00 $40.67
0.41 $100 $0.00

The payback period of project B is also between three and four years (3.41 years)
Notice that $40.67/$100 = 0.41 (approximately)

Project C: Payback calculation

Period Cash flow Amount left to recover

0 -$9,687.23 -$9,687.23
1 $5,200 $4,487.23
2 $4,000 $487.23
0.49 $1,000 $0.00

The payback of project C is 2.49 years. Notice that $487.23/$1,000 = 0.49 (approximately)

Ranking:
1. project C: 2.49 years
2. project B: 3.41 years
3. project A: 3.83 years

All three projects are viable, but project C is the first to recover its initial cost.

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Discounted payback period (DPB)

DPB is the time it takes to recover the initial cost of the investment.
Payback uses nominal CF; DPB uses discounted CF

Decision rule: Take the project with the shortest discounted payback period.
Disadvantages: DPB ignores cash inflows beyond the cutoff point

The calculation of discounted payback is exactly the same as that of payback, except that instead of
using nominal cash flow, we use present values instead.

Project A: Discounted payback calculation

Period Cash flow at 7.7% Amount left to recover
0 -$5,045.00 -$5,045.00
1 $371.40 $4,673.60
2 $1,077.65 $3,595.95
3 $720.44 $2,875.51
4 $2,229.76 $645.75
0.94 $690.12 0
The discounted payback of project A is just under 5 years (4.94)
Notice that $645.75/$690.12 = 0.94

Project B: Discounted payback calculation

Period Cash flow at 3% Amount left to recover
0 -$490.67 -$490.67
1 $97.09 $393.58
2 $188.52 $205.06
3 $137.27 $67.79
0.76 $88.85 $0.00
The discounted payback of project B is just under 4 years (3.76)
Notice that $67.79/$88.85 = 0.76

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Project C: Discounted payback calculation
Period Cash flow at 6% Amount left to recover
0 -$9,687.23 -$9,687.23
1 $4,905.66 $4,781.57
2 $3,559.99 $1,221.58
3 $839.62 $381.96
4 $158.42 $223.55
5 $74.73 $148.82
Notice that the project never recovers its initial cost. At the end of year 5 there is still $148.82 left.

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Internal Rate of Return

IRR is the discount rate that makes the present value of the project equal to its initial cost.

Decision rule: Take the project If the IRR exceeds the required rate of return

Disadvantages:
Reinvestment rate assumption is unrealistic
Multiple IRR
IRR cannot rank mutually exclusive projects

Calculation

Project A:
Set: Initial cost (A) = PV(project A):
$5,045 = $400/(1+IRR) + $1,250/(1+IRR)2 + $900/(+IRR)3 + $3,000/(1+IRR)4 + $1,000/(1+IRR)5
IRR(A) = 8%
Since IRR(A) > 7.7%, accept project (A)

Project B:
$490.67 = $100/(1+IRR) + $400/(1+IRR)2 + $150/(1+IRR)3 + $100/(1+IRR)4 + $50/(1+IRR)5
IRR(B) = 8%
Since IRR(B) > 3%, accept project B

Project C:
$9,687.23=$5,200/(1+IRR) + $4,000/(1+IRR)2 + $1,000/(1+IRR)3 + $200/(1+IRR)4 + $100/(1+IRR)5
IRR(C) = 5%.
Since IRR(C) < 6%, reject project C

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Modified Internal Rate of Return

MIRR is the discount rate that makes the future value of the project equal the future value of the initial
cost. MIRR requires a reinvestment rate.

Decision rule: Take the project if MIRR is larger than the required rate.
Disadvantages: MIRR cannot rank mutually exclusive projects.

MIRR calculation

Project A: Let us assume the reinvestment rate is 5%.

Set the future value of project's cash flow at 5%. The time horizon, i.e. number of periods, will equal
the duration of the project.

FV(CF at 5%) = $400(1.05)4 + $1,250(1.05)3 + $900(1.05)2 + $3,000(1.05) + $1,000

On the other hand, the FV of the initial cost compounded at MIRR is:
FV (initial cost) = $5,045(1+MIRR)5

Obviously, MIRR is unknown at this stage, and this is precisely the quantity we want to find. To do so
we need to solve the equation:

$400(1.05)4 + $1,250(1.05)3 + $900(1.05)2 + $3,000(1.05) + $1,000 = $5,045(1+MIRR(A))5

Using elementary algebra, we find that:

MIRR(A)= ([ $400(1.05)4 + $1,250(1.05)3 + $900(1.05)2 + $3,000(1.05) + $1,000]/$5,045)1/5 - 1
MIRR(A) = 7%
Since MIRR is less than 7.7% (the required rate of return for A), we must reject project A.

