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RULES
9
W hen making capital budgeting decisions, a firm evaluates the
expected future cash flows in relation to the required initial invest-
ment. The objective is to find investment projects that will add
value to the firm. These are projects that are worth more to the firm than
they cost—projects that have a positive NPV.
The pivotal role of capital budgeting and the risks associated with cap-
ital investments are dramatically demonstrated by comparing the initial cash
outflow, which can be huge, to that of the relatively much smaller expected
periodic future cash inflows. The risk is especially obvious if you consider the
tremendous uncertainty associated with the timing and size of the future
cash flows. A firm might invest $200 million now, hoping to net $30 million
per year after several years of development!
A firm’s evaluation of a long-term investment project is like an individ-
ual’s investment decision. The steps are the same:
1. Estimate the expected future cash flows from the project, like esti-
mating the coupon payments for a bond or the dividend stream for
a stock, and a maturity value or terminal sale price.
2. Assess the risk and determine a required return for discounting the
expected future cash flows.
3. Compute the present value of the expected future cash flows.
4. Determine the cost of the project and compare it to what the pro-
ject is worth. If the project is worth more than it costs—if it has a
positive NPV—it will create value.
ISBN: 0-536-42875-1
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
CHAPTER 9 BUSINESS INVESTMENT RULES 217
FOCUS ON PRINCIPLES
• Valuable Ideas: Look for new ideas to use as a basis for capital budgeting projects that
will create value.
• Comparative Advantage: Look for capital budgeting projects that will use the firm’s
comparative advantage to create value.
• Incremental Benefits: Identify and estimate the expected future cash flows for a capital
budgeting project on an incremental basis.
• Risk-Return Trade-Off: Incorporate the risk of a capital budgeting project into its cost
of capital —the project’s required return.
• Time Value of Money: Measure the current value a capital budgeting project will cre-
ate, its NPV.
• Options: Recognize the value of options, such as the options to expand, postpone, or
abandon a capital budgeting project.
• Two-Sided Transactions: Consider why the other party to a transaction is willing to
participate.
• Signaling: Consider the products and actions of competitors.
In this chapter we present the process of capital budgeting as it is practiced in most corpo-
rations. We show you ways to measure the attractiveness of projects. As you will see, some badly
flawed methods remain in practice and can lead to bad decisions. We also show how sound meth-
ods of evaluating business investments can be applied to both proposed projects and to current
operations. When combined with reasonable estimates of future outcomes, these methods sup-
port good decisions.
Throughout this chapter on investment rules, we ignore taxes and certain other complica-
tions to focus on basic investment criteria and the process of capital budgeting.
Idea Generation
The first—and most important—part of the capital budgeting process is generating new ideas.
Its critical importance is obvious from the Principle of Valuable Ideas. Unfortunately, we can-
not teach people how to come up with valuable new ideas. If we could, we would already be
wealthy from having followed the procedure ourselves! However, although we don’t have a
process that ensures the creation of new ideas, it is important to stress their value. Such an
emphasis makes it more likely that those ideas that do occur to us and to others will be given
serious consideration.
ISBN: 0-536-42875-1
Where do new ideas come from? Ideas for capital budgeting projects come from all levels
within an organization. Figure 9-1 shows the desirable flow of capital investment ideas within a
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
218 PART III CAPITAL BUDGETING
FIGURE 9-1
The desirable flow of
capital budgeting ideas Division
within a firm. management
ideas ideas
ideas
ideas
Production
management
and other
employees
firm. Often plant managers are responsible for identifying potential projects that will enable their
plants to operate on a different scale or on a more efficient basis. For instance, a plant manager
might suggest adding 10,000 square feet of production space to a plant or replacing a piece of
equipment with a newer, more efficient machine. After screening out the less advantageous or less
attractive ideas, the manager would send the ones that appear to be attractive to the divisional
level, along with supporting documentation.
Division management not only reviews such proposals, but also adds ideas of its own. For
example, division management may propose the introduction of a new product line or combin-
ing two plants and eliminating the less efficient one. Such ideas are less likely to come from the
plant managers!
This bottom-up process results in ideas percolating upward through the organization. At
each level, ideas submitted by lower-level managers are screened; some are forwarded to the next
level. In addition, the managers at successively higher levels, who are in a position to take a
broader view of the firm’s business, add ideas that may not be visible to lower-level managers.
At the same time, there is also a top-down process at work in most firms. Strategic planners
will generate ideas regarding new businesses the firm should enter, other firms it might acquire,
and ways to modify its existing businesses to achieve greater profitability. Strategic planning is a
critical element in the capital budgeting process. The processes complement one another; the top-
down process generates ideas of a broader, more strategic nature, whereas the bottom-up process
generates ideas of a more project-specific nature.
In addition, some firms have a research-and-development group, either within a produc-
tion division or as a separate department. A research-and-development group often provides new
ideas for products that can be sent on to a marketing research department. Table 9-1 lists the typ-
ical stages for the development and approval of a capital investment proposal.
TA B L E 9 - 1
1. Approve funds for research that may result in a product idea.
Development and
2. Approve funds for market research that may result in a product proposal.
approval stages for a 3. Approve funds for product development that may result in a usable product.
proposed capital
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4. Approve funds for plant and/or equipment for the production and sale of the new product.
budgeting project.
