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Chapter 10 - Capital Budgeting

Capital Budgeting
A major part of the financial management of the firm
Kinds Of Spending In Business
Short term - to support day to day operations
Long term - to support long lived equipment and projects
Long term money and the things acquired with it are both called capital

Capital Budgeting
Planning and Justifying How Capital Dollars Are Spent On Long
Term Projects
Provides methods for evaluating whether projects make financial
sense and for choosing among them
Capital Budgeting

Capital budgeting involves planning and

justifying large expenditures on long-
term projects
Projects can be classified as:
Replacement low risk
Expansion moderate risk
New venture high risk

Characteristics of Business Projects

Project Types and Risk

Capital projects have increasing risk according to
whether they are replacements, expansions or new
Stand-Alone and Mutually Exclusive Projects
Stand-alone project has no competing alternatives
Mutually exclusive projects involve selecting one
project from among two or more alternatives

Characteristics of Business Projects

Project Cash Flows

Reduce projects to a series of cash flows:

C0 $(50,000)
C1 (10,000)
C2 15,000
C3 15,000
C4 15,000
C5 5,000

Business projects: early cash outflows and later inflows

C0 is the Initial Outlay and usually required to get started

Characteristics of Business Projects

The Cost of Capital

The average rate a firm pays investors for
use of its long term money
Firms raise money from two sources: debt and

Capital Budgeting Techniques

Payback Period
How many years to recover initial cost
Net Present Value
Present value of inflows less outflows
Internal Rate of Return
Projects return on investment
Profitability Index
Ratio of present value of inflows to outflows

Capital Budgeting Techniques
Payback period is the time it takes to recover early
cash outflows
Shorter paybacks are better
Payback Decision Rules
Stand-alone projects
Mutually Exclusive Projects
Weaknesses of the Payback Method
Ignores time value of money
Ignores cash flows after payback period

Concept Connection Example 10-1
Payback Period

Payback period is easily visualized by the cumulative cash flows

Example 10-2: Weakness of the
Payback Technique
Use the payback period technique to choose between mutually exclusive
projects A and B.

Project As payback is 3 years as its initial outlay is fully recovered

in that time. Project B doesnt fully recover until sometime in the
4th year. Thus, according to the payback method, Project A is
better than B. But project B is clearly better because of the large
inflows in the last two years

The present value of future cash flows is what counts
when making decisions based on value.
The Net Present Value of all of a project's cash flows is its expected
to the firm's value and shareholder wealth
PVs are taken at k, the cost of capital
C C Cn
NPV = C0 1 2 ...
(1 k) (1 k)2 (1 k)n

Calculate NPV using

NPV = C0 + C1[PVFk,1] + C2[PVFk,2] + + Cn[PVFk,n]

Outflows are Ci with negative values and tend to occur first

NPV: Difference between the present values of positives and negatives
Projects with positive NPVs increase the firms value
Projects with negative NPVs decrease the firms value
Net Present Value (NPV)

NPV and Shareholder Wealth

A projects NPV is the net effect that it is
expected to have on the firms value

To maximize shareholder wealth, select the

capital spending program with the highest

Net Present Value (NPV)

Decision Rules

Stand-alone Projects
NPV > 0 accept
NPV < 0 reject

Mutually Exclusive Projects

NPVA > NPVB choose Project A over B

Concept Connection Example 10-3
Net Present Value (NPV)
Project Alpha has the following cash flows. If
the firm considering Alpha has a cost of capital
of 12%, should the project be undertaken?

Concept Connection Example 10-3
Net Present Value (NPV)

The NPV is found by summing the present value of the

cash flows when discounted at the firms cost of capital.
NPVAlpha 5,000 (11,.000 2, 000 3, 000
12 ) 1 1.12 2 1.12 3

$5,000 $1,000(.8929) $2,000(.7972) $3,000(.7118)

$5,000 $829.90 $1,594.40 $2135.40

$5,000 $4,622.70 Since Alphas

NPV<0, it should
($377.30) not be

Internal Rate of Return (IRR)

A projects IRR is the return it generates on the investment of its

cash outflows
For example, if a project has the following cash flows

The price of receiving

the inflows

The IRR is the interest rate at which the present value of the three
inflows just equals the $5,000 outflow

Defining IRR Through the NPV Equation
At the IRR the PVs of project inflows and
outflows are equal, so NPV = 0
C C Cn
NPV = C0 1 2 ...
(1 k) (1 k)2 (1 k)n

Set NPV=0 and substitute IRR for k

C1 C2 Cn
0 = C0 ...
(1 IRR ) (1 IRR ) 2
(1 IRR )n

0 = C0 + C1[PVFIRR,1] + C2[PVFIRR,2] + + Cn[PVFIRR,n]

IRR is the solution to this equation for a given set of Ci
Requires an iterative approach if the Ci are irregular
Internal Rate of Return (IRR)

Decision Rules

Stand-alone Projects
If IRR > cost of capital (k) accept
If IRR < cost of capital (k) reject

Mutually Exclusive Projects

IRRA > IRRB choose Project A over Project B

Internal Rate of Return (IRR)

Calculating IRRs
Finding IRRs usually requires an iterative,
trial-and-error technique
Guess at the projects IRR
Calculate the projects NPV using this interest
If NPV = zero, guessed interest rate is the projects
If NPV > 0, try a higher interest rate
If NPV < 0, try a lower interest rate

Concept Connection Example 10-5
IRR Iterative Procedure

Find the IRR for the following series of cash flows:

If the firms cost of capital is 8%, is the project a

good idea? What if the cost of capital is 10%?