For project B:
FV(CF at 5%) = $100(1.05)4 + $200(1.05)3 + $150(1.05)2 + $100(1.05) + $50
FV (initial cost) = $490.67(1+MIRR(B))5
$100(1.05)4 + $200(1.05)3 + $150(1.05)2 + $1001.05) + $50 = $490.67(1+MIRR(B))5
MIRR(B) = 6.54%
Since MIRR is more than 3% (the required rate of return for B), we should accept project B.

Project C:
FV(CF at 5%) = $5,200(1.05)4 + $4,000(1.05)3 + $1,000(1.05)2 + $200(1.05) + $100
FV (initial cost) = $9,687.23(1+MIRR(C))5
$5,200(1.05)4 + $4,000(1.05)3 + $1,000(1.05)2 + $2001.05) + $100 = $9,687.23(1+MIRR(C))5
MIRR(C) = 5%
Since MIRR is less than 6% (the required rate of return for C), we must reject project C.

Only is B viable, given a reinvestment rate of 5%

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Net Present Value

Net Present Value is the difference between the present value of a project and its initial cost:
NPV= Present value - Initial Cost

Decision rule: If NPV is positive, take the project.

Disadvantages: Very complex analysis, too many variables to forecast, as it will be seen later.

Calculation:
In order to calculate NPV, we must first estimate the PV of total cash flows; then we subtract the initial
cost of the project.

Project A:
PV(A) =$400/(1.077) + $1,250/(1.077)2 + $900/(1.077)3 + $3,000/(1.077)4 + $1,000/(1.077)5
Initial cost (A) = $5,045
NPV(A) = $44.36

Project B:
PV(B) =$100/(1.03) + $400/(1.03)2 + $150/(1.03)3 + $100/(1.03)4 + $50/(1.03)5
Initial cost (B) = $490.67
NPV (B) = $64.2

Project C:
PV(C) =$5,200/(1.06) + $4,000/(1.06)2 + $1,000/(1.06)3 + $200/(1.06)4 + $100/(1.06)5
Initial cost (C) = $9,687.23
NPV (C) = -$148.81

Corollary: When Required Rate = IRR, then NPV = 0

Remember that IRR is the discount rate that makes the PV of the project equal its initial cost. In other
words, IRR is the rate that makes the NPV of the project equal to zero. If still not convinced, consider
the present value of our projects at the IRR.

If the discount rate is equal to 8%,

NPV(A) = $400/(1.08) + $1,250/(1.08)2 + $900/(1.08)3 + $3,000/(1.08)4 + $1,000/(1.08)5 - $5,045
NPV(A) = 0

When the discount rate equals 8%:

NPV(B) = $100/(1.08) + $400/(1.08)2 + $150/(1.08)3 + $100/(1.08)4 + $50/(1.08)5 - $490.67
NPV(B) = 0

When the discount rate equals 5%:

NPV(C) = $5,200/(1.05) + $4,000/(1.05)2 + $1,000/(1.05)3 + $200/(1.05)4 + $100/(1.05)5 - $9,687.23
NPV(C) = 0

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The Profitability Index

The profitability index is the ratio of project PV to initial cost

PI = PV/Initial cost

Decision rule: Take the project if PI > 1

Disadvantages
PI cannot rank mutually exclusive projects.

PI calculation

Project A:
PI(A) = PV(A)/Initial cost = 5,089.36/$5,045
PI(A) = $400/(1.077) + $1,250/(1.077)2 + $900/(1.077)3 + $3,000/(1.077)4 + $1,000/(1.077)5/$5,045
PI(A) = 1.0088

Project B:
PI(B) = $100/(1.03) + $400/(1.03)2 + $150/(1.03)3 + $100/(1.03)4 + $50/(1.03)5 /$490.67
PI(B) = 1.131

Project C:
PI(C) = $5,200/(1.06) + $4,000/(1.06)2 + $1,000/(1.06)3 + $200/(1.06)4 + $100/(1.06)5 /$9,687.23
PI(C) = 0.9846

Only A and B are viable

Why cant PI rank the projects?

