Whats next?

Capital Budgeting: involves making

decisions about real asset investments.
Chapter 7: Net Present Value and Other
Investment Criteria
Chapter 8: Estimating cash flows for a potential
investment.
Chapter 12: Estimating a required rate of return
for a potential investment = opportunity cost of
capital. (need chapters 10 & 11 to help us with
chapter 12)
 Chapter 7
Net Present Value & Other
Investment Criteria
 Topic Overview
Project Types
Capital Budgeting Decision Criteria
Net Present Value (NPV)
Payback Period
Internal Rate of Return (IRR)
Profitability Index (PI)
Equivalent Annual Cost and Equivalent
Annual Annuity
Capital Rationing
 Learning Objectives
Understand how to calculate and use
capital budgeting decision
techniques: Payback, NPV, IRR, & PI.
Understand the advantages and

disadvantages of each technique.

Understand which project to select

when there is a ranking conflict

between NPV and IRR.
 Think about this as we
cover Chapter 7 Investment
Criteria.
Which of the following investment
opportunities would you prefer?
#1) Give me $1 now and Ill give you
$2 at the end of class.
#2) Give me $100 now and Ill give
you $150 at the end of class.
 Project Types
Independent Projects dont affect acceptance
of other projects
Mutually Exclusive Projects interact with other
projects or accomplish the same objective

Normal Projects -only one sign change in

sequence of cash flows
Non-normal Projects - multiple sign changes in
cash flow series.
 Our Case Study
We want to help Marge Simpson, Inc. analyze
the following business opportunities by using
the following cash flow information. Assume
Marge's opportunity cost of capital is 12%.

Time Falafel-Full How 'Bout A Pretzel?

0 (20,000) (20,000)
1 15,000 2,000
2 15,000 2,500
3 13,000 3,000
4 3,000 50,000
 Net Present Value

Net Present Value - Present value of cash

flows minus initial investments.

Opportunity Cost of Capital - Expected rate

of return given up by investing in a project
 Net Present Value

NPV = PV - required investment

Ct
NPV C0
(1 r ) t

C1 C2 Ct
NPV C0 ...
(1 r ) (1 r )
1 2
(1 r ) t
 Net Present Value

Terminology
C = Cash Flow
t = time period of the investment
r = opportunity cost of capital

The Cash Flow could be positive or

negative at any time period.
 Net Present Value

Net Present Value Rule

Managers increase shareholders
wealth by accepting all projects that
are worth more than they cost.

Therefore, they should accept all

projects with a positive net present
value.
 Marges NPVs: r = 12%
Time Falafel-Full PV(CF) How 'Bout A Pretzel? PV(CF)
0 (20,000) (20,000) (20,000) (20,000)
1 15,000 13,393 2,000 1,786
2 15,000 11,958 2,500 1,993
3 13,000 9,253 3,000 2,135
4 3,000 1,907 50,000 31,776
NPV 16,510 17,690

Calculator Steps. Falafel-Full: CF0 = -20,000, C01 = 15,000,

F01 = 2, C02 = 13,000, F02 = 1, C03 = 3,000. NPV: I = 12,
CPT NPV = 16,510
Pretzel: CF0 = -20,000, C01 = 2,000, F01=1, C02 = 2,500,
F02=1, C03 = 3,000, F03=1, C04 = 50,000. NPV: I = 12,
CPT NPV = 17,690
 Excel and NPV: Why
Microsoft deserves its legal
troubles.
Excels NPV function is goofed up. =NPV(r,
range of cash flows)
Assumes first cash flow in range occurs at t
= 1.
See spreadsheet.
Solution to this spreadsheet problem:
exclude initial cost (t = 0 cash flow) from
NPV cell range and add initial cost (if
already negative) to the NPV function.
 Marges NPV Decision
If projects are independent,
Marge should select both.
Both have positive NPV.
If the projects are mutually
exclusive, select How Bout A
Pretzel?
Pretzel NPV > Falafel NPV.
 Payback Period (PB)
Measures how long it takes to
recovers a projects cost.
Easy to calculate and a good
measure of a projects risk and
liquidity.
Decision Rule: Accept if PB < some
maximum period of time.
 Marges Payback (Assume
Marges max is 2 years)
Time Falafel-Full Cumulative CF How 'Bout A Pretzel? Cumulative CF
0 (20,000) (20,000) (20,000) (20,000)
1 15,000 (5,000) 2,000 (18,000)
2 15,000 10,000 2,500 (15,500)
3 13,000 23,000 3,000 (12,500)
4 3,000 26,000 50,000 37,500