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
CHAPTER 9 BUSINESS INVESTMENT RULES 219
Each stage in Table 9-1 involves a capital budgeting decision at one or more levels of the
firm. Therefore, at each stage, the firm reestimates the NPV of going ahead. With this kind of
sequential appropriation of funds, an automatic progress review is enforced, which enables early
cancellation of unsuccessful projects. So each stage includes options, for example, to abandon,
postpone, change, or continue.
MAINTENANCE EXPENDITURES At a most basic level, a firm must make certain investments
to continue to be a healthy, profitable business. Replacing worn-out or damaged equipment is
necessary to continue in business. Therefore, the major questions concerning such investments
are: “Should we continue in this business?” and if so, “Should we continue to use the same pro-
duction process?” Because the answers to these questions are so frequently “yes,” an elaborate
decision-making process is not a good use of resources. Typically, such decisions are approved
with only routine review.
is inherently more difficult than approving maintenance or cost-savings proposals. Firms have to
consider the economics of expanding or adding new facilities and must also prepare demand
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
220 PART III CAPITAL BUDGETING
NEW PRODUCTS AND NEW BUSINESSES These projects, which include research-and-
development activities, are among the most difficult to evaluate. Their newness and long lead
times make it very difficult to forecast product demand accurately. In many cases, the project
may be of special interest because it would give the firm an option to break into a new market.
For example, a firm that possesses a proprietary technology might spend additional research-
and-development funds trying to develop new products based on this technology. If successful,
these new products could pave the way for future profitable investment opportunities. Access
to such follow-up opportunities creates options for the firm, which are valuable.
appropriate discount rate, or simply the discount rate. Although these terms may be used inter-
changeably, it is important to remember that the cost of capital reflects the riskiness of the cap-
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
CHAPTER 9 BUSINESS INVESTMENT RULES 221
ital budgeting project’s cash flows, not the interest rate on its bonds or the riskiness of the firm’s
existing assets.
REVIEW
1. What are the five steps in the capital budgeting process? Which is most important?
2. Why are capital budgeting projects frequently classified into groups such as mainte-
nance projects, cost savings/revenue-enhancement projects, capacity-expansion proj-
ects, new product/new business projects, and projects mandated by regulation or
firm policy?
3. What other names are used to refer to the cost of capital, a capital budgeting project’s
required return?
Although it is delightful to contemplate the money you made in our example, think about
how you could have known enough to undertake this capital budgeting project in the first place.
You could find the building’s market value by offering it for sale—the highest offer you get is its
market value. However, that is possible only after doing the renovations. Although you might be
able to offer the building for sale before doing the renovations by describing your plans, at best
this would be awkward, time-consuming, and expensive. Furthermore, keep in mind the Principle
of Two-Sided Transactions: Once you pointed out the potential value of renovating the building
to other people, some of them might decide to bid on the building now for more than the
$420,000 you hoped to pay for it.
To estimate the market value after renovation, you might have looked at other buildings in
good repair to see what they were worth and then adjusted for differences between them and the
one you were considering. You would also estimate the cost of the needed renovations and add
ISBN: 0-536-42875-1
that to the cost of buying the building, to determine the total cost. Finally, you would compare
your market value estimate to your total cost estimate.
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
222 PART III CAPITAL BUDGETING
If the estimates told you the project created value, and your estimates were correct, then
you would get the value that was created. You can see right away how important accurate esti-
mates are!
Another way to determine value is to use discounted-cash-flow (DCF) analysis and com-
pute the present value of all the cash flows connected with ownership. This is like discounting the
interest payments on a bond or dividends on a stock.
The NPV of a capital budgeting project is the present value of all of the cash flows con-
nected with the project, all its costs and revenues, now and in the future:
CF1 CF2 CFn
NPV = CF0 + + +…+
(1 + r ) (1 + r )2 (1 + r )n
(9.1) n
CF
= ∑ (1 + rt )t
t =0
DECISION RULE for net present value: Undertake a capital budgeting project if the
NPV is positive.
E X A M P L E Computing an NPV
Suppose that instead of expecting to sell the building after you renovate it, you expect to lease
it out for 20 years and then sell the building for $250,000. You expect the lease to pay you
CALCULATOR SOLUTION $110,000 per year. Finally, the cost of capital in this case is 12%. What is the NPV of this
Data Input Function Key renovation project?
20 N Using Equation (9.1), the NPV is $127,555.49:
12 I
20
The NPV is the present value of the future cash flows, which is $847,555.49 minus the
initial cost of $720,000.
It is important to note that the risk connected with the estimates of revenues, costs, and sell-
ing price are included in the cost of capital (required return). That is to say, computing the NPV
does not reduce the risk. If the estimates are realized, however, you will be richer for undertaking
the project.
is it the case when a project is a complete surprise and the market makes the identical estimate
of NPV.
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
CHAPTER 9 BUSINESS INVESTMENT RULES 223
REVIEW
1. What is the NPV of a capital budgeting project?
2. State the decision rule for net present value.
3. What is discounted-cash-flow analysis?
DECISION RULE for internal rate of return: Undertake the capital budgeting project if
the IRR exceeds r, the project’s cost of capital.
In its simplest form, the IRR rule is intuitively appealing. In essence, it asks whether the
capital budgeting project’s expected return exceeds its required return. In other words, will it cre-
ate value?
At first glance, this seems to be saying the same thing as the NPV rule. As we will see, this
is generally true—but not always. The intuitive appeal of the IRR rule, however, probably
accounts for its widespread use (in fact, many practitioners prefer it).
Like other expected returns, the IRR must be calculated by trial and error. Although many
calculators and spreadsheets can solve for the IRR, they also are using trial and error.
