Capital Budgeting

Chapter 8

© 2009 Cengage Learning/South-Western

 The Capital Budgeting Decision Process

The capital budgeting process involves three basic

steps:

• Generating long-term investment proposals;

• Reviewing, analyzing, and selecting from the
proposals that have been granted, and
• Implementing and monitoring the proposals
that have been selected.

Managers should separate investment and

financing decisions.
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 Capital Budgeting Decision Techniques
Accounting rate of return (ARR): focuses on
project’s impact on accounting profits

Payback period: most commonly used

Net present value (NPV): best technique

theoretically; difficult to calculate realistically

Internal rate of return (IRR): widely used with

strong intuitive appeal

Profitability index (PI): related to NPV

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 A Capital Budgeting Process Should:

Account for the time value of money;

Account for risk;

Focus on cash flow;

Rank competing projects appropriately, and

Lead to investment decisions that maximize

shareholders’ wealth.
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 Example: Global Wireless

• Global Wireless is a worldwide provider of

wireless telephony devices.
• Global Wireless is contemplating a major
expansion of its wireless network in two
different regions:
– Western Europe expansion
– A smaller investment in Southeast U.S. to establish a
toehold

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 Global Wireless

Initial Outlay -$250

Year 1 inflow $35
Year 2 inflow $80
Year 3 inflow $130
Year 4 inflow $160
Year 5 inflow $175

Initial Outlay -$50

Year 1 inflow $18
Year 2 inflow $22
Year 3 inflow $25
Year 4 inflow $30

6 Year 5 inflow $32

 Accounting Rate Of Return (ARR)

Can be computed from available accounting data

Average profits after taxes

ARR 
Average investment
• Need only profits after taxes and depreciation.
• Average profits after taxes are estimated by
subtracting average annual depreciation from the
average annual operating cash inflows.
Average profits = Average annual – Average annual
after taxes operating cash inflows depreciation

ARR uses accounting numbers, not cash flows;

7 no time value of money.
 Payback Period

The payback period is the amount of time required

for the firm to recover its initial investment.

• If the project’s payback period is less than the

maximum acceptable payback period, accept
the project.
• If the project’s payback period is greater than
the maximum acceptable payback period,
reject the project.

Management determines maximum acceptable

payback period.
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 Payback Analysis For Global Wireless
• Management’s cutoff is 2.75 years.
• Western Europe project: initial outflow of -$250M
– But cash inflows over first 3 years is only $245 million.
– Global Wireless will reject the project (3>2.75).
• Southeast U.S. project: initial outflow of -$50M
– Cash inflows over first 2 years cumulate to $40 million.
– Project recovers initial outflow after 2.40 years.
• Total inflow in year 3 is $25 million. So, the project
generates $10 million in year 3 in 0.40 years ($10 million 
$25 million).
– Global Wireless will accept the project (2.4<2.75).

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 Pros and Cons of the Payback Method

Advantages of payback method:

• Computational simplicity
• Easy to understand
• Focus on cash flow

Disadvantages of payback method:

• Does not account properly for time value of money

• Does not account properly for risk
• Cutoff period is arbitrary
• Does not lead to value-maximizing decisions
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 Discounted Payback
• Discounted payback accounts for time value.
• Apply discount rate to cash flows during payback period.
• Still ignores cash flows after payback period.

• Global Wireless uses an 18% discount rate.

Reject (166.2 < 250) Reject (46.3<50)

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 Net Present Value (NPV)

NPV: The sum of the present values of a project’s

cash inflows and outflows.

Discounting cash flows accounts for the time value

of money.

Choosing the appropriate discount rate accounts for

risk.

CF1 CF2 CF3 CFN

NPV  CF0     ... 
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) N

Accept projects if NPV > 0.

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 Net Present Value (NPV)

CF1 CF2 CF3 CFN

NPV  CF0     ... 
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) N

A key input in NPV analysis is the discount rate.

r represents the minimum return that the

project must earn to satisfy investors.

r varies with the risk of the firm and /or the risk
of the project.
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 NPV Analysis for Global Wireless
• Assuming Global Wireless uses 18% discount rate,
NPVs are:

Western Europe project: NPV = $75.3 million

35 80 130 160 175
NPVW esternEurope  $75.3  250     
(1.18) (1.18) 2 (1.18)3 (1.18) 4 (1.18)5

Southeast U.S. project: NPV = $25.7 million

18 22 25 30 32
NPVSoutheastU .S .  $25.7  50     
(1.18) (1.18) 2 (1.18)3 (1.18) 4 (1.18)5

Should Global Wireless invest in one project or both?

