Prentice Hall, 2004

6
Corporate Financial Management 2e
Emery Finnerty Stowe
Business
Investment Rules
Learning Objectives
Understand the practice of capital budgeting
as it is practiced in most corporations.
Understand how sound methods of
evaluating business investments can be
applied to both proposed projects and
current operations.
Focus on Principles
Valuable Ideas
Look for new ideas to use as a basis for capital
budgeting projects will create value
Comparative Advantage
Look for capital budgeting projects that will use the
firms comparative advantage to create value.
Incremental benefits
Identify and estimate the expected future cash flows for
a capital budget project on an incremental basis.
Focus on Principles
Risk-Return Trade-Off
Incorporate the risk of a capital budgeting
project into its cost of capitalthe projects
required return.
Time-Value-Of-Money
Measure the current value a capital budgeting
project will create, its NPV.
Focus on Principles
Options
Recognize the value of options, such as the
option to delay, expand, or abandon a project.
Two-Sided Transactions
Consider why the other party to a transaction is
willing to participate.
Signaling
Consider the products and actions of
competitors.
Chapter Outline
6.1 The Capital Budgeting Process
6.2 Net Present Value
6.3 Internal Rate of Return
6.4 Using the NPV and IRR Criteria
6.5 Other Widely Used Capital Budgeting
Criteria
6.6 Business Investment in Practice
6.1 The Capital Budgeting Process
The process can be broken down into five steps as a
project moves from idea to reality:
1.Generating ideas for capital budgeting projects.
2.Reviewing existing projects and facilities.
3.Preparing proposals.
4.Evaluating proposed projects and creating the
capital budget.
5.Preparing appropriation requests.
Generating ideas for capital
budgeting projects
Research and
Development
Division
Management
Plant
Management
Production
Management
Strategic
Planning
ideas
ideas ideas
ideas
ideas ideas
ideas ideas
Classifying Capital Budgeting Projects
Maintenance Projects
Cost Savings / Revenue Enhancement
Capacity Expansions in Current Business
New Products and New Businesses
Projects Required by Government
Regulation or Firm Policy
Preparing Proposals
Generally, the originator presents a written
proposal.
Most large firms use standard forms, and
these are typically supplemented by written
memoranda.
There may be consulting studies prepared
by outside experts.
Capital Budgeting and the
Required Return
The required return is the minimum rate of
return that you need to earn to be willing to
make an investment.
It is the rate of return that compensates you
for the risk of the expected future cash
flows.
It depends on the use of the money not the
source.
6.2 Net Present Value
Recall that an assets net present value
(NPV) is the difference between what it is
worth and what it costs.
The major difficulty of finding a projects
NPV rests with the need to see situations
differently from other people in the market.
NPV example
Suppose you notice a run-down house for sale in
your neighborhood.
The price is $80,000 as the house stands today.
The house requires $40,000 worth of repairs.
The repairs would take a year to complete.
Fixed up, you could sell the house in one year for
$135,000.
Having a slightly better neighborhood increases
the value of your own home by $5,000.
NPV example
If your discount rate is 10%, the net present value
of the project to you is $7,273:
) 10 . 1 (
000 , 140 $
000 , 120 $ NPV
The net present value of the project to someone
who does not live in the neighborhood is $2,727:
) 10 . 1 (
000 , 135 $
000 , 120 $ NPV
6.3 Internal Rate of Return
The internal rate of return is the discount
rate that sets NPV of the expected cash
flows to zero.
The internal rate of return is the projects
expected return.
Undertake a project if the IRR exceeds r,
the projects cost of capital.
IRR example
CALCULATOR SOLUTION
Data Input Function Key
N
I
PV
PMT
FV
6

10,000
2,100
0
7.03
A project costs $10,000
and is expected to
generate cash flows of
$2,100 each year for six
years. What is the
projects IRR?
6.4 Using the NPV and IRR
Criteria
Most of the time NPV and IRR are both
valuable guides to making decisions.
There are occasions, however, where NPV
and IRR disagree.
When in doubt, you can trust the NPV.
NPV Profile
An NPV profile plots the projects NPV as
a function of the discount rate.
It shows both the NPV and the IRR of the
project.
It can be used to identify the range of cost
of capital at which the project would add
value to the firm.
NPV Profile: Example

Cash Flow
Initial Investment

Cash Flow in years 1 to 5

Cash Flow in years 6 to 9

Cash Flow in year 10
- $3,985,000

$806,000

$926,000

$1,151,000

Consider a 10-year project with these cash flows:
NPV Profile
$(2,000)
$(1,000)
$-
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
0% 5% 10% 15% 20% 25%
N
P
V

(
$

t
h
o
u
s
a
n
d
s
)

Discount Rate
The project has a positive
NPV at discount rates less
than 16.95%
And a negative NPV at
discount rates more than
16.95%
When IRR and NPV Can Disagree
Mutually exclusive Capital Budgeting
Projects
When IRR and NPV Can Disagree
Consider a firm that needs to buy a new
heating system. They only need one.
The choice is down to two systems:
1. System A has high up-front costs and low
maintenance costs.
2. System B is inexpensive to install, but has
high maintenance costs.
Either system will offer savings over the
current system.