FIGURE 9-2
Year 0 1 2 3 4 Expected future net cash
flows for Reebok’s capital
ISBN: 0-536-42875-1
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
224 PART III CAPITAL BUDGETING
If you consider a project in which the cash flows are more complex and uneven, you
can see the value of a spreadsheet. In practice, spreadsheets are used for all but the simplest
projects.
REVIEW
1. What is a capital budgeting project’s IRR?
2. State the decision rule for internal rate of return. What does it mean in practical terms?
3. Does the IRR rule usually lead to the same investment decisions as the NPV rule?
future year is expected to be positive. Purchasing a stock or bond is a simple example of a con-
ventional capital budgeting project: You buy the security (a negative cash flow), and the terminal
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
CHAPTER 9 BUSINESS INVESTMENT RULES 225
sale price and any dividends or interest payments while you own it will not be negative (you have
limited liability).
NPV Profile
Another way to look at this problem is to graph NPV as a function of the discount rate. This
graph is called an NPV profile, which is a very useful tool.
The NPV profile includes both NPV and IRR, as well as the project’s value at various costs
of capital. Therefore, if you are unsure about the project’s cost of capital, you can use the NPV
profile to identify costs of capital at which the project would not create value.
An NPV profile for our IRR computation example is presented in Figure 9-3. To con-
struct this NPV profile, we use the calculations in the example and a couple more. One of the
additional calculations assumes a cost of capital of 0%, in which case the NPV would be +250.
This calculation is straightforward because it is simply the undiscounted sum of all the cash
flows. We also calculated what the NPV would be at discount rates of 5% and 20%, to fill in the
graph.
The NPV profile in Figure 9-3 shows the general relationship between IRR and NPV for
independent, conventional projects. If the IRR exceeds the cost of capital, the NPV is positive. If
the IRR is less than the cost of capital, the NPV is negative.
FIGURE 9-3
NPV An NPV profile.
300
250
200
Positive NPV Negative NPV
150
100
50
0 r (%)
5 10 15 20 25
—50
—100
0
IRR
ISBN: 0-536-42875-1
13.02
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
226 PART III CAPITAL BUDGETING
Conflicting recommendations can occur because there is a difference in (1) the size of the
projects, or (2) the cash flow timing. An example of the latter occurs when cash flows from one
project come in mostly early and cash flows from the other project come in later. We will look at
each of these types of differences in turn.
SIZE DIFFERENCES When one project is larger than another, the smaller project can have a
larger IRR but a smaller NPV. For example, suppose project A has an IRR of 30% and an NPV
of $100, and project B has an IRR of 20% and an NPV of $200. The choice between these two
projects—and therefore the resolution of such conflicts—is fairly straightforward: You need only
decide whether you would rather have more wealth or a larger IRR. Like you, we will take the
wealth, thank you. Therefore, the NPV decision rule is the better rule to follow when mutually
exclusive projects differ in size.
CASH FLOW TIMING DIFFERENCES The problem of cash flow timing can arise because of the
reinvestment rate assumption. The question is: “What will the cash inflows from the investment
earn when they are subsequently reinvested in other projects?” The IRR method assumes the
future cash inflows will earn the project’s IRR. The NPV method assumes they will earn the cost
of capital.
The following example illustrates the conflict in the reinvestment rate assumption that
results from a difference in cash flow timing. As you will see, the NPV profiles diverge at a
crossover point, a cost of capital at which the two projects have equal NPV.
FIGURE 9-4
Alternative short- and Year 0 1 2 3 4 5 6 IRR NPV
long-term capital bud-
geting projects for Guess. Project S ⫺250 100 100 75 75 50 25 22.08% 76.29
Project L ⫺250 50 50 75 100 100 125 20.01% 94.08
1You can compute the crossover point by finding the rate that makes the present value of the cash flow differences
equal zero. Thus, for this example, the yearly differences are
Year 0 1 2 3 4 5 6
Cash flow difference 0 50 50 0 −25 −50 −100
ISBN: 0-536-42875-1
You can verify that 15.3985% will make the present value of this cash flow stream equal zero.
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
CHAPTER 9 BUSINESS INVESTMENT RULES 227
FIGURE 9-5
NPV A comparison of NPV
and IRR.
300
200
150 NPVL
100
Crossover
Project S NPVS point Project S
50
IRRS
0
IRRL
–50 r (%)
0 5 10 15 20 25 30
15.4
Which method makes the better assumption about what the reinvested cash flows will
earn? If the cost of capital is computed correctly, it is the project’s required return. In equilibrium,
the required return equals the expected return and, over time, competitive forces drive investment
returns to equilibrium.
Although new ideas can be very valuable, after a while most people will be using them, and
they will no longer command a positive NPV. So the NPV from future projects based on the same
sort of idea will tend toward zero. In the long run, then, reinvested cash flows can earn the cost of
capital, but not the extra, positive, NPV. So the NPV method’s assumption that the reinvestment
rate will equal the cost of capital is the better assumption. And, again, the NPV decision rule is
superior to the IRR decision rule.
the project is terminated. Another example is a project that requires one or more major renovations
during its life. Let’s take a look at the kinds of conflicts that can arise in these more complex situations.
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
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228 PART III CAPITAL BUDGETING
Unfortunately, calculators and currently available PC software generally are not fully
equipped to handle the problem of multiple IRRs. They often report only the IRR their trial-and-
error process happens to find first. However, they can be used to create an NPV profile. And, in
any case, that provides a much more complete view of the project’s potential value.