Consider the following example:

Project x Project y
Present value $25,000,000 $3,000
Initial cost $24,000,000 $1,000
PI 1.042 3
NPV $1,000,000 $2,000.00

PI(x) < PI(y)

but
NPV(x) > NPV(y)
In project valuation, measures of absolute wealth are more appropriate than measures of relative
efficiency.

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Summary:

The results of our capital budgeting techniques are summarized below.

Project A: Project B: Project C:

Required rate 7.7% 3% 6%

Cost $5,045 $490.67 $9,687.23
Present value $5,089.36 $554.84 9,538.42
Future value (5%) $7,075.45 $673.45 $12,363.5
Payback period 3.83 years 3.41 years 2.49 years
Discounted payback 4.94 years 3.76 years N/A
IRR 8.00% 8.00% 5%
MIRR 7.00% 6.54% 5%
Net present value $44.36 $64.20 -$148.81
Profitability index 1.01 1.13 0.9846

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NPV profiles

NPV profiles are graphs showing the relationship between discount rates and NPV. For projects with
conventional cash flows, this relationship is usually downward sloping; that is, as the discount rate
increases, NPV is decreasing.

NPV profiles are especially useful when all projects have the same required rate of return, or when the
discount rate is hard to ascertain.

NPV Profiles

$2,000.00

$1,500.00

$1,000.00

$500.00

$0.00

-$500.00

NPV ($) -$1,000.00

-$1,500.00

-$2,000.00

-$2,500.00

-$3,000.00
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%
Discount rate (%)

NPV (A) NPV (B) NPV (C)

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What are the discount rates at which we are indifferent among those three projects? We have to find the
point where all three profiles intersect at the same time. Following a casual inspection of the NPV
profiles, it is not hard to see that they do not intersect. There is no rate at which the NPV of all three is
the same.

At least, we can search for the discount rate that makes us indifferent between project A and B. This
amounts to finding the rate at which NPV(A) = NPV(B)

Set:
NPV(A) = NPV(B) and solve for the discount rate, that is:

$400/(1+r) + $1,250/(1+r)2 + $900/(+r)3 + $3,000/(1+r)4 + $1,000/(1+r)5 - $5,045 =

= $100/(1+r) + $400/(1+r)2 + $150/(1+r)3 + $100/(1+r)4 + $50/(1+r)5 - $490.67

Using elementary algebra, or trial-and-error (more likely), we find that the NPVs of the two projects
are equal when r = 8% (approximately). At any rate below 8% for both projects project A is better.
Beyond 8% both projects have negative NPVs.

What is the discount rate that makes us indifferent between project A and C? This amounts to finding
the rate at which NPV(A) = NPV(C)
$400/(1+r) + $1,250/(1+r)2 + $900/(+r)3 + $3,000/(1+r)4 + $1,000/(1+r)5 - $5,045 =
= $5,200/(1+r) + $4,000/(1+r)2 + $1,000/(1+r)3 + $200/(1+r)4 + $100/(1+r)5 -$9,687.23

It is not hard to see that for any discount rate within a reasonable range (that is 0 to 100%) there is no
solution to this equation. The NPV profile of project A and C never meet. We will always prefer A over
C regardless of the discount rate, because the profile of A is always above that of C.

What is the discount rate that makes us indifferent between project B and C? This amounts to finding
the rate at which NPV(B) = NPV(C)

$100/(1+r) + $400/(1+r)2 + $150/(1+r)3 + $100/(1+r)4 + $50/(1+r)5 - $490.67

= $5,200/(1+r) + $4,000/(1+r)2 + $1,000/(1+r)3 + $200/(1+r)4 + $100/(1+r)5 -$9,687.23

Using elementary algebra, or trial-and-error, we find r = 4.75% (approximately). Between 0 and 4.75%
for both projects, C is always preferred over B. For discount rates above 4.75%, up to 8%, B is always
preferred over C.