Falafel PB = less than 2 years

Pretzel PB = less than 4 years
Marge should choose Falafel using
Payback Period.
 Problems with Payback
Ignores time value of money!
Ignores cash flows beyond payback
period.
Not a good investment decision
technique.
Internal Rate of Return (IRR)
Internal Rate of Return is a projects expected rate
of return on its investment.
IRR is the interest rate where the PV of the
projects cash flows equals its cost.
In other words, the IRR is the rate where a
projects NPV = 0.
CFt/(1 + IRR)t = Cost
Decision Rule: Accept if IRR > r (opportunity
cost of capital).
Non-normal projects have multiple IRRs. Dont use
IRR to decide on non-normal projects.
 Marges IRRs
Time Falafel-Full How 'Bout A Pretzel?
0 (20,000) (20,000)
1 15,000 2,000
2 15,000 2,500
3 13,000 3,000
4 3,000 50,000

Best to use calculator. Calculator Steps.

Falafel-Full: CF0 = -20,000, C01 = 15,000, F01 = 2, C02 =
13,000, F02 = 1, C03 = 3,000. Press IRR, then CPT: IRR = 54.7%
Pretzel: CF0 = -20,000, C01 = 2,000, F01=1, C02 = 2,500,
F02=1, C03 = 3,000, F03=1, C04 = 50,000. Press IRR, then CPT:
IRR = 33.3%
r = 12%. If independent projects: select both, IRRs >
12%. Mutually exclusive: select Falafel; higher IRR.
 Comparison of NPV & IRR
For normal independent projects, all
three methods give same
accept/reject decision.
NPV > 0 yields IRR > r in order to
lower NPV to 0.
However, these methods can rank
mutually exclusive projects differently.
What to do, then?
 NPV Profiles
A graph which shows a projects NPV at different
interest rates (opportunity cost of capital).
Can illustrate ranking conflicts between NPV and
IRR.
Below is a table of NPVs for Marges projects.
r Falafel-Full How 'Bout A Pretzel?
0% 26,000 37,500
5% 21,589 27,899
10% 17,849 20,289
12% 16,510 17,690
15% 14,649 14,190
25% 9,485 5,216
35% 5,529 (874)
55% (68) (8,201)
Marges Projects
 Determining NPV/IRR
Conflict Range
For each year, subtract one projects cash
flows from the other.
If there is a change of signs of these cash
flow differences, a ranking conflict exists.
Find IRR of these cash flow differences to
find rate where the two projects have the
same NPV = crossover rate.
At a cost of capital less than this crossover
rate, a ranking conflict between NPV and IRR
exists.
 Marges crossover rate
Time Falafel-Full How 'Bout A Pretzel? Falafel - Pretzel
0 (20,000) (20,000) - CF0
1 15,000 2,000 13,000 C01
2 15,000 2,500 12,500 C02
3 13,000 3,000 10,000 C03
4 3,000 50,000 (47,000) C04
IRR = Crossover Rate 14.1%
At a cost of capital less than 14.1%, Pretzel has higher NPV but lower IRR =
Ranking Conflict.
At cost of capital greater than 14.1%, Falafel has the higher NPV and IRR.
Why? Cash flow timing differences in this case.
Other cause: initial cost differences, but not here.
 Reconciling NPV/IRR
Ranking Conflicts
Shareholder Wealth Maximization :
Want to add more value to the firm than
less.
Result: Choose project with highest
NPV when NPV/IRR ranking conflict
exists for mutually exclusive
projects.
Also, IRR has the multiple IRR problem
for non-normal projects like the
following.
 Acme, Inc. Rocket-Powered
Roller Blade Project
Acme is considering the following project which
would market these roller blades to coyotes trying
to catch road runners. Acme expects a cash inflow
in the year 1, but an outflow in the 2 nd (last) year of
the project due to liability claims from injured
cartoon coyotes. Acmes opportunity cost of
capital is 13%.
Year 0 1 2
Cash Flow (5) 30 (30)
NPV = -1.95 IRR = 26.8%
 Rocket-Powered Roller Blade
NPV Profile
4
NPV