IRR, on Balance
At this point, you may ask, “Why use the IRR rule, when you may have to make several NPV cal-
culations in the course of computing the IRR?” Our answer is that you should not use the IRR
rule. Use NPV, instead.
In practice, however, the IRR rule is more widely used than the NPV rule. Many people
prefer the intuitive feel of the IRR rule: After all, if the expected return is big enough, it will surely
exceed the required return, and the project is a good investment. Such straightforward simplicity
is appealing. For example, in cases when the cost of capital is especially uncertain, as in the case of
FIGURE 9-6
A capital budgeting pro- NPV
ject with multiple IRRs.
+2,000
NPV > 0
NPV < 0 NPV < 0
0
–2,000
–4,000 r (%)
0 5 10 15 20 25 30 35
10.8% 25.4%
2The number of IRRs is never more than the number of sign reversals in the stream of cash flows. So conventional
projects and reverse conventional projects have only one IRR because they have only one sign reversal—a negative
ISBN: 0-536-42875-1
followed by all positives, or a positive followed by all negatives. In this example, there can be at most two IRRs
because there are two reversals, the flows go from negative to positive, and back to negative.
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
CHAPTER 9 BUSINESS INVESTMENT RULES 229
an entirely new product, using the IRR rule gets around having to compute the cost of capital
carefully.
Also, if the IRR for a conventional project is large enough, say 88%, it is probably not
worth the trouble to estimate the cost of capital accurately. Because the cost of capital would vir-
tually never be that high, we can simply undertake the project without wasting additional
resources on analysis. Those resources can be spent instead on making the project successful!
REVIEW
1. What is the difference between mutually exclusive projects and independent projects?
2. Distinguish between a conventional project and a nonconventional project.
3. When do the NPV and IRR methods agree? Under what circumstances can they differ?
4. When the NPV and IRR methods disagree, which is usually more reliable?
5. Describe an NPV profile in your own words. Why is it so useful?
Profitability Index
Another time-value-of-money-adjusted method that can be used to evaluate capital budgeting
projects is the profitability index (PI), or benefit-cost ratio as it is sometimes called. The PI for a
project equals the present value of the future cash flows divided by the initial investment. One
way to view the PI is that it is 1 plus the NPV divided by the initial investment:
If a project had an NPV of $240 and required an initial cash flow of −$1,000, the project’s
PI would be 1.24 (= 1 + 240/1,000).
DECISION RULE for the profitability index: Undertake the capital budgeting project if
the PI is greater than 1.0.
You probably wonder why we bother introducing this method, because it is obvious the
NPV decision rule will give you the identical recommendation.3 The idea underlying the PI is to
measure the capital budgeting project’s “bang for the buck.” By scaling (dividing) the present
value of the future cash flows by the initial outlay, you can see how much return is obtained per
dollar invested. For example, with a PI of 1.24, you get $1.24 of present value back for each $1
invested, or an NPV of $0.24 for each $1 invested.
Although the PI works fine for independent projects, the scale problem of mutually exclu-
sive projects we saw with IRR also occurs with PI. For example, suppose project A has a PI of 1.6
and an NPV of $100. Project B has a PI of 1.3 and an NPV of $200. The choice between these
3In fact, some people define the PI as simply the NPV divided by the initial investment. Such a definition changes
ISBN: 0-536-42875-1
the scale to center on zero, rather than 1.0. There is no substantive difference because such a definition simply
changes the cutoff for the PI rule to zero from 1.0.
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
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230 PART III CAPITAL BUDGETING
two projects is again straightforward: Would you rather have more wealth or a larger PI? (Again,
like you, we will take the wealth.) Therefore, the NPV decision rule is the better rule to follow
when mutually exclusive projects differ in size.
FV (cash inflows)
(9.4) PV ( cash outflows) =
(1 + MIRR)N
MIRR is used by some firms, such as FedEx, because it is a better measure than IRR but has
the same intuitive appeal. The decision rule for MIRR is the same as for IRR.
DECISION RULE for modified internal rate of return: Undertake the capital budgeting
CALCULATOR SOLUTION
project if the MIRR exceeds the project’s cost of capital.
Data Input Function Key
4 N
12 I
0 PV E X A M P L E Computing the MIRR for Reebok’s Project
300 PMT
The cash flows for this project (Figure 9-2) for times 0 through 4 are, respectively, −800, 300,
−1,433.80 FV
300, 300, 150, and the cost of capital is 12%. The present value of the cash outflows is sim-
ply the 800 at time 0. The future value of 300 per year for four years at 12% is 1,433.80.
CALCULATOR SOLUTION So the future value of all the cash flows is 1,283.80 (= 1,433.80 − 150). The MIRR,
Data Input Function Key which equates the present and future values, is 12.5516%.
4 N
−800 PV
0 PMT MIRR, ON BALANCE MIRR is a better measure than IRR, but it offers the same intuitive
1,283.80 FV appeal. Still, like IRR and PI, although MIRR offers a good measure of “bang for the buck,” it is
12.5516 I best used in conjunction with NPV.
Payback
An appealing investment concept is that of “getting your money back.” Of course, risk may
intervene, but investors often want an estimate of the time it will take to recover the initial
cash outflow. When this amount of time is calculated without regard to the time value of
money, it is called a project’s payback. Payback is computed by simply summing all the
expected cash flows (without discounting them) in sequential order until the sum equals the
initial outflow.
