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CHAPTER 11
The Basics of Capital Budgeting

Should we
build this
plant?
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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.
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Capital Budgeting Decision Rules

 5 keys methods to rank project

 Payback
 Discounted Payback
 Accounting Rate of Return
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Modified Internal Rate of Return (MIRR)
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Steps

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine k = WACC (adj.).
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR >
WACC.
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What is the difference between
independent and mutually exclusive
projects?

Projects are:
independent, if the cash flows of
one are unaffected by the
acceptance of the other.
mutually exclusive, if the cash flows
of one can be adversely impacted
by the acceptance of the other.
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An Example of Mutually Exclusive

Projects

BRIDGE vs. BOAT to get

products across a river.
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Normal Cash Flow Project:

Cost (negative CF) followed by a
series of positive cash inflows.
One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs.
Most common: Cost (negative
CF), then string of positive CFs,
then cost to close project.
Nuclear power plant, strip mine.
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Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
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What is the payback period?

- The number of years required to

recover a project’s cost,
- or how long does it take to get our
money back?

Payback = Year before full recovery +

the last unrecovered cost
Cash flow during year
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Example: Allied Components Company
Project’s net cash flows ($000), Allied
Project‘s WACC = 10%

Year Project L Project S

0 (100) (100)
1 10 70
2 60 50
3 80 20
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Payback for Project L

(Long: Large CFs in later years)

0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

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Project S (Short: CFs come quickly)

0 1 1.6 2 3

CFt -100 70 100 50 20

Cumulative -100 -30 0 20 40

Paybacks = 1 + 30/50 = 1.6 years

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Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
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Discounted Payback: Uses discounted

for project L rather than raw CFs.
0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 years

Recover invest. + cap. costs in 2.7 years.

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Accounting Rate of Return (ARR)

 ARR = Average Annual Income

Average Investment
 Average Annual Income =
Average Cash Flow – Average depreciation
 Average Investment =
(Cost + Salvage Value)/2
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Accounting Rate of Return (ARR)

 Average Annual Income (AAI) L:

 Average cash flow L: 150/3 = 50
 Average depreciation: 100/3 = 33.3
 AAI L: 50 – 33.3 = 16.7
 Average Investment L:
 (Cost + Salvage Value)/2: (100+0)/2 = 50
 ARR L = 16.7/50  33.4%
 ARR S = 13.4/50  26.8%
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NPV: Sum of the PVs of inflows and

outflows.

n
CFt
NPV   t .
t 0 1  k 
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What’s Project L’s NPV?

Project L:
0 1 2 3
10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL
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Calculator Solution
Enter in CF for L:
-100 CF0

10 CF1

60 CF2

80 CF3

10 i% RCL NPV = 18.78 = NPVL

NPVS = $19.98.
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Rationale for the NPV Method

NPV = PV inflows – Cost

= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually

exclusive projects on basis of
higher NPV. Adds most value.
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Using NPV method, which project(s)

should be accepted?

 If Projects S and L are mutually

exclusive, accept S because
NPVs > NPVL .
 If S & L are independent,
accept both; NPV > 0.
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Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = cost. This is the same
as forcing NPV = 0.
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NPV: Enter k, solve for NPV.

n
CFt

t 0 1  k 
t  NPV .

IRR: Enter NPV = 0, solve for IRR.

n
CFt

t 0 1  IRR 
t  0.
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What’s Project L’s IRR?

0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Enter CFj in CF, then press IRR:
IRRL = 18.13%. IRRS = 23.56%.
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Find IRR if CFs are constant:
0 1 2 3
IRR = ?

-100 40 40 40

INPUTS 3 -100 40 0
N COMP i% PV PMT FV
OUTPUT 9.70%

Or, with CF, enter CFj and press

IRR = 9.70%.
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Q. How is a project’s IRR
related to a bond’s YTM?
A. They are the same thing.
A bond’s YTM is the IRR
if you invest in the bond.

