Capital Budgeting Decision

Rules
What real investments should
firms make?

Alternative Rules in Use

Today

NPV
IRR
Profitability Index
Payback Period

Discounted Payback Period

Accounting Rate of Return

NPV Analysis

The recommended approach to any significant

capital budgeting decision is NPV analysis.

NPV = PV of the incremental benefits PV of

the
incremental costs.
When evaluating independent projects, take a project
if and only if it has a positive NPV.
When evaluating interdependent projects, take the
feasible combination with the highest total NPV.

The NPV rule appropriately accounts for the

opportunity cost of capital and so ensures the
project is more valuable than comparable
alternatives available in the financial market.

Lockheed Tri-Star

As an example of the use of NPV analysis

we will use the Lockheed Tri-Star case.
To examine the decision to invest in the
Tri-Star project, we first need to forecast
the cash flows associated with the TriStar project for a volume of 210 planes.
Then we can ask: What is a valid
estimate of the NPV of the Tri-Star project
at a volume of 210 planes as of 1967.

Lockheed Tri-Star Key Points

Pre-production costs estimated at $900 million
incurred between 1967 and 1971.
Total of 210 planes delivered from 1972-1977
Revenues of $16 million per unit, 25% of revenue
received 2 years in advance of delivery.
Production costs of $14 million (at 210 units could
decline to $12.5 million at 300) from 1971-1976.
Discount rate of 10% per year.

Tri-Star Cash Flows

210 planes (1972-1977)

Production Costs (1971-1976)

Planes per year = 210/6=35

35($14M)=$490M per year
Dont forget the preproduction costs of $900M

Revenues (1970-1977)

Total Revenues 35($16M)=$560M per year

Deposits=0.25($560M)=$140M (2 yrs in
advance)
Net Revenues=$560-$140=$420M on delivery

Tri-Star Cash Flows

(210 Planes)

Tri-Star NPV @10% in 1967

200 200
60
550
70
NPV 100

2
3
4
(1.10) (1.10) (1.10) (1.10) (1.10)5
70
70
70
70
420

6
7
8
9
(1.10) (1.10) (1.10) (1.10) (1.10)10
$584 Million

Accounting Profits at 210

Production revenues are $16M per plane and

production costs are $14M per plane. Profit is $2M
per plane.
210$2M = $420M production profits. $420M vs.
$900M preproduction costs is breakeven?
Suppose production cost is $12.5M per plane
(learning curve hits early). Profit per plane is
$3.5M. At 210 planes this is $735M production
profit.
Now take the extreme low-end of the $800M - $1B
preproduction cost range.
Suddenly you have breakeven. Smart huh?

Tri-Star NPV 1967

($Millions)
Units
Sold
323

Average Accountin NPV

Unit Cost g Profit
$12.25
$311
-$195

400

$12.00

$700

-$12

400

$11.75

$800

$42

500

$11.00

$1,600

$441

Tri-Star Cash Flows 1970

(210 Planes)

1970 Tri-Star NPV @10%

550
70
70
70
70
NPV 140

2
3
4
5
(1.10) (1.10)
(1.10) (1.10)
(1.10)
70
420

6
7
(1.10)
(1.10)
$18 Million

Tri Star Post Mortem

Accounting breakeven approximately 275 planes

$16M - $12.5M = $3.5M per plane

$3.5M275 = $962M profit versus $960M in actual
development costs known in 1970
This more realistic breakeven level announced
subsequent to the guarantees being granted.

NPV breakeven approximately 400 planes

Total free world market demand for wide-body aircraft

approximately 325 planes

Optimistic estimate: total demand 775 and 40% of that is

310

Lockheed share price

$64 Jan 1967 drops to $11 Jan 1971

($64-$11)(11.3 Million shares)=-$599 Million

Compare to -$584 Million NPV

Internal Rate of Return

Definition: The discount rate that sets the NPV of a

project to zero (essentially project YTM) is the
projects IRR.
IRR asks: What is the projects rate of return?
Standard Rule: Accept a project if its IRR is greater
than the appropriate market based discount rate,
reject if it is less. Why does this make sense?
For independent projects with normal cash flow
patterns IRR and NPV give the same conclusions.
IRR is completely internal to the project. To use
the rule effectively we compare the IRR to a
market rate.

IRR Normal Cash Flow

Pattern

Consider the following stream of cash flows:

0

-$1,000

1
$400

2
$400

3
$400

Calculate the NPV at different discount

rates until you find the discount rate where
the NPV of this set of cash flows equals
zero.
Thats all you do to find IRR.

IRR NPV Profile Diagram

Evaluate the NPV at various discount rates:

Rate NPV
0
$200
10
-$5.3
20
-$157.4

At r = 9.7%,
NPV = 0

The Merit to the IRR

Approach

The IRR (as with the YTM) is an

approximation to the return generated over
the life of a project on the initial investment.
As with NPV, the IRR is based on incremental
cash flows, does not ignore any cash flows,
and (by comparison to the appropriate
discount rate, r) take proper account of the
time value of money and risk.
In short, it can be useful.