ISBN: 0-536-42875-1
DECISION RULE for payback: Undertake the capital budgeting project if the payback
is less than a preset amount of time.
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
CHAPTER 9 BUSINESS INVESTMENT RULES 231
FIGURE 9-7
Year 0 1 2 3 4 5 6 7 8 Payback for the building
renovation project.
Cash flows ⫺720 110 110 110 110 110 110 110 110
Cumulative ⫺720 ⫺610 ⫺500 ⫺390 ⫺280 ⫺170 ⫺60 ⫹50
Payback: ↑6.55 years
E X A M P L E Computing a Payback
Let’s return to the building-renovation example we used earlier in the chapter to illustrate the
NPV method. We expected to purchase the building for $420,000 and spend $300,000 on
renovations. After renovation, we expected to be able to lease the building out for $110,000
per year. Ignoring taxes, this would give the cash flows in Figure 9-7. What is this project’s
payback?
The payback is 6.55 years (= 720,000/110,000), because $110,000 per year for 6.55
years equals $720,000, the initial investment.
The idea underlying the payback method is simple: The shorter the payback the better.
But, there are serious deficiencies in the payback method. You are probably already saying,
“But, but, but—it ignores the time value of money!” This is true. And it also ignores risk dif-
ferences. In fact, the cutoff is entirely arbitrary, and all cash flows beyond the cutoff are
ignored.
PRACTICAL VALUE OF PAYBACK Despite the drawbacks of the payback method, the gut reac-
tion of wanting to “at least get your money back” is a powerful feeling to overcome. Moreover,
payback provides a control on liquidity, offers a different type of risk control, is easy to compute,
and is simple to understand.
Payback controls liquidity because it rejects excessively long-term projects. This may be
important for a smaller, less liquid firm because it favors investments that will return cash sooner.
That cash can be reinvested in other profitable projects.
Cash flows further in the future are arguably more risky. As a risk-control device, payback
addresses this harshly by simply ignoring those beyond the payback period.
Finally, we would add two other practical considerations: First, most investments with a
short payback, and additional benefits beyond that, will also have a positive NPV. Second, for rel-
atively small investments, the cost of extensive analysis can exceed the potential loss from a mis-
take. This can make the simplicity of payback attractive.
PAYBACK, ON BALANCE Probably because of the practical considerations just noted, the pay-
back rule is still widely used in practice despite its serious deficiencies. However, very few firms
use payback by itself. Most firms also require investments to be acceptable on the basis of other
rules, such as NPV. Because of its weaknesses, payback should be viewed, at best, as a supplement
to the discounted-cash-flow techniques.
Discounted Payback
If a firm wants to use the payback method, a better measure is a variation of payback called
discounted payback. The discounted payback is the amount of time it takes for the project’s
discounted cash flows to equal the project’s initial cost. The idea underlying the discounted pay-
ISBN: 0-536-42875-1
back period is to incorporate the time value of money into the basic notion of getting your
money back.
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232 PART III CAPITAL BUDGETING
DECISION RULE for discounted payback: Undertake the capital budgeting project if
the discounted payback is less than a preset amount of time.
You can probably see that for conventional projects, which are the most common type, a
project that meets a discounted payback cutoff will always have a positive NPV. This is because
the present value of the future cash flows during the discounted payback period alone cover the
initial cost. The project’s NPV, then, is the present value of the remaining cash flows—those
ignored by the discounted-payback-period computation.
Discounted payback is superior to the payback method because it includes the effects of the
time value of money. However, it too is arbitrary and suffers from the weakness of ignoring all
cash flows beyond the cutoff. This can be a significant problem when there are negative expected
future cash flows. The rule can break down in such cases.
Urgency
The final method we look at can be described by inverting Ben Franklin’s advice and asking,
“Why do today what you can put off until tomorrow?” The corollary to this perverse statement as
applied to capital budgeting is “Do not replace it until we absolutely have to.” No need for
replacement studies. Wait until the machine breaks down, then air-freight in a new one. At that
point, the specter of costly downtime will be sufficient to convince management to skip the
analysis and simply order the replacement equipment.
Such a policy has obvious disadvantages, yet stories of plants that have critical equipment
held together by “chewing gum and baling wire” loom large in industrial folklore. Capital bud-
geting projects and key pieces of equipment should be reviewed at regular intervals. A firm
should develop a program of preventive maintenance and should estimate a probable replace-
ment date each time it acquires a significant piece of equipment. This will help to ensure that
the assets are used with maximum efficiency and that equipment is replaced when it is most
advantageous to do so—rather than when the baling wire finally snaps and the equipment stops
working!
URGENCY, ON BALANCE Urgency is a frequently used but extremely poor basis for making
ISBN: 0-536-42875-1
important decisions. Firms should instead plan ahead. Drawing on Ben Franklin again, with
accuracy this time, “An ounce of prevention is worth a pound of cure.”
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CHAPTER 9 BUSINESS INVESTMENT RULES 233
REVIEW
1. What is the profitability index? How is it calculated? What is its decision rule?
2. What is the payback rule? Why is it inferior to NPV? Does it have any practical
value? Does the discounted payback method avoid the shortcomings of the simple
payback method?
Methods of Evaluation
Just about all firms use the evaluation methods we have discussed, in one form or another. The
single most useful tool is the NPV profile. This is because it provides the most complete view of the
project. It incorporates both NPV and IRR, and it also sheds light on the problem of an uncer-
tain required return.
