Chapter 12

Capital Budgeting:
Decision Criteria
1

Topics

Overview
Methods

NPV
IRR, MIRR
Profitability Index
Payback, discounted payback

Unequal lives
Economic life
2

Capital Budgeting:

Analysis of potential projects

Long-term decisions
Large expenditures
Difficult/impossible to reverse
Determines firms strategic
direction
3

Steps in Capital Budgeting

Estimate cash flows (Ch 13)

Assess risk of cash flows (Ch 13)
Determine r = WACC for project
(Ch10)

Evaluate cash flows Chapter 12

Independent versus Mutually

Exclusive Projects

Independent:

The cash flows of one are unaffected

by the acceptance of the other

Mutually Exclusive:

The acceptance of one project

precludes accepting the other

Cash Flows for Projects L

and S

NPV: Sum of the PVs of all

cash flows.
n

NPV =

t=0

CFt .
(1 + r)t
NOTE: t=0

Cost often is CF0 and is negative

n

NPV =

t=1

CFt
(1 + r)t

- CF0
7

Project Ss NPV

Project Ls NPV

TI BAII+: Project L NPV

Display

Cash Flows:

You Enter

CF0

-1000

CF1

100

CF2

300

CF3

400

CF4

600

C00
C01
F01
C02
F02
C03
F03
C04
F04
I
NPV

1000
100
1
300
1
400
1
600
1
10

49.18

10

Rationale for the NPV

Method

NPV = PV inflows Cost

NPV=0 Projects inflows are exactly sufficient to repay

the invested capital and provide the required rate of return.

NPV = net gain in shareholder wealth

Choose between mutually exclusive projects

on basis of higher NPV

Rule: Accept project if NPV > 0

11

NPV Method

Meets all desirable criteria

Considers all CFs

Considers TVM
Can rank mutually exclusive projects
Value-additive

Directly related to increase in VF

Dominant method; always prevails

12

Using NPV method, which

franchise(s) should be accepted?

Project S NPV = $78.82

Project L NPV = $49.18
If Franchise S and L are mutually
exclusive, accept S because NPVs
> NPVL
If S & L are independent, accept
both; NPV > 0
13

Internal Rate of Return:

IRR
IRR = the discount rate that forces
PV inflows = cost
Forcing NPV = 0
YTM on a bond
Preferred by executives 3:1
14

NPV vs IRR
NPV: Enter r, solve for NPV
n CF
t
= NPV
(1 + r)t
t=0

IRR: Enter NPV = 0, solve for IRR

n

t=0

CFt
=0
(1 + IRR)t
15

Franchise Ls IRR

16

TI BAII+: Project L IRR

Display

Cash Flows:

You Enter

CF0

-1000

CF1

100

CF2

300

CF3

400

CF4

600

C00
C01
F01
C02
F02
C03
F03
C04
F04
I
IRR

1000
100
1
300
1
400
1
600
1
10

11.79

17

Decisions on Projects S
and L per IRR

Project S IRR = 14.5%

Project L IRR = 11.8%
Cost of capital = 10.0%
If S and L are independent, accept
both: IRRS > r and IRRL > r
If S and L are mutually exclusive,
accept S because IRRS > IRRL
18

Construct NPV Profiles

Enter CFs in CFLO and find NPVL and

NPVS at different discount rates:

19

NPV Profile

20

To Find the Crossover Rate

Find cash flow differences between the

projects.
Enter these differences in CFLO register,
then press IRR.
Crossover rate = 7.17%, rounded to 7.2%.
Can subtract S from L or vice versa
If profiles dont cross, one project
dominates the other
21

Finding the Crossover Rate

22

NPV and IRR:

No conflict for independent
projects
NPV ($)
IRR > r
and NPV > 0
Accept

r > IRR
and NPV < 0.
Reject

IRR

r (%)
23

Mutually Exclusive
Projects
r > 7.2%
NPVS> NPVL
IRRS > IRRL
NO CONFLICT

NPV
L

S
7.2

r < 7.2%
NPVL> NPVS
IRRS > IRRL
CONFLICT

IRRS

%
IRRL

24

Mutually Exclusive
Projects
CONFLICT

r < 7.2%
NPVL> NPVS
IRRS > IRRL
r > 7.2%
NPVS > NPVL
IRRS > IRRL
NO CONFLICT

25

Two Reasons NPV Profiles

Cross

Size (scale) differences

Smaller project frees up funds sooner for

investment
The higher the opportunity cost, the more
valuable these funds, so high r favors small
projects

