Im 10

The BasicsChapter
of Capital
10 Budgeting
LEARNING OBJECTIVES
After reading this chapter, students should be able to:
Define capital budgeting, explain why it is important, and state how

project proposals are generally classified.
List the steps involved in evaluating a capital budgeting project.
Calculate payback period, discounted payback period, Net Present Value

(NPV), and Internal Rate of Return (IRR) for a given project and
evaluate each method.
Define NPV profiles, and explain the rationale behind the NPV and IRR
methods, their reinvestment rate assumptions, and which method is
better when evaluating independent versus mutually exclusive projects.
Briefly explain the problem of multiple IRRs and when this situation
could occur.
Calculate the Modified Internal

project and evaluate this method.
Identify at least one relevant piece of information provided to

decision makers for each capital budgeting decision method discussed in
the chapter.
Identify and explain the purposes of the post-audit in the capital

budgeting process.
Identify a number of different types of decisions that use the capital

budgeting techniques developed in this chapter.
Rate
of
Return
(MIRR)
for
given
Learning Objectives: 10 - 1
LECTURE SUGGESTIONS
This is a relatively straight-forward chapter, and, for the most part, it is

a direct application of the time value concepts first discussed in Chapter 6.
We point out that capital budgeting is to a company what buying stocks or
bonds is to an individual--an investment decision, when the company wants to
know if the expected value of the cash flows is greater than the cost of the
project, and whether or not the expected rate of return on the project
exceeds the cost of the funds required to take on the project. We cover the
standard capital budgeting procedures--payback, discounted payback, NPV, IRR,
and MIRR.
At this point, students who have not yet mastered time value concepts
and how to use their calculator efficiently get another chance to catch on.
Students who have mastered those tools and concepts have fun, because they
can see what is happening and the usefulness of what they are learning.
The details of what we cover, and the way we cover it, can be seen by
scanning Blueprints, Chapter 10.
For other suggestions about the lecture,
please see the Lecture Suggestions in Chapter 2, where we describe how we
conduct our classes.
DAYS ON CHAPTER:
3 OF 58 DAYS (50-minute periods)
Lecture Suggestions: 10 - 2
ANSWERS TO END-OF-CHAPTER QUESTIONS
10-1
Project classification schemes can be used to indicate how much

analysis is required to evaluate a given project, the level of the
executive who must approve the project, and the cost of capital that
should be used to calculate the projects NPV.
Thus, classification
schemes can increase the efficiency of the capital budgeting process.
10-2
The NPV is obtained by discounting future cash flows, and the

discounting process actually compounds the interest rate over time.
Thus, an increase in the discount rate has a much greater impact on a
cash flow in Year 5 than on a cash flow in Year 1.
10-3
This question is related to Question 10-2 and the same rationale

applies. With regard to the second part of the question, the answer is
no; the IRR rankings are constant and independent of the firms cost of
capital.
10-4
The NPV and IRR methods both involve compound interest, and the
mathematics of discounting requires an assumption about reinvestment
rates.
The NPV method assumes reinvestment at the cost of capital,
while the IRR method assumes reinvestment at the IRR.
MIRR is a
modified version of IRR that assumes reinvestment at the cost of
capital.
10-5
The statement is true.

The NPV and IRR methods result in conflicts
only if mutually exclusive projects are being considered since the NPV
is positive if and only if the IRR is greater than the cost of capital.
If the assumptions were changed so that the firm had mutually exclusive
projects, then the IRR and NPV methods could lead to different
conclusions.
A change in the cost of capital or in the cash flow
streams would not lead to conflicts if the projects were independent.
Therefore, the IRR method can be used in lieu of the NPV if the
projects being considered are independent.
10-6
Yes, if the cash position of the firm is poor and if it has limited
access to additional outside financing it might be better off to choose
a machine with a rapid payback.
But even here, the relationship
between present value and cost would be a better decision tool.
10-7
a. In general, the answer is no. The objective of management should be

to maximize value, and as we point out in subsequent chapters, stock
values are determined by both earnings and growth.
The NPV
calculation automatically takes this into account, and if the NPV of
a long-term project exceeds that of a short-term project, the higher
future growth from the long-term project must be more than enough to
compensate for the lower earnings in early years.
Answers and Solutions: 10 - 3
b. If the same $100 million had been spent on a short-term project--one

with a faster payback--reported profits would have been higher for a
period of years.
This is, of course, another reason why firms
sometimes use the payback method.
10-8
Mutually exclusive projects are a set of projects in which only one of

the projects can be accepted.
For example, the installation of a
conveyor-belt system in a warehouse and the purchase of a fleet of
forklifts for the same warehouse would be mutually exclusive projects-accepting one implies rejection of the other.
When choosing between
mutually exclusive projects, managers should rank the projects based on
the NPV decision rule. The mutually exclusive project with the highest
positive NPV should be chosen.
The NPV decision rule properly ranks
the projects because it assumes the appropriate reinvestment rate is
the cost of capital.
10-9
Project X should be chosen over Project Y. Since the two projects are
mutually exclusive, only one project can be accepted.
The decision
rule that should be used is NPV. Since Project X has the higher NPV,
it should be chosen.
The cost of capital used in the NPV analysis
appropriately includes risk.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
10-1
$52,125/$12,000 = 4.3438, so the payback is about 4 years.
10-2
Financial Calculator Solution:

Input CF0 = -52125, CF1-8 = 12000, I =
12, and then solve for NPV = $7,486.68.
10-3
Financial Calculator Solution:

then solve for IRR = 16%.
10-4
Project Ks discounted payback period is calculated as follows:

Period
0
1
2
3
4
5
6
7
8
Input CF0 = -52125, CF1-8 = 12000, and
Annual
Cash Flows
($52,125)
12,000
12,000
12,000
12,000
12,000
12,000
12,000
12,000
Discounted @12%
Cash Flows
($52,125.00)
10,714.29
9,566.33
8,541.36
7,626.22
6,809.12
6,079.57
5,428.19
4,846.60
The discounted payback period is 6 +
Cumulative
($52,125.00)
(41,410.71)
(31,844.38)
(23,303.02)
(15,676.80)
(8,867.68)
(2,788.11)
2,640.08
7,486.68
$2,788.11
years, or 6.51 years.
$5,428.19
Alternatively, since the annual cash flows are the same, one can divide
$12,000 by 1.12 (the discount rate = 12%) to arrive at CF 1 and then
continue to divide by 1.12 seven more times to obtain the discounted
cash flows (Column 3 values). The remainder of the analysis would be
the same.
10-5
MIRR:
PV Costs = $52,125.
FV Inflows:
PV
0
1
12%
|
|
12,000
2
|
12,000
3
|
12,000
4
|
12,000
5
|
12,000
6
|
12,000
(1.12)2
(1.12)
(1.12)4
(1.12)5
(1.12)
7
|
12,000
1.12
FV
8
|
12,000
13,440
15,053
16,859
18,882
21,148
23,686
26,528
MIRR
=
(1.12)7
52,125
147,596
Financial Calculator Solution: Obtain the FVA by inputting N = 8, I =
12, PV = 0, PMT = 12000, and then solve for FV = $147,596. The MIRR
can be obtained by inputting N = 8, PV = -52125, PMT = 0, FV = 147596,
and then solving for I = 13.89%.
13.89%
10-6
Project A:
Using a financial calculator, enter the following:
CF0
CF1
CF2
CF3
= -15000000
=
5000000
= 10000000
= 20000000
I = 10; NPV = $12,836,213.

Change I = 10 to I = 5; NPV = $16,108,952.
Change I = 5 to I = 15; NPV = $10,059,587.
Project B:
Using a financial calculator, enter the following:
CF0
CF1
CF2
CF3
= -15000000
= 20000000
= 10000000
=
6000000
I = 10; NPV = $15,954,170.

Change I = 10 to I = 5; NPV = $18,300,939.
Change I = 5 to I = 15; NPV = $13,897,838.
10-7
Truck:
Financial Calculator Solution: Input CF0 = -17100, CF1-5 = 5100, I = 14,
and then solve for NPV = $408.71 $409 and IRR = 1499% 15%.
MIRR:
PV Costs = $17,100.
FV Inflows:
PV
0 14%
|
1
|
5,100
2
|
5,100
3
|
5,100
4
|
5,100
1.14
(1.14)2
FV
5
|
5,100
5,814
6,628
7,556
8,614
17,100
MIRR = 14.54% (Accept)
33,712
14, PV = 0, PMT = 5100, and then solve for FV = $33,712. The MIRR can
be obtained by inputting N = 5, PV = -17100, PMT = 0, FV = 33712, and
then solving for I = MIRR = 14.54%.
(1.14)3
(1.14)4
Pulley:
Financial Calculator Solution: Input CF0 = -22430, CF1-5 = 7500, I = 14,
and then solve for NPV = $3,318.11 $3,318 and IRR = 20%.
MIRR:
PV Costs = $22,430.
FV Inflows:
PV
0
14%
|
1
|
7,500
2
|
7,500
3
|
7,500
(1.14)2
4
|
7,500
1.14
(1.14)
(1.14)4
22,430
MIRR = 17.19% (Accept)
FV
5
|
7,500
8,550
9,747
11,112
12,667
49,576

14, PV = 0, PMT = 7500, and then solve for FV = $49,576. The MIRR can
be obtained by inputting N = 5, PV = -22430, PMT = 0, FV = 49576, and
then solving for I = 17.19%.
10-8
Using a financial calculator:

NPVS = $448.86; NPVL = $607.20.
IRRS = 15.24%; IRRL = 14.67%.
MIRR:
PV costsS = $15,000.
FV inflowsS = $29,745.47.
MIRRS = 14.67%.
PV costsL = $37,500.
FV inflowsL = $73,372.16.
MIRRL = 14.37%.
Thus, NPVL > NPVS, IRRS > IRRL, and MIRRS > MIRRL. The scale difference
between Projects S and L results in IRR and MIRR selecting S over L.
However, NPV favors Project L, and hence Project L should be chosen.
10-9
a. The IRRs of the two alternatives are undefined.