Understandably, however, most firms use more than one evaluation technique. Over the
last 30 years, the use of techniques based on the time value of money, especially the NPV method,
has increased substantially. We hope that means that when you finish school and apply the things
you have learned here, you will be able to convince your employer to use the better discounted-
cash-flow techniques that are available for capital budgeting if they are not already being used.
Appropriations
A decision to include an investment in the capital budget seldom means automatic approval of
the required expenditures. Most firms require that plant managers or division heads submit
detailed appropriation requests before funds can be released for a project.
Firms often create manuals that specify how appropriation requests must be prepared. This
helps maintain managerial control over investments and their associated costs.
Conducting a review of a budgeted capital expenditure just prior to releasing funds pro-
vides one last check before making the expenditure. This can be valuable in cases in which new
information has come to light that might make one or more changes advantageous.
be evaluated and held accountable for their work tends to motivate people to seek better methods
and work to eliminate both conscious and unconscious biases. This kind of process is sometimes
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
234 PART III CAPITAL BUDGETING
referred to as continuous improvement, and it is part of the concept of total quality management
(TQM).
Although very difficult in some situations, postaudits are extremely important because of
their potential impact on value. In Chapter 11, we discuss postaudits further.
REVIEW
1. What is the single most useful capital budgeting evaluation tool?
2. Why are appropriation requests useful in the capital budgeting process?
3. What is a postaudit? Why are postaudits useful in the capital budgeting process?
SUMMARY
The capital budgeting process and the investment criteria used to make capital budgeting deci-
sions are critical because firms are effectively defined by the products and services they provide
using their capital assets.
• Idea generation is the first and most important part of the capital budgeting process.
Sources of potential valuable ideas include production employees, managers at all levels,
sales and marketing staff, research and development groups, and the strategic planning
process.
• The net present value (NPV) method discounts all cash flows at the project’s required
return—its cost of capital. The NPV measures the value the project will create, which is
the difference between what the project is worth and what it will cost to undertake. The
NPV method recommends that all independent projects with a positive NPV be under-
taken. The NPV method is widely used in practice.
• The internal rate of return (IRR) is the project’s expected return. It is the return that
would make the NPV zero if it were the project’s cost of capital. The IRR method rec-
ommends that every conventional capital budgeting project with an IRR greater than its
cost of capital be undertaken. Caution is needed because the IRR decision rule can
break down when projects are mutually exclusive or nonconventional. IRR is widely
used in practice, probably because of its “intuitive feel.”
• The profitability index (PI) method calculates one plus the project’s NPV divided by its
initial cost. The idea is to measure the project’s “bang for the buck.” The PI rule can
break down when projects are mutually exclusive.
• The payback method finds the length of time it takes to recover the initial investment,
without regard to the time value of money. It recommends acceptance of projects that
“return the investment” quickly. The payback method has several serious deficiencies
that can cause bad recommendations, but it may have some practical value. In particu-
lar, it can provide a liquidity screen, which might be desirable in some situations.
Although widely used in conjunction with other methods, payback is rarely used alone.
• The discounted payback method is like payback but it incorporates the effect of the
time value of money. The discounted payback is the time it takes the project to earn a
present value equal to its initial cost. Although this method is superior to the payback
method, it is still inferior to NPV because it ignores the value of cash flows after the pay-
back point. Discounted payback is not widely used in practice, probably because it is
neither as conceptually correct as NPV nor as simple as payback.
ISBN: 0-536-42875-1
• Urgency is a dangerous but widely used method of allocating resources. Its use is short-
sighted. Many potential crises can be avoided through good planning.
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CHAPTER 9 BUSINESS INVESTMENT RULES 235
• In practice, most firms use multiple evaluation methods for investments of any signifi-
cance. However, the NPV profile is the single most useful tool. It provides the project’s
NPV, IRR, and sensitivity to the discount rate at a glance.
• The postaudit is a critical and ongoing part of capital budgeting. It provides a signifi-
cant opportunity to create value through continuous improvement in forecasting out-
comes and in choosing and operating projects.
E Q U AT I O N S U M M A RY
CF1 CF2 CFn
NPV = CF0 + + +…+
(1 + r ) (1 + r )2 (1 + r )n
(9.1) n
CF
= ∑ (1 + rt )t
t =0
FV (cash inflows)
(9.4) PV ( cash outflows) =
(1 + MIRR)N
QUESTIONS
1. Briefly describe the five steps in the capital budgeting process.
2. Why is the Principle of Valuable Ideas of critical importance to the capital budgeting
process?
3. Define the term independent project.
4. Define the terms conventional project and nonconventional project.
5. Define the term mutually exclusive projects.
6. Define the term profitability index and describe the concept.
7. Define the term payback and describe the concept.
8. What is an internal rate of return (IRR)?
9. Briefly explain why capital budgeting projects are frequently classified into groups such as
maintenance projects, cost savings/revenue-enhancement projects, capacity-expansion pro-
jects, new product/new business projects, and projects mandated by regulation or firm
policy.
10. Why can the NPV and IRR methods disagree on the rankings for mutually exclusive projects?
11. What are the strengths and weaknesses of the payback and the discounted payback?
ISBN: 0-536-42875-1
12. Which of the capital budgeting criteria are the most sound? Which are the least sound?
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.
236 PART III CAPITAL BUDGETING
13. Suppose you were restricted to using only one method of analysis to evaluate a capital bud-
geting project. Briefly explain why the NPV profile is the best method to use.