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A summary of NPV profiles
Range of discount Significance of Project A Project B Project C Ranking
rates upper bound
0 to 4.75% Crossover between Accept Accept Accept A, C, B
B&C (marginally)
4.75% to 5% IRR(C) Accept Accept Accept A, B, C
(marginally)
5% to 8% IRR (A), IRR (B) Accept Accept Reject A, B, C
and crossover (marginally)
between A & B
8% and beyond Reject Reject reject B, A, C

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Example 2

Consider the following cash flows:

Period Cash flow A Cash flow B Cash flow C

0 -$1,600.00 -$451.00 -$503.99

1 $0.00 $100.00 $2,862.00
2 $0.00 $200.00 -$6,070.00
3 $400.00 $150.00 $5,700.00
4 $400.00 $100.00 -$2,000.00
5 $400.00 $50.00
6 $400.00
7 $400.00

Discount rate 4.60% 3.00% 66.90%

Reinvestment rate 3.00% 10.00% 10.00%

Payback
Discounted payback
IRR
MIRR
NPV
PI

Projects A and B are nice, clean, and comforting conventional projects; project C has alternating sign
cash flow, which spells trouble. As will see, the estimation and interpretation of the IRR is more
problematic, but luckily we can always fall back on MIRR and NPV, especially NPV.

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Payback

Project A: Discounted payback calculation

Period Cash flow Amount left to recover
0 -$1,600.00 -$1,600.00
1 $0.00 $1,600.00
2 $0.00 $1,600.00
3 $400.00 $1,200.00
4 $400.00 $800.00
5 $400.00 $400.00
6 $400.00 $0.00

The payback of project A is exactly 6 years

Project B: Discounted payback calculation

Period Cash flow Amount left to recover
0 -$451.00 -$451.00
1 $100.00 $351.00
2 $200.00 $151.00
3 $150.00 $1.00
0.01 $100.00 $0.00

The discounted payback of project B is 3 years (3.01)

Project C has cash flow with alternating signs. The initial cost is recovered after the first year, but
subsequent negative cash outflows make the estimation of payback less meaningful.

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Discounted payback

Project A: Discounted payback calculation

Period Cash flow at 4.60% Amount left to recover
0 -$1,600.00 -$1,600.00
1 $0.00 $1,600.00
2 $0.00 $1,600.00
3 $349.51 $1,250.49
4 $334.14 $916.34
5 $319.45 $596.89
6 $305.40 $291.49
7 $291.97 $0.00

The payback of project A is exactly 7 years

Project B: Discounted payback calculation

Period Cash flow at 3% Amount left to recover
0 -$451.00 -$451.00
1 $97.09 $353.91
2 $188.52 $165.39
3 $137.27 $28.12
0.32 $88.85 $0.00

The discounted payback of project B is years (3.32). notice that $28.12/$88.85 = 0.32

Project C has cash flow with alternating signs. Again, estimating the discounted payback is a rather not
an insightful exercise.

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Internal Rate of Return

Project A:

$1,600 = $400/(1+IRR)3 + $400/(1+IRR)4 + $400/(1+IRR)5 + $400/(1+IRR)6 + $400/(1+IRR)7

Using trial and error we find that the IRR(A) is approximately 4.6%, virtually equal to the required
rate.

Project B

$451 = $100/(1+IRR) + $200/(1+IRR)2 + $150/(1+IRR)3 + $100/(1+IRR)4 + $50/(1+IRR)5

Using trial and error we find that the IRR(B) is approximately 11.7%, larger than the required rate.

Project C
$503.99 = $2,862/(1+IRR) - $6,070/(1+IRR)2 + $5,700/(1+IRR)3 - $2,000/(1+IRR)4
Using trial and error we find two internal rates:
One at approximately 24.1% and the other one at 66.9%, virtually equal to the required rate. There are
two more rates, but we do not bother with them since they must be outside of any reasonable range.
What significance would a negative, or a positive but large rate could add to an already ambiguous
situation. How do we interpret the results? The answer will become clear when discussing NPV
profiles.

Modified internal rate of return

Project A:

$1,600(1+MIRR)7 = $400(1.03)4 + $400(1.03)3 + $400(1.03)2 + $400/(1.03) + $400

We find that the MIRR(A) is approximately 4.13%

Project B

$451(1+MIRR)5 = $100(1.1)4 + $200(1.1)3 + $150/(1.1)2 + $100(1.1) + $50

We find that the MIRR(B) is approximately 10.8%, larger than the required rate, yet smaller than the
IRR, simply because reinvestment was made at a rate lower than 11.7%

Project C
$503.99(1+MIRR)4 = $2,862(1.1)3 - $6,070(1.1)2 + $5,700(1.1) - $2,000
We find that the MIRR(C) is approximately 9.9%