When IRR and NPV Can Disagree
The current system costs $400 per year to operate.
The current system can be sold for $400 at time 0.
The costs to install and operate the two alternative
systems are shown below
-400 -350 -300 -250 -200 -600 B
-50 -50 -50 -50 -50 -1,000 A
5 4 3 2 1 0
When IRR and NPV Can Disagree
Project A has a much higher NPV
Project B has a higher IRR
0 1 2 3 4 5 IRR NPV
A -600 350 350 350 350 350 51% $573
B -200 200 150 100 50 0 68% $182
When IRR and NPV can Disagree
The incremental costs (after taking into account
that the current system costs $400 per year to run)
to install and operate the two alternative systems
are shown below.
The table also shows the IRRs and the NPV
calculated at a discount rate of 15%
0 1 2 3 4 5 IRR NPV
A -600 350 350 350 350 350 51% $573
B -200 200 150 100 50 0 68% $182
NPV Profile Projects A and B
($200)
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
0 20 40 60 80 100
N
P
V
NPV A
NPV B
rate
-over
Cross
45%
If the discount rate is less than
45%, project A is the best choice.
If the discount rate is more
than 45%, project B is the
best choice.
If the discount
rate is more
than 68% dont
take A or B
Non-Conventional Projects
Consider a proposal to mine asbestos in an
ecologically sensitive area.
The project will require investment of $5,200,000
today, generate 12.3 million cash inflow at the end of
year one and require shut down and reclamation
expenses of $7.25 million at the end of year 2.
Year 0 1 2
Cash Flow ($5,200,000) $12,300,000 ($7,250,000)
Non-Conventional Projects
At a discount rate of 12%, the project has a
zero NPV.
Does that mean that if our cost of capital is
10% that we should start the project?

NPV Profile of Non-
Conventional Projects
($160)
($120)
($80)
($40)
$0
$40
0% 5% 10% 15% 20% 25% 30%
Discount Rate
N
P
V

IRR
2
= 25%
IRR
1
= 12%
Here we see that the project actually has
two IRRs: 12% and 25%
You have to be careful interpreting IRR.
IRR on Balance
IRR is widely used in practice.
More widely used than NPV actually.
Many people prefer the intuitive feel of the
IRR rule.
6.5 Other Widely Used Capital
Budgeting Criteria
Profitability Index
Payback
Discounted Payback
Average Rate of Return
Return on Investment
Urgency
Profitability Index
PI
PV of Future Cash Flows
Initial Investment
NPV
Initial Investment
=
=
+
1
Decision Rule:
Undertake the project if PI > 1.0
Profitability Index
Perma-Filter is considering two mutually exclusive
one-year projects, whose cash flows are shown
below. The cost of capital for either project is 12%.
Compute the NPV and the PI for each project and
indicate which one should be undertaken.
Project CF
0
CF
1
Alpha
Beta
($1,000)
($8,000)
$1,200
$9,200
Profitability Index
Project Alpha Project Beta
Year 0 Cash Flow
Year 1 Cash Flow
($1,000)
$1,200
($8,000)
$9,200
NPV @ 12%
PI
$71.43
1.071
$214.29
1.027
Profitability Index
PI measures the NPV per dollar invested.
For independent projects, the PI method yields
conclusions identical to the NPV method.
For mutually exclusive projects, differences in
project size can lead to conflicting conclusions.
Use the NPV method.
PI is useful when there is capital rationing.
Payback Method
The payback is the length of time it takes for
the projects cash flows to equal its
investment.

Decision Rule:
Undertake the project if the payback is
less than a preset amount of time.
Discounted Payback Method
The discounted payback is the length of time
it takes for the projects discounted cash flows
to equal its investment.

Decision Rule:
Undertake the project if the discounted
payback is less than a preset amount of time.
Payback and Discounted Payback
The cash flows for two mutually exclusive projects
X and Y are shown on the next slide. The cost of
capital for each project is 12%. Compute the NPV,
the payback, and the discounted payback for each
project. Which project should the firm choose?
Payback and Discounted Payback
Year Project X Project Y
0
1
2
3
4
($8,000)
$4,000
$4,000
$2,000
$2,000
($8,000)
$2,000
$2,000
$4,000
$6,000
Payback and Discounted Payback
for Project X
Discounted
Year
Cash
Flow
Cumulative
Cash Flow
Cash
Flow
Cumulative
Cash Flow
0
1
2
3
4
($8,000)
$4,000
$4,000
$2,000
$2,000
($8,000)
($4,000)
$0
($8,000)
$3,571
$3,189
$1,424
$1,271
($8,000)
($4,429)
($1,240)
$184
Payback and Discounted Payback
for Projects X and Y
Project X Project Y
Payback
Discounted Payback*
NPV*
2 years
2.87 years
$1,455
3 years
3.46 years
$2,040
* Discount rate = 12%
Payback and Discounted Payback
Payback ignores the time value of money.
Both require an arbitrary cutoff value.
Payback ignores risk differences between projects.
Both ignore cash flows after the payback period.
Average Rate of Return (ARR)
ARR
Average Cash Flow
Average Amount Invested
=
The ARR method distorts all cash flows by
averaging them over time.
It ignores the time value of money.
It is a useless method.
Return on Investment (ROI)
ROI is sometimes defined as the Internal
Rate of Return (IRR), and sometimes as the
Average Rate of Return (ARR).
It is also defined in terms of accounting
income instead of cash flows.
If the definition differs from that of the IRR,
it should not be used.
Recall the drawbacks of the IRR method.
Urgency
This method says invest in the project
when you absolutely have to.
Replacement decisions: replace asset after it has
broken down!
It ignores planning ahead.
A pound of prevention is worth a pound of
cure!
6.6 Capital Budgeting in Practice
Most firms used more than one method for capital
budgeting project evaluation.
The NPV profile is the most useful item.
It provides the most complete view of the project.
A process for appropriating capital after the
projects have been selected must be created by the
firm.
Review of project performance must be done
periodically.
Summary
The capital budgeting process and the
investment criteria used to make capital
budgeting decision are critical because
firms are effectively defined by the products
and services they provide using their capital
assets.