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 The NPV Rule and Shareholder Wealth

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 Pros and Cons of NPV

NPV is the “gold standard” of investment decision

rules.

Key benefits of using NPV as decision rule:

• Focuses on cash flows, not accounting earnings

• Makes appropriate adjustment for time value of money
• Can properly account for risk differences between
projects

Though best measure, NPV has some drawbacks:

• Lacks the intuitive appeal of payback, and

16 • Doesn’t capture managerial flexibility (option value) well.
 Internal Rate of Return (IRR)

IRR: the discount rate that results in a zero NPV for

a project.

CF1 CF2 CF3 CFN

NPV  0  CF0     .... 
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) N

The IRR decision rule for an investing project is:

• If IRR is greater than the cost of capital, accept

the project.
• If IRR is less than the cost of capital, reject the
project.
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 NPV Profile and Shareholder Wealth

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 IRR Analysis for Global Wireless

Global Wireless will accept all projects with at least

18% IRR.

Western Europe project: IRR (rWE) = 27.8%

35 80 130 160 175
0  250     
(1  rW E ) (1  rW E ) 2
(1  rW E ) 3
(1  rW E ) 4
(1  rW E )5

Southeast U.S. project: IRR (rSE) = 36.7%

18 22 25 30 32
0  50     
(1  rSE ) (1  rSE ) 2 (1  rSE )3 (1  rSE ) 4 (1  rSE )5

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 Pros and Cons of IRR

Advantages of IRR:

• Properly adjusts for time value of money

• Uses cash flows rather than earnings
• Accounts for all cash flows
• Project IRR is a number with intuitive appeal

Disadvantages of IRR:

• “Mathematical problems”: multiple IRRs, no real

solutions
• Scale problem
20 • Timing problem
 Multiple IRRs

IRR

IRR

When project cash flows have multiple sign changes, there can
be multiple IRRs.

21 Which IRR do we use?

 No Real Solution

Sometimes projects do not have a real IRR solution.

Modify Global Wireless’s Western Europe project to

include a large negative outflow (-$355 million) in
year 6.

• There is no real number that will make NPV=0, so

no real IRR.

Project is a bad idea based on NPV. At r =18%,

project has negative NPV, so reject!

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 Conflicts Between NPV and IRR:
The Scale Problem

NPV and IRR do not always agree when ranking

competing projects.

The scale problem:

Project IRR NPV (18%)

Western Europe 27.8% $75.3 mn

Southeast U.S. 36.7% $25.7 mn

• The Southeast U.S. project has a higher IRR, but

doesn’t increase shareholders’ wealth as much as
the Western Europe project.
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 Conflicts Between NPV and IRR:
The Scale Problem

Why the conflict?

• The scale of the Western Europe expansion is
roughly five times that of the Southeast U.S.
project.
• Even though the Southeast U.S. investment
provides a higher rate of return, the opportunity
to make the much larger Western Europe
investment is more attractive.

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 Conflicts Between NPV and IRR:
The Timing Problem

• The product development proposal generates a higher

NPV, whereas the marketing campaign proposal offers a
higher IRR.
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 Conflicts Between NPV and IRR:
The Timing Problem

Because of the
differences in the timing
of the two projects’ cash
flows, the NPV for the
Product Development
proposal at 10%
exceeds the NPV for the
Marketing Campaign.

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 Profitability Index

Calculated by dividing the PV of a project’s cash

inflows by the PV of its initial cash outflows.
CF1 CF2 CFN
  ... 
(1  r ) (1  r ) 2
(1  r ) N
PI 
CF0
Decision rule: Accept project with PI > 1.0, equal to NPV > 0
Project PV of CF (yrs1-5) Initial Outlay PI

Western Europe $325.3 million $250 million 1.3

Southeast U.S. $75.7 million $50 million 1.5

• Both PI > 1.0, so both acceptable if independent.

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Like IRR, PI suffers from the scale problem.
 Capital Budgeting

Methods to generate, review, analyze, select, and

implement long-term investment proposals:
• Accounting rate of return
• Payback Period
• Discounted payback period
• Net Present Value (NPV)
• Internal rate of return (IRR)
• Profitability index (PI)

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