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Net Present Value

Project A

NPV(A) = -$1,600 + $400/(1.046)3 + $400/(1.046)4 + $400/(1.046)5 + $400/(1.046)6 + $400/(1.046)7

NPV(A) = $0.48

Project B
NPV(B) = -$451 + $100/(1.03) + $200/(1.03)2 + $150/(1.03)3 + $100/(1.03)4 + $50/(1.03)5
NPV(B) = $103.86

Project C
NPV(C) = -$503.99 + $2,862/(1.67) - $6,070/(1.67)2 + $5,700/(1.67)3 - $2,000/(1.67)4
NPV(C) = 0

Profitability index

PI(A) = [$400/(1.046)3 + $400/(1.046)4 + $400/(1.046)5 + $400/(1.046)6 + $400/(1.046)7 ]/$1,600

PI(A) = 1

PI(B) = [$100/(1.03) + $200/(1.03)2 + $150/(1.03)3 + $100/(1.03)4 + $50/(1.03)5]/$451

PI(B) = 1.23

PI(C) = [$2,862/(1.67) - $6,070/(1.67)2 + $5,700/(1.67)3 - $2,000/(1.67)4]/$503.99

PI(C) = 1

18
 Summary of several capital budgeting methods.

Period Cash flow A Cash flow B Cash flow C

0 -$1,600.00 -$451.00 -$503.99

1 $0.00 $100.00 $2,862.00
2 $0.00 $200.00 -$6,070.00
3 $400.00 $150.00 $5,700.00
4 $400.00 $100.00 -$2,000.00
5 $400.00 $50.00
6 $400.00
7 $400.00

Discount rate 4.60% 3.00% 66.90%

Reinvestment rate 3.00% 10.00% 10.00%

Payback 6 3.01 na.

Discounted 7 3.32 na.
payback
IRR 4.60% 11.70% 24.10% & 67.00%
MIRR 4.13% 10.83% 9.90%
NPV $0.48 $103.86 $0.00
PI 1.00 1.23 1.00

In this example, for the given combination of discount rates and cash flows, project B clearly
dominates the other two projects. Although project A's NPV is marginally positive, the project
represents a questionable choice. The same goes for project C. A zero net present value makes us
indifferent between accepting and rejecting the project, that is, in theory. Without other extra-monetary
considerations, it is hard to justify taking on a project that offers no obvious benefits.

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 NPV Profiles

$600.00

$400.00

$200.00

$0.00

-$200.00

-$400.00
NPV ($)

-$600.00

-$800.00

-$1,000.00

-$1,200.00
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%

Discount rate (%)

NPV (A) NPV (B) NPV (C)

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Crossover rate between Projects A and B

Period Cash flow A Cash flow B A-B

0 -$1,600.00 -$451.00 -$1,149

1 $0.00 $100.00 -$100
2 $0.00 $200.00 -$200
3 $400.00 $150.00 $250
4 $400.00 $100.00 $300
5 $400.00 $50.00 $350
6 $400.00 $0.00 $400
7 $400.00 $0.00 $400

In order to find the crossover rate between projects A and B, we need to estimate the discount rate that
makes the present value of the difference in the cash flow between the two projects equal to zero. In
other words we take the difference in cash flow between the two projects and we estimate the IRR.

In the equation below, r is the crossover rate between projects A and B:

-$1,149-$100/(1+r) -$200/(1+r)2+$250/(1+r)3 + $300/(1+r)4 +$350/(1+r)5 +$400/(1+r)6 +$400(1+r)7 =0
Using trial and error we find that r is approximately equal to 3.35%. At rates between 0 and 3.35%,
project A ranks better than project B, that is, it has a higher net present value. Beyond 3.35%, project B
ranks better than project A.

Crossover rate between projects A and C

Period Cash flow A Cash flow C A-C

0 -$1,600.00 -$503.99 -$1,096

1 $0.00 $2,862.00 -$2,862.00
2 $0.00 -$6,070.00 $6,070.00
3 $400.00 $5,700.00 -$5,300.00
4 $400.00 -$2,000.00 $2,400.00
5 $400.00 $0.00 $400.00
6 $400.00 $0.00 $400.00
7 $400.00 $0.00 $400.00

In the equation below, r is the crossover rate between projects A and C:

-$1,096-$2,862/(1+r)+$6,070/(1+r)2-$5,300/(1+r)3 +$2,400/(1+r)4 +$400/(1+r)5 +$400/(1+r)6 +$400/
(1+r)7 =0
Using trial and error, we find the crossover rate between projects A and B approximately equal to
4.67%. Between zero and 4.67%, Project A ranks better than project C, that is, it has a higher net
present value. Beyond 4.67%, project C ranks better than A.

