Capital Budgeting

1-1
6 Overview of Capital Budgeting

 Capital Budgeting
◦ The process of evaluating and selecting long-term
investments that are worth more than they cost and
create wealth for investors
 Capital Expenditure
◦ An outlay of funds that produces benefits over
several years
6 Overview of Capital Budgeting
 The Capital Budgeting Process
◦ Consists of five distinct but interrelated steps:
proposal generation, review and analysis,
decision making, implementation, and follow-
up
◦ 1. Proposal Generation
 Managers at all levels in a business make proposals for
new investment projects
◦ 2. Review and Analysis
 Financial managers perform a formal review and analysis
to assess the merits of investment proposals
 Proposals that require large outlays receive greater
scrutiny than less costly ones
6 Overview of Capital Budgeting

 Steps in the Process

◦ 3. Decision Making
 Firms typically delegate capital expenditure decisions
on the basis of dollar limits
 Generally, the board of directors or a team of very
senior executives must authorize expenditures
beyond a certain amount
 Mid-level managers may authorize more routine
investments requiring smaller cash outlays
6 Overview of Capital Budgeting
• Steps in the Process
◦ 4. Implementation
 Following approval, firms make expenditures and
implement projects
 Expenditures for a large project often occur in phases
◦ 5. Follow-up
 Managers monitor results and compare actual costs and
benefits to the projections that they originally used to
justify making the investment
 Managers may take actions to expand, contract, or shut
down investments when actual outcomes differ from
projected ones
6 Overview of Capital Budgeting

 Terminology
◦ Independent Projects
 Projects whose cash flows are unrelated to (or
independent of) one another; accepting or rejecting
one project does not change the desirability of other
projects
◦ Mutually Exclusive Projects
 Projects that compete with one another so that the
acceptance of one eliminates from further
consideration all other projects that serve a similar
function
6 Overview of Capital Budgeting

 Terminology
◦ Unlimited Funds
 A firm has sufficient internal funds or can raise
external funds to pay for all attractive investment
opportunities
◦ Capital Rationing
 The firm has a fixed investment budget and numerous
projects compete for those dollars
6 Overview of Capital Budgeting

 Terminology
◦ Accept–Reject Decision
 The evaluation of capital expenditure proposals to
determine whether they meet the firm’s minimum
acceptance criterion
6 Overview of Capital Budgeting
 Capital Budgeting Techniques
◦ To ensure that the investment projects firms pursue have the best
chance of creating wealth for shareholders, financial managers
need tools to help them evaluate the merits of individual projects
and to rank competing investments
◦ A number of techniques are available for performing such analyses
◦ The best techniques evaluate projects based on the timing and
risk of the cash flows they generate
◦ Project evaluation methods that fail to account for money’s time
value or for risk may lead to suboptimal investment decisions,
either by directing managers to make value-destroying
investments or discouraging them from pursuing value-creating
projects
6 Overview of Capital Budgeting

 Capital Budgeting Techniques

◦ Bennett Company’s Project Cash Flows
 We will use one problem to illustrate several capital
budgeting methods
 The problem concerns Bennett Company, a medium-sized
metal fabricator that is currently contemplating two
projects that require cash outlays up front to generate
cash inflows in later years
 Project A requires an initial investment of $420,000, and
project B requires $450,000
 The projected cash flows for the two projects appear in
Table 6.1 and on the timelines in Figure 6.1
 Table 6.1 Capital Expenditure Data
for Bennett Company

Blank
Project A Project B
Initial investment −$420,000 −$450,000
Year Cash inflows
1 $140,000 $280,000
2 140,000 120,000
3 140,000 100,000
4 140,000 100,000
5 140,000 100,000
Figure 6.1 Bennett Company’s
Projects A and B
6.1 Payback Period

