CH 10

Fundamentals of Corporate
Finance
by
Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.
Chapter 10 The Fundamentals of Capital Budgeting
Copyright 2008 John Wiley & Sons
CHAPTER 10
The Fundamentals of
Capital Budgeting
Outline
Introduction to Capital Budgeting
Net Present Value
The Payback Period
Accounting Rate of Return
Internal Rate of Return
Capital Budgeting in Practice
Introduction to Capital
Budgeting
The Importance of Capital Budgeting
Capital-budgeting decisions are the most important
investment decisions made by management.

The goal of these decisions is to select capital
projects that will increase the value of the firm.
Exhibit 10.1: Key Reasons

for Making Capital
Expenditures
Budgeting
The Importance of Capital Budgeting
Capital investments are important because they
involve substantial cash outlays and, once made,

are not easily reversed.
Capital-budgeting techniques help management
to systematically analyze potential business

opportunities in order to decide which are worth
undertaking.
Budgeting
Sources of Information
Most of the information needed to make capital-
budgeting decisions is generated internally, likely

beginning with the sales force.
Then the production team is involved, followed by
the accountants.
All this information is then reviewed by the
financial managers who evaluate the feasibility of

the project.
Budgeting
Classification of Investment Projects
Capital budgeting projects can be broadly classified
into three types.

1. Independent projects
2. Mutually exclusive projects
3. Contingent projects
Budgeting
1. Independent Projects
Projects are independent when their cash
flows are unrelated.

If two projects are independent, accepting or
rejecting one project has no bearing on the
decision for the other.
Budgeting
2. Mutually Exclusive Projects
When two projects are mutually exclusive,
accepting one automatically precludes the

other.
Mutually exclusive projects typically perform
the same function.
10
Budgeting
3. Contingent Projects
Contingent projects are those where the
acceptance of one project is dependent on

another project.
There are two types of contingency situations
1. Projects that are mandatory.

2. Projects that are optional.
11
Budgeting
Basic Capital-Budgeting Terms
The cost of capital is the minimum return that a
capital-budgeting project must earn for it to be

accepted.
It is an opportunity cost since it reflects the rate of
return investors can earn on financial assets of

similar risk.
Capital rationing implies that a firm does not have
the resources necessary to fund all of the

available projects.
12
Budgeting
Basic Capital-Budgeting Terms
Capital rationing implies that funding needs exceed
funding resources.
Thus, the available capital will be allocated to the
projects that will benefit the firm and its

shareholders the most.
13
Net Present Value

Net Present Value (NPV)
It is a capital-budgeting technique that is consistent
with goal of maximizing shareholder wealth.

The method estimates the amount by which the
benefits or cash flows from a project exceeds the

cost of the project in present value terms.
14
Exhibit 10.2: Sample

Worksheet for Net Present
Value Analysis
15
Net Present Value

Valuation of Real Assets
Valuing real assets calls for the same steps as
valuing financial assets.

Estimate future cash flows.
Determine the investors cost of capital or
required rate of return.

Calculate the present value of the future
cash flows.
16
Net Present Value

Valuation of Real Assets
However, there are some practical difficulties in
following the process for real assets.

First, cash-flow estimates have to be prepared
in house and are not readily available as they

for financial assets in legal contracts.
Second, estimates of required rates of
return are more difficult than estimates of
financial assets because no market data is
available for real assets.
17
Net Present Value

NPV The Basic Concept
The present value of a project is the difference between the present
value of the expected future cash flows and the initial cost of the project.
Accepting a positive NPV project leads to an
increase in shareholder wealth, while accepting a

negative NPV project leads to a decline in
shareholder wealth.
Projects that have an NPV equal to zero implies
that management will be indifferent between
accepting and rejecting the project.
18
Net Present Value

Framework for Calculating NPV
The NPV technique uses the discounted cash flow
technique.
Our goal is to compute the net cash flow (NCF)
for each time period t, where:

NCFt = (Cash inflows Cash outflows)
for the period t
19
Exhibit 10.3: Pocket Pizza

Project Timeline and Cash
Flows
20
Exhibit 10.4: Pizza Dough

Project Timeline and Cash
Flows
21
Net Present Value

A five-step approach can be utilized to compute the NPV
1.Determine the cost of the project.
Identify and add up all expenses related to the
cost of the project.