-1 0% 50% 100% 150% 200% 250% 300% 350% 400% 450% 500% 550%

-6

At Acmes 13% opportunity cost of capital, the project has

a negative NPV even though the IRRs is greater than 13%.
Because of this conflict, dont use IRR to make decisions
for non-normal projects! (or look for a first IRR that is less
than cost of capital)
 Comparing Projects with
unequal lives
To replace the Budweiser sign that the ferret dropped in the frog
pond, Louie the Lizard is evaluating two new signs. Louie must
purchase and care for a replacement sign indefinitely. Here are
the annual costs for the two replacement signs.
Which sign should Louie choose given an opportunity cost of

capital of 11%?
Year Frying Frogs Lizards Leaping over Frogs
0 4,000 6,000
1 1,000 900
2 1,000 700
3 700
4 700

 Equivalent Annual Cost

Equivalent Annual Cost - The cost per

period with the same present value
as the cost of buying and operating a
machine.
present value of costs
Equivalent annual cost =
annuity factor
 Louie The Lizards Decision,
r = 11%
Year Frying Frogs Lizards Leaping over Frogs
0 4,000 6,000
1 1,000 900
2 1,000 700
3 700
4 700
Frying Frogs (FF) PV of costs = 5713
Lizards Leaping (LL) PV of costs = 8352
FF EAC: 5713=PV, 11=I/Y, 2=N, 0=FV, CPT PMT = 3336
LL EAC: 8352=PV, 11=I/Y, 4=N, 0=FV, CPT PMT = 2692
Louie should choose the Lizards Leaping over Frogs sign
because of its lower cost on an annual basis.
 Comparing Projects (NPV>0)
with unequal lives: Equivalent
Annual Annuity
Burns Power is considering the following

mutually exclusive projects in order to increase

power consumption in Springfield indefinitely.
Which project should be selected if Burns
Powers opportunity cost of capital is 10%?

Year 0 1 2 3
Sun-Blocker (50) 60 60
Fog-Maker (30) 40 40
40
 Find NPV and Equivalent
Annual Annuity
net present value
Equivalent annual annuity =
annuity factor

NPV of Sun-Blocker = $54.1 m

NPV of Fog-Maker = $69.5 m
Sun-Blocker EAA: -54.1=PV, 10=I/Y, 2=N, 0=FV,
CPT PMT = $31.2m
Fog-Maker EAA: -69.5=PV, 10=I/Y, 3=N, 0=FV,
CPT PMT = $27.9m
Burns should choose the Sun-Blocker because it
would add the most value on an annual basis.
 Investment Timing

Sometimes you have the ability to

defer an investment and select a time
that is more ideal at which to make
the investment decision. A common
example involves a tree farm. You
may defer the harvesting of trees. By
doing so, you defer the receipt of the
cash flow, yet increase the cash flow.
Investment Timing: #31, pg
207 of textbook
Can purchase a scanner today for $400
that would provide $60 in annual benefits
for 10 years. However, scanner prices are
expected to decrease 20% per year.
Should you purchase the scanner today or
wait if your discount rate is 10%?
PV of annual benefits: 60=PMT, 10=N,
10=I/Y, 0=FV, CPT PV = $369
NPV = $369 Expected Scanner Cost
 Investment Timing Example
(cont.): r = 10%
Year Cost PV Benefits NPV at Purchase NPV Today
0 400 369 -31 -31
1 320 369 49 45
2 256 369 113 93
3 205 369 164 123
4 164 369 205 140
5 131 369 238 148
6 105 369 264 149
7 84 369 285 146
To maximize value, you should wait 6 years to buy the
 Capital Rationing
Capital Rationing - Limit set on the amount of
funds available for investment.

Soft Rationing - Limits on available funds

imposed by management.

Hard Rationing - Limits on available funds

imposed by the unavailability of funds in the
capital market.
 Profitability Index (PI)
The ratio of the net present value of a
projects cash flows to its cost.
PI = NPV/Cost
Decision Rule: Accept if PI > 0
PI can be used to rank projects under capital
rationing conditions. Accept highest PI projects
under the capital constraint to maximize NPV.
CAUTION: PI can rank mutually exclusive
projects that have different initial costs
differently than NPV.
 Summary of Capital
Budgeting Methods
Want a method the uses the time value of
money with all project cash flows: NPV, PI,
IRR.
IRR can give erroneous decision for non-
normal projects.
Overall, NPV is the best and preferred
method.
However, under capital rationing (budget
restraint), ranking projects by PI can be
useful in helping to maximize NPV under
capital constraint.