 Payback Period
◦ The time it takes an investment to generate cash
inflows sufficient to recoup the initial outlay required
to make the investment
 Decision Criteria
◦ 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
Example 6.1
We can calculate the payback period for Bennett Company’s projects A and B, using the
data in Table 10.1. For project A, which is an annuity, the payback period is 3.0 years
($420,000 initial investment ÷ $140,000 annual cash inflow).
Because project B generates a mixed stream of cash inflows, the calculation of its payback
period is not as clear-cut. In year one, the firm will recover $280,000 of its $450,000 initial
investment. By the end of year two, $400,000 ($280,000 from year one + $120,000 from
year two) will have been recovered. At the end of year three, $500,000 will have been
recovered. Only 50% of the year-three cash inflow of $100,000 is needed to complete the
payback of the initial $450,000. The payback period for project B is therefore 2.5 years (two
years + 50% of year three).

If Bennett’s maximum acceptable payback period were 2.75 years, it would reject project A
and accept project B. If the maximum acceptable payback period were 2.25 years, Bennett
would reject both projects. If Bennett ranked the projects, B would rank above A because it
has a shorter payback period. Note, however, that no matter what payback period Bennett
requires, it is unclear from payback analysis which investment will do the most to increase
shareholder wealth. All we can say is that project B recoups the initial investment more
rapidly than does project A.
 Example 6.2
DeYarman Enterprises, a small medical appliance manufacturer, is analyzing mutually
exclusive projects named Gold and Silver. The firm uses the payback period to choose
projects, and it requires any investment to recover its initial cost within four years. The
cash flows and payback period for each project appear in Table 10.2.
Table 6.2 Cash Flows and Payback Periods for DeYarman Enterprises’ Projects
Project Gold Project Silver
Initial investment −$50,000 −$50,000
Year Cash inflows
1 $ 5,000 $40,000
2 5,000 2,000
3 40,000 8,000
4 10,000 10,000
5 10,000 10,000
Payback period 3 years 3 years
Both projects have three-year payback periods, which suggests they are equally desirable. Comparing the
cash flow patterns reveals that Silver produces more cash flow sooner than Gold. In year one, Silver
generates $40,000 in cash inflow compared to just $5,000 for Gold. We know that because money has a
time value, it is preferable to receive cash flow sooner rather than later. The payback approach fails to
recognize that benefit. Any capital budgeting tool that properly accounts for the time value of money
would rightly favor project Silver over project Gold.
6.2 Net Present Value (NPV)
 Net Present Value (NPV)
◦ A capital budgeting technique that measures an
investment’s value by calculating the present value of
its cash inflows and outflows
◦ NPV = Present Value of Cash Inflows − Initial
Investment

n
CFt
NPV =  − CF0 (10.1)
t =1 (1 + r )
t
6.2 Net Present Value (NPV)

 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
◦ The investment’s cash inflows exceed outflows on a
present value basis, so the firm’s market value will
increase by an amount equal to the NPV
Example 6.2
We can use Equation to calculate the NPV for Bennett
Company projects A and B, whose cash flows appeared in
previous Table. Using Bennett’s 10% cost of capital to
discount the project cash flows, the calculations result in
net present values for projects A and B of $110,710 and
$109,244, respectively.
$140, 000 140, 000 140, 000 140, 000 140, 000
NPVA = −$420, 000 + + + + +
(1 + 0.10)1 (1 + 0.10) 2 (1 + 0.10)3 (1 + 0.10) 4 (1 + 0.10)5
$120, 000 $120, 000 $120, 000 $120, 000 $120, 000
NPVB = −$450, 000 + + + + + +
(1 + 0.10)1 (1 + 0.10) 2 (1 + 0.10)3 (1 + 0.10) 4 (1 + 0.10)5
Example 6.2
Figure 6.2 depicts the cash flows and NPVs for the
Bennett projects. With positive NPVs, both
projects are acceptable, but project A is more
valuable than B. Project A’s higher NPV means that
it creates more value for investors, so if managers
can pursue only one investment, they would
choose A.
Figure 6.2 Calculation of NPVs for Bennett Company’s
Capital Expenditure Alternatives
Example 6.2