0 1 2 10
IRR = ? ...
-1134.2 90 90 1090

IRR = 7.08%
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Rationale for the IRR Method

If IRR > WACC, then the project’s

rate of return is greater than its
cost--some return is left over to
boost stockholders’ returns.

Example: WACC = 10%, IRR = 15%.

Profitable.
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IRR Acceptance Criteria

 If IRR > k, accept project.

 If IRR < k, reject project.

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Decisions on Projects S and L per IRR

 If S and L are independent, accept

both. IRRs > k = 10%.
 If S and L are mutually exclusive,
accept S because IRRS > IRRL .
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Construct NPV Profiles

Enter CFs in CFLO and find NPVL and

NPVS at different discount rates:
k NPVL NPVS
0 50 40
5 29
10 33 20
15 19 12
20 7
(4) 5
(4
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NPV ($) k NPVL NPVS
60
0 50 40
50 . 5 33 29
40 .
Crossover 10 19 20
. Point = 8.7%
15 7 12
30 . 20 (4) 5
20 . S
. IRRS = 23.6%
10 L . .
0
.20 . Discount Rate (%)
5 10 15 23.6
-10
IRRL = 18.1%
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NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)
IRR > k k > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.

k (%)
IRR
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Mutually Exclusive Projects

NPV k < 8.7: NPVL> NPVS , IRRS > IRRL

CONFLICT
L k > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT

S IRRS

k 8.7 k %
IRRL
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To Find the Crossover Rate

1. Find cash flow differences between

the projects. See data at beginning
of the case.
2. Enter these differences in CFLO
register, then press IRR. Crossover
rate = 8.68%, rounded to 8.7%.
3. Can subtract S from L or vice versa,
but better to have first CF negative.
4. If profiles don’t cross, one project
dominates the other.
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To Find the Crossover Rate

Project Cross
Year Project S L-S
L over
0 (100) (100) 0

1 10 70 -60

2 60 50 10

3 80 20 60 8.68%
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Two Reasons NPV Profiles Cross

1. Size (scale) differences. Smaller

project frees up funds at t = 0 for
investment. The higher the opportunity
cost, the more valuable these funds, so
high k favors small projects.
2. Timing differences. Project with faster
payback provides more CF in early
years for reinvestment. If k is high,
early CF especially good, NPVS > NPVL.
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Reinvestment Rate Assumptions

 NPV assumes reinvest at k (opportunity

cost of capital).
 IRR assumes reinvest at IRR.
 Reinvest at opportunity cost, k, is more
realistic, so NPV method is best. NPV
should be used to choose between
mutually exclusive projects.
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Managers like rates--prefer IRR to NPV
comparisons. Can we give them a
better IRR?

Yes, MIRR is the discount rate that

causes the PV of a project’s terminal
value (TV) to equal the PV of costs.
TV is found by compounding inflows
at WACC.

Thus, MIRR assumes cash inflows are

reinvested at WACC.
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MIRR for Project L (k = 10%)

0 1 2 3
10%

-100.0 10.0 60.0 80.0

10%
66.0
10%
12.1
-100.0 MIRR =
158.1
16.5%
0 $158.1
$-100 TV inflows
(1 + MIRRL)3
PV outflows=
MIRRL = 16.5%
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To find TV with Casio, enter in CFLO:

CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80

i% = 10
RCL NPV = 118.78 = PV of inflows.
Enter PV = -118.78, n = 3, i% = 10, PMT = 0.
Press COMP FV = 158.10 = FV of inflows.
Enter FV = 158.10, PV = -100, PMT = 0,
n = 3.
Press COMP i% = 16.50% = MIRR.
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Why use MIRR versus IRR?

MIRR correctly assumes reinvestment

at opportunity cost = WACC. MIRR
also avoids the problem of multiple
IRRs.
Managers like rate of return
comparisons, and MIRR is better for
this than IRR.