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Crossover rate between projects B and C
Period Cash flow B Cash flow C B-C

0 -$451.00 -$503.99 $52.99

1 $100.00 $2,862.00 -$2,762.00
2 $200.00 -$6,070.00 $6,270.00
3 $150.00 $5,700.00 -$5,550.00
4 $100.00 -$2,000.00 $2,100.00
5 $50.00 $0.00 $50.00

In the equation below, r is the crossover rate between projects B and C:

$52.99-$2,762/(1+r)+$6,270/(1+r)2-$5,550/(1+r)3 +$2,100/(1+r)4 +$50/(1+r)5 =0
Using trial and error, we find the crossover rate between projects B and C approximately equal to
11.8%. Between zero and 11.8%, Project B ranks better than project C, that is, it has a higher net
present value. Beyond 11.8%, project C ranks better than B.

A summary of NPV profiles

Range of discount Significance of Project A Project B Project C Ranking
rates upper bound
0 to 3.35% Crossover between Accept Accept Reject A, B, C
A&B
3.35% to 4.6% IRR(A) Accept Accept Reject B, A, C
4.6% to 4.67% Crossover between Reject Accept Reject B, A, C
A&C
4.67% to 11.7% IRR(B) Reject Accept Reject B, C, A
11.7% to 11.8% Crossover between Reject Reject Reject B, C, A
B&C
11.8% to 24.1% IRR(C)1 Reject Reject Reject C, B, A
24.1% to 67% IRR(C)2 Reject Reject Accept C, B, A
(marginally)
67% and beyond Reject Reject Reject C, B, A

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Example 3

Consider the following three projects:

Period Cash flow A Cash flow B Cash flow C
0 -$1,600.00 $500 $500
1 $1,600.00 $0 -$500
2 -$400 $500
3 -$500
4 $500
5 -$500

Discount rate 30.00% 11.00% 30.00%

Reinvestment 3.00% 0.00% 10.00%

Payback
Discounted payback
IRR
MIRR
NPV
PI

The three projects have again different lives and unconventional cash flows, which makes comparison
and evaluation a little trickier.

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Project A

Payback:
It is obviously one year, no need to engage in redundant calculations.

Discounted payback:
As long as the discount rate is larger than zero, the project will never pay back, since the PV of $1,600
will always be less than $1,600

IRR:
$1,600 = $1,600/(1+IRR)
The PV of $1,600 is equal to $1,600 only when the discount rate is zero, hence IRR = 0%

MIRR
MIRR = $1,600(1+MIRR) = $1,600
Obviously, MIRR has to equal zero.

NPV
NPV = $1,600/(1.3) - $1,600 = -$369.23

PI
PI = [$1,600/(1.3)]/$1,600 = 0.77

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Project B

Project B has unconventional cash flow. There is a cash inflow at the beginning (that is, no initial cost),
and a cash outflow in the second period. It does not make to estimate neither payback nor discounted
payback for the simple reason that both require an initial cost.

IRR
-$500 = -$400/(1+IRR)2
IRR = ($500/$400)1/2 -1
IRR = -10.56%
Obviously, this number does not have any real meaning, hence we could safely conclude that there is
no finite positive rate that satisfies the equation. The interpretation given to this measure is that the rate
of return cannot be calculated, yet the project is valuable because the future cash outflow is smaller
in magnitude then present cash inflow.

MIRR
The rate that makes the future value of the initial cost equal the future value of the cash flow reinvested
at 0% can be found by solving the following equation:

-$500(1+MIRR)2 = -$400
MIRR = -10.56%
Again, due to the special nature of this cash flow, it hard to interpret this result. Suffice to say that
common sense indicates that the project is no doubt valuable.

NPV
It is not hard to see that Net Present Value is positive for any positive discount rate.
NPV = -$400/(1+ r)2 + $500 > 0
NPV = -$400/(1.11)2 + $500 = $175.35

PI
PI = [-$400/(1+ r)2 ]/-$500 = 0.65

For the uninitiated, this result will probably cast doubts over the viability of the project. Using a purely
procedural approach, we should reject the project based on this calculation. Make no mistake, rejecting
would be a big mistake. This example represents a dream investment. Would you not like to borrow
$500 million, and have to repay only $400 in two years? Any common sense investor would jump at
this opportunity. A mathematician would probably explain that this amounts to a negative interest rate,
but we do not even need to do the calculation to grasp the concept. The benefits of such an investment
are staring in you in the face.

