CHAPTER 13

WEIGHING NET PRESENT VALUE

AND OTHER CAPITAL BUDGETING
CRITERIA
M: Finance 3rd Edition
Cornett, Adair, and Nofsinger
Copyright © 2016 by McGraw-Hill Education. All rights reserved.
Capital Budgeting Techniques

• Project evaluation methods

• Net Present Value (NPV) is preferred method
• Internal Rate of Return (IRR)
• Payback (PB)
Capital Budgeting Techniques

• Project evaluation methods

• Discounted Payback (DPB)
• Modified Internal Rate of Return (MIRR)
• Profitability Index (PI)
Choice of Decision Statistic Format

• Financial decisions primarily driven by

• Currency
• Time
• Rate of return
Capital Budgeting Decisions

• Deciding on single project acceptance

• Compute statistic
• Compare with benchmark
Capital Budgeting Decisions

• Deciding on mutually exclusive

projects
• Compute statistic
• Conduct “runoff” between mutually exclusive
projects
• Compare winning project with benchmark
Payback and Discounted Payback

• Payback statistic
• Break-even calculation for costs of financing
new project
Payback Benchmark

• Benchmark can vary

• Based on relevant external constraint
Discounted Payback Statistic

• Compensates for time value of money

Discounted Payback Benchmark

• Not recommended to compare

Discounted Payback Benchmark
(DPB) with Payback Benchmark (PB)
• DPB will be larger than regular PB
Payback and Discounted Payback Strengths

• Strengths
• Easy to calculate
• Intuitive

• Weaknesses
• Accept/reject benchmarks are arbitrary
• Ignore cash flows after the payback period
• PB ignores the time value of money
Net Present Value
• Measures value created by the project
NPV Benchmark
• Includes all cash flows – both inflows
and outflows
NPV Strengths and Weaknesses
• Strengths
• Not a ratio
• Works well for both independent projects and
mutually-exclusive projects
• Weaknesses
• Managers can misinterpret the results
• May compare NPV to cost even though cost
already incorporated into the NPV
IRR and Modified Internal Rate of Return
• IRR most popular technique
• IRR gives same accept/reject decision
as NPV when used with normal cash-
flow projects
NPV vs. IRR
• NPV and IRR are closely related
Internal Rate of Return Statistic
• To calculate IRR, solve the NPV
formula for interest rate that makes
NPV equal zero
IRR Benchmark
• Calculate the IRR and compare cost of
capital (investors’ required return) to
see if the project is acceptable
Problems with IRR
• IRR will be consistent with NPV as
long as project
• Has normal cash flows
• Is independent of other projects
IRR and NPV with Non-Normal Cash Flows

• Recommended not to use IRR with

non-normal cash flows
• Modified Internal Rate of Return is
better
Differing Reinvestment Rate Assumptions
• NPV and IRR assumptions differ re:
reinvestment of cash flows
• IRR assumes reinvestment in another project
with same earning power
• NPV assumes investment are reinvested at
cost of capital
• NPV’s reinvestment rate assumption is
considered superior to IRR’s
Modified Internal Rate of Return
• “Fixes” IRR reinvestment rate problem
• Uses cost of capital to move cash
flows
• MIRR not appropriate for mutually
exclusive projects
IRR, MIRR, NPV Mutually Exclusive Projects

• Rate-based statistics cause problems

when project cash flows have
differences in
• Scale
• Timing
MIRR Strengths and Weakness
• Strengths
• Corrects IRR’s reinvestment rate assumption
• Fixes non-normal cash flows problem

• Weakness
• Does not correct IRR issues with choosing the
wrong mutually exclusive project for range of
rates
Profitability Index
• Based on NPV
• Use when firm has resource
constraints on capital available for new
projects