A Comparison of Capital Budgeting Techniques

With definitions and exemplifications

 Capital budgeting

Cost/benefit analysis:

• Estimating the value of investment projects

• Making informed choices
 Capital Budgeting Techniques

A collection of methods allowing the manager to choose among a variety of

investment projects.
 Problem

Value, rank and select investment projects

 Exemplification

Project A: Project B: Project C:

Required rate 7.7% 3% 6%

year 1: $400 $100 $5,200
year 2 $1,250 $200 $4,000
year 3 $900 $150 $1,000
year 4 $3,000 $100 $200
year 5 $1,000 $50 $100
Initial Cost $5,045 $490.67 $9,687.23
 Clarifications

Required rate: a fair discount rate given each project’s risk

 Methods:

• Average Accounting Return

• Payback

• Discounted payback

• Internal Rate of Return

• Modified Internal Rate of Return

• Net Present Value

• Profitability Index
 Average Accounting Return

AAR is the ratio of the Average Net Income to the Average Book Value.

Decision rule
Take the project if AAR is greater than some target ratio set by accountants.

Disadvantages
It has too many flaws, don't ever use it.
 Payback period

PB is the time it takes to recover the initial cost of the investment

 Payback period

Decision rule
Take the project with the shortest payback period

Disadvantages

• Ignores time value of money

• Ignores risk

• Ignores cash inflows beyond the cutoff point

 Payback period

In our example:

project C: 2.49 years

project B: 3.41 years
project A: 3.83 years

All three projects are viable

 Discounted payback period

DPB is the time it takes to recover the initial cost of the investment

• PB uses nominal CF
• DPB uses discounted CF
 Discounted payback period

Decision rule
Take the project with the shortest discounted payback period.

Disadvantages

DPB ignores cash inflows beyond the cutoff point

 Discounted payback period

project A: 4.94 years

project B: 3.76 years
project C would need more than 5 years

Only A and B are viable

 Internal Rate of Return

IRR is the discount rate that makes the present value of the project
equal to its initial cost.
 Internal Rate of Return

Decision rule:
Take the project If the IRR exceeds the required rate of return

Disadvantages:

• Reinvestment rate assumption is unrealistic

• Multiple IRR

• IRR cannot rank mutually exclusive projects

 Internal Rate of Return Calculation

Set: Initial cost = PV(project)

$5,045 = $400/(1+r) + $1,250/(1+r) 2 + $900/(+r)3 + $3,000/(1+r)4 + $1,000/(1+r)5

r = 8%.
 Internal Rate of Return

IRR(A) = 8%
IRR(B) = 8%
IRR(C) = 5%.

Only A and B are viable

 Modified Internal Rate of Return

MIRR is the discount rate that makes the future value of the project equal to its
initial cost.

MIRR requires a reinvestment rate.

 Modified Internal Rate of Return

Decision rule
Take the project if MIRR is larger than the required rate.

Disadvantages
MIRR cannot rank mutually exclusive projects.
 MIRR calculation

Project A:

Set FV(at 5%) = $5,045(1+MIRR)5

MIRR = 7%
 MIRR calculation

MIRR(A) = 7%
MIRR(B) = 6.54%
MIRR(C) = 5%

Only A and B are viable

 NPV

Net Present Value is the difference between the present value of a project and its
initial cost

NPV = PV - Initial cost

 NPV

Decision rule
If NPV is positive, take the project.

Disadvantages
Very complex analysis, too many variables to forecast
 NPV:Corollary

Required Rate = IRR  NPV = 0

…and vice-versa.
 NPV calculation

project A:

PV =$400/(1.077) + $1,250/(1.077) 2 + $900/(1.077)3 + $3,000/(1.077)4 + $1,000/(1.077)5

PV=$5,089.36

NPV= Present value - Initial Cost

NPV = $5,089.36 - $5,045 = $44.36
 NPV calculation

NPV(A)= +$44.36
NPV(B)= +$64.17
NPV(C)= -$148.81

Only A and B are viable

B is better because it adds more value

 The Profitability Index

The profitability index is the ratio of project PV to initial cost

PI = PV/Initial cost
 The Profitability Index

Decision rule
Take the project if PI > 1

Disadvantages
PI cannot rank mutually exclusive projects.
 PI calculation

Project A:

PI(A) = PV(A)/Initial cost = 5,089.36/$5,045

PI(A) = 1.0088
 PI Calculation

PI(A) = 1.0088
PI(B) = 1.131
PI(C) = 0.9846

Only A and B are viable

 Why can’t PI rank the projects?
Exemplification

Project x Project y

Present value $25,000,000 $3,000

Initial cost $24,000,000 $1,000

PI 1.042 3

NPV $1,000,000 $2,000

Why can’t PI rank the projects?

PI(x) < PI(y)

but

NPV(x) > NPV(y)

 Answer

NPV rules.

Always.
 Important side note

In project valuation, measures of absolute wealth are more appropriate

than measures of relative efficiency.
 Project A: Project B: Project C:

Required rate 7.7% 3% 6%

Cost $5,045 $490.67 $9,687.23
Present value $5,089.36 $554.84 9,538.42
Future value (5%) $7,075.45 $673.45 $12,363.5
Payback period 3.83 years 3.41 years 2.49 years*
Discounted payback 4.94 years 3.76 years* N/A
IRR 8%* 8%* 5%
MIRR 7%* 6.54%* 5%
Net present value $44.36* $64.17* ($148.81)
Profitability index 1.0088* 1.131* 0.9846