To calculate an
IRR, the cash flow stream must include both cash inflows and
outflows.
b. The PV of costs for the conveyor system is -$556,717, while the PV
of costs for the forklift system is -$493,407.
Thus, the forklift
system is expected to be -$493,407 - (-$556,717) = $63,310 less
costly than the conveyor system, and hence the forklifts should be
used.
10-10 Project X:
0 12%
|
-1,000
1
|
100
2
|
300
3
|
400
1.12
(1.12)2
(1.12)3
1,000
13.59% = MIRRX
4
|
700.00
448.00
376.32
140.49
1,664.81
$1,000 = $1,664.81/(1 + MIRRX)4.

Project Y:
0 12%
|
-1,000
1
|
1,000
2
|
100
3
|
50
1.12
(1.12)2
(1.12)3
1,000
13.10% = MIRRY
4
|
50.00
56.00
125.44
1,404.93
1,636.37
$1,000 = $1,636.37/(1 + MIRRY)4.

Thus, since MIRRX > MIRRY, Project X should be chosen.
Alternate step: You could calculate NPVs, see that Project X has the
higher NPV, and just calculate MIRRX.
NPVX = $58.02 and NPVY = $39.94.
10-11 Input the appropriate cash flows into the cash flow register, and then
calculate NPV at 10 percent and the IRR of each of the projects:
Project S:
NPVS = $39.14; IRRS = 13.49%.
Project L:
NPVL = $53.55; IRRL = 11.74%.
Since Project
IRRL = 11.74%.
10-12 Step 1:
has
the
Determine the PMT:
higher
NPV,
it
is
the
better
project.
0 12%
|
-1,000
1
|
PMT
10
|
PMT
With a financial calculator, input N = 10, I = 12, PV = -1000,

and FV = 0 to obtain PMT = $176.98.
Step 2:
Calculate the projects MIRR:

0 10%
1
|
|
-1,000 176.98
2
|
176.98
9
|
176.98
1.10
(1.10)8
(1.10)9
1,000
10
|
176.98
194.68
.
.
.
379.37
417.31
10.93% = MIRR
FV of inflows: With a financial calculator, input N = 10, I =

10, PV = 0, and PMT = -176.98 to obtain FV = $2,820.61. Then
input
N = 10, PV = -1000, PMT = 0, and FV = 2820.61 to obtain
I = MIRR = 10.93%.
10-13 a. Purchase price
Installation
Initial outlay
900,000
165,000
$1,065,000
CF0 = -1065000; CF1-5 = 350000; I = 14; NPV = ?

NPV = $136,578; IRR = 19.22%.
b. Ignoring environmental concerns, the project should be undertaken
because its NPV is positive and its IRR is greater than the firms
cost of capital.
c. Environmental effects could be added by estimating penalties or any
other cash outflows that might be imposed on the firm to help return
the land to its previous state (if possible). These outflows could
be so large as to cause the project to have a negative NPV, in which
case the project should not be undertaken.
10-14 a. Year
0
1
2
3
Sales
($20,000)
75,000
52,500
22,500
Royalties
Marketing
($5,000)
(3,500)
(1,500)
($10,000)
(10,000)
Net
($20,000)
60,000
39,000
21,000
Payback period = $20,000/$60,000 = 0.33 year.

NPV = $60,000/(1.11)1 + $39,000/(1.11)2 + $21,000/(1.11)3 - $20,000
= $81,062.35.
Using a financial calculator, input CF0 = -20000; CF1 = 60000, CF2 =
39000, CF3 = 21000, and then solve for IRR = 261.90%.
b. Finance theory dictates that this investment should be accepted.
However, ask your students Does this service encourage cheating?
If yes, does a businessperson have a social responsibility not to
make this service available?
10-15 Facts:
5 years remaining on lease; rent = $2,000/month; 60 payments
left, payment at end of month.
New lease terms:
$0/month for 9 months; $2,600/month for 51 months.
Cost of capital = 12% annual (1% per month).

a. 0 1%
|
1
|
-2,000
2
|
-2,000
PV cost of old lease:

PV = -$89,910.08.
0 1%
|
1
|
0
PV cost of new lease:

= -$94,611.45.
59
|
-2,000
60
|
-2,000
N = 60; I = 1; PMT = -2000; FV = 0; PV = ?

9
|
0
10
|
-2,600
59
|
-2,600
60
|
-2,600
CF0 = 0, CF1-9 = 0; CF10-60 = -2600; I = 1.
NPV
Sharon should not accept the new lease because the present value of
its cost is $94,611.45 - $89,910.08 = $4,701.37 greater than the old
lease.
b. 0 1%
|
1
|
-2,000
2
|
-2,000
9
|
-2,000
10
|
PMT
59
|
PMT
60
|
PMT
FV of first 9 months rent under old lease:

N = 9; I = 1; PV = 0; PMT = -2000; FV = ?
FV = $18,737.05.
The FV of the first 9 months rent is equivalent to the PV of the

51-period annuity whose payments represent the incremental rent
during months 10-60. To find this value:
N = 51; I = 1; PV = -18737.05; FV = 0; PMT = ?
PMT = $470.80.
Thus, the new lease payment that will make her indifferent is $2,000
+ $470.80 = $2,470.80.
Check:
0 1%
|
1
|
0
9
|
0
PV cost of new lease:
10
|
-2,470.80
59
|
-2,470.80
60
|
-2,470.80
CF 0 = 0; CF1 - 9 = 0; CF10 - 60 = -2470.80; I = 1.
NPV = -$89,909.99.
Except for rounding; the PV cost of this lease equals the PV cost of
the old lease.
c. Period
Old Lease
New Lease
Lease
0
0
0
0
1-9
-2,000
0
-2,000
10-60
-2,000
-2,600
600
CF0 = 0; CF1-9 = -2000; CF10-60 = 600; IRR = ? IRR = 1.9113%. This is
the periodic rate. To obtain the nominal cost of capital, multiply
by 12: 12(0.019113) = 22.94%.
Check:
Old lease terms:
N = 60; I = 1.9113; PMT = -2000; FV = 0; PV = ?
PV = -$71,039.17.
New lease terms:

CF0 = 0; CF1-9 = 0; CF10-60 = -2600; I = 1.9113; NPV = ? NPV = $71,038.98.
Except for rounding differences; the costs are the same.
10-16 a. The payback periods for Projects A and B are calculated as follows:
Period
(B)
0
1
2
3
4
5
Project A
Cash flows
Cumulative (A)
Project B
Cash flows
($400)
55
55
55
225
225
($400)
(345)
(290)
(235)
(10)
215
($600)
300
300
50
50
50
Cumulative
($600)
(300)
0
50
100
150
Project A's payback is 4 + $10/$225 = 4.04 years, while Project B's

payback is 2 years. According to the payback rule, Project B would
be preferred to Project A.
b. The discounted payback periods for Projects A and B are calculated
as follows:
Disc. @ 10%
Disc. @ 10%
Project A
Project B
Period
(B)
0
1
2
3
4
5
Cash flows
Cumulative (A)
Cash flows
($400.00)
50.00
45.45
41.32
153.68
139.71
($400.00)
(350.00)
(304.55)
(263.22)
(109.55)
30.16
($600.00)
272.73
247.93
37.57
34.15
31.05
Cumulative
($600.00)
(327.27)
(79.34)
(41.77)
(7.62)
23.42
Project A's payback is 4 + $109.55/$139.71 = 4.78 years, meanwhile

Project B's payback is 4 + $7.62/$31.05 = 4.245 years. According to
the discounted payback rule, Project B would be preferred to Project
A.
c. Finding net present values, use a financial calculator and enter the
following data:
Project A
CF0 = -400
CF1 =
55
CF2 =
55
CF3 =
55
CF4 = 225
CF5 = 225
Project B
CF0 = -600
CF1 = 300
CF2 = 300
CF3 =
50
CF4 =
50
CF5 =
50
I = 10
NPV = $30.16
I = 10
NPV = $23.42
By the NPV criterion, Project A is preferred to Project B.

d. Finding the IRR, use a financial calculator and enter the following:
Project A
CF0 = -400
CF1 =
55
CF2 =
55
CF3 =
55
CF4 = 225
CF5 = 225
Project B
CF0 = -600
CF1 = 300
CF2 = 300
CF3 =
50
CF4 =
50
CF5 =
50
IRR = 12.21%
IRR = 12.28%
According to the IRR criterion, Project B is preferred to Project A.

e. Project
0 10%
|
-400
A:
1
|
55
2
|
55
3
|
55
4
|
225
1.10
5
|
225
247.50
66.55
73.21
80.53
692.78
4
|
50
1.10
5
|
50
55.00
60.50
399.30
439.23
1,004.03
(1.10)2
(1.10)
(1.10)4
$400 = $692.78/(1 + MIRRA )5

MIRRA = 11.61%.
Project
0 10%
|
-600
B:
1
|
300
2
|
300
3
|
50
(1.10)2
(1.10)3
(1.10)4
$600 = $1,004.03/(1 + MIRRA )5

MIRRA = 10.85%.
According to the MIRR criterion, Project A is the superior project.