Calculator use We can use the cash

flow register CF and preprogrammed NPV
function in a financial calculator to
perform the NPV calculation. The
keystrokes for project A begin with
entering the investment amount as a cash
outflow at time 0, CF0 = -420,000. Next,
enter the first annuity cash inflow, CF1 =
140,000, and then indicate the frequency
of the annuity’s cash inflow, F01 = 5. After
entering the discount rate, I/Y = 10,
compute the NPV.
Example 6.2

The keystrokes for project B—the

mixed stream—appear in the left margin.
Because the last three cash inflows for
project B are the same (CF3 = CF4 = CF5
= 100,000), after inputting the first of
these cash inflows, CF3, we merely input
its frequency, F03 = 3.
The calculated NPVs for projects A and
B of $110,710 and $109,244,
respectively, agree with the NPVs
already cited.
6.2 Net Present Value (NPV)
 NPV and the Profitability Index
◦ A variation of the NPV rule
◦ For a project that has an initial cash outflow followed
by cash inflows, the profitability index (PI) is simply
equal to the present value of cash inflows divided by
the absolute value of the initial cash outflow:

n
CFt

t =1 (1 + r )
t
PI = (10.2)
CF0
6.2 Net Present Value (NPV)
 NPV and the Profitability Index
◦ A PI greater than one implies that the present value of
cash inflows is greater than the (absolute value of the)
initial cash outflow, so a profitability index greater than
one corresponds to a positive net present value
◦ In other words, the NPV and PI methods will always
come to the same conclusion regarding whether a
particular investment is worth doing or not
Example 6.3
Figure 6.2 shows the present value of cash inflows for Bennett’s
projects A and B. Dividing those present values by each investment’s
initial cost gives the profitability index for each investment.
PIA = $530,710 ÷ $420,000 = 1.26
PIB = $559,244 ÷ $450,000 = 1.24
According to the profitability index, both projects are acceptable
(because PI > 1.0 for both), which shouldn’t be surprising because both
projects have positive NPVs. Furthermore, in this particular case, the
NPV rule and the PI both indicate that project A is preferred over
project B. It is not always true that the NPV and PI methods will rank
projects in exactly the same order. Different rankings can occur when
alternative projects require initial outlays that have very different
magnitudes.
6.3 Internal Rate of Return (IRR)
 Internal Rate of Return (IRR)
◦ The discount rate that equates the NPV of an
investment opportunity with $0 (because the
present value of cash inflows equals the initial
investment); it is the rate of return that the firm will
earn if it invests in the project and receives the
projected cash inflows
n
CFt
$0 =  − CF0 (10.4)
t =1 (1 + IRR) t

 Recognizing that projects may have cash inflows

or outflows in any time period (including period
0), we can define the IRR more generally as
n
CFt
$0 =  (10.4a)
t =0 (1 + IRR)
t
6.3 Internal Rate of Return (IRR)
 Internal Rate of Return (IRR)
◦ Decision Criteria
 If the IRR is greater than the cost of capital, accept
the project
 If the IRR is less than the cost of capital, reject the
project

 By following this rule, managers pursue only the

investments they expect to earn a rate of return
that meets or exceeds the firm’s required rate of
return. Investing in those projects should increase
the firm’s market value.
Example 6.4

Return once more to the data for the

Bennett Company in previous Table. Finding
the IRR for projects A and B means finding a
discount rate that equates the present value
of each investment’s cash inflows to its
initial outflow as shown in the timelines in
Figure 6.3.
Figure 6.3 Calculation of IRRs for Bennett
Company’s Capital Expenditure Alternatives
Example 6.4
The IRRs in shown in Figure 10.3 indicate that
both projects are acceptable because they each
provide a return greater than Bennett’s 10% cost
of capital.
IRRA = 19.9% > 10.0%
IRRB = 21.7% > 10.0%
Where do the IRR values come from? For project A,
the IRR is the interest rate that solves this equation.
$140, 000 $140, 000 $140, 000 $140, 000 $140, 000
0 = −420, 000 + + + + +
(1 + IRR) (1 + IRR) (1 + IRR) (1 + IRR) (1 + IRR)5
1 2 3 4
 Example 6.4
And likewise, the IRR for project B is the
interest rate that solves this equation