While we are mostly looking at projects whose
entire cost occurs at the start of the project, we
need to recognize that some projects may have
costs occurring beyond the first year also.
The cash flow in year 0 (NCF0) is negative,
indicating a cost.
22
Net Present Value

2.Estimate the projects future cash flows over its
forecasted life.
Both cash inflows (CIF) and cash outflows
(COF) are likely in each year of the project.

Estimate the net cash flow (NCFt) = CIFt COFt
for each year of the project.
Remember to recognize any salvage value
from the project in its terminal year.

23
Net Present Value

3.Determine the riskiness of the project and estimate
the appropriate cost of capital.
The cost of capital is the discount rate used in
determining the present value of the future

expected cash flows.
The riskier the project, the higher the cost of
capital for the project.
24
Net Present Value

4.Compute the projects NPV.
Determine the difference between the present
value of the expected cash flows from the

project and the cost of the project.
5. Make a decision.
Accept the project if it produces a positive NPV
or reject the project if NPV is negative.
25
Net Present Value

NPV Equation
NCF1 NCF2
NCFn
NPV NCF0
...
2
1 k (1 k)
(1 k) n
n
(10.1)
NCFt
t
(1
k)
t 0
26
Net Present Value

NPV Example
Find the net present value of the example in Exhibit 10.3.
$80
$80
$80
$80
$(80 30)
NPV -$300
1.15 (1.15)2 (1.15)3 (1.15)4

(1.15)5
- $300 - $69.58 60.49 52.60 $45.74 $54.69
-$16.91
27
Net Present Value

NPV Example - Financial Calculator Solution
Enter
15
Answer
PV
80
30
PMT
FV
-283.09
NPV $283.09 $300.00 $16.91
28
Using Excel - Net Present

Value
29
Net Present Value

Concluding Comments on NPV
Beware of optimistic estimates of future cash flows.
Recognize that the estimates going into calculating
NPV are estimates and not market data. Estimates

based on informed judgments are considered
acceptable.
The NPV method of determining project viability is
the recommended approach for making capital

investment decisions.
30
Net Present Value

Concluding Comments on NPV
The NPV decision criteria can be summed up as
follows:
31
The Payback Period

The Payback Period
It is one of the most widely used tools for evaluating
capital projects.
The payback period represents the number of years
it takes for the cash flows from a project to recover

the projects initial investment.
A project is accepted if its payback period is below
some pre-specified threshold.
This technique can serve as a risk indicatorthe
more quickly you recover the cash, the less risky
is the project.
32
The Payback Period

Computing the Payback Period
To compute the payback period, we need to know
the projects cost and estimate its future net cash

flows.
Equation 10.2 shows how to compute the payback
period.
Remaining cost to recover

PB Years before cost recovery
(10.2)
Cash flow during the year
33
Exhibit 10.5: Payback

Period Cash Flows and
Calculations
34
The Payback Period

Payback Period Example
Calculate the payback period for the example in
Exhibit 10.5.
$70,000 - $60,000
PB 2 years
$20,000
$10,000
2 years
$20,000
2 years 0.5
2.5 years
35
The Payback Period

Computing the Payback Period
There is no economic rationale that links the
payback method to shareholder wealth

maximization.
If a firm has a number of projects that are mutually
exclusive, the projects are selected in order of their

payback rank: projects with the lowest payback
period are selected first.
36
The Payback Period

How the Payback Period Performs
The payback period analysis can lead to
erroneous decisions because the rule does not

consider cash flows after the payback period.
A rapid payback does not necessarily mean a good
investment. See Exhibit 10.6 Projects D and E.
37
Exhibit 10.6: Payback

