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Learning Objectives
Chapter 9
Capital-Budgeting Decision Criteria
Learning Objectives
• Determine whether a new project should be
accepted using the profitability index.
• Determine whether a new project should be
accepted using the internal rate of return.
• Explain the importance of ethical
considerations in capital-budgeting decisions.
• Discuss the trends in the use of different
capital-budgeting criteria.
Capital Budgeting
•
•
•
•
•
Payback Period
Net Present Value
Profitability Index
Internal Rate of Return
Capital Rationing
 Discuss the difficulty of finding profitable
projects in competitive markets.
 Determine whether a new project should be
accepted using the payback period.
 Determine whether a new project should be
accepted using the net present value.
Capital Budgeting
• Investments in fixed assets
• An approach to source and evaluate
profitable projects
• Evaluating the profitability of projects
• Often choosing between one or more
projects
Payback Period
• Number of years needed to recover the
initial cash outlay of a capital budgeting
project
• Deals with cash flows
• Ignores the time value of money and
does not discount these free cash flows
back to the present.
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Payback Period
Example:
Project with an initial cash outlay of $10,000 with
following free cash flows for 5 years.
YEAR
CASH FLOW
BALANCE
$
2,000
($ 8,000)
2
4,000
(
3
3,000
(
4
3,000
2,000
5
10,000
12,000
1
Payback Period
• Ignores the time value of money and
does not discount these free cash flows
back to the present.
4,000)
1,000)
Payback is 3 1/2 years
Net Present Value or NPV
• Present value of the free cash flows less
the initial outlay
• Gives a measurement of the net value of
a project in today’s dollars
• If NPV > 0, accept
• If NPV < 0, reject
NPV
• Examines cash flows, not profits
• Recognizes time value of money
• By accepting only positive NPV projects,
increases value of the firm
Net Present Value or NPV
Example: Project with an initial cash outlay of $40,000
with following free cash flows for 5 years.
Yr
FCF
Yr
FCF
Initial outlay -40,000
3
13,000
1
14,000
4
12,000
2
13,000
5
11,000
The firm has a 12% required rate of return and the present
value of the FCF’s is $47,678. Subtracting the initial
cash outlay of $40,000 leaves an NPV of $7,678.
NPV>0, therefore we accept.
Profitability Index
• Benefit-cost ratio
• Ratio of the present value of the future
free cash flows to the initial outlay
• Generates same results as NPV
• PI = PV FCF/ Initial outlay
• PI > 1 = accept PI < 1 = reject
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Profitability Index
Profitability Index
FCF
A firm with a 10% required rate of
return is considering investing in a
new machine with an expected life of
six years. The initial cash outlay is
$50,000.
Profitability Index
PI = ($13,635 + $6,608+$7,510 + $8,196 + $8,694
+ $9,024) / $50,000
=$53,667/$50,000
= 1.0733
Project PI > 1
• Therefore, accept.
Internal Rate of Return or IRR
• Discount rate that equates the present
value of a project’s future net cash flows
with the project’s initial cash outlay
• If IRR > Required rate of return, accept
• IF IRR < Required rate of return, reject
PV (@10%)
Initial
Outlay
-$50,000
-$50,000
Year 1
15,000
13,635
Year 2
8,000
6,608
Year 3
10,000
7,510
Year 4
12,000
8,196
Year 5
14,000
8,694
Year 6
16,000
9,024
NPV and PI
• When the present value of a project’s
cash flows are greater than the initial
cash outlay, the project NPV will be
positive.
• PI will also be greater than 1.
• NPV and PI will always yield the same
decision
IRR and NPV
• If NPV is positive, IRR will be greater
than the required rate of return
• If NPV is negative, IRR will be less than
required rate of return
• If NPV = 0, IRR is the required rate of
return.
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Modified IRR
IRR
Purchase $3,817
Cash flows Yr.1=$1,000, Yr. 2=$2,000, Yr.
3=$3,000
Discount rate
NPV
15%
$4,356
20%
$3,958
22%
$3,817
IRR is between 22% because the NPV equals
the initial cash outlay
Calculating the MIRR
• Project having a 3yr. Life and a required
rate of return of 10% with the following
cash flows:
FCF’s
FCF’s
Initial
Outlay
-$6,000
Year 2
$3,000
Year 1
2,000
Year 3
4,000
Capital Rationing
• Limit on the dollar size of the capital
budget
• Often a firm may select a set of projects
with the highest NPV– subject to the
capital constraint
• May preclude accepting the highest
ranked project in terms of PI or IRR
• Primary drawback of the IRR relative to the
net present value is the reinvestment rate
assumption made by the internal rate of return
• Modified IRR allows the decision maker to
directly specify the appropriate reinvestment
rate
• MIRR> required rate of return: Accept
• MIRR< required rate of return: Reject
Calculating the MIRR
• Step 1: Determine the PV of the project’s cash outflows. $6,000 is
already at present.
• Step 2: Determine the terminal value of the project’s free cash flows.
To do this use the project’s required rate of return to calculate the
FV of the project’s three cash flows of the project’s cash outflows.
They turn out to be $2,420 +$3,300 + $4,000 = $9,720 for the
terminal value
• Step 3: Determine the discount rate that equates to the PV of the
terminal value and the PV of the project’s cash outflows. MIRR=
17.446% > required rate of return: Accept
Ranking Problems
• Size Disparity
• Time Disparity
• Unequal Life
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Popularity of Capital
Budgeting Techniques
The Multinational Firm: Capital
Budgeting
Percent of Firms Using Each
Method used
PrimarySecondary
Method Method Firms
IRR
NPV
Payback
PI
88%
63%
24%
15%
11%
22%
59%
18%
Total
99%
85%
83%
33%
Source: Harold Bierman, Jr.,”Capital Budgeting in 1992: A Survey,”
Financial Management (Autumn 1993):24.
• The key to success in capital budgeting is
finding good projects
• Often these projects are overseas in today’s
global environment
• Joint ventures and strategic alliances are
current trends
• Some companies have > 50% of their
revenues from sales abroad
How Do Financial Managers
Use this Material?
• If you don’t take on new projects, a company
couldn’t continue to exist
• Finding new projects and correctly evaluating
them are key
• Whatever decision made results in an
investment in fixed assets
• Process often called “strategic planning” but
involves the Capital Budgeting Process
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