$280,000 $280,000 $280,000 $280,000 $280,000

0 = − 450,000 + + + + +
(1+ IRR) (1+ IRR) (1+ IRR) (1+ IRR) (1 + IRR)5
1 2 3 4
Example 6.4
Solving for the IRR means either using a trial-and-error
approach, a financial calculator, or a spreadsheet. It is
typically easy to make a good educated guess about where
to start. For example, project A has a large NPV when its
cash flows are discounted at 10%, which implies that the
IRR must be greater than 10%. Applying a 15% discount rate
results in an NPV of $49,302. Because the NPV is greater
than zero, the IRR must be higher still. Ultimately, through
trial-and-error you will find that the IRR is 19.9%. Likewise,
the IRR for project B is the discount rate that makes the
NPV of that project’s cash flows equal zero. Using the trial-
and-error approach you will find that the IRR for project B
is 21.7%.
Example 6.4

Calculator use To find the

IRR using the preprogrammed
function in a financial
calculator, the keystrokes for
each project are nearly the
same as those for the NPV
calculation. Rather than
entering a value for I/Y and
computing NPV, enter the
cash flows and push CPT and
IRR.
Example 6.5
Lorenzo Flores is evaluating an investment
opportunity that costs $7,500. He expects
to receive annual cash flows of $500 per
year in each of the first four years,
followed by $700 per year at the end of
years five through eight. He plans to sell
the investment at the end of year eight
and net $9,000. Based on the investment’s
risk, Lorenzo wants to earn at least a 9%
return.
Example 6.5
To calculate the investment’s IRR, Lorenzo first summarizes the cash flows as
shown in the following table:

Year Cash flow

0 −$7,500 (Initial investment)
1 500
2 500
3 500
4 500
5 700
6 700
7 700
8 9,700 ($700 + $9,000)

Substituting the cash flows for years zero through eight into a financial calculator
or spreadsheet, he finds the investment’s IRR of 9.54%. Given that the projected
IRR of 9.54% exceeds Lorenzo’s 9% required return, he chooses to spend $7,500
to make the investment.
Example 10.15 (2 of 2)

With a single present value at time zero and a

single future value at time two, the MIRR equals:
1
 
2

 
$248  (1 + 0.15)1
MIRR =   −1
 −$160 
 −$93 + 
 (1 + 0.15) 2

1
 $285.20 2
=  −1
 $213.98 
= 0.1545or15.45%

The MIRR of 15.45% is greater than the cost of capital of 15%, so

the project is worth undertaking.
Comparing NPV and IRR Techniques

 Is NPV or IRR Better?

◦ Theoretical View
 On a theoretical basis, NPV is the better approach
to capital budgeting for several reasons
 Most importantly, the NPV measures how much
wealth a project creates (or destroys if the NPV is
negative) for shareholders
 “Gold standard” for evaluating investment
opportunities
Comparing NPV and IRR Techniques

 Which Approach Is Better?

◦ Theoretical View
 For an investment project, the NPV calculation
always provides a single answer, but sometimes the
IRR calculation has more than one solution
 Makes implementing the accept-or-reject decision
problematic
Comparing NPV and IRR Techniques
 Which Approach Is Better?
◦ Practical View
 Despite the advantages of NPV, financial managers use
the IRR approach as often, or perhaps more often, than
the NPV method
 The intuitive appeal of the IRR technique is due to the
general disposition of business people to think in
terms of rates of return rather than actual dollar
returns
◦ Firms that analyze investments using the IRR
technique often calculate project NPVs as well, so
the theoretical shortcomings of the IRR most likely
do not often lead managers to make suboptimal
decisions
 End of Week 8

McGraw-Hill/Irwin 1-40