Chapter 11

Capital Budgeting
ACCT 2200
PROFESSOR THOMAS BOURVEAU
Capital Budgeting Methods
Learning Objective 11-4

Predict the internal rate of return

and describe its relationship to net
present value.
 Internal Rate of Return (IRR)
The internal rate of return is the interest
rate that makes . . .
 Present Present
value of = value of
cash inflows cash outflows

 The net present value equal zero.

 Internal Rate of Return (IRR)
The internal rate of return is the discount rate which equates the NPV of a
stream of cash flows to zero.
CFt
0
(1  IRR) t

If the IRR can be determined, then, in general,

choosing IRR > r often leads to the same decision as choosing NPV > 0.

The IRR criterion is useful for choosing among projects with the same NPV.

Using the cash flows for the preceding example, we get:

55 60.50
0 = – 90 + +
(1 + IRR)1 (1 + IRR)2

IRR = 18% > 10% Accept the project

5
 Computing IRR in Excel

One important note about the IRR function is that you must
include the original cash outflow in the calculation.
Internal Rate of Return (IRR)
 Application
A local company, Lester Inc. has a minimum required rate of
return / cost of capital of 8% per year. The company is considering
investing in a robotic project that costs HKD68,337 and is expected
to generate cash flows of approximately HKD 27,000 per year for
the next three years. The approximate internal rate of return of
this project is:
A. 8%
B. 9%
C. 10%
D. Less than the required 8%
 Solutions
IRR USING EXCEL IRR USING TRIAL AND ERROR

1) PV for stream of $27,000 cash inflow

for 3 years at 8%:
$27,000 * 2.5771 = $69,581.70
 Positive NPV (69,581 – 68,337),
therefore IRR should be higher than
8%.
2) PV for stream of $27,000 cash inflow
for 3 years at 9%:
$27,000 * 2.5313 = $68,345.10
IRR = 9%
 Almost zero NPV (68,345-68,337).
Therefore the IRR is 9%.
 Profitability Index
The profitability index is the ratio of a project’s benefits (measured
by the present value of the future cash flows) to its costs (or
required investment).

Profitability Index > 1 = Project Acceptable

Profitability Index < 1 = Project Unacceptable

Comparing Capital Budgeting Methods
Learning Objective 11-5

Use the net present value method to

analyze mutually exclusive capital
investments.
 Case 1: Lease or Buy Equipment
iKids Touch is trying to decide whether to buy a new copier or
lease it from a copier company, and has gathered the following
information about the two options:

iKids Touch uses net present value to evaluate

investment options. If the discount rate is 10%,
should the company lease or buy?
 Case 1: Lease or Buy Equipment

To analyze this decision, we can use the NPV method to

compare the relevant costs (in present dollar values) of
each option.

Lease option costs $1,419 less.

 Case 2: Investing in Automation
iKids Touch is thinking of spending $10,000,000 to
automate a production facility. The investment is
expected to have the following effects:

• Automation will increase the capacity of the plant and allow it

to boost production and sales by 20 percent.
•The company will be able to reduce packaging labor cost per
unit by 30 percent.
•Factory supervision costs will increase by $500,000 per year.
•The estimated useful life of the equipment is six years, at which
point it will have a residual value of $1,000,000. Straight-line
depreciation of the assets will be $1,500,000 per year
[($10,000,000 – 1,000,000) ÷ 6 years = $1,500,000].
 Case 2: Investing in Automation
This table summarizes the effects on net income. The per-unit costs
in the first column are assumed. Note that automation increases net
income by $1,100,000.

iKids Touch uses net present value to evaluate

investments. If the discount rate is 12%, should
the company make the $10,000,000 investment?
 Case 2: Investing in Automation
Remember that the net present value method is based on cash flow
rather than net income. So, we need to add back the depreciation (a
noncash expense) to net income to get net cash flow. We also need
to incorporate the initial investment (at time zero) and the salvage
value of the machinery at the end of six years.

The positive net present value of $1,196,240 means that the

proposed investment in automation will generate a return in excess
of the 12% cost of capital.
Learning Objective 11-6

Use the profitability index to

prioritize independent capital
investment projects.
 Prioritizing Independent
Projects
The profitability index is used to prioritize
capital investment projects.

Present Value of
Profitability
Index = Future Cash flows ÷ Initial
Investment

When using the profitability index to prioritize projects,

the preference rule is: the higher the profitability index,
the more desirable the project.
 Prioritizing Independent
Projects

iKids Touch is trying to decide how to prioritize their limited

research and development budget. They are
considering these three independent projects.

How should iKids Touch prioritize these three projects?

A, then B, then C
 Application (1)
Walter Inc. just raised HKD1,000,000 from investors in Hong Kong to
fund the creation of a new robot with a cost of capital of 10%. The CEO
of the company hesitates between two different mutually exclusive
projects. Both of them requires an initial cash outflow of HKD1,000,000
but have the following cash flow patterns:

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Project A 800,000 600,000 400,000 200,000 100,000 2,100,000
Project B 100,000 200,000 400,000 600,000 800,000 2,100,000

Which one should the firm opt for?

 Solution
Project A Project B
PV of $1 Future Cash PV of Future PV of Future
Year at 10% Flow Cash Project B Cash
1 0.9091 800,000.00 727,280.00 100,000.00 90,910.00
2 0.8264 600,000.00 495,840.00 200,000.00 165,280.00
3 0.7513 400,000.00 300,520.00 400,000.00 300,520.00
4 0.6830 200,000.00 136,600.00 600,000.00 409,800.00
5 0.6209 100,000.00 62,090.00 800,000.00 496,720.00
Total 1,722,330.00 Total 1,463,230.00
Profitability Index 1.72 1.46

Firm should choose Project A.

 Application (2)
Sai Kung Transportation is considering the purchase
of a new junk carrier for HKD8 million. The forecast
revenues are HKD5 million a year and total operating
costs are HKD4 million. A major refit costing HKD2
million will be required after both the fifth and tenth
years. After 15 years, the ship is expected to be sold for
scrap at HKD1.5 million.
Required: If the discount rate is 8 percent, what is the
NPV of investing in the new ship?
 Solution
Cash outflows:

HKD8,000,000 at t = 0

NPV of refit #1 after 5 years = 2,000,000 * (1 / (1.08)^5) = 1,361166

NPV of refit #2 after 10 years = 2,000,000 * (1 / (1.08)^10) = 926,386

Cash inflows:

NPV of the stream of net annual cash flows of HKD1 million over 15 years = 8,559,478

NPV of the value of the asset at the end = 1,500,000 * (1/(1.08)^15) = 472,862

NPV = -1,255,212 -> No Investment

WARNING: this solution is assuming that the depreciation expense is NOT part of the
operating expense. Otherwise, if you make a different assumption you would have to add
it back to compute the net annual cash flows.
Exercise E11-7
 Solution to E11-7
Purchase Option
PV Factor Present
Year Cash Flow (10%) Value
Initial Investment 0 $ (26,500.00) $ (26,500.00)
Cash operating costs 1-5 $ (500.00) 3.7908 * $ (1,895.40)
Salvage values 5 $ 10,500.00 0.6209 ** $ 6,519.45
NPV = $ (21,875.95)
Lease Option
PV Factor Present
Year Cash Flow (10%) Value
Lease Payments 1-5 $ (3,480.00) 3.7908 * $ (13,191.98)
NPV = $ (13,191.98)
*PV of annuity for 5 years at 10%. ** PV of $1 for 5 years at 10%

Lease option costs $8,683.97 less.

Therefore Harold should lease instead of buying the car.