This is a glaring example of the limitations of quantitative measures of performance. These measures
are accurate for some instances, and dead wrong for other situation. In this particular situation, it is not
hard to see it is dead wrong. Unfortunately, there are other real life situations in which the indicator
gives us a wrong or conflicting answer, but we have no way of knowing it, because our intuition and
common sense are overwhelmed by the complexity of the problem at hand.

Of course, there are cases when the opposite is true: our common sense might give false answers,

25
which are at odds with numerical calculations.

Project C

Project C boasts unconventional cash flow as well. Cash inflows and outflows alternate according to a
simple pattern. It starts with a cash inflow, followed by a cash outflow of equal magnitude, followed by
another cash inflow, etc up to year five. As in the previous example, at some point, we will have to
check our numerical answers against our intuition and common sense .

Payback and discounted payback.

The project starts with a cash inflow, hence, calculating a payback period is uninformative and difficult
to interpret.

IRR

-$500 = -$500/(1+IRR) + $500/(1+IRR)2 - $500/(1+IRR)3 + $500/(1+IRR)4 - $500/(1+IRR)5

Since the sign of the cash flow is alternating, we expect multiple IRRs. One solution is immediately
visible through casual inspection. At 0% the present value of all cash flow equals zero. That is, the
nominal cash flow adds up to zero. Between zero and 100% there is no other solution, and at this point
we should give up trying to estimate IRR because it provides mixed signals.

MIRR

-$500(1+MIRR)5 = -$500(1.1)4 + $500(1.1)3 - $500/(1.1)2 + $500(1.1) - $500

MIRR is 4.5%, but given the ambiguity shown by the IRR calculation we should be very suspicious of
the MIRR as well at this point.

NPV

NPV = -$500/(1.3) + $500/(1.3)2 - $500/(1.3)3 + $500/(1.3)4 - $500/(1.3)5 +$500 = $224.06

PI
PI = [ -$500/(1.3) + $500/(1.3)2 - $500/(1.3)3 + $500/(1.3)4 - $500/(1.3)5 ]/-$500 = 0.55

It appears that PI and IRR suggest we should reject the project. Yet again, this is another example of
conflicting results in which IRR and PI are dead wrong. NPV clearly shows that adding the present of
current and future cash flow results in a positive number. This is also consistent with our common
sense which tells us that cash inflows are acquired earlier than cash outflow. Again, this example
amounts to a situation in which we borrow every other year, only to pay less the following year. If
banks agreed to terms like these, that they would run out of business fairly quickly. Evidently, we
should accept the project.

If the three projects were mutually exclusive, we should pick C because it has the largest NPV. Project
A is out of the question regardless of the situation.

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Summary

Period Cash flow A Cash flow B Cash flow C

0 -$1,600.00 $500.00 $500.00
1 $1,600.00 $0.00 -$500.00
2 -$400.00 $500.00
3 -$500.00
4 $500.00
5 -$500.00

Discount rate 30.00% 11.00% 30.00%

Reinvestment 3.00% 0.00% 10.00%

Payback 1.00 na. na.

Discounted payback na. na. na
IRR 0.00% -10.56% 0.00%
MIRR 0.00% -10.56% 4.45%
NPV -$369.23 $175.35 $224.06
PI 0.77 0.65 0.55

Our analysis yields interesting result. As already pointed out, some results are contradictory,. Here we
had clearly shown that some measures can be wrong at times, yet NPV is the only one in sync with our
common sense. In this example we do not doubt our common sense, but in more complex situations
common sense can ply trick on us; hence we should always rely on NPV beacon guiding our
investment decision, as the ultimate test, as the golden standard. (NPV is not without problems, but
they are of a different nature, as it will be seen later).

In the example above, that is, for the given combination of discount rates, C dominates all other
choices, but B is acceptable as well. A would not be acceptable in any case. If we do not face mutually
exclusive choices, we should pick both B, and C; other wise we should pick C for it has the larger NPV.