10-17 Since the IRR is the cost of capital at which the NPV of a project
equals zero, the projects inflows can be evaluated at the IRR and the
present value of these inflows must equal the initial investment.
Using a financial calculator enter the following:
CF0 = 0
CF1 = 7500
Nj = 10
CF1 = 10000
Nj = 10
I = 10.98; NPV = $65,002.11.
Therefore, the initial investment for this project is
Using a calculator, the project's NPV can now be solved.
$65,002.11.
CF0 = -65002.11
CF1 = 7500
Nj = 10
CF1 = 10000
Nj = 10
I = 9; NPV = $10,239.20.
10-18 The MIRR can be solved with a financial calculator by finding the
terminal future value of the cash inflows and the initial present value
of cash outflows, and solving for the discount rate that equates these
two values. In this instance, the MIRR is given, but a cash outflow is
missing and must be solved for.
Therefore, if the terminal future
value of the cash inflows is found, it can be entered into a financial
calculator, along with the number of years the project lasts and the
MIRR, to solve for the initial present value of the cash outflows. One
of these cash outflows occurs in Year 0 and the remaining value must be
the present value of the missing cash outflow in Year 2.
Cash inflows
CF1 = 202
CF3 = 196
CF4 = 350
CF5 = 451
Compounding Rate
(1.10)4
(1.10)2
1.10
1.00
FV in Year 5 @ 10%
295.75
237.16
385.00
451.00
1368.91
Using the financial calculator to solve for the present value of cash
outflows:
N = 5
I = 14.14
PV = ?
PMT = 0
FV = 1368.91
The total present value of cash outflows is $706.62, and since the outflow
for Year 0 is $500, the present value of the Year 2 cash outflow is
$206.62. Therefore, the missing cash outflow for Year 2 is $206.62 (1.1)2
= $250.01.
10-19 a. At k = 12%, Project A has the greater NPV, specifically $200.41 as
compared to Project Bs NPV of $145.93.
Thus, Project A would be
selected.
At k = 18%, Project B has an NPV of $63.68 which is
higher than Project As NPV of $2.66. Thus, choose Project B if k =
18%.
b.
NPV
($)
1,0 00
90 0
80 0
70 0
60 0
50 0
Project A
40 0
30 0
20 0
10 0
-1 00
Pro ject B
Co st of
Ca pital (%)
10
15
20
25
30
-2 00
-3 00
k
0.0%
10.0
12.0
18.1
20.0
24.0
30.0
NPVA
$890
283
200
0
(49)
(138)
(238)
NPVB
$399
179
146
62
41
0
(51)
c. IRRA = 18.1%; IRRB = 24.0%.

d. To find the crossover rate, construct a Project
difference in the two projects cash flows:
Year
0
1
2
3
4
5
6
7
which is the
Project =
CFA - CFB
$ 105
(521)
(327)
(234)
466
466
716
(180)
IRR = Crossover rate = 14.53%.

Projects A and B are mutually exclusive, thus, only one of the

projects can be chosen. As long as the cost of capital is greater
than the crossover rate, both the NPV and IRR methods will lead to
the same project selection. However, if the cost of capital is less
than the crossover rate the two methods lead to different project
selections--a conflict exists.
When a conflict exists the NPV
method must be used.
Because of the sign changes and the size of the cash flows, Project
has multiple IRRs. Thus, a calculators IRR function will not work.
One could use the trial and error method of entering different discount
rates until NPV = $0. However, an HP can be tricked into giving the
roots. After you have keyed Project Deltas cash flows into the cash
flow registers of an HP-10B, you will see an Error-Soln message. Now
enter 10 STO IRR/YR and the 14.53 percent IRR is found. Then
enter 100 STO IRR/YR to obtain IRR = 456.22%. Similarly, Excel
can also be used.
e. Here is the MIRR for Project A when k = 12%:
PV costs = $300 + $387/(1.12)1 + $193/(1.12)2
+ $100/(1.12)3 + $180/(1.12)7 = $952.00.
TV inflows = $600(1.12)3 + $600(1.12)2 + $850(1.12)1 = $2,547.60.
Now, MIRR is that discount rate which forces the TV of $2,547.60 in
7 years to equal $952.00.
Using a financial calculator enter the following inputs: N = 7, PV
=
-952, PMT = 0, and FV = 2547.60. Then solve for I = MIRRA = 15.10%.
Similarly, MIRRB = 17.03%.
At k = 18%,
MIRRA = 18.05%.
MIRRB = 20.49%.
10-20 a.
NPV
(Million s of Do llars)
30
Plan B
24
18
12
Crossover Rate = 16.07%

Plan A
IR R A = 20%
2.4
k (%)
0
10
15
IR RB = 16.7%
20
25
The crossover rate is approximately 16 percent.

If the cost of
capital is less than the crossover rate, then Plan B should be
accepted; if the cost of capital is greater than the crossover rate,
then Plan A is preferred. At the crossover rate, the two projects
NPVs are equal. Thus, other criteria such as the IRR must be used to
evaluate the projects.
The exact crossover rate is calculated as
16.07 percent, the IRR of Project , the difference between the cash
flow streams of the two projects.
b. Yes. Assuming (1) equal risk among projects, and (2) that the cost
of capital is a constant and does not vary with the amount of
capital raised, the firm would take on all available projects with
returns greater than its 12 percent cost of capital.
If the firm
had invested in all available projects with returns greater than 12
percent, then its best alternative would be to repay capital. Thus,
the cost of capital is the correct reinvestment rate for evaluating
a projects cash flows.
10-21 a. Using a financial calculator, we get:
NPVA = $14,486,808.
IRRA = 15.03%.
NPVB = $11,156,893.
IRRB = 22.26%.
b.
NPV
(Millions of Dollars)
80
60
40
20
0
-10
IRRS = 22.26%
10
15
20
25
k (%)
IRRA = 15.03%
The crossover rate is somewhere between 11 percent and 12 percent.

The exact crossover rate is calculated as 11.7 percent, the IRR of
Project , which represents the differences between the cash flow
streams of the two projects.
c. The NPV method implicitly assumes that the opportunity exists to
reinvest the cash flows generated by a project at the cost of
capital, while use of the IRR method implies the opportunity to
reinvest at the IRR.
The firm will invest in all independent
projects with an NPV > $0.

As cash flows come in from these
projects, the firm will either pay them out to investors, or use
them as a substitute for outside capital which, in this case, costs
10 percent. Thus, since these cash flows are expected to save the
firm 10 percent, this is their opportunity cost reinvestment rate.
The IRR method assumes reinvestment at the internal rate of
return itself, which is an incorrect assumption, given a constant
expected future cost of capital, and ready access to capital markets.
10-22 a. The projects expected cash flows are as follows (in millions of
dollars):
Time
0
1
2
Net Cash Flow

($ 2.0)
13.0
(12.0)
We can construct the following NPV profile:
NPV
(Million s of Do llars)
1.5
1.0
0.5
0
-0.5
-1.0
10 0
0%
10
50
80
100
200
300
400
410
420
430
450
20 0
30 0
40 0
50 0
k (%)
NPV
($1,000,000)
(99,174)
1,333,333
1,518,519
1,500,000
1,000,000
500,000
120,000
87,659
56,213
25,632
(33,058)
b. If k = 10%, reject the project since NPV < $0. Its NPV at k = 10%
is equal to -$99,174. But if k = 20%, accept the project because NPV
> $0. Its NPV at k = 20% is $500,000.
c. Other possible projects with multiple rates of return could

nuclear power plants where disposal of radioactive wastes
required at the end of the projects life.
be
is
d. MIRR @ k = 10%:
PV costs = $2,000,000 + $12,000,000/(1.10)2 = $11,917,355.
FV inflows = $13,000,000 1.10 = $14,300,000.
MIRR = 9.54%. (Reject the project since MIRR < k.)
MIRR @ k = 20%:
PV costs = $2,000,000 + $12,000,000/(1.20)2 = $10,333,333.
FV inflows = $13,000,000 1.20 = $15,600,000.
MIRR = 22.87%. (Accept the project since MIRR > k.)
Looking at the results, this projects MIRR calculations lead to the
same decisions as the NPV calculations.
However, the MIRR method
will not always lead to the same accept/reject decision as the NPV
method. Decisions in which two mutually exclusive projects are
involved and differ in scale (size), MIRR can conflict with NPV. In
those situations, the NPV method should be used.
10-23 a. Payback A (cash flows in thousands):
Period
0
1
2
3
4
Annual
Cash Flows
($25,000)
5,000
10,000
15,000
20,000
Cumulative
($25,000)
(20,000)
(10,000)
5,000
25,000
PaybackA = 2 + $10,000/$15,000 = 2.67 years.