14. Why do firms perform postaudits, reviewing and measuring the performance of their previ-
ous capital investments?
CHALLENGING QUESTION
15. A staff analyst has just brought you an incomplete capital budgeting analysis that shows you
only that the discounted payback of this conventional project is 5.24 years. A moment later,
before you can fully collect your thoughts and ask the analyst any questions, the marketing
vice president calls you and asks if the project analysis shows a positive NPV. You answer yes.
Explain how you know this.
PROBLEMS
■ LEVEL A (BASIC)
A1. (NPV and IRR) An investment of $100 at time 0 generates a cash flow of $150 at time 1.
If the cost of capital is 10%, what is the NPV? What is the IRR?
A2. (Mutually exclusive projects) Consider the cash flows given below for the mutually exclu-
sive projects, S and L.
a. If the cost of capital is 10%, what is the NPV of each investment?
b. What is the IRR of each investment?
c. Which investment should you accept?
YEAR 0 1 2
A3. (NPV and PI) Vu Trading Company is evaluating a project that has the estimated cash
flows given here. The cost of capital is 14%.
a. What is the project’s NPV?
b. What is the profitability index?
YEAR 0 1 2 3 4
A4. (Investment criteria) An investment of $100 returns exactly $100 in one year. The cost of
capital is 10%.
a. What are the payback, NPV, and IRR for this investment?
b. Is this a profitable investment?
A5. (Investment criteria) Compute the NPV, IRR, and payback period for the following invest-
ment. The cost of capital is 10%.
YEAR 0 1 2 3
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CHAPTER 9 BUSINESS INVESTMENT RULES 237
A6. (Payback and discounted payback) Find the payback and the discounted payback for a pro-
ject with the cash flows given here. The cost of capital is 12%.
YEAR 0 1 2 3 4
A7. (NPV and IRR) A project is expected to generate cash flows of $14,000 annually for five
years plus an additional $27,000 in year 6. The cost of capital is 10%.
a. What is the most that you can invest in this project at time 0 and still have a positive
NPV?
b. What is the most that you can invest in this project at time 0 if you want to have a 15%
IRR?
A8. (Investment criteria) An investment of $100,000 generates cash flows of $30,000 annu-
ally for the next four years. Find the NPV using a 10% cost of capital, the IRR, and the
payback.
A9. (NPV) An investment of $10 will generate an annual cash flow of $1 forever. If the cost of
capital is 8%, what is the NPV of this investment?
A10. (NPV) An investment of $25 will generate an annual cash flow of $2 forever. If the cost of
capital is 7%, what is the NPV of this investment?
A11. (Payback and NPV) Three projects have the cash flows given here. The cost of capital is 10%.
a. Calculate the paybacks for all three projects. Rank the projects from best to worst based
on their paybacks.
b. Calculate the NPVs for all three projects. Rank the projects from best to worst based on
their NPVs.
c. Why are these two sets of rankings different?
YEAR 0 1 2 3 4 5
Project 1 −10 4 3 2 1 5
Project 2 −10 1 2 3 4 5
Project 3 −10 4 3 2 1 10
■ LEVEL B
B1. (Reverse conventional project) You have an opportunity to undertake a project that has a
positive cash flow of $100 at time 0 and a negative cash flow of $100 at time 1. The cost of
capital is 10%.
a. What is the IRR?
b. What is the NPV?
c. Should you accept this project?
B2. (Reverse conventional project) You can undertake a project with the following cash flows:
The cost of capital is 10%. The internal rate of return is 15.8%. Should you accept this
project? Why or why not?
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238 PART III CAPITAL BUDGETING
B3. (NPV) Truman State University is evaluating an investment in new air handling systems for
some of its major buildings. The expected outlays and the expected savings, in millions of
dollars, are given here:
TIME 0 1 2 3 4 THROUGH 10
What is the net present value of this investment if the required return is 8%?
B4. (NPV and shareholder wealth) Stockholders are surprised to learn that the firm has
invested $43 million in a project that has an expected payoff of $8 million per year for six
years. The project’s cost of capital is 12%.
a. What is the project’s NPV?
b. There are 3 million outstanding shares. What should be the direct impact of this invest-
ment on the per-share value of the common stock?
B5. (Investment criteria) Pierre Bouvier is evaluating four projects. The cash flows for the four
projects are given here.
a. Pierre thinks you can rank these projects from best to worst by simply inspecting the
cash flows (and not calculating anything). Try to do so.
b. Pierre next found the NPV of each project, discounting future cash flows at 10%. What
is the NPV for each project?
c. Do your rankings in parts a and b agree?
TIME 0 1 2 3 4
Project K −100 40 40 40 40
Project L −100 40 80 0 40
Project M −90 40 80 0 30
Project N −90 40 80 0 40
B6. (Investment criteria) Consider the cash flows for the two capital budgeting projects given
here. The cost of capital is 10%.
a. Calculate the NPV for both projects.
b. Calculate the IRR for both.
c. Calculate the PI for both.
d. Calculate the MIRR for both.
e. Calculate the payback for both.
f. Which is the better project? Why?
YEAR 0 1 2 3 4
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CHAPTER 9 BUSINESS INVESTMENT RULES 239
c. What is the crossover point, the discount rate that would have the same NPV for both
projects? (Hint: Find the differential cash flows between the two projects. Then find the
IRR for the differential cash flows.)