Example 10-5
IRR Iterative Procedure
Start by guessing IRR = 12% and calculate NPV.

NPV = C0 + C1[PVFk,1] + C2[PVFk,2] + + Cn[PVFk,n]

NPV = -5,000 + 1,000[PVF12,1] + 2,000[PVF12,2] + 3,000[PVF12,3]
NPV = -5,000 + 1,000[.8929] + 2,000[.7972] + 3,000[.7118]
NPV = -5,000 + 892.90 + 1,594.4 + 2,135.40
NPV = -$377.30
Since NPV<0,
the projects IRR
must be < 12%.

Figure 10-1 NPV Profile
A projects NPV profile is a graph of its NPV vs. the cost
of capital. It crosses the horizontal axis at the IRR.

Concept Connection Example 10-5
IRR Iterative Procedure
Well try a different, lower interest rate, say 10%. At 10%, the projects
NPV is ($184). Since the NPV is still less than zero, we need to try a still
lower interest rate, say 9%. The following table lists the projects NPV at
different interest rates.
Interest Rate Calculated
Guess NPV
12% ($377)
Since NPV becomes positive
10 ($184) somewhere between 8% and
9 ($83) 9%, the projects IRR must be
between 8% and 9%. If the
8 $22 firms cost of capital is 8%, the
7 $130 project is marginal. If the
firms cost of capital is 10%,
the project is not a good idea.

Techniques: Internal Rate of Return
Technical Problems with IRR
Multiple Solutions
Unusual projects can have more than one IRR
The number of positive IRRs to a project
depends on the number of sign reversals to the
projects cash flows
The Reinvestment Assumption
IRR method implicitly assumes cash inflows will
be reinvested at the projects IRR

Comparing IRR and NPV

NPV and IRR do not always select the same project in

mutually exclusive decisions

A conflict can arise if NPV profiles cross in the first


In the event of a conflict The selection of the NPV

method is preferred

Figure 10-2 Projects for Which IRR and
NPV Can Give Different Solutions

At a cost of capital of
k1, Project A is better
than Project B, while
at k2 the opposite is

Many projects are characterized by an initial outflow
and a series of equal, regular inflows:

PV of annuity formula makes the pattern easy to work


NPV: NPV = C0 + C [PVFAk,n]

IRR: 0 = C0 + C [PVFAIRR,n]
Example 10-6 Regular Cash Inflows
Find the NPV and IRR for the following project if the cost of capital is
C0 C1 C2 C3
($5,000) $2,000 $2,000 $2,000

Solution: For NPV

NPV = C0 + C[PVFAk,n]
= -$5,000 + $2,000[PVFA12,3]
= -$5,000 + $2,000(2.4018)
= -$196.40
0 = C0 + C[PVFAIRR,n]
= -$5,000 + $2,000[PVFAIRR,3]
PVFAIRR,3 = $5,000 / $2,000
= 2.5000
From which IRR is between 9% and 10%
Profitability Index (PI)

Is a variation on the NPV method

A ratio of the present value of a projects
inflows to the present value of a projects
Projects are acceptable if PI>1

Profitability Index (PI)

Also known as the benefit/cost ratio

Positive future cash flows are the benefit
Negative initial outlay is the cost
C1 C2 Cn

1+k 1+k 1+k
1 2 n

present value of inflows
present value of outflows

Profitability Index (PI)

Decision Rules
Stand-alone Projects
If PI > 1.0 accept
If PI < 1.0 reject
Mutually Exclusive Projects
PIA > PIB choose Project A over Project B
Comparison with NPV
With mutually exclusive projects the two
methods may not lead to the same choices
Comparing Projects with Unequal Lives

If a significant difference exists between

mutually exclusive projects lives, a direct
comparison is meaningless
The problem arises due to the NPV
Longer lived projects almost always have
higher NPVs

Comparing Projects with Unequal Lives

Two solutions exist

Replacement Chain Method
Extends projects until a common time horizon is
Equivalent Annual Annuity (EAA) Method
Replaces each project with an equivalent
perpetuity that equates to the projects original

Concept Connection Example 10-8
Replacement Chain
The IRR method argues for undertaking the Short-Lived
Project while the NPV method argues for the Long-Lived
Project. Well correct for the unequal life problem by using
both the Replacement Chain Method and the EAA Method.
Both methods will lead to the same decision.

Thus, choosing the Long-Lived Project is a better decision

than choosing the Short-Lived Project twice.

Concept Connection Example 10-8
Replacement Chain
Which of the two following mutually exclusive projects should a firm

Concept Connection Example 10-9
Equivalent Annual Annuity (EAA)
The EAA Method equates each projects original NPV to an
equivalent annual annuity. For the Short-Lived Project the EAA is
$167.95 (the equivalent of receiving $432.82 spread out over 3 years
at 8%); while the Long-Lived Project has an EAA of $187.58 (the
equivalent of receiving $867.16 spread out over 6 years at 8%).

Concept Connection Example 10-9
Equivalent Annual Annuity (EAA)

Because the Long-Lived Project has the higher EAA,

it should be chosen. This is the same decision
reached by the Replacement Chain Method.

Capital Rationing

Used when capital funds for new projects

are limited
Generally rank projects in descending
order of IRR and cut off at the cost of
However this doesnt always make the
best use of capital so a complex
mathematical process called constrained
maximization can be used

Figure 10-6 Capital Rationing