Period with Various CashFlow Patterns
38
The Payback Period

The Discounted Payback Period
One of the weaknesses of the ordinary payback
period is that it does not take into account the time

value of money.
The discounted payback period calculation calls
for the future cash flows to be discounted by the

firms cost of capital.
The major advantage of the discounted payback
is that it tells management how long it takes a

project to reach a positive NPV.
39
Exhibit 10.7: Discounted

Payback Period Cash Flows
and Calculations
40
The Payback Period

The Discounted Payback Period
However, this method still ignores all cash flows
after the arbitrary cutoff period, which is a major

flaw.
41
The Payback Period

Evaluating the Payback Rule
The standard payback period is widely used in
business.
It provides a simple measure of an investments
liquidity risk.
The greatest advantage of the payback period is
its simplicity.
It ignores the time value of money.
42
The Payback Period

It does not adjust or account for differences in the
overall, or total, risk for a project, which could

include operating, financing, and foreign exchange
risk.
The biggest weakness of either the standard or
discounted payback methods is their failure to

consider cash flows after the payback.
43
The Payback Period

The table below summarizes this capital-
budgeting technique:
44
The Accounting Rate of

Return
The Accounting Rate of Return
It is sometimes called the book rate of return.
This method computes the return on a capital
project using accounting numbersthe projects

net income (NI) and book value (BV) rather than
cash flow data.
The most common definition is the one given in
the equation below.
Average net income
ARR =
Average book value
45
(10.3)
The Accounting Rate of

Return
The Accounting Rate of Return
It has a number of major flaws as a tool for
evaluating capital expenditure decisions.
First, the ARR is not a true rate of return. ARR
simply gives us a number based on average
figures from the income statement and
balance sheet.
It ignores the time value of money.
There is no economic rationale that links a
particular acceptance criterion to the goal of
maximizing shareholders wealth.
46

The IRR is an important and legitimate alternative
to the NPV method.
The NPV and IRR techniques are similar in that
both depend on discounting the cash flows from a

project.
47

When we use the IRR, we are looking for the rate
of return associated with a project so we can

determine whether this rate is higher or lower
than the firms cost of capital.
The IRR is the discount rate that makes the NPV
to equal zero.
48

Calculating the IRR
The IRR is an expected rate of return, much like
the yield to maturity calculation that was made on
bonds.
We will need to apply the same trial-and-error
method to compute the IRR.
49
Exhibit 10.8: Time Line and

Cash Flows for Ford Project
50

Calculating the IRR Financial Calculator Solution
Find the IRR of the cash flows in Exhibit 10.8 using
a financial calculator.
Enter
N
Answer
-560
240
PV
PMT
FV
13.7
51
Using Excel - Internal Rate of

Return
52

When IRR and NPV Methods Agree
The two methods will always agree when the
projects are independent and the projects cash
flows are conventional.
After the initial investment is made (cash outflow),
all the cash flows in each future year are positive
(inflows).
53
Exhibit 10.9: NPV Profile for

the Ford Project
54

When IRR and NPV Methods Disagree
The IRR and NPV methods can produce different
accept/reject decisions if a project either has
unconventional cash flows or the projects are
mutually exclusive.
55

Unconventional Cash Flows
Unconventional cash flows could follow several
different patterns.
A positive initial cash flow followed by
negative future cash flows.
Future cash flows from a project could include
both positive and negative cash flows.

A cash flow stream that looks similar to a
conventional cash flow stream except for a

final negative cash flow.
56

Unconventional Cash Flows
In these circumstances, the IRR technique can
provide more than one solution. This makes the

result unreliable and should not be used in deciding
about accepting or rejecting a project.
57
Exhibit 10.10: NPV Profile for

Gold-Mining Operation
58

Mutually Exclusive Projects
When you are comparing two mutually exclusive
projects, the NPVs of the two projects will equal each

other at a certain discount rate. This point at which
the NPVs intersect is called the crossover point.
Depending upon whether the required rate of return
is above or below this crossover point, the ranking of
the projects will be different. While it is easy to
identify the superior project based on the NPV, one
cannot do this based on the IRR. Thus, ranking
conflicts can arise.
59

Mutually Exclusive Projects
A second situation involves comparing projects with
different costs. While IRR gives you a return based

on the dollar invested, it does not recognize the
difference in the size of the investments. NPV does!
60
Exhibit 10.11: NPV Profiles

for Two Mutually Exclusive
Projects
61
Modified Internal Rate of

Return
Modified Internal Rate of Return (MIRR)
A major weakness of the IRR compared to the NPV
method is the reinvestment rate assumption.