Pitfalls of the IRR Approach

Multiple IRRs

There can be as many solutions to the IRR

definition as there are changes of sign in the
time ordered cash flow series.
Consider:
0
1
2
-$100

$230

-$132

This can (and does) have two IRRs.

Pitfalls of IRR cont

Pitfalls of IRR cont

Pitfalls of IRR cont

Mutually exclusive projects:

IRR can lead to incorrect conclusions

about the relative worth of projects.
Ralph owns a warehouse he wants to
fix up and use for one of two
purposes:
A.
B.

Store toxic waste.

Store fresh produce.

Lets look at the cash flows, IRRs and NPVs.

Mutually Exclusive Projects and

IRR
Project
A
B

Year 0 Year 1 Year 2 Year 3

-10,000 10,000 1,000
1,000
-10,000 1,000
1,000
12,000

Project

NPV @
0%
$2000
$4000

A
B

NPV @ NPV@
10%
15%
$669
$109
$751
-$484

IRR
16.04%
12.94%

 At low discount rates, B is better. At high discount rates, A is

better.
But A always has the higher IRR. A common mistake to make
is choose A regardless of the discount rate.
Simply choosing the project with the larger IRR would be
justified only if the project cash flows could be reinvested at the
IRR instead of the actual market rate, r, for the life of the
project.

Summary of IRR vs. NPV

IRR analysis can be misleading if you dont fully

understand its limitations.

For individual projects with normal cash flows NPV and

IRR provide the same conclusion.
For projects with inflows followed by outlays, the
decision rule for IRR must be reversed.
For Multi-period projects with several changes in sign of
the cash flows multiple IRRs exist. Must compute the
NPVs to see what is appropriate decision rule.
IRR can give conflicting signals relative to NPV when
ranking projects.

I recommend NPV analysis, using others as

backup.

Profitability Index

Definition: The present value of the cash

flows that accrue after the initial outlay
divided by the initial cash outlay.
Rule: Take any/only the projects with a PI>1.

The PI does a benefit/cost (bang for the buck)

analysis. Any time the PV of the future benefits
is larger than the current cost PI > 1. When this
is true what is the NPV? Thus for independent
projects the rules make exactly the same
decision.
N

PI

t
CF
/(
1

r
)
t
t 1

CF0

PI and Mutually Exclusive

Projects

Example:
Project
CF0
CF1
NPV @ 10%
PI
A -$1,000
$1,500
$364
1.36
B -$10,000 $13,000
$1,818
1.18
Since you can only take one and not both the NPV rule
says B, the PI rule would suggest A. Which is right?

The projects are mutually exclusive so the NPV of

one is an opportunity cost to the other. We must
take B, in this respect A has a negative NPV.
PI treats scale strangely. It measures the bang per
buck invested. This is larger for A but since we
invest more in B it will create more wealth for us.

Payback Period Rule

Frequently used as a check on NPV analysis

or by small firms or for small decisions.

Payback period is defined as the number of years

before the cumulative cash inflows equal the initial
outlay.
Provides a rough idea of how long invested capital
is at risk.
Example: A project has the following cash flows
Year 0 Year 1 Year 2 Year 3 Year 4
-$10,000 $5,000 $3,000 $2,000 $1,000
The payback period is 3 years. Is that good or
bad?

Payback Period Rule

Frequently used as a check on NPV analysis

or by small firms or for small decisions.

Payback period is defined as the number of years

before the cumulative cash inflows equal the initial
outlay.
Provides a rough idea of how long invested capital
is at risk.
Example: A project has the following cash flows
Year 0 Year 1 Year 2 Year 3 Year 4
-$10,000 $5,000 $3,000 $2,000 $1,000,000
The payback period is 3 years. Is that good or
bad?

Payback Period Rule

An adjustment to the payback period rule that is

sometimes made is to discount the cash flows
and calculate the discounted payback period.
This new rule continues to suffer from the
problem of ignoring cash flows received after an
arbitrary cutoff date.
If this is true, why mess up the simplicity of the
rule? Simplicity is its one virtue.
At times the payback or discounted payback
period may be valuable information but it is not
often that this information alone makes for good
decision-making.

Average Accounting
Return

Definition: The average net income

after depreciation and taxes (before
interest) divided by the average
book value of the investment.
Rule: If the AAR is above some
cutoff take the project.
This is essentially a measure of
return on assets (ROA).

AAR

Problems

Doesnt use cash flows but rather

accounting numbers.
Ignores the time value of money.
Does not adjust for risk.
Uses an arbitrarily specified cutoff
rate.