Capital Budgeting and

Decision Criteria
Chapter 9
Learning Goals
Discuss the difficulty of finding profitable projects
in competitive markets.

Determine whether a new project should be

accepted using
1. PAYBACK PERIOD
2. NET PRESENT VALUE
3. PROFITABILITY INDEX
4. INTERNAL RATE OF RETURN
The NPV - IRR Relationship 

Net present value profile 

Net present value profile

- a graph showing how a project' net

present value changes as
the discount rate changes.

(IRR - the discount rate that equates

the present value of the inflows with
the present value of the outflows )
Illustration 1

Initial outlay : $105,517

Cash flow : $30,000
Duration : 5 years
 DISCOUNT RATE PROJECT’S NPV
0% $ 44, 483
15 % $ 24, 367
10 % $ 8, 207
13% $0
15% -$ 4, 952
20% -$ 15,799
25% -$ 24,839
Modified Internal Rate Of
Return

MIRR
Modified Internal Rate Of Return

the discount rate that equates the

present value of the free cash
outflows with the present value of the
project's terminal value.
What does it mean?

While the internal rate of return (IRR)

assumes the cash flows from a
project are reinvested at the IRR, the
modified IRR assumes that all cash
flows are reinvested at the firm's cost
of capital. Therefore, MIRR more
accurately reflects the profitability of a
project.
Steps in calculating the MIRR

1. Determine the PV of the project's free

cash outflows.

1. Determine the terminal value of the

project's free cash inflows.

3. Determine the discount rate that equates

the PV of the terminal value and the
present value of the project's cash
outflow.
Sample Problem
Galaxy Angels Company is considering
two mutually exclusive projects. The
firm, which has a 12% cost of capital,
has estimated its cash flows as shown
below. 
Requirements:

a. NPV of each project

b. IRR for each project
c. NPV profiles for both projects
CHAPTER 11:

CAPITAL
BUDGETING AND
RISK ANALYSIS
1. Explain what the appropriate measure of
risk is for capital-budgeting purposes.
2. Determine the acceptability of a new
project using both the certainty
equivalent and risk-adjusted discount
rate methods of adjusting for risk.

3. Explain the use of simulation and

probability trees for imitating the
performance under evaluation.
RISK AND THE
INVESTMENT DECISION

There are two (2) basic issues:

1. What is risk in terms of capital-budgeting
decisions, how should it be measured?
2. How should risk be incorporated into
capital budgeting analysis?
THREE MEASURES OF
RISK

1. Project standing alone risk- it is measured by

the variability of the asset’s expected returns.
2. Project’s contribution- to- firm risk- the
amount of risk that a project contributes to
the firm as a whole.
3. Systematic risk- the risk of a project
measured from the point of view of a well-
diversified shareholder.
METHODS FOR INCORPORATING RISK
INTO CAPITAL-BUDGETING

1. Certainty Equivalent- under this method, the

decision maker substitutes a set of equivalent
riskless cash flows for the expected cash flows
and then discounts these cash flows back to
the present.
2. Risk-adjusted discount rate- in this method, the
discount rate is adjusted to compensate for
risk.
 Sample problem: Certainty equivalent
ZERO Corporation is studying the long-term impact of the two projects
and has gathered the following data for analysis:

A CE factor B CE factor
IO 20,000 100% 12,000 100%
CI
1 16,000 95% 8,000 94%
2 8,000 92% 5,000 83%
3 6,000 86% 4,000 80%
4 0 5,000 70%
5 0 4,000 60%
Discount 12% 14%
rate
Sample problem. Risk-adjusted discount
rate
Project A Project B
IO 20,000 12,000
Cash Inflows
1 16,000 8,000
2 8,000 5,000
3 6,000 4,000
4 0 5,000
5 0 4,000
Discount rate 12% 14%
Coefficient of variation 5% 20%
Risk-adjusted discount 12.6% 16.8%
rate