Timing differences

Project with faster payback provides more CF

in early years for reinvestment
If r is high, early CF especially good, NPV S >
NPVL

26

Issues with IRR

Reinvestment rate
assumption
Non-normal cash flows

27

Reinvestment Rate
Assumption

NPV assumes reinvest at r

(opportunity cost of capital)
IRR assumes reinvest at IRR
Reinvest at opportunity cost, r, is
more realistic, so NPV method is best
NPV should be used to choose
between mutually exclusive projects
28

Modified Internal Rate of

Return (MIRR)

MIRR = discount rate which causes

the PV of a projects terminal value
(TV) to equal the PV of costs

TV = inflows compounded at WACC

MIRR assumes cash inflows

reinvested at WACC

29

MIRR for Project S:

First, find PV and TV (r =
10%)

30

Second: Find discount rate

that equates PV and TV

1579.5
MIRR
( 1 MIRR ) 4

MIRR = 12.1%
31

Second: Find discount rate

that equates PV and TV

PV = PV(Outflows) = -1000
FV = TV(Inflows) = 1579.5
N=4
PMT = 0
CPY I/Y = 12.1063 = 12.1%
EXCEL: =MIRR(Value Range, FR, RR)
32

MIRR versus IRR

MIRR correctly assumes reinvestment

at opportunity cost = WACC

MIRR avoids the multiple IRR problem

Managers like rate of return

comparisons, and MIRR is better for
this than IRR

33

Normal vs. Nonnormal Cash

Flows

Normal Cash Flow Project:

Cost (negative CF) followed by a series of

positive cash inflows
One change of signs

Nonnormal Cash Flow Project:

Two or more changes of signs

Most common: Cost (negative CF), then string
of positive CFs, then cost to close project
For example, nuclear power plant or strip mine

34

Pavilion Project: NPV and

IRR?
0

r = 10%

-800

5,000

-5,000

Enter CFs, enter I = 10

NPV = -386.78
IRR = ERROR
35

Nonnormal CFs:
Two sign changes, two IRRs
NPV Profile

NPV

IRR2 = 400%
450
0
-800

100

400

IRR1 = 25%
36

Multiple IRRs

Descartes Rule of Signs

n

CFt
0

t
t 0 ( 1 IRR )

Polynomial of degree nn roots

1 real root per sign change

Rest = imaginary (i2 = -1)
37

Logic of Multiple IRRs

At very low
discount rates:

The PV of CF2 is
large & negative
NPV < 0

At very high
discount rates:

The PV of both CF1

and CF2 are low
CF0 dominates
Again NPV < 0

38

Logic of Multiple IRRs

In between:

The discount rate hits CF2 harder

than CF1
NPV > 0

Result: 2 IRRs

39

The Pavillion Project:

Non-normal CFs and MIRR:
1

0
-800,000

5,000,000

RR

-5,000,000

FR

PV outflows @ 10% = -4,932,231.40

TV inflows @ 10% = 5,500,000.00
MIRR = 5.6%
40

Profitability Index

PI =present value of future cash

flows divided by the initial cost
Measures the bang for the buck

41

Project Ss PV of Cash
Inflows

42

Profitability Indexs
PIS =

PV future CF
Initial Cost

$1078.82
$1000

PIS = 1.0788
PIL = 1.0492
43

Profitability Index

Rule: If PI>1.0 Accept

Useful in capital rationing
Closely related to NPV
Can conflict with NPV if projects
are mutually exclusive

44

Profitability Index

Strengths:

Considers all CFs

Considers TVM
Useful in capital rationing

Weaknesses:

Cannot rank mutually exclusive

Not Value-additive
45

Payback Period

The number of years required to

recover a projects cost
How long does it take to get the
businesss money back?
A breakeven-type measure
Rule: Accept if PB<Target
46

Payback for Projects S and

L

Payback Years before full recovery

Unrecovered cost at start of year

Cash flow during year

47

Payback for Projects S and

L

Payback Years before full recovery

Unrecovered cost at start of year

Cash flow during year

48

Strengths and
Weaknesses of Payback

Strengths:

Provides indication of project risk and liquidity

Easy to calculate and understand

Weaknesses:

Ignores the TVM

Ignores CFs occurring after the payback
period
Biased against long-term projects
ASKS THE WRONG QUESTION!