Payback B (cash flows in thousands):
Period
0
1
2
3
4
Annual
Cash Flows
($25,000)
20,000
10,000
8,000
6,000
Cumulative
($25,000)
(5,000)
5,000
13,000
19,000
PaybackB = 1 + $5,000/$10,000 = 1.50 years.

b. Discounted payback A (cash flows in thousands):
Period
0
1
2
3
4
Annual
Cash Flows
($25,000)
5,000
10,000
15,000
20,000
Discounted @10%
Cash Flows
($25,000.00)
4,545.45
8,264.46
11,269.72
13,660.27
Cumulative
($25,000.00)
(20,454.55)
(12,190.09)
(920.37)
12,739.90
Discounted PaybackA = 3 + $920.37/$13,660.27 = 3.07 years.

Discounted payback B (cash flows in thousands):
Period
0
1
2
3
4
Annual
Cash Flows
($25,000)
20,000
10,000
8,000
6,000
Discounted @10%
Cash Flows
($25,000.00)
18,181.82
8,264.46
6,010.52
4,098.08
Cumulative
($25,000.00)
(6,818.18)
1,446.28
7,456.80
11,554.88
Discounted PaybackB = 1 + $6,818.18/$8,264.46 = 1.825 years.

c. NPVA = $12,739,908; IRRA = 27.27%.
NPVB = $11,554,880; IRRB = 36.15%.
Both projects
undertaken.
have
positive
NPVs,
so
both
projects
should
be
d. At a discount rate of 5 percent, NPVA = $18,243,813.

At a discount rate of 5 percent, NPVB = $14,964,829.
At a discount rate of 5 percent, Project A has the higher NPV;
consequently, it should be accepted.
e. At a discount rate of 15 percent, NPVA = $8,207,071.
At a discount rate of 15 percent, NPVB = $8,643,390.
At a discount rate of 15 percent, Project B has the higher NPV;
consequently, it should be accepted.
f.
Year
Project =
CFA - CFB
1
2
3
4
(15)
0
7
14
$ 0
IRR = Crossover rate = 13.5254% 13.53%.

g. Use 3 steps to calculate MIRRA @ k = 10%:
Step 1:
Calculate the NPV of the uneven cash flow stream, so its FV

can then be calculated. With a financial calculator, enter
the cash flow stream into the cash flow registers, then
enter I = 10, and solve for NPV = $37,739,908.
Step 2:
Calculate the FV of the cash flow stream as follows:

Enter N = 4, I = 10, PV = -37739908, and PMT = 0 to solve
for FV = $55,255,000.
Step 3:
Calculate MIRRA as follows:

Enter N = 4, PV = -25000000, PMT = 0, and FV = 55255000 to
solve for I = 21.93%.
Use 3 steps to calculate MIRRB @ k = 10%:

Step 1:
Calculate the NPV of the uneven cash flow stream, so its FV

can then be calculated. With a financial calculator, enter
the cash flow stream into the cash flow registers, then
enter I = 10, and solve for NPV = $36,554,880.
Step 2:
Calculate the FV of the cash flow stream as follows:

Enter N = 4, I = 10, PV = -36554880, and PMT = 0 to solve
for FV = $53,520,000.
Step 3:
Calculate MIRRB as follows:

Enter N = 4, PV = -25000000, PMT = 0, and FV = 53520000 to
solve for I = 20.96%.
According to the MIRR approach, if the 2 projects were mutually

exclusive, Project A would be chosen because it has the higher MIRR.
This is consistent with the NPV approach. Note: Because these two
projects are equal in size, we dont need to worry about a conflict
between the MIRR and NPV decisions.
SPREADSHEET PROBLEM
10-24 The detailed solution for the spreadsheet problem is available both on the
instructors resource CD-ROM and on the instructors side of South-Westerns
web site, http://brigham.swlearning.com.
Spreadsheet Problem: 10 - 23
INTEGRATED CASE
Allied Components Company

Basics of Capital Budgeting
10-25
ASSUME THAT YOU RECENTLY WENT TO WORK FOR ALLIED COMPONENTS COMPANY,
A
SUPPLIER
OF
AUTO
REPAIR
PARTS
USED
IN
THE
AFTER-MARKET
WITH
PRODUCTS FROM DAIMLER CHRYSLER, FORD, AND OTHER AUTO MAKERS. YOUR
BOSS, THE CHIEF FINANCIAL OFFICER (CFO), HAS JUST HANDED YOU THE
ESTIMATED CASH FLOWS FOR TWO PROPOSED PROJECTS. PROJECT L INVOLVES
ADDING A NEW ITEM TO THE FIRMS IGNITION SYSTEM LINE; IT WOULD TAKE
SOME TIME TO BUILD UP THE MARKET FOR THIS PRODUCT, SO THE CASH
INFLOWS WOULD INCREASE OVER TIME. PROJECT S INVOLVES AN ADD-ON TO AN
EXISTING LINE, AND ITS CASH FLOWS WOULD DECREASE OVER TIME. BOTH
PROJECTS HAVE 3-YEAR LIVES, BECAUSE ALLIED IS PLANNING TO INTRODUCE
ENTIRELY
NEW
MODELS
AFTER
3 YEARS.
HERE ARE THE PROJECTS NET CASH FLOWS (IN THOUSANDS OF DOLLARS):
YEAR
0
1
2
3
EXPECTED NET CASH FLOWS

PROJECT L
PROJECT S
($100)
($100)
10
70
60
50
80
20
DEPRECIATION, SALVAGE VALUES, NET OPERATING WORKING CAPITAL REQUIREMENTS, AND TAX EFFECTS ARE ALL INCLUDED IN THESE CASH FLOWS.
THE CFO ALSO MADE SUBJECTIVE RISK ASSESSMENTS OF EACH PROJECT,
AND HE CONCLUDED THAT BOTH PROJECTS HAVE RISK CHARACTERISTICS THAT
ARE
SIMILAR
TO
THE
FIRMS
AVERAGE
PROJECT.
AVERAGE COST OF CAPITAL IS 10 PERCENT.
ALLIEDS
WEIGHTED
YOU MUST NOW DETERMINE
WHETHER ONE OR BOTH OF THE PROJECTS SHOULD BE ACCEPTED.

A.
WHAT IS CAPITAL BUDGETING?
ARE THERE ANY SIMILARITIES BETWEEN A
FIRMS CAPITAL BUDGETING DECISIONS AND AN INDIVIDUALS INVESTMENT

DECISIONS?
Integrated Case: 10 - 24
ANSWER:
[SHOW S10-1 THROUGH S10-3 HERE.]

OF
ANALYZING
ADDITIONS
TO
CAPITAL BUDGETING IS THE PROCESS
FIXED
ASSETS.
CAPITAL
BUDGETING
IS
IMPORTANT BECAUSE, MORE THAN ANYTHING ELSE, FIXED ASSET INVESTMENT

DECISIONS CHART A COMPANYS COURSE FOR THE FUTURE.
CONCEPTUALLY,
THE CAPITAL BUDGETING PROCESS IS IDENTICAL TO THE DECISION PROCESS

USED BY INDIVIDUALS MAKING INVESTMENT DECISIONS.
THESE STEPS ARE
INVOLVED:
1. ESTIMATE THE CASH FLOWS--INTEREST AND MATURITY VALUE OR DIVIDENDS
IN THE CASE OF BONDS AND STOCKS, OPERATING CASH FLOWS IN THE CASE
OF CAPITAL PROJECTS.
2. ASSESS THE RISKINESS OF THE CASH FLOWS.
3. DETERMINE THE APPROPRIATE DISCOUNT RATE, BASED ON THE RISKINESS
OF THE CASH FLOWS AND THE GENERAL LEVEL OF INTEREST RATES.
THIS
IS CALLED THE PROJECT COST OF CAPITAL IN CAPITAL BUDGETING.