B8. (Investment criteria) Consider a project that has these cash flows. The required return on
the investment is 10%. Compute the:
a. Payback
b. Discounted payback
c. NPV
d. Profitability index
e. IRR
f. MIRR
YEAR 0 1 2 3 4
B9. (NPV) Bill Scott estimates that a project will involve an outlay of $125,000 and will return
$40,000 per year for six years. The required return is 12%.
a. What is the NPV using Bill’s estimates?
b. David Scott is less optimistic about the project. David thinks the outlay will be 10%
higher, the annual cash flows will be 5% lower, and the project will have a five-year
life. David does agree with Bill’s required return. What is the NPV using David’s
estimates?
B10. (Investment criteria) Suppose Reebok has a possible capital budgeting project with a cost of
capital of 10%, and the expected cash flows shown here.
a. Calculate the project’s NPV. Should Reebok accept the project?
b. Calculate the project’s IRR. Should Reebok accept the project according to the IRR rule?
c. Calculate the project’s payback. What does payback tell you about the project’s
acceptability?
YEAR 0 1 2 3 4 5
B11. (Investment criteria) Texaco has a capital budgeting project with a cost of capital of 12%
and the following expected cash flow pattern:
a. Calculate NPV. Should the firm accept the project?
b. Calculate IRR. Should the firm accept the project?
ISBN: 0-536-42875-1
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240 PART III CAPITAL BUDGETING
d. How would your answers to parts a or b change if you were told that the project is one
of two mutually exclusive projects the firm has under consideration?
YEAR 0 1 2 3
B12. (Mutually exclusive projects) Sperry is considering two mutually exclusive capital budget-
ing projects with a cost of capital of 14% and the expected cash flows shown here. Which,
if either, project should Sperry undertake? Justify your answer.
YEAR 0 1 2 3 4 5
Project A −100 30 40 50 40 30
Project B −150 45 60 75 60 60
B13. (Excel: NPV profile) Helix, Inc., is considering two mutually exclusive one-time projects.
Both require an initial investment of $80,000. Project A will last for six years and has
expected net future cash flows of $40,222 per year. Project B will last for five years and has
expected net future cash flows of $44,967 per year. The cost of capital for this project
is 12%.
a. Calculate the NPV for each project.
b. Calculate the IRR for each project.
c. Graph the NPV of the projects as a function of the discount rate, including solving for
the crossover point by trial and error.
d. Which project should Helix take?
B14. (Excel: NPV profile) Watson, Inc., is considering two mutually exclusive one-time pro-
jects. Both require an initial investment of $50,000. Project A will last for six years and has
expected net future cash flows of $25,000 per year. Project B will last for five years and has
expected net future cash flows of $20,000 per year. The cost of capital for this project
is 10%.
a. Calculate the NPV for each project.
b. Calculate the IRR for each project.
c. Which project should Watson, Inc., take?
B15. (Excel: Choosing among mutually exclusive projects) Suppose Kodak is considering
two mutually exclusive capital budgeting projects with the following expected cash flow
patterns:
TIME 0 1 2 3 4 5 6
d. If the cost of capital is precisely 12%, which project should Kodak undertake?
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CHAPTER 9 BUSINESS INVESTMENT RULES 241
B16. (Excel: Finding NPV and IRR) Use the worksheet functions in your spreadsheet to find the
NPV, IRR, and PI of the following project. The cost of capital is 10%. Are you getting the
correct values in your spreadsheet?
Time 0 1
Cash flow −100 +120
B17. (Excel: Finding NPV and IRR) Kennesaw Instrument Company is looking at six pro-
jects with the following cash flows (investment outlays are negative cash flows):
TIME 0 1 2 3 4 5 6 7 8
Project A −10 2 3 4 5 4 3 2 1
Project B −8 −3 5 5 5 2 0 0 0
Project C −45 25 20 15 5 0 0 0 0
Project D −1 2 2 2 0 0 0 0 0
Project E −30 6 6 6 6 6 0 0 0
Project F −10 −20 5 5 8 8 8 8 8
1 −200 300 0 0
2 −200 0 0 400
■ LEVEL C (ADVANCED)
C1. (Investment criteria) Nassau Manufacturing Company is considering two capital budget-
ing projects with a cost of capital of 15% and the expected cash flows shown here.
a. Calculate the NPV and IRR for each project.
Which project(s) should Nassau accept, assuming they are:
b. Independent?
c. Dependent (both or neither are required)?
d. Mutually exclusive?
YEAR 0 1 2 3 4 5
Project A −100 25 30 40 30 25
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Project B −50 10 15 25 15 15
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242 PART III CAPITAL BUDGETING
C2. (Excel: Multiple rates of return) Consider the oil pump cash flows given here:
TIME 0 1 2
a. Calculate the NPV for the oil pump using discount rates between 0% and 500%, in
25% increments.
b. What are the two internal rates of return?
c. Where is the highest NPV?
d. Graph the NPV profile.
ISBN: 0-536-42875-1
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CHAPTER 9 BUSINESS INVESTMENT RULES 243
When the Boeing Corporation announced its intention to $5 billion. Production facilities and personnel training
build a new plane, the project was an enormous undertak- would require an additional investment of $2.0 billion, and
ing. Research and development had already begun two and they would need $1.7 billion in working capital when
a half years earlier, and Boeing had already spent $873 mil- deliveries began in six years. The following table shows pro-
lion. Aggregate development cost, disregarding the time jected future cash flows for the project at the time of
value of money, was expected to be between $4 billion and Boeing’s announcement. Boeing’s cost of capital was 18%.
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson
Education, Inc.