49

Discounted Payback:
Use discounted CFs

50

Summary

Calculate ALL -- each has value

Method

What it measures

Metric

NPV $ increase in VF $$
Payback Liquidity
Years
IRR E(R), risk
%
MIRR
Corrects IRR %
PI
If rationed Ratio
51

Business Practices

52

Special Applications

Projects with Unequal Lives

Economic vs. Physical life

The Optimal Capital Budget

Capital Rationing

53

SS and LL are mutually

exclusive.
r = 10%.
0

Project SS:
60
(100)

60

Project LL:
33.5
(100)

33.5

33.5

33.5

54

NPVLL > NPVSS

But is LL better?
SS
CF0

LL

-100,000 -100,000

CF1

60,000

33,500

F
I
NPV

2
10
4,132

4
10
6,190
55

Solving for EAA

PMT = EAA
Project SS
2

10

4132
0

= 2.38
=PMT(0.10,2,-4132,0)

Project LL
4

10

6190
0

= 1.95
=PMT(0.10,4,-6190,0)
56

Unequal Lives

Project SS could be repeated after

2 years to generate additional
profits
Use Replacement Chain to put
projects on a common life basis
Note: equivalent annual annuity
analysis is alternative method.
57

Replacement Chain Approach

(000s)
Project SS with Replication:
0

Project SS:

(100)

60

(100)

60

NPVSS = $7,547

60
(100)
(40)

60
60

60
60

Compare: NPVLL = $6,190

58

Or, use NPVss:

0
4,132
3,415
7,547

1
10%

4,132

Compare to Project LL NPV =

$6,190

59

Suppose cost to repeat SS in two

years rises to $105,000
0

Project SS:
(100)
60

60
(105)
(45)

60

60

NPVSS = $3,415 < NPVLL = $6,190

60

Economic Life vs. Physical

Life

Consider a project with a 3-year

life
If terminated prior to Year 3, the
machinery will have positive
salvage value
Should you always operate for the
full physical life?
61

Economic Life vs. Physical

Life

62

Economic vs. Physical Life

63

Conclusions

NPV(3) = -$14.12
NPV(2) = $34.71
NPV(1) = -$254.55
The project is acceptable only if
operated for 2 years.
A projects engineering life does
not always equal its economic life.
64

The Optimal Capital Budget

Finance theory says:

Accept all positive NPV projects

Two problems can occur when there

is not enough internally generated
cash to fund all positive NPV
projects:

An increasing marginal cost of capital

Capital rationing
65

Increasing Marginal Cost of

Capital

Externally raised capital large flotation

costs

Investors often perceive large capital

budgets as being risky

Increases the cost of capital

Drives up the cost of capital

If external funds will be raised, then the

NPV of all projects should be estimated
using this higher marginal cost of capital
66

Increasing Marginal Cost of

Capital
% 16
15
14

WACC2 = 12.5%

13
12

WACC1 = 11.0%

External debt
& equity

10
9

No external funds

500

700 Capital Required

61

Capital Rationing

Firm chooses not to fund all

positive NPV projects
Company typically sets an upper
limit on the total amount of capital
expenditures that it will make in
the upcoming year

68

Capital Rationing Reason

1

Reason:

Companies want to avoid the direct costs

(i.e., flotation costs) and the indirect costs
of issuing new capital

Solution:

Increase the cost of capital by enough to

reflect all of these costs
Then accept all projects that still have a
positive NPV with the higher cost of
capital
69

Capital Rationing Reason

2

Reason:

Companies dont have enough

managerial, marketing, or engineering
staff to implement all positive NPV
projects

Solution:

Use linear programming to maximize

NPV subject to not exceeding the
constraints on staffing
70

Capital Rationing Reason

3

Reason:

Companies believe that the projects managers

forecast unreasonably high cash flow estimates
Filter out the worst projects by limiting the
total amount of projects that can be accepted

Solution:

Implement a post-audit process and tie the

managers compensation to the subsequent
performance of the project

71

Excel Spreadsheet Functions

FV(Rate,Nper,Pmt,PV,0/1)
PV(Rate,Nper,Pmt,FV,0/1)
RATE(Nper,Pmt,PV,FV,0/1)
NPER(Rate,Pmt,PV,FV,0/1)
PMT(Rate,Nper,PV,FV,0/1)

Inside parens: (RATE,NPER,PMT,PV,FV,0/1)

0/1 Ordinary annuity = 0 (default; no entry
needed)
Annuity Due = 1 (must be entered)
72

Excel Spreadsheet Functions

NPV(Rate, Value Range**)

IRR(Value Range)
MIRR(Value Range, FR, RR)

** NPV value range includes CF1 through CFn

CF0 must be handled independently, outside the function
=NPV(Rate, CF1-CFn) + CF0
73