Capital Budgeting
Processes And Techniques
Professor XXXXX
Course Name / Number
The Capital Budgeting Decision
Process
The Capital Budgeting Process involves three basic
steps:
• Generating long-term investment proposals
• Reviewing, analyzing, and selecting from the proposals
that have been generated
• Implementing and monitoring the proposals that have
been selected
Managers should separate investment and
financing decisions
2
Capital Budgeting Decision
Techniques
– Payback period: most commonly used
– Accounting rate of return (ARR): focuses
on project’s impact on accounting profits
– Net present value (NPV): best technique
theoretically
– Internal rate of return (IRR): widely used
with strong intuitive appeal
– Profitability index (PI): related to NPV
3
A Capital Budgeting Process
Should:
Account for the time value of money
Account for risk
Focus on cash flow
Rank competing projects appropriately
4
Lead to investment decisions that maximize
shareholders’ wealth
Entropica Investment
• Entropica is a provider of magnetic resonance
imaging devices
• Entropica evaluating two investment proposals
– Construction of completely new manufacturing plant
– Refurbishing an existing plant
Construction ($ millions)
5
Refurbishing ($ millions)
Initial outlay
-$1,200
Initial outlay
-$75
Year 1 inflow
$100
Year 1 inflow
$22
Year 2 inflow
$250
Year 2 inflow
$30
Year 3 inflow
$400
Year 3 inflow
$41
Year 4 inflow
$740
Year 4 inflow
$47
Year 5 inflow
$850
Year 5 inflow
$48
Payback Period
The payback period is the amount of time required
for the firm to recover its initial investment
– If the project’s payback period is less than the
maximum acceptable payback period, accept the
project
– If the project’s payback period is greater than the
maximum acceptable payback period, reject the
project
6
Management determines maximum
acceptable payback period
Calculating Payback Periods For
Entropica Projects
• Management selects a 3-year payback period
• Construction project has initial outflow of
-$1,200 million
– But cash inflows over first 3 years only $750 million
– Entropica would reject construction project based on
payback
• Refurbishing project has initial outflow of -$75
million
– Cash inflows over first 3 years cumulate to $93
million
– Project recovers initial outflow middle of year 3
– Entropica would accept the project
7
Pros And Cons Of Payback Method
Advantages of payback method:
– Computational simplicity
– Easy to understand
– Focus on cash flow
Disadvantages of payback method:
– Does not account properly for time value of money
– Does not account properly for risk
– Cutoff period is arbitrary
8
– Does not lead to value-maximizing decisions
Discounted Payback Period
• Discounted payback accounts for time value
– Apply discount rate to cash flows during payback
period
– Still ignores cash flows after payback period
• Entropica uses a 16% discount rate
PV Factors
(16%)
Construction
project ($million)
Refurbishing
project
($million)
PV Year 1 inflow
0.8621
$86.21
$18.97
PV Year 2 inflow
0.7432
$185.79
$22.29
PV Year 3 inflow
0.6407
$256.26
$26.27
Cumulative PV
--
$528.26
$67.53
Accept / reject
--
Reject
Reject
Item
9
Accounting Rate Of Return (ARR)
Can be computed from available accounting data
– Need only profits after taxes and depreciation
– Accounting ROR = Average profits after taxes 
Average investment
• Average profits after taxes are estimated by
subtracting average annual depreciation from
the average annual operating cash inflows
Average profits = Average annual
operating cash inflows
after taxes
10
Average annual
depreciation
• ARR uses accounting numbers, not cash flows; no time
value of money
Net Present Value
The present value of a project’s cash inflows and
outflows
Discounting cash flows accounts for the time value
of money
Choosing the appropriate discount rate accounts for
risk
CF3
CFN
CF1
CF2
NPV  CF0 


 ... 
2
3
N
(1  r )
(1  r )
(1  r )
(1  r )
11
Accept projects if NPV > 0
Net Present Value
CF3
CFN
CF1
CF2
NPV  CF0 


 ... 
2
3
(1  r )
(1  r )
(1  r )
(1  r ) N
A key input in NPV analysis is the discount rate
r represents the minimum return that the
project must earn to satisfy investors
r varies with the risk of the firm and/or the risk
of the project
12
Calculating NPVs For Entropica’s
Projects
• Assuming Entropica uses 16% discount rate,
NPVs are:
Construction project: NPV = $141.65 million
NPVConstruction  141.65  1,2 00 
100
250
400
740
850




(1.16) (1.16) 2 (1.16) 3 (1.16) 4 (1.16) 5
Refurbishing project: NPV = $41.43 million
NPVRe furbishing  41.34  75 
22
30
41
47
48




