Weighing Net Present Value and Other Capital Budgeting
Criteria
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
1 McGraw-Hill/Irwin

Capital Budgeting Techniques
Project evaluation methods
• Net Present Value (NPV) is preferred method
• Internal Rate of Return (IRR)
• Payback (PB)
13-2

Capital Budgeting Techniques
Project evaluation methods
• Discounted Payback (DPB)
• Modified Internal Rate of Return (MIRR)
• Profitability Index (PI)
13-3

Choice of Decision Statistic
Format
• Financial decisions primarily driven by
– Currency
– Time
– Rate of return
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Capital Budgeting Decisions
• Deciding on single project acceptance
– Compute statistic
– Compare with benchmark
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Capital Budgeting Decisions
• Deciding on mutually exclusive projects
– Compute statistic
– Conduct “runoff” between mutually exclusive projects
– Compare winning project with benchmark
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Payback and Discounted Payback
• Payback statistic
– Break-even calculation for costs of financing new project
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Payback Benchmark
• Benchmark can vary
• Based on relevant external constraint
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Discounted Payback
Statistic
• Compensates for time value of money
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Discounted Payback Benchmark
• Not recommended to compare Discounted
Payback Benchmark (DPB) with Payback
Benchmark (PB)
• DPB will be larger than regular PB
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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
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Net Present Value
• Measures value created by the project
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NPV Benchmark
• Includes all cash flows – both inflows and outflows
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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
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Internal Rate of Return 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
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NPV vs. IRR
• NPV and IRR are closely related
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Internal Rate of Return Statistic
• To calculate IRR, solve the NPV formula for interest rate that makes NPV equal zero
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IRR Benchmark
– Calculate the IRR and compare cost of capital (investors’ required return) to see if the project is acceptable
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Problems with IRR
• IRR will be consistent with NPV as long as project:
– has normal cash flows
– is independent
13-19

IRR and NPV with Non-normal
Cash Flows
• Recommended not to use IRR with nonnormal cash flows
• Modified Internal Rate of Return is better
13-20

Differing Reinvestment Rate
Assumptions of NPV and IRR
• NPV and IRR assume cash flows are reinvested in firm
• NPV’s reinvestment rate assumption is considered superior to IRR’s
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Modified Internal Rate of Return
• “Fixes” IRR reinvestment rate problem
• Modification to IRR
– Uses cost of capital to move cash flows
• MIRR not appropriate for mutually exclusive projects
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IRR, MIRR, NPV
Mutually Exclusive Projects
• Rate-based statistics cause problems when project cash flows have differences in
– scale
– timing
13-23

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
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Profitability Index
• Based on NPV
• Use when firm has resource constraints on capital available for new project
13-25