4. FIND (A) THE PV OF THE EXPECTED CASH FLOWS AND/OR (B) THE ASSETS
RATE OF RETURN.
5. IF THE PV OF THE INFLOWS IS GREATER THAN THE PV OF THE OUTFLOWS
(THE NPV IS POSITIVE), OR IF THE CALCULATED RATE OF RETURN (THE
IRR)
IS
HIGHER
THAN
THE
PROJECT
COST
OF
CAPITAL,
ACCEPT
THE
PROJECT.
B.
WHAT IS THE DIFFERENCE BETWEEN INDEPENDENT AND MUTUALLY EXCLUSIVE

PROJECTS?
ANSWER:
BETWEEN PROJECTS WITH NORMAL AND NONNORMAL CASH FLOWS?
[SHOW S10-4 AND S10-5 HERE.]
PROJECTS ARE INDEPENDENT IF THE CASH
FLOWS OF ONE ARE NOT AFFECTED BY THE ACCEPTANCE OF THE OTHER. CONVERSELY, TWO PROJECTS ARE MUTUALLY EXCLUSIVE IF ACCEPTANCE OF ONE
IMPACTS ADVERSELY THE CASH FLOWS OF THE OTHER; THAT IS, AT MOST ONE
OF TWO OR MORE SUCH PROJECTS MAY BE ACCEPTED. PUT ANOTHER WAY, WHEN
PROJECTS ARE MUTUALLY EXCLUSIVE IT MEANS THAT THEY DO THE SAME JOB.
FOR
EXAMPLE,
FORKLIFT
TRUCK
VERSUS
CONVEYOR
SYSTEM
TO
MOVE
MATERIALS, OR A BRIDGE VERSUS A FERRY BOAT.
PROJECTS WITH NORMAL CASH FLOWS HAVE OUTFLOWS, OR COSTS, IN THE

FIRST YEAR (OR YEARS) FOLLOWED BY A SERIES OF INFLOWS. PROJECTS WITH
NONNORMAL CASH FLOWS HAVE ONE OR MORE OUTFLOWS AFTER THE INFLOW
STREAM HAS BEGUN.
HERE ARE SOME EXAMPLES:
NORMAL
INFLOW
0
-
NONNORMAL
C.
1. WHAT IS THE PAYBACK PERIOD?
ANSWER:
(+) OR OUTFLOW (-) IN YEAR

1
2
3
4
5
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
-
+
+
FIND THE PAYBACKS FOR PROJECTS L AND S.
THE PAYBACK PERIOD IS THE EXPECTED
NUMBER OF YEARS REQUIRED TO RECOVER A PROJECTS COST.
WE CALCULATE
THE PAYBACK BY DEVELOPING THE CUMULATIVE CASH FLOWS AS SHOWN BELOW

FOR PROJECT L (IN THOUSANDS OF DOLLARS):
EXPECTED NCF
CUMULATIVE
($100)
(90)
(30)
80
YEAR
0
1
2
ANNUAL
($100)
10
60
3
0
|
-100
1
|
10
-90
PAYBACK IS BETWEEN
50
t = 2
AND t = 3
2
|
60
-30
3
|
80
+50
PROJECT LS $100 INVESTMENT HAS NOT BEEN RECOVERED AT THE END OF

YEAR 2, BUT IT HAS BEEN MORE THAN RECOVERED BY THE END OF YEAR 3.
THUS, THE RECOVERY PERIOD IS BETWEEN 2 AND 3 YEARS.
IF WE ASSUME
THAT THE CASH FLOWS OCCUR EVENLY OVER THE YEAR, THEN THE INVESTMENT
IS RECOVERED $30/$80 = 0.375 0.4 INTO YEAR 3.
THEREFORE, PAYBACK L
= 2.4 YEARS. SIMILARLY, PAYBACKS = 1.6 YEARS.
C.
2. WHAT IS THE RATIONALE FOR THE PAYBACK METHOD?
ACCORDING TO THE
PAYBACK CRITERION, WHICH PROJECT OR PROJECTS SHOULD BE ACCEPTED IF

THE FIRMS MAXIMUM ACCEPTABLE PAYBACK IS 2 YEARS, AND IF PROJECTS L
AND S ARE INDEPENDENT?
IF THEY ARE MUTUALLY EXCLUSIVE?
ANSWER:
PAYBACK REPRESENTS A TYPE OF
BREAKEVEN ANALYSIS:
THE PAYBACK
PERIOD TELLS US WHEN THE PROJECT WILL BREAK EVEN IN A CASH FLOW
SENSE.
WITH A REQUIRED PAYBACK OF 2 YEARS, PROJECT S IS ACCEPTABLE,
BUT PROJECT L IS NOT.
WHETHER THE TWO PROJECTS ARE INDEPENDENT OR
MUTUALLY EXCLUSIVE MAKES NO DIFFERENCE IN THIS CASE.
C.
3. WHAT IS THE DIFFERENCE BETWEEN THE REGULAR AND DISCOUNTED PAYBACK

PERIODS?
ANSWER:
[SHOW S10-9 HERE.]
DISCOUNTED PAYBACK IS SIMILAR TO PAYBACK EXCEPT
THAT DISCOUNTED RATHER THAN RAW CASH FLOWS ARE USED.
OPTIONAL QUESTION
SETUP FOR PROJECT LS DISCOUNTED PAYBACK, ASSUMING A 10 PERCENT COST OF
CAPITAL:
YEAR
0
1
2
3
EXPECTED NET CASH FLOWS

DISCOUNTED
CUMULATIVE
($100.00)
($100.00)
9.09
(90.91)
49.59
(41.32)
60.11
18.79
RAW
($100)
10
60
80
DISCOUNTED PAYBACKL = 2 + ($41.32/$60.11) = 2.69 = 2.7 YEARS.

VERSUS 2.4 YEARS FOR THE REGULAR PAYBACK.
C.
4. WHAT IS THE MAIN DISADVANTAGE OF DISCOUNTED PAYBACK?
IS THE PAYBACK
METHOD OF ANY REAL USEFULNESS IN CAPITAL BUDGETING DECISIONS?

ANSWER:
REGULAR PAYBACK HAS TWO CRITICAL DEFICIENCIES:
(1) IT IGNORES THE
TIME VALUE OF MONEY, AND (2) IT IGNORES THE CASH FLOWS THAT OCCUR
AFTER THE PAYBACK PERIOD.
DISCOUNTED PAYBACK DOES CONSIDER THE TIME
VALUE OF MONEY, BUT IT STILL FAILS TO CONSIDER CASH FLOWS AFTER THE
PAYBACK
PERIOD;
HENCE
IT
HAS
BASIC
FLAW.
IN
SPITE
OF
ITS
DEFICIENCY, MANY FIRMS TODAY STILL CALCULATE THE DISCOUNTED PAYBACK

AND GIVE SOME WEIGHT TO IT WHEN MAKING CAPITAL BUDGETING DECISIONS.
HOWEVER, PAYBACK IS NOT GENERALLY USED AS THE PRIMARY DECISION TOOL.
RATHER, IT IS USED AS A ROUGH MEASURE OF A PROJECTS LIQUIDITY AND

RISKINESS.
D.
1. DEFINE THE TERM NET PRESENT VALUE (NPV).
ANSWER:
WHAT IS EACH PROJECTS NPV?
THE NET PRESENT VALUE (NPV) IS
SIMPLY THE SUM OF THE PRESENT VALUES OF A PROJECTS CASH FLOWS:
CFt
(1 + k)
NPV =
t=0
PROJECT LS NPV IS $18.79:

010%
|
-100.00 1/1.10
9.09 1/(1.10)2
49.59 1/(1.10)3
60.11
18.79 = NPVL
1
|
10
2
|
60
3
|
80
NPVs ARE EASY TO DETERMINE USING A CALCULATOR WITH AN NPV FUNCTION.

ENTER
THE
CASH
FLOWS
SEQUENTIALLY,
WITH
OUTFLOWS
ENTERED
AS
NEGATIVES; ENTER THE COST OF CAPITAL; AND THEN PRESS THE NPV BUTTON
TO
OBTAIN
THE
DIFFERENCE).
D.
PROJECTS
NPV,
$18.78
(NOTE
THE
ROUNDING
THE NPV OF PROJECT S IS NPVS = $19.98.
2. WHAT IS THE RATIONALE BEHIND THE NPV METHOD?

WHICH
PENNY
PROJECT
OR
PROJECTS
SHOULD
BE
ACCORDING TO NPV,
ACCEPTED
IF
THEY
ARE
INDEPENDENT? MUTUALLY EXCLUSIVE?

ANSWER:
[SHOW
S10-13
HERE.]
STRAIGHTFORWARD:
IF
THE
A
RATIONALE
PROJECT
HAS
BEHIND
NPV
THE
$0,
NPV
THEN
METHOD
THE
IS
PROJECT
GENERATES EXACTLY ENOUGH CASH FLOWS (1) TO RECOVER THE COST OF THE
INVESTMENT AND (2) TO ENABLE INVESTORS TO EARN THEIR REQUIRED RATES
OF RETURN (THE OPPORTUNITY COST OF CAPITAL).
IF NPV = $0, THEN IN A
FINANCIAL (BUT NOT AN ACCOUNTING) SENSE, THE PROJECT BREAKS EVEN. IF

THE NPV IS POSITIVE, THEN MORE THAN ENOUGH CASH FLOW IS GENERATED,
AND CONVERSELY IF NPV IS NEGATIVE.
CONSIDER PROJECT LS CASH INFLOWS, WHICH TOTAL $150.
THEY ARE
SUFFICIENT (1) TO RETURN THE $100 INITIAL INVESTMENT, (2) TO PROVIDE

INVESTORS
WITH
THEIR
10
PERCENT
AGGREGATE
OPPORTUNITY
COST
OF
CAPITAL, AND (3) TO STILL HAVE $18.78 LEFT OVER ON A PRESENT VALUE
BASIS.
THIS
$18.78
EXCESS
PV
BELONGS
TO
THE
SHAREHOLDERS--THE
DEBTHOLDERS CLAIMS ARE FIXED, SO THE SHAREHOLDERS WEALTH WILL BE

INCREASED BY $18.78 IF PROJECT L IS ACCEPTED.
SIMILARLY, ALLIEDS
SHAREHOLDERS GAIN $19.98 IN VALUE IF PROJECT S IS ACCEPTED.

