Chapter 13
What is Capital Budgeting?
• Involves long term decision making
• Capital projects typically require a large
commitment of time and funds from an
organization
• Determination and evaluation of alternative
projects
– Compare costs and benefits of new projects
– Which projects to accept and reject?
• Critical for future success of company
General Methodology
1. Determine costs (outlays)
2. Project cash flows (inflows) – normal or non-
normal
3. Estimate risk of cash flows (CF)
4. Determine risk-adjusted cost of capital
5. Discount CF (inflows and outlays)
6. Compare costs and benefits
Project Types
• Independent or mutually exclusive
1. Replacement – maintenance/obsolescence
2. Replacement – cost reduction
3. Expansion – new or existing
products/markets, R&D
4. Regulatory – safety/environmental
5. Other – parking lots, aircraft
Capital Budgeting Methodologies
• Simple payback period in years.
• Discounted payback period in years.
• Net present valuation method (NPV).
• Internal rate of return (IRR).
• Modified internal rate of return (MIRR).
• Profitability index (PI).
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 Project L & Project S Assumptions Payback Period
• Project life of three years • How long does it take to recover initial
• Depreciation, salvage value, net working capital investment?
requirements, and tax effects includes in expected
cash flows (see Chapter 14) – When does project “break even”?
• “Average” risk for each project compared to other • RULE: Accept project if payback period less
projects within the firm than “corporate maximum”
• WACC for the firm is 10%

Simple Payback Period for Project L Simple Payback Period for Project S

Timeline of Cash Flows Timeline of Cash Flows

Year 0 1 2 3 Year 0 1 2 3

Cashflow (100) 10 60 80 Cashflow (100) 70 50 20

Cumulative (100) (90) (30) 50 Cumulative (100) (30) 20 40

Simple Payback Formula: Simple Payback Formula:

= (Year Before + = (Year Before +
Payback Period (Years) Unrecovered Cost At Start of Year Payback Period (Years) Unrecovered Cost At Start of Year
Full Recovery) Full Recovery)
Cash Flow During Year Cash Flow During Year

Payback Period (Years) = 2 + (30/80) Payback Period (Years) = 1 + (30/50)

= 2.375 = 1.600

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 Advantages/Disadvantages of Discounted Payback Period
Payback Period Methodology
• Advantages • Addresses TVM concern ignored with payback
– Easy to understand period
– Liquidity bias (short-term) • Apply payback period to DISCOUNTED
– Considers how long invested capital at risk project cash flows
• Disadvantages
• Still ignores long-term cash flows
– Does not account for present value
– Completely ignores long-term inflows
– No long-term projects

Discounted Payback Period for Project Discounted Payback Period for Project
L (10% cost of capital) S (10% cost of capital)
Timeline of Cash Flows Timeline of Cash Flows

Year 0 1 2 3 Year 0 1 2 3

Cashflow (100.00) 10.00 60.00 80.00 Cashflow (100.00) 70.00 50.00 20.00

Present Value of Each Present Value of Each

Cash Flow (100.00) 9.09 49.59 60.11 Cash Flow (100.00) 63.64 41.32 15.03

Cumulative (100.00) (90.91) (41.32) 18.79 Cumulative (100.00) (36.36) 4.96 19.99

Discounted Payback Formula: Discounted Payback Formula:

= (Year Before + = (Year Before +
Payback Period (Years) Unrecovered Cost At Start of Year Payback Period (Years) Unrecovered Cost At Start of Year
Full Recovery) Full Recovery)
Cash Flow During Year Cash Flow During Year

Payback Period (Years) = 2 + (41.32/60.11) Payback Period (Years) = 1 + (36.36/41.32)

= 2.687 = 1.880

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 Net Present Value for Project L
Net Present Value (NPV) (10% cost of capital)
• Discount all cash flows (inflows and outlays) at the
cost of capital
Timeline of Cash Flows
– Outlays are negative
• RULE: Accept if NPV >= 0 Year 0 1 2 3
• Accepted projects have CF that are sufficient to repay
Cashflow (100.00) 10.00 60.00 80.00
investors’ capital
– Excess (if NPV>0) is increase in wealth to shareholders Present Value 9.09
Present Value 49.59
• Disadvantage – requires L-T projections Present Value 60.11
Net Present Value 18.79

