Chapter 13 –

Support
Capital Budgeting
Techniques

13b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? The Different
Methods of Evaluation?
• Payback Period (PBP)
• Internal Rate of Return (IRR)
• Net Present Value (NPV)
• Profitability Index (PI)
Let us use the ‘New Asset’ project
from Chapter 12 (VW13E-13b.xlsx)

13b.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Project Evaluation:
Alternative Methods
We will start with the cash
flows of the project and also
calculate the cumulative
cash flow values.

We can use Excel functions / approaches to calculate each of

the following methods from the above cash flows.

13b.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember to refer to Excel spreadsheet
IRR: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.

Project Evaluation

The Internal Rate of Return function is built into Excel!

Simply use the formula above:
• $L$24:$L$28: represents the cash flows from period 0
through the last period (4 in our example)
• K31: represents a “guess” as to the answer, but you
do not need to put this in the formula

13b.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember to refer to Excel spreadsheet
NPV: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.

Project Evaluation
•The Net Present Value (NPV) function is built into
•Excel and we used it in the TVM chapter!
• K31: represents the rate of return investors expect to earn for the
given amount of risk (discount rate)
• $L$25:$L$28: represents the cash flows from period 1 through the
last period (we do NOT use period 0)
• $L$24: We subtract the ICO (or add if we already assigned it a
negative sign as we did in slide 3).
• This is an important “quirk” with the Excel function

13b.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember to refer to Excel spreadsheet
PI: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.

Project Evaluation

The Profitability Index (PI) function does not exist in

Excel, but we can use a simple calculation using the NPV answer
or a second method directly using the NPV function.
• We can simply use the NPV earlier ($K$34) and divide by the ICO (-$L$24)
and add this to 1.00 – [Method #1]
• Second, we use the NPV formula and calculate the present value of cash
flows in periods 1 through 4 discounted at the $K$31 discount rate. This value
we simply divide by the ICO of -$L$24 – [Method #2]

13b.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember to refer to Excel spreadsheet
PBP: ‘VW13E-13b.xlsx’ and the ‘New Asset’ tab.

Project Evaluation

The Payback Period (PBP) function does not exist in

Excel either, but this complicated formula is one way to write a set of if
functions to determine PBP.
• The IF statements attempt to find when the cumulative cash flows change from a
negative sign to a positive sign.
• Once that occurs, we know the core number of years and we can then calculate the
portion of the next year to get payback
• To make this work for a longer project life, you need to add additional imbedded if
statements

13b.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Asset Replacement?
• Now go back to Chapter 12 and the cash
flows we developed for the ‘Asset
Replacement’ project and calculate the PBP,
IRR, NPV and PI.
• Hint: The answers are shown in ‘VW13E-
13b.xlsx’ file on the ‘Asset Replacement’ tab.
• Given are assumptions, would you want to
replace the project? Why or why not?

13b.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Potential Problems
Under Mutual Exclusivity

Ranking of project proposals may

create contradictory results.

A. Scale of Investment
B. Cash-flow Pattern
C. Project Life

13b.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
A. Scale Differences
Compare a small (S) and a
large (L) project.

NET CASH FLOWS

END OF YEAR Project S Project L
0 –$100 –$100,000
1 0 0
2 $400 $156,250
13b.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember to refer to Excel spreadsheet
‘VW13E-13b.xlsx’ and the ‘Scale’ tab.

A. Scale Differences

Refer to VW13E-13b.xlsx on the ‘Scale’ tab.

13b.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 A. Scale Differences
• Remember that we evaluate the projects
based on maximizing shareholder wealth
• So we choose the ‘Large’ project even
though the other evaluation methods seem
better!
• In Excel, we can use the functions or
alternatively ‘Data Tables’ to create the
chart on the previous slide which allows us
to easily graph the NPV Profiles.

13b.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
B. Cash Flow Pattern
Let us compare a decreasing cash-flow (D)
project and an increasing cash-flow (I) project.

NET CASH FLOWS

END OF YEAR Project D Project I
0 –$1,200 –$1,200
1 1,000 100
2 500 600
3 100 1,080
13b.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember to refer to Excel spreadsheet
‘VW13E-13b.xlsx’ and the ‘Pattern’ tab.

B. Cash Flow Pattern

Refer to VW13E-13b.xlsx on the ‘Pattern’ tab.