IF
PROJECTS
AND
ARE
INDEPENDENT,
THEN
BOTH
SHOULD
BE
ACCEPTED, BECAUSE THEY BOTH ADD TO SHAREHOLDERS WEALTH, HENCE TO

THE
STOCK
PRICE.
IF
THE
PROJECTS
ARE
MUTUALLY
EXCLUSIVE,
THEN
PROJECT S SHOULD BE CHOSEN OVER L, BECAUSE S ADDS MORE TO THE VALUE

OF THE FIRM.
D.
3. WOULD THE NPVs CHANGE IF THE COST OF CAPITAL CHANGED?
ANSWER:
THE NPV OF A PROJECT IS DEPENDENT ON THE COST OF CAPITAL USED. THUS,

IF
THE
CHANGE.
E.
1. DEFINE
COST
OF
CAPITAL
CHANGED,
THE
NPV
OF
EACH
PROJECT
WOULD
NPV DECLINES AS k INCREASES, AND NPV RISES AS k FALLS.
THE
TERM
INTERNAL
RATE
OF
RETURN
(IRR).
WHAT
IS
EACH
PROJECTS IRR?
ANSWER:
[SHOW S10-14 HERE.]
THE INTERNAL RATE OF RETURN (IRR) IS THAT
DISCOUNT RATE WHICH FORCES THE NPV OF A PROJECT TO EQUAL ZERO:

0
|
CF0
PVCF1
PVCF2
PVCF3
1
|
CF1
2
|
CF2
= SUM OF PVs = NPV.
EXPRESSED AS AN EQUATION, WE HAVE:

n
IRR:
t= 0
CFt
(1 + IRR)
= $0 = NPV.
3
|
CF3
NOTE THAT THE IRR EQUATION IS THE SAME AS THE NPV EQUATION, EXCEPT
THAT TO FIND THE IRR THE EQUATION IS SOLVED FOR THE PARTICULAR
DISCOUNT RATE, IRR, WHICH FORCES THE PROJECTS NPV TO EQUAL ZERO
(THE
IRR)
RATHER
THAN
USING
THE
COST
OF
CAPITAL
(k)
IN
THE
DENOMINATOR AND FINDING NPV. THUS, THE TWO APPROACHES DIFFER IN ONLY
ONE RESPECT:
IN THE NPV METHOD, A DISCOUNT RATE IS SPECIFIED (THE
PROJECTS COST OF CAPITAL) AND THE EQUATION IS SOLVED FOR NPV, WHILE
IN THE IRR METHOD, THE NPV IS SPECIFIED TO EQUAL ZERO AND THE
DISCOUNT RATE (IRR) THAT FORCES THIS EQUALITY IS FOUND.
PROJECT LS IRR IS 18.1 PERCENT:
0
1
2
3
18.1%
|
|
|
|
-100.00
10
60
80
1/1.181
8.47
1/(1.181)2
43.02
1/(1.181)3
48.57
$ 0.06 $0 IF IRRL = 18.1% IS USED AS THE DISCOUNT RATE.
THEREFORE, IRRL 18.1%.
A FINANCIAL CALCULATOR IS EXTREMELY HELPFUL WHEN CALCULATING IRRs.
THE CASH FLOWS ARE ENTERED SEQUENTIALLY, AND THEN THE IRR BUTTON IS
PRESSED.
FOR
PROJECT
S,
IRRS
23.6%.
NOTE
THAT
WITH
MANY
CALCULATORS, YOU CAN ENTER THE CASH FLOWS INTO THE CASH FLOW REGISTER,
ALSO ENTER k = I, AND THEN CALCULATE BOTH NPV AND IRR BY PRESSING THE
APPROPRIATE BUTTONS.
E.
2. HOW IS THE IRR ON A PROJECT RELATED TO THE YTM ON A BOND?
ANSWER:
[SHOW S10-15 HERE.]
THE IRR IS TO A CAPITAL PROJECT WHAT THE YTM IS
TO A BOND--IT IS THE EXPECTED RATE OF RETURN ON THE PROJECT, JUST AS

THE YTM IS THE PROMISED RATE OF RETURN ON A BOND.
E.
3. WHAT IS THE LOGIC BEHIND THE IRR METHOD?

PROJECTS
SHOULD
BE
ACCEPTED
IF
THEY
ARE
ACCORDING TO IRR, WHICH

INDEPENDENT?
MUTUALLY
EXCLUSIVE?
ANSWER:
[SHOW
S10-16
AND
S10-17
HERE.]
IRR
MEASURES
PROFITABILITY IN THE RATE OF RETURN SENSE:
PROJECTS
IF A PROJECTS IRR
EQUALS ITS COST OF CAPITAL, THEN ITS CASH FLOWS ARE JUST SUFFICIENT
TO PROVIDE INVESTORS WITH THEIR REQUIRED RATES OF RETURN.
AN IRR
GREATER THAN k IMPLIES AN ECONOMIC PROFIT, WHICH ACCRUES TO THE

FIRMS SHAREHOLDERS, WHILE AN IRR LESS THAN k INDICATES AN ECONOMIC
LOSS, OR A PROJECT THAT WILL NOT EARN ENOUGH TO COVER ITS COST OF
CAPITAL.
PROJECTS IRRs ARE COMPARED TO THEIR COSTS OF CAPITAL, OR HURDLE
RATES.
SINCE
PROJECTS
AND
BOTH
HAVE
HURDLE
RATE
OF
10
PERCENT, AND SINCE BOTH HAVE IRRs GREATER THAN THAT HURDLE RATE,
BOTH SHOULD BE ACCEPTED IF THEY ARE INDEPENDENT. HOWEVER, IF THEY
ARE MUTUALLY EXCLUSIVE, PROJECT S WOULD BE SELECTED, BECAUSE IT HAS
THE HIGHER IRR.
E.
4. WOULD THE PROJECTS IRRs CHANGE IF THE COST OF CAPITAL CHANGED?
ANSWER:
IRRs ARE INDEPENDENT OF THE COST OF CAPITAL.

NOR IRRL WOULD CHANGE IF k CHANGED.
THEREFORE, NEITHER IRR S
HOWEVER, THE ACCEPTABILITY OF
THE PROJECTS COULD CHANGE--L WOULD BE REJECTED IF k WERE GREATER

THAN 18.1 PERCENT, AND S WOULD BE REJECTED IF k WERE GREATER THAN
23.6 PERCENT.
F.
1. DRAW NPV PROFILES FOR PROJECTS L AND S.
AT WHAT DISCOUNT RATE DO
THE PROFILES CROSS?

ANSWER:
THE NPV PROFILES ARE PLOTTED IN THE
FIGURE BELOW.
NOTE THE FOLLOWING POINTS:
1. THE Y-INTERCEPT IS THE PROJECTS NPV WHEN k = 0%.
THIS IS $50
FOR L AND $40 FOR S.

2. THE X-INTERCEPT IS THE PROJECTS IRR.
L AND 23.6 PERCENT FOR S.
THIS IS 18.1 PERCENT FOR
3. NPV
k
PROFILES ARE CURVES RATHER THAN STRAIGHT LINES.
THIS, NOTE THAT THESE PROFILES APPROACH COST = -$100 AS
NPV
($)
50
APPROACHES INFINITY.
Project L
40
4.
FROM
30
IS
TO SEE
Project S
THE
FIGURE
IRRS = 23.6%
10
10
15
20
25
IRRL = 18.1%
-10
IT
APPEARS THAT THE CROSSOVER RATE
BETWEEN 8 AND 9 PERCENT.
20
BELOW,
THE PRECISE
VALUE
IS
APPROXIMATELY
k (%)
PERCENT.
ONE
CALCULATE
THE
8.7
CROSSOVER
CAN
RATE
BY
(1) GOING BACK TO THE DATA ON THE PROBLEM, FINDING THE CASH FLOW
DIFFERENCE
FOR
EACH
YEAR,
(2) ENTERING THOSE DIFFERENCES INTO THE CASH FLOW REGISTERS, AND
(3) PRESSING THE IRR BUTTON TO GET THE CROSSOVER RATE, 8.68%
8.7%.
k
0%
5
10
15
20
NPVL
$50
33
19
7
(4)
NPVS
$40
29
20
12
5
F.
2. LOOK AT YOUR NPV PROFILE GRAPH WITHOUT REFERRING TO THE ACTUAL NPVs
AND IRRs.
WHICH PROJECT OR PROJECTS SHOULD BE ACCEPTED IF THEY ARE
INDE-PENDENT?
MUTUALLY
EXCLUSIVE?
EXPLAIN.
ARE
YOUR
ANSWERS
CORRECT AT ANY COST OF CAPITAL LESS THAN 23.6 PERCENT?