Net Present Value for Project S Net Present Values for Project L and
(10% cost of capital) Project S
WACC Project L NPV Project S NPV
0.00% 50.00 40.00
Timeline of Cash Flows 2.00% 42.86 35.53
4.00% 36.21 31.32
6.00% 30.00 27.33
Year 0 1 2 3
8.00% 24.21 23.56
Cashflow (100.00) 70.00 50.00 20.00 10.00% 18.78 19.98
12.00% 13.70 16.60
Present Value 63.64 14.00% 8.94 13.38
Present Value 41.32 16.00% 4.96 10.32
Present Value 15.03 18.00% 0.26 7.40
Net Present Value 19.99
20.00% (3.70) 4.63
22.00% (7.43) 1.98
24.00% (10.95) (0.54)

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NPV ($)
60
k NPVL NPVS Internal Rate of Return (IRR)
0 50 40
50 . 5 33 29 • IRR is discount rate that equates:
40 . Crossover 10 19 20
PV (Costs ) = PV ( Inflows )
. Point = 8.7% 15 7 12
30 . 20 (4) 5
• Simple example
20 . S - Invest $100 today, next yr return of $110
. • Equivalently it is discount rate that gives
10 L . .
. Discount Rate (%) NPV=0
0
.20
5 10 15 23.6 • RULE: Accept project if IRR>= “hurdle rate”
-10

Internal Rate of Return (IRR) Pavilion Project: NPV and IRR?

Formula

IRR Equation 0 1 2
k = 10%
CF1 CF2 CFn
NPV = CF0 + 1
+ 2
+…+ n
=0
(1+IRR) (1+IRR) (1+IRR) -800 5,000 -5,000

Enter CFs in CFLO, enter I = 10.

NPV = -386.78
IRR = ERROR. Why?

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 We got IRR = ERROR because there NPV ($) k NPVL NPVS
are 2 IRRs. Nonnormal CFs--two sign 60
0 50 40
changes. Here’s a picture: 50 . 5 33 29

NPV NPV Profile 40 . Crossover 10 19 20

. Point = 8.7% 15 7 12
30 . 20 (4) 5
IRR2 = 400% 20 . S
450 . IRRS = 23.6%
0 k
10 L . .
100 400 0
.20 . Discount Rate (%)
5 10 15 23.6
IRR1 = 25% -10
IRRL = 18.1%
-800

Modified Internal Rate of Return (MIRR)
Methodology
• Calculates a rate of return on the project’s
costs
• A project’s terminal value is the sum of all
future values of cash flows compounded at the
WACC rate
• MIRR, find discount rate so
PV of = PV of Project’s Terminal Value
Modified Internal Rate of Return (MIRR)
Methodology
• Advantages:
– Cash flows received are reinvested at the cost of
capital rate. (we’ll see IRR doesn’t do this
– Only one set of cash flows can have only one
modified internal rate of return.

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 Modified Internal Rate of Return for Modified Internal Rate of Return for
Project S (10% cost of capital) Project L (10% cost of capital)

Timeline of Cash Flows Timeline of Cash Flows

Year 0 1 2 3 Year 0 1 2 3

Cashflow -100.00 70.00 50.00 20.00 Cashflow -100.00 10.00 60.00 80.00
Cash Inflows Cash Inflows
55.00 Future Value 66.00 Future Value
84.70 Future Value 12.10 Future Value
159.70 Total Future value 158.10 Total Future value
Future value of cash inflows 159.70 Future value of cash inflows 158.10
Present value of cash outflows (100.00) Present value of cash outflows (100.00)
Number of years 3.0 Number of years 3.0
Modified Internal Rate of Return 16.89% Modified Internal Rate of Return 16.50%

When there are nonnormal CFs and Profitability Index (PI) Methodology
more than one IRR, use MIRR:
• Calculates the relative profitability of project
0 1 2 • Present value of future cash flows (benefits)
per dollar of initial cost
-800,000 5,000,000 -5,000,000 • Profitability Index (PI) = PV of future cash
flows / Initial project cost
PV outflows @ 10% = -4,932,231.40.
TV inflows @ 10% = 5,500,000.00.
MIRR = 5.6%