13b.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 B. Cash Flow Pattern
• Remember that we evaluate the projects based on
maximizing shareholder wealth, but in this case they have
essentially the SAME NPVs.
• So we evaluate the uncertainty … to the left of the
intersection the increasing CF pattern is best and to the
right it is decreasing
• Both are acceptable projects, but if we must choose only
one, the “decreasing” pattern might be better
• It generates cash quicker which has less risk
• It has a positive NPV as long as the discount rate is less
than about 23%
• Again, we can use the functions or ‘Data Tables’ to create
the chart on the previous slide.
13b.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
C. Project Life Differences
Let us compare a long life (X) project
and a short life (Y) project.

NET CASH FLOWS

END OF YEAR Project X Project Y
0 –$1,000 –$1,000
1 0 2,000
2 0 0
3 3,375 0
13b.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember to refer to Excel spreadsheet
‘VW13E-13b.xlsx’ and the ‘Life’ tab.

C. Project Life Differences

13b.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 B. Cash Flow Pattern
(NOT renewing project)
• Remember that we evaluate the projects based on
maximizing shareholder wealth, but in this case we have an
overriding question – what happens at the end of the first
year if we choose project “Y”?
• We do indeed choose Project “X” (see previous slide)
because the NPV is greatest if, and only if, this is a project
that won’t be repeated or renewed. With the discount rates
we used, X is superior to Y in every scenario shown.
• If this project is repeated, then we need to re-evaluate the
cash flows as follows.
• Again, we can use the functions or ‘Data Tables’ to create
the chart on the previous slide.

13b.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember to refer to Excel spreadsheet
‘VW13E-13b.xlsx’ and the ‘Life2’ tab.

C. Project Life Differences

13b.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 B. Cash Flow Pattern
(NOT renewing project)
• Notice on the previous slide that we created the repeated
cash flows for the project assuming no change in cash
flows.
• We are still evaluating projects based on maximizing
shareholder wealth.
• We now choose Project “Y” (see previous slide) because the
NPV is greatest!
• In fact, Y is greatly superior to X in all of the scenarios
shown.
• Again, we can use the functions or ‘Data Tables’ to create
the chart on the previous slide.

13b.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for this
capital budgeting period.
13b.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Capital Rationing
We can use the “Solver” Add-in for Excel to find the
optimal mix EASILY!!! First make sure you have it
available on your computer by:
• Click the round Microsoft Office button (upper left corner of
screen) when Excel is open, click “Excel Options” at the
bottom, and then click the “Add-ins” category on the left side.
• In the “Manage” box at the bottom, choose “Excel Add-ins”,
and then click the “Go” button.
• In the pop-up box of Add-ins available, check the “Solver
Add-in” box, and then click OK.

13b.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Available Projects for BW
Project ICO IRR NPV PI
A $ 500 18% $ 50 1.10
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
E 12,500 26 500 1.04
F 15,000 28 21,000 2.40
G 17,500 19 7,500 1.43
H 25,000 15 6,000 1.24
13b.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Rationing
• We are going to use this data that can be found in VW13E-13b.xlsx
or you can enter the data yourself.
• Your data should look something like below in the yellow section.
• The “Yes/No” box is a binary variable that determines if we want to
keep that project as being optimal.

13b.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Rationing
• Let us open
Solver. Click
on the ‘Data’
tab and then in
the ‘Analysis’
ribbon choose
‘Solver’.
• The box
should open
like the
following
example:

13b.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Rationing
• “Set Target
Cell” equal to
the box that
sums the NPVs
and click on the
“Max” option
• In the “By
Changing
Cells” area, set
it to the binary
‘Yes / No’
values (F3:F10
in this case)

13b.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Rationing
• Now we need to
add our
constraints.
• We want the
values of
F3:F10 to be
ONLY a “0” or a
“1” value
• We want G11,
sum of the ICOs
to be $32,500 or
less

13b.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Rationing
Now we solve by clicking the ‘SOLVE’ button! Look, only projects
B, C, D and F are chosen!!

If you look at the Excel

formulas for columns
‘G’ and ‘H’ you will see
that the values are set
to the “Yes/No”
variable value (either 0
or 1) multiplied by the
original value in
columns ‘C’ and ‘E’.
This is a nifty way to
find the optimal
decision!
13b.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.