ANSWER:
THE NPV PROFILES SHOW THAT THE IRR
AND NPV CRITERIA LEAD TO THE SAME ACCEPT/REJECT DECISION FOR ANY
INDEPENDENT PROJECT.
AT
ITS
IRR,
18.1
CONSIDER PROJECT L.
PERCENT.
IT INTERSECTS THE X-AXIS
ACCORDING
TO
ACCEPTABLE IF k IS LESS THAN 18.1 PERCENT.
THE
IRR
RULE,
IS
ALSO, AT ANY k LESS THAN
18.1 PERCENT, LS NPV PROFILE WILL BE ABOVE THE X-AXIS, SO ITS NPV
WILL BE GREATER THAN $0.
THUS, FOR ANY INDEPENDENT PROJECT, NPV AND
IRR LEAD TO THE SAME ACCEPT/REJECT DECISION.

NOW ASSUME THAT L AND S ARE MUTUALLY EXCLUSIVE.
CONFLICT MIGHT ARISE.
IN THIS CASE, A
FIRST, NOTE THAT IRRS = 23.6% > 18.1% = IRRL.
THEREFORE, REGARDLESS OF THE SIZE OF k, PROJECT S WOULD BE RANKED

HIGHER BY THE IRR CRITERION.
HOWEVER, THE NPV PROFILES SHOW THAT NPV L
> NPVS IF k IS LESS THAN 8.7 PERCENT.
THEREFORE, FOR ANY k LESS THAN
THE 8.7 PERCENT CROSSOVER RATE, SAY k = 7 PERCENT, THE NPV RULE SAYS
CHOOSE L, BUT THE IRR RULE SAYS CHOOSE S.
THUS, IF k IS LESS THAN THE
CROSSOVER RATE, A RANKING CONFLICT OCCURS.
G.
1. WHAT IS THE UNDERLYING CAUSE OF RANKING CONFLICTS BETWEEN NPV AND

IRR?
ANSWER:
[SHOW S10-22 HERE.]

PROJECT
MUST
HAVE
FOR NORMAL PROJECTS NPV PROFILES TO CROSS, ONE

BOTH
HIGHER
STEEPER SLOPE THAN THE OTHER.
VERTICAL
AXIS
INTERCEPT
AND
A PROJECTS VERTICAL AXIS INTERCEPT
TYPICALLY DEPENDS ON (1) THE SIZE OF THE PROJECT AND (2) THE SIZE
AND TIMING PATTERN OF THE CASH FLOWS--LARGE PROJECTS, AND ONES WITH
LARGE
DISTANT
CASH
FLOWS,
WOULD
GENERALLY
RELATIVELY HIGH VERTICAL AXIS INTERCEPTS.
BE
EXPECTED
TO
HAVE
THE SLOPE OF THE NPV
PROFILE DEPENDS ENTIRELY ON THE TIMING PATTERN OF THE CASH FLOWS-LONG-TERM PROJECTS HAVE STEEPER NPV PROFILES THAN SHORT-TERM ONES.
THUS, WE CONCLUDE THAT NPV PROFILES CAN CROSS IN TWO SITUATIONS:
(1) WHEN MUTUALLY EXCLUSIVE PROJECTS DIFFER IN SCALE (OR SIZE) AND
(2) WHEN THE PROJECTS CASH FLOWS DIFFER IN TERMS OF THE TIMING
PATTERN OF THEIR CASH FLOWS (AS FOR PROJECTS L AND S).
G.
2. WHAT IS THE REINVESTMENT RATE ASSUMPTION, AND HOW DOES IT AFFECT

THE NPV VERSUS IRR CONFLICT?
ANSWER:
[SHOW S10-23 HERE.]
THE UNDERLYING CAUSE OF RANKING CONFLICTS IS
THE REINVESTMENT RATE ASSUMPTION.
ALL DCF METHODS IMPLICITLY ASSUME
THAT CASH FLOWS CAN BE REINVESTED AT SOME RATE, REGARDLESS OF WHAT

IS ACTUALLY DONE WITH THE CASH FLOWS. DISCOUNTING IS THE REVERSE OF
COM-POUNDING.
SINCE
COMPOUNDING
ASSUMES
REINVESTMENT,
SO
DOES
DISCOUNTING. NPV AND IRR ARE BOTH FOUND BY DISCOUNTING, SO THEY BOTH
IMPLICITLY
ASSUME
SOME
DISCOUNT
RATE.
INHERENT
IN
THE
NPV
CALCULATION IS THE ASSUMPTION THAT CASH FLOWS CAN BE REINVESTED AT

THE PROJECTS COST OF CAPITAL, WHILE THE IRR CALCULATION ASSUMES
REINVESTMENT AT THE IRR RATE.
G.
3. WHICH METHOD IS THE BEST?
ANSWER:
WHY?
WHETHER NPV OR IRR GIVES BETTER RANKINGS DEPENDS ON WHICH HAS THE
BETTER REINVESTMENT RATE ASSUMPTION. NORMALLY, THE NPVS ASSUMPTION
IS BETTER. THE REASON IS AS FOLLOWS:
A PROJECTS CASH INFLOWS ARE
GENERALLY
OUTSIDE
USED
AS
SUBSTITUTES
FOR
CAPITAL,
THAT
IS,
PROJECTS CASH FLOWS REPLACE OUTSIDE CAPITAL AND, HENCE, SAVE THE
FIRM THE COST OF OUTSIDE CAPITAL.
THEREFORE, IN AN OPPORTUNITY COST
SENSE, A PROJECTS CASH FLOWS ARE REINVESTED AT THE COST OF CAPITAL.

NOTE,
HOWEVER,
THAT
NPV
AND
IRR
ALWAYS
GIVE
THE
SAME
ACCEPT/REJECT DECISIONS FOR INDEPENDENT PROJECTS, SO IRR CAN BE USED

JUST AS WELL AS NPV WHEN INDEPENDENT PROJECTS ARE BEING EVALUATED.
THE
NPV
VERSUS
IRR
CONFLICT
ARISES
ONLY
IF
MUTUALLY
EXCLUSIVE
PROJECTS ARE INVOLVED.
H.
1. DEFINE THE TERM MODIFIED IRR (MIRR). FIND THE MIRRs FOR PROJECTS L AND
S.
ANSWER:
MIRR IS THAT DISCOUNT RATE WHICH
EQUATES THE PRESENT VALUE OF THE TERMINAL VALUE OF THE INFLOWS,

COMPOUNDED AT THE COST OF CAPITAL, TO THE PRESENT VALUE OF THE
COSTS. HERE IS THE SETUP FOR CALCULATING PROJECT LS MODIFIED IRR:
0 k = 10%
|
PV OF COSTS = (100.00)
1
|
10
PV OF TV = 100.00
MIRR = ?
$100 =
2
|
60
1.10
3
|
80.00
66.00
(1.10)2
12.10
TV OF INFLOWS = 158.10
$158.10
(1 + MIRR)3
n
PV COSTS =
TV
=
(1 + MIRR)n
COFt
=
t
t = 0 (1 + k)
n
CIF (1 + k)
nt
t=1
(1 + MIRR)
AFTER YOU CALCULATE THE TV, ENTER N = 3, PV = -100, PMT = 0, FV =

158.1, AND THEN PRESS I TO GET THE ANSWER, MIRRL = 16.5%.
WE COULD
CALCULATE MIRRS SIMILARLY: MIRRS = 16.9%.
THUS, PROJECT S IS RANKED
HIGHER THAN L. THIS RESULT IS CONSISTENT WITH THE NPV DECISION.
H.
2. WHAT
ARE
THE
REGULAR IRR?
MIRRS
ADVANTAGES
AND
DISADVANTAGES
VIS-A-VIS
THE
WHAT ARE THE MIRRS ADVANTAGES AND DISADVANTAGES VIS-
A-VIS THE NPV?