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 Project L Profitability Index (PI) Project S Profitability Index (PI)

Present Value of Cash Inflows Present Value of Cash Inflows

Profitability Index (PI) = Profitability Index (PI) =
Initial Cash Outflow Initial Cash Outflow

118.79 119.99
= =
100 100

= 1.1879 = 1.1999

Net Present Value for Project L Net Present Value for Project S
(10% cost of capital) (10% cost of capital)

Timeline of Cash Flows

Timeline of Cash Flows

Year 0 1 2 3 4
Year 0 1 2 3 4
Cashflow (100,000) 33,500 33,500 33,500 33,500
Cashflow (100,000) 60,000 60,000 - -
Present Value 30,455
Present Value 27,686 Present Value 54,545
Present Value 25,169 Present Value 49,587
Present Value 22,881 Net Present Value 4,132
Net Present Value 6,191

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 Net Present Value for Project S with Net Present Value for Project S
Replication (10% cost of capital) Adjusted for 5% Inflation with
Replication (10% cost of capital)
Timeline of Cash Flows Timeline of Cash Flows

Year 0 1 2 3 4 Year 0 1 2 3 4

Cashflow (100,000) 60,000 60,000 Cashflow (100,000) 60,000 60,000

(100,000) 60,000 60,000 (105,000) 60,000 60,000
Present Value 54,545 Present Value 54,545
Present Value (33,058) Present Value (37,190)
Present Value 45,079 Present Value 45,079
Present Value 40,981 Present Value 40,981
Net Present Value 7,547 Net Present Value 3,415

CFs Under Each Alternative (000s)

Early termination?

Year CF Salvage Value

0 ($5,000) $5,000 0 1 2 3
1 2,100 3,100 1. No termination (5) 2.1 2 1.75
2 2,000 2,000
2. Terminate 2 years (5) 2.1 4
3 1,750 0
3. Terminate 1 year (5) 5.2

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 Ranking Projects Size Disparity
• NPV and IRR, by itself, may be misleading Project A $300 inflow
when projects are mutually exclusive
• Conflicts may arise between the two $200 cost

• Problems with ranking

1. Size disparity Project B
$1,900 inflow
2. Time disparity
3. Unequal lives
$1,500 cost

Capital Rationing Capital Rationing Example

• Potential reasons: • $100,000 capital budget

– Money is limited (internal or external)
Project NPV Cost
– Reluctance to issue new stock
1 5,000 10,000
– Constraints on key personnel
2 5,000 5,000
– Cash flow estimation bias by project leaders
3 10,000 90,000
• Solution: choose the set of projects with the
4 15,000 60,000
highest total NPV
5 15,000 75,000
6 3,000 15,000

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 Time Disparity Reinvestment Assumption
Project C $100 $200 $2,000 • Issue is what is done with early cash flows
– Reinvest
$1,000 cost • IRR assumes that early flows are reinvested at
same IRR
Project D
• NPV uses cost of capital as reinvestment rate
$650 $650 $650
• Which is better?
$1,000 cost

Unequal Lives Replacement Chain

Project E $500 $500 $500 Project E $500 $500 $500 $500 $500 $500

$1,000 cost $1,000 cost

$1,000 cost

Project F $300 $300 $300 $300 $300 $300 Project F $300 $300 $300 $300 $300 $300

$1,000 cost $1,000 cost

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 Equivalent Annual Annuity
Other Uses of EAA
(Infinite Replacement)
• Assume NPV is derived from equal annual • Cost only
annuity payments for the life of the project – Choice of cheap model vs. premium model
• Annual payment is EAA • Repair/ replace
– Stopgap repair or pay the big dollars now to
replace?
Project F EAA EAA EAA EAA EAA EAA

NPV=

Summary:
NPV vs. IRR
• NPV is considered “superior” to IRR
– Specifically addresses wealth
– Multiple root problem of IRR
– Reinvestment assumption in NPV is cost of capital
• But IRR is still very popular
– Easy to understand
– Provides some info about “cushion”

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