Chapter 10

Capital
Budgeting
Techniques

Copyright © 2012 Pearson Prentice Hall.

All rights reserved.
Overview of Capital
Budgeting
 Capital budgeting is the process of evaluating and
selecting long-term investments that are consistent
with the firm’s goal of maximizing owner wealth.
 A capital expenditure is an outlay of funds by the
firm that is expected to produce benefits over a
period of time greater than 1 year.
 An operating expenditure is an outlay of funds by
the firm resulting in benefits received within 1 year.

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 What is capital budgeting?
 Analysis of potential additions to fixed assets.
 Long-term decisions; involve large
expenditures.
 Very important to firm’s future.
Categories of Capital Budgeting:
 Replacements needed to continue current operations.
For damaged assets.
 Replacement for cost reduction due to obsolete assets.
 Expansion of existing products or markets.
 Expansion into new products and markets.
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 What is the difference between
independent and mutually exclusive
projects?
 Independent projects – if the cash flows
of one are unaffected by the acceptance of
the other.
 Mutually exclusive projects – if the
cash flows of one are adversely impacted
by the acceptance of the other.

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What is the difference between normal
and nonnormal cash flow streams?
 Normal cash flow stream – Cost (negative
CF) followed by a series of positive cash
inflows. One change of signs.
 Nonnormal cash flow stream – Two or
more changes of signs. Most common:
Cost (negative CF), then string of positive
CFs, then cost to close project.

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 Criteria to evaluate Capital
Budgeting Projects
Five methods are used to evaluate projects:
(1) Payback
(2) Discounted payback
(3) Net Present Value (NPV)
(4) Internal Rate of Return (IRR)
(5) Modified Internal Rate of Return (MIRR)

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What is the payback
period?
 The number of years required to recover a
project’s cost by its net revenue, or “How
long does it take to get our money back?”
 Calculated by adding project’s cash inflows to
its cost until the cumulative cash flow for the
project turns positive.

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 Calculating payback (when
uneven CF)
0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

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 Calculating payback (When
the cash flows are equal)
0 1 2 2.2 3
Project A

CFt -100 45 45 100 45

 Pay Back Period= $100/45

= 2.22 years

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Payback Period Decision criteria:
The payback method is the amount of time required
for a firm to recover its initial investment in a project,
as calculated from cash inflows.
Decision criteria:
 The length of the maximum acceptable payback

period is determined by management.

 If the payback period is less than the maximum

acceptable payback period, accept the project.

 If the payback period is greater than the

maximum acceptable payback period, reject the

project.
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Strengths and weaknesses of
payback
 Strengths
 Provides an indication of a project’s risk
and liquidity.
 Easy to calculate and understand.
 Weaknesses
 Ignores the time value of money.
 Ignores CFs occurring after the payback
period.
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 Discounted payback period
 Uses discounted cash flows rather than raw CFs.
 The length of time required for an investment’s cash flows,
discounted at the investment’s cost of capital, to cover its cost.

0 10% 1 2 2.7 3

CFt -100 10 60 80
PV of CFt -100 10/(1+.10)^1=9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years
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Net Present Value (NPV)
Net present value (NPV) is a sophisticated capital
budgeting technique; found by subtracting a project’s
initial investment from the present value of its cash
inflows discounted at a rate equal to the firm’s cost
of capital.
NPV = Present value of cash inflows – Initial
investment

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Net Present Value (NPV)
(cont.)
Decision criteria:
 If the NPV is greater than $0, accept the

project.
 If the NPV is less than $0, reject the project.

If the NPV is greater than $0, the firm will earn a

return greater than its cost of capital. Such action
should increase the market value of the firm, and
therefore the wealth of its owners by an amount
equal to the NPV.
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Figure 10.2 Calculation of NPVs for Bennett
Company’s Capital Expenditure Alternatives

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Project Decision based on NPV
NPV = PV of inflows – Cost
= Net gain in wealth
 If projects are independent, accept if the project

NPV > 0.
 If projects are mutually exclusive, accept projects

with the highest positive NPV, those that add the

most value.
For example, accept Project A, if mutually exclusive
(if, NPVA > NPVB)
 If no project has a positive NPV, reject them all.

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Internal Rate of Return
(IRR)
 A project’s IRR is the discount rate that
forces the PV of cash inflows to equal the
cost (initial outlay).
 This is equivalent to forcing the NPV to equal
zero .
 The IRR is an estimate of the project’s rate of
return, and it is comparable to the YTM on a
bond.

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Rationale for the IRR method
 If IRR > WACC, the project’s rate of
return is greater than its costs.
There is some return left over to
boost stockholders’ returns.

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Project decision based on IRR
 Independent projects: If IRR exceeds
the project’s WACC (k) accept the
project and vice versa.
 Mutually exclusive projects: Accept the
project with the highest IRR, provided
the IRR is greater than WACC. Reject all
projects if the best IRR does not exceed
WACC.
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IRR Acceptance Criteria
 If IRR > k, accept project.
 If IRR < k, reject project.

 If projects are independent, accept

both projects, as both IRR > k

 If projects are mutually exclusive,

accept A, because IRRA > IRRB.
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NPV vs IRR
 IRR is logically appealing since it is useful
to know rates of return on proposed
investments.
 However when NPV and IRR give

conflicting conclusions then it is better to

decide based on NPV.
◦ NPV assumes cash flows are reinvested at
WACC which is possible in reality.
◦ IRR assumes cash flows are reinvested at IRR
which is flawed.

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