ANSWER:
[SHOW S10-26 HERE.]
MIRR IS A BETTER RATE OF RETURN MEASURE THAN
IRR FOR TWO REASONS:
(1) IT CORRECTLY ASSUMES REINVESTMENT AT THE
PROJECTS COST OF CAPITAL RATHER THAN AT ITS IRR.
(2) MIRR AVOIDS
THE PROBLEM OF MULTIPLE IRRs--THERE CAN BE ONLY ONE MIRR FOR A GIVEN
PROJECT.
MIRR
DOES
NOT
ALWAYS
LEAD
TO
THE
SAME
DECISION
MUTUALLY EXCLUSIVE PROJECTS ARE BEING CONSIDERED.
AS
NPV
WHEN
IN PARTICULAR,
SMALL PROJECTS OFTEN HAVE A HIGHER MIRR, BUT A LOWER NPV, THAN
LARGER PROJECTS.
THUS, MIRR IS NOT A PERFECT SUBSTITUTE FOR NPV,
AND NPV REMAINS THE SINGLE BEST DECISION RULE.
HOWEVER, MIRR IS
SUPERIOR TO THE REGULAR IRR, AND IF A RATE OF RETURN MEASURE IS

NEEDED, MIRR SHOULD BE USED.
BUSINESS
EXECUTIVES
AGREE.
AS
NOTED
IN
THE
TEXT,
BUSINESS
EXECUTIVES PREFER TO COMPARE PROJECTS RATES OF RETURN TO COMPARING

THEIR NPVs.
THIS IS AN EMPIRICAL FACT.
AS A RESULT, FINANCIAL
MANAGERS ARE SUBSTITUTING MIRR FOR IRR IN THEIR DISCUSSIONS WITH

OTHER
CORPORATE
EXECUTIVES.
THIS
FACT
WAS
BROUGHT
OUT
IN
THE
OCTOBER 1989 FMA MEETINGS, WHERE EXECUTIVES FROM DU PONT, HERSHEY,

AND AMERITECH, AMONG OTHERS, ALL REPORTED A SWITCH FROM IRR TO MIRR.
I.
AS
SEPARATE
PROJECT
(PROJECT
P),
THE
FIRM
IS
SPONSORING A PAVILION AT THE UPCOMING WORLDS FAIR.
CONSIDERING
THE PAVILION
WOULD COST $800,000, AND IT IS EXPECTED TO RESULT IN $5 MILLION OF

INCREMENTAL CASH INFLOWS DURING ITS 1 YEAR OF OPERATION.
IT
WOULD
THEN
TAKE
ANOTHER
YEAR,
AND
$5
MILLION
OF
HOWEVER,
COSTS,
DEMOLISH THE SITE AND RETURN IT TO ITS ORIGINAL CONDITION.
TO
THUS,
PROJECT PS EXPECTED NET CASH FLOWS LOOK LIKE THIS (IN MILLIONS OF
DOLLARS):
YEAR
NET CASH FLOWS

0
1
2
($0.8)
5.0
(5.0)
THE PROJECT IS ESTIMATED TO BE OF AVERAGE RISK, SO ITS COST OF

CAPITAL IS 10 PERCENT.
I.
1. WHAT IS PROJECT Ps NPV?
ANSWER:
WHAT IS ITS IRR?
ITS MIRR?
HERE IS THE TIME LINE FOR THE
CASH FLOWS, AND THE NPV:

0
10%
|
-800,000
1
|
5,000,000
2
|
-5,000,000
NPVP = -$386,776.86.
WE CAN FIND THE NPV BY ENTERING THE CASH FLOWS INTO THE CASH FLOW
REGISTER,
ENTERING
10,
AND
THEN
PRESSING
THE
NPV
BUTTON.
HOWEVER, CALCULATING THE IRR PRESENTS A PROBLEM. WITH THE CASH FLOWS
IN
THE
REGISTER,
PRESS
THE
IRR
BUTTON.
AN
HP-10B
CALCULATOR WILL GIVE THE MESSAGE ERROR-SOLN.

PROJECT P HAS MULTIPLE IRRs.
FINANCIAL
THIS MEANS THAT
AN HP-17B WILL ASK FOR A GUESS.
YOU GUESS 10 PERCENT, THE CALCULATOR WILL PRODUCE IRR = 25%.
IF
IF YOU
GUESS A HIGH NUMBER, SUCH AS 200 PERCENT, IT WILL PRODUCE THE SECOND
IRR, 400 PERCENT1.
THE MIRR OF PROJECT P = 5.6% , AND IS FOUND BY
COMPUTING THE DISCOUNT RATE THAT EQUATES THE TERMINAL VALUE ($5.5
MILLION) TO THE PRESENT VALUE OF COSTS ($4.93 MILLION).
I.
2. DRAW
PROJECT
PS
NPV
NONNORMAL CASH FLOWS?

ANSWER:
PROFILE.
DOES
PROJECT
HAVE
NORMAL
OR
SHOULD THIS PROJECT BE ACCEPTED?
YOU COULD PUT THE CASH FLOWS IN YOUR CALCULATOR AND THEN ENTER A
SERIES OF I VALUES, GET AN NPV FOR EACH, AND THEN PLOT THE POINTS TO
CONSTRUCT THE NPV PROFILE.
WE USED A SPREADSHEET MODEL TO AUTOMATE
THE PROCESS AND THEN TO DRAW THE PROFILE.
NOTE THAT THE PROFILE
1 Looking at the figure below, if you guess an IRR to the left of the peak NPV rate,
the lower IRR will appear.
appear.
If you guess IRR > peak NPV rate, the higher IRR will
CROSSES
THE
X-AXIS
TWICE,
AT
25
PERCENT
SIGNIFYING TWO IRRs.
WHICH IRR IS CORRECT?
ARE--BOTH
PROJECTS
CAUSE
THE
NPV
TO
AND
AT
400
PERCENT,
IN ONE SENSE, THEY BOTH
EQUAL
ZERO.
HOWEVER,
IN
ANOTHER SENSE, BOTH ARE WRONG--NEITHER HAS ANY ECONOMIC OR FINANCIAL

SIGNIFICANCE.
PROJECT P HAS NONNORMAL CASH FLOWS; THAT IS, IT HAS MORE THAN ONE
CHANGE OF SIGNS IN THE CASH FLOWS.
WITHOUT THIS NONNORMAL CASH FLOW
PATTERN, WE WOULD NOT HAVE THE MULTIPLE IRRs.

SINCE
PROJECT
Ps
NPV
IS
NEGATIVE,
THE
PROJECT
SHOULD
BE
REJECTED, EVEN THOUGH BOTH IRRs (25 PERCENT AND 400 PERCENT) ARE
GREATER THAN THE PROJECTS 10 PERCENT COST OF CAPITAL.
THE MIRR OF
5.6 PERCENT ALSO SUPPORTS THE DECISION THAT THE PROJECT SHOULD BE
REJECTED.
NPV
(Thousands of Dollars)
500
375
250
125
100
200
300
400
500
k (%)
-125
-250
-375

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The BasicsChapter

After reading this chapter, students should be able to:

Define capital budgeting, explain why it is important, and state how

List the steps involved in evaluating a capital budgeting project.

Calculate payback period, discounted payback period, Net Present Value

Calculate the Modified Internal

Identify at least one relevant piece of information provided to

Identify and explain the purposes of the post-audit in the capital

Identify a number of different types of decisions that use the capital

This is a relatively straight-forward chapter, and, for the most part, it is

3 OF 58 DAYS (50-minute periods)

ANSWERS TO END-OF-CHAPTER QUESTIONS

Project classification schemes can be used to indicate how much

The NPV is obtained by discounting future cash flows, and the

This question is related to Question 10-2 and the same rationale

The statement is true.

a. In general, the answer is no. The objective of management should be

b. If the same $100 million had been spent on a short-term project--one

Mutually exclusive projects are a set of projects in which only one of

Answers and Solutions: 10 - 4

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

$52,125/$12,000 = 4.3438, so the payback is about 4 years.

Financial Calculator Solution:

Financial Calculator Solution:

Project Ks discounted payback period is calculated as follows:

Input CF0 = -52125, CF1-8 = 12000, and

The discounted payback period is 6 +

Answers and Solutions: 10 - 5

I = 10; NPV = $12,836,213.

I = 10; NPV = $15,954,170.

Answers and Solutions: 10 - 6

MIRR = 17.19% (Accept)

Financial Calculator Solution: Obtain the FVA by inputting N = 5, I =

Using a financial calculator:

Answers and Solutions: 10 - 7

a. The IRRs of the two alternatives are undefined.

$1,000 = $1,664.81/(1 + MIRRX)4.

$1,000 = $1,636.37/(1 + MIRRY)4.

NPVS = $39.14; IRRS = 13.49%.

NPVL = $53.55; IRRL = 11.74%.

Determine the PMT:

Answers and Solutions: 10 - 8

With a financial calculator, input N = 10, I = 12, PV = -1000,

Calculate the projects MIRR:

FV of inflows: With a financial calculator, input N = 10, I =

CF0 = -1065000; CF1-5 = 350000; I = 14; NPV = ?

Answers and Solutions: 10 - 9

Payback period = $20,000/$60,000 = 0.33 year.

$0/month for 9 months; $2,600/month for 51 months.

Cost of capital = 12% annual (1% per month).

PV cost of old lease:

PV cost of new lease:

N = 60; I = 1; PMT = -2000; FV = 0; PV = ?

CF0 = 0, CF1-9 = 0; CF10-60 = -2600; I = 1.

FV of first 9 months rent under old lease:

The FV of the first 9 months rent is equivalent to the PV of the

PV cost of new lease:

CF 0 = 0; CF1 - 9 = 0; CF10 - 60 = -2470.80; I = 1.

Old lease terms:

N = 60; I = 1.9113; PMT = -2000; FV = 0; PV = ?

New lease terms:

Project A's payback is 4 + $10/$225 = 4.04 years, while Project B's

Project A's payback is 4 + $109.55/$139.71 = 4.78 years, meanwhile