(1.16) (1.16) 2 (1.16) 3 (1.16) 4 (1.16) 5
Should Entropica invest in one project or both?
13
Independent versus Mutually
Exclusive Projects
• Independent projects – accepting/rejecting one
project has no impact on the accept/reject decision
for the other project
• Mutually exclusive projects – accepting one project
implies rejecting another
• Both Entropica projects deal with production
capacity
– If demand is high enough, projects may be independent
– If demand warrants only one investment, projects are
mutually exclusive
• When ranking mutually exclusive projects, choose
the project with highest NPV
14
Pros and Cons Of Using NPV As
Decision Rule
• NPV is the “gold standard” of investment
decision rules
• Key benefits of using NPV as decision rule
– Focuses on cash flows, not accounting earnings
– Makes appropriate adjustment for time value of
money
– Can properly account for risk differences between
projects
• Though best measure, NPV has some drawbacks
– Lacks the intuitive appeal of payback
– Doesn’t capture managerial flexibility (option value)
well
15
Internal Rate of Return
Internal rate of return (IRR) is the discount rate
that results in a zero NPV for the project
CF3
CFN
CF1
CF2
NPV  0  CF0 


 .... 
2
3
(1  r ) (1  r )
(1  r )
(1  r ) N
• IRR found by computer/calculator or manually by
trial and error
The IRR decision rule is:
– If IRR is greater than the cost of capital, accept the
project
– If IRR is less than the cost of capital, reject the project
16
Calculating IRRs For Entropica’s
Projects
• Entropica will accept all projects with at least
16% IRR:
Construction project: IRR (rC) = 19.63%
0  1,200 
100
250
400
740
850




(1  rC ) (1  rC ) 2 (1  rC ) 3 (1  rC ) 4 (1  rC ) 5
Refurbishing project: IRR (rR) = 34.54%
0  75 
22
30
41
47
48




(1  rR ) (1  rR ) 2 (1  rR ) 3 (1  rR ) 4 (1  rR ) 5
Which project looks better if Entropica can invest only in
one?
17
Advantages of IRR
Properly adjusts for time value of money
Uses cash flows rather than earnings
Accounts for all cash flows
Project IRR is a number with intuitive appeal
18
Disadvantages of IRR
Three key problems encountered in using
IRR:
– Lending versus borrowing?
– Multiple IRRs
– No real solutions
IRR and NPV rankings do not always agree
19
Lending Versus Borrowing
IRR can give incorrect answers for projects with
non-standard cashflows
– Project 1: Invest $120 today, receive $170 in one year
– Project 2: Receive $120 today, pay back $170 in one
year
– Project 1 amounts to lending; project 2 to borrowing
Project
#1
#2
20
CF today
-$120
+$120
CF in one yr
+$170
-$170
IRR
41.67%
41.67%
NPV (20%)
+$21.67
-$21.67
• Both projects have same IRR, but #1 obviously
superior
– When borrowing, a low IRR is preferred on the loan.
Multiple IRRs
NPV ($)
IRR
NPV>0
NPV>0
NPV<0
NPV<0
Discount
rate
IRR
When project cash flows have multiple sign changes, there can be
multiple IRRs
21
With multiple IRRs, which do we compare with the cost of capital to
accept/reject the project?
No Real Solution
Sometimes projects do not have a real IRR solution
– Modify Entropica’s construction project to
include a large negative outflow (-$1,300
million) in year 6.
– There is no real number that will make NPV=0,
so no real IRR.
– Project is a bad idea based on NPV. At r =16%,
project has NPV= -$391.92 million, so
reject!
22
Conflicts Between NPV and IRR
• NPV and IRR do not always agree when
ranking competing projects
• The scale problem
Project
IRR
NPV (16%)
Construction
19.63%
$141.65 mn
Refurbishing
36.53%
$41.34 mn
• Refurbishing project has higher IRR, but doesn’t
increase shareholders’ wealth as much as
construction project
23
The Timing Problem
NPV
Long-term
project
IRR = 15%
Short-term
project
13% 15%
17%
IRR = 17%
Discount
rate
• The NPV of the long-term project is more sensitive to the discount
rate than the NPV of the short-term project is
24
• Long-term project has higher NPV if the cost of capital is less than
13%. Short-term project has higher NPV if the cost of capital is
greater than 13%
Reconciling NPV and IRR
• Timing and scale problems can cause NPV
and IRR methods to rank projects differently
• In these cases, calculate the IRR of the
incremental project
– Cash flows of large project minus cash flows of
small project
– Cash flows of long-term project minus cash flows
of short-term project
• If incremental project’s IRR exceeds the cost
of capital
– Accept the larger project
– Accept the longer term project
25
Profitability Index
Calculated by dividing the PV of a project’s cash
inflows by the PV of its outflows
CF1
CF2
CFT

 ... 
2
(1  r ) (1  r )
(1  r ) T
PI 
CF0
• Decision rule: Accept projects with PI > 1.0, equal to NPV > 0
Project
PV of CF (yrs1-5)
Initial Outlay
PI
Construction
$1341.65 mn
$1.2 bn
1.12
Refurbishing
$116.34 mn
$75 mn
1.55
• Both projects’ PI > 1.0, so both acceptable if independent
26
Like IRR, PI suffers from the scale problem
Capital Budgeting
Generating, reviewing, analyzing, selecting, and
implementing long-term investment proposals
Payback Period
Discounted payback period
Accounting rate of return
Net Present Value (NPV)
Internal rate of return (IRR)
Profitability index (PI)