One of the question I always like to ask is whether the cash flow of project B appears to be realistic; are
there real-life project resembling this pattern? Is it simply a figment of my imagination, concocted to
torment unsuspecting kindred Bishop's souls? The cash flow of project B is much more prevalent in
real life than many people imagine. The simples example that comes to mind is a (successful) short
sale. Imagine selling short the shares of some company for $400. After two days you buy back the
stock (which meanwhile has dropped in price by 20%) at $400 and make $100 in profit; actually more
than $100, if the time elapsed is long enough to make time value of money a significant factor. In our
case, at a required rate of 11%, you make exactly $175.35 in profit .

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 NPV ($)
NPV Profiles

$400.00

$300.00

$200.00

$100.00

$0.00

-$100.00

-$200.00

-$300.00

-$400.00

-$500.00
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%
NPV (A) NPV (B) NPV (C) Discount rate (%)

A summary of NPV profles

Range of discount Significance of Project A Project B Project C Ranking
rates upper bound
0.00% Crossover between Reject Accept Accept B, C, A
A&C
0% and beyond Reject Accept Accept B, C, A

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One last question: Why is NPV the golden standard in capital budgeting? Why not IRR, or PI, or the
payback period?

Payback is a fairly crude measure, and has too many flaws: it ignores cash flows after the cutoff point,
it ignores time value of money. IRR cannot rank projects, and is based on unrealistic assumptions (i.e.,
reinvestment rate). PI cannot rank projects, and is easily fooled by unconventional cash flow.

Remarkably, both payback and IRR are widely used still in capital budgeting. The reason for this
resilience is to be found in their simplicity: both can be conveyed in one simple number, easy to pitch
to no-nonsense, straight-taking, business folk. NPV can also be conveyed in one number, but the
concept is more difficult to grasp than a simple rate of return, or a payback period. In addition, one has
to specify a myriad of other assumptions that led to its calculation. Chief among those assumption is
the required rate.

Imagine yourself trying to convince a bunch of old-fashioned, grudging, and reluctant accountants; or a
group of corporate directors in a hurry about the merits of such and such project. You can do an
elaborate slide presentation with tables and neat formulas, or you can tell them the project will pay
back in three years, and will return 11%. Now, that is much more poignant than engaging in a long
discussion about what you think is an appropriate rate of return, bla, bla, bla. Many will have the same
reaction you have when attending a lecture on NPV estimation: they will start yawning and rolling their
eyes.

We must acknowledge, however, that NPV is is better in theory, but its practical estimation is a
headache, as it will be seen later. But the first question remains: why is it considered beforehand
superior to all other methods?

Let us go back to project B in example nr. 1, the first in the series of three examples presented earlier.
Period Cash flow
Required rate 0.03%
Cost -$490.67
Present value (at 3%) $554.84
Future value ( at 5%) $673.45
Payback period 3.41 years
Discounted payback 3.76 years
IRR 8.00%
MIRR 6.54%
Net present value $64.20

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Imagine an entrepreneur gearing up to start the project. At the very beginning the balance sheet of the
project would look like this:

Assets
Cash $490.67

Liabilities and equity

Equity $490.67

Remember that the cash flow of the project is only a projection at this stage, that is, we expect it to be
as shown above (this is why the investment is called project); however, we understand that this
projection represents our best guess; in reality things might turn out differently; but, what if they do
turn out the way we projected? At the end of the project, given a reinvestment rate of 5%, the balance
sheet would look like this:

Assets
Cash $673.45

Liabilities and equity

Equity $673.45

In other words, the project would have created value for our entrepreneur. In a world of perfect
information and rational expectations, everyone would know in advance the magnitude of the gain. In
other words, the moment the entrepreneur buys specific assets, everyone will foresee the cash flow and
the gains engendered by this investment. It follows that the entrepreneur could turn around and sell his
equity before the project actually begins for more than the $490.67 initially invested. At the inception
of the project, just after the cash has been spent on firm-specific assets, the books (at fair market value)
should look like this (assuming a 3% required rate of return):

Assets
Firm-specific assets at cost $490.67
Intangibles $64.20
Liabilities and equity
Equity $554.87

In other words, by signalling the intention to engage in the project, the market value of the project
should jump by $64.20, which is exactly the NPV of the project. Remember that in a world predicated
on rational behavior and rational expectations, the maximization of shareholders' wealth is the ultimate
goal of business. NPV is the golden standard of investment because it estimates by how much the
wealth of shareholders is changing. In a different cultural setting, in which business is geared towards
attaining other goals, NPV would be of secondary importance at best.

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