IRR assumes that the cash flows from the
project are reinvested at the IRR, while the
NPV assumes that they are invested at the
firms cost of capital.
This optimistic assumption in the IRR method
leads to some projects being accepted when
they should not be.
62

Return
Modified Internal Rate of Return (MIRR)
An alternative technique is the modified internal rate of return (MIRR). Here,
each operating cash flow is reinvested at the firms cost of capital.
The compounded values are summed up to get
the projects terminal value.

The MIRR is the interest rate which equates the
projects cost to the terminal value at the end of

the project.
63

Return
Equation 10.5 shows how to calculate the MIRR.
PV(Cost of the project) PV(Cash flows)

PVCost PVTV
TV
PVCost
(1 MIRR)n
64
(10.5)

Return
MIRR example
Calculate the MIRR of the project described in

Exhibit 10.8.
TV = $240(1.12)2 + $240(1.12) + $240 = $809.86
$809.86
$560 =
(1+MIRR)3
$809.86
3
(1+MIRR) =
= 1.4462
$560
1
(1.4462) 3
(1+MIRR) =
= 1.1309
MIRR = 0.1309,or 13.09%
65
IRR versus NPV: A Final

Comment
IRR versus NPV: A Final Comment
While the IRR has an intuitive appeal to managers
because of the output being in the form of a return,

the technique has some critical problems.
On the other hand, decisions made based on the
projects NPV are consistent with goal of

shareholder wealth maximization. In addition, the
result shows the management the dollar amount
by which each project is expected to increase the
value of the firm.
66
IRR versus NPV: A Final

Comment
IRR versus NPV: A Final Comment
For these reasons, the NPV method should be used
to make capital-budgeting decisions.
The table below summarizes the IRR decision-
making criteria:
67
Capital Budgeting in
Practice
Practitioners Methods of Choice
Exhibit 10.12 summarizes surveys of practitioners on
the capital-budgeting methods of choice.
There has been significant changes in the
techniques financial managers use.
68
Exhibit 10.12: CapitalBudgeting Techniques Used

by Business Firms
69
Practice
Practitioners Methods of Choice
Now, there is better alignment between practitioners
and the academic community.

Many financial managers use multiple capital
budgeting tools.
70
Practice
Ongoing and Post-audit Reviews
Management should systematically review the status
of all ongoing capital projects and perform postaudits on all completed capital projects.
In a post-audit review, management compares the
actual results of a project with what was projected

in the capital-budgeting proposal.
A post-audit examination would determine why
the project failed to achieve its expected
financial goals.
71
Practice
Ongoing and Post-audit Reviews
Managers should also conduct ongoing reviews of
capital projects in progress.

The review should challenge the business
plan, including the cash flow projections and
the operating cost assumptions.
Management must also evaluate people
responsible for implementing a capital project.
72

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Fundamentals of Corporate

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

investment decisions made by management.

projects that will increase the value of the firm.

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

Exhibit 10.1: Key Reasons

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

involve substantial cash outlays and, once made,

to systematically analyze potential business

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

budgeting decisions is generated internally, likely

financial managers who evaluate the feasibility of

Copyright 2008 John Wiley & Sons

into three types.

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

flows are unrelated.

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

accepting one automatically precludes the

the same function.

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

acceptance of one project is dependent on

1. Projects that are mandatory.

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

capital-budgeting project must earn for it to be

It is an opportunity cost since it reflects the rate of

return investors can earn on financial assets of

the resources necessary to fund all of the

Copyright 2008 John Wiley & Sons

Thus, the available capital will be allocated to the

projects that will benefit the firm and its

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

Net Present Value

with goal of maximizing shareholder wealth.

benefits or cash flows from a project exceeds the

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

Exhibit 10.2: Sample

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

Net Present Value

valuing financial assets.

required rate of return.

Chapter 10 The Fundamentals of Capital Budgeting

Copyright 2008 John Wiley & Sons

Net Present Value

following the process for real assets.

in house and are not readily available as they

Copyright 2008 John Wiley & Sons

Net Present Value

Accepting a positive NPV project leads to an