CHAPTER 10
The Fundamentals of Capital Budgeting
Learning Objectives
1. Discuss why capital budgeting decisions are the most important decisions made by a
firm’s management.
2. Explain the benefits of using the net present value (NPV) method to analyze capital
expenditure decisions, and be able to calculate the NPV for a capital project.
3. Describe the strengths and weaknesses of the payback period as a capital
expenditure decision-making tool, and be able to compute the payback period for a
capital project.
4. Explain why the accounting rate of return (ARR) is not recommended for use as a
capital expenditure decision-making tool.
5. Be able to compute the internal rate of return (IRR) for a capital project, and
discuss the conditions under which the IRR technique and the NPV technique
produce different results.
6. Explain the benefits of a postaudit review of a capital project.
I.
Chapter Outline
10.1
An Introduction to Capital Budgeting
A.
The Importance of Capital Budgeting
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
Capital budgeting decisions are the most important investment decisions made
by management.

The goal of these decisions is to select capital projects that will increase the
value of the firm.

Capital investments are important because they involve substantial cash
outlays and, once made, are not easily reversed.

Capital budgeting techniques help management to systematically analyze
potential business opportunities in order to decide which are worth
undertaking.
B.
Sources of Information

Most of the information needed to make capital budgeting decisions is
generated internally, beginning likely with the sales force.

Then the production team is involved, followed by the accountants.

All this information is then reviewed by the financial managers, who evaluate
the feasibility of the project.
C.
Classification of Investment Projects

Capital budgeting projects can be broadly classified into three types: (1)
independent projects; (2) mutually exclusive projects; and (3) contingent
projects.
1. Independent Projects

Projects are independent when their cash flows are unrelated.

If two projects are independent, accepting or rejecting one project has
no bearing on the decision on the other.
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2. Mutually Exclusive Projects

When two projects are mutually exclusive, accepting one
automatically precludes the other.

Mutually exclusive projects typically perform the same function.
3. Contingent Projects

Contingent projects are those in which the acceptance of one project is
dependent on another project.

There are two types of contingency situations:

Projects that are mandatory

Projects that are optional
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D.
Basic Capital Budgeting Terms

The cost of capital is the minimum return that a capital budgeting project
must earn for it to be accepted.

It is an opportunity cost since it reflects the rate of return investors can earn on
financial assets of similar risk.

Capital rationing implies that a firm does not have the resources necessary to
fund all of the available projects.

It implies that funding needs exceed funding resources.

Thus, the available capital will be allocated to the set of projects that will
benefit the firm and its shareholders the most.
10.2
Net Present Value

It is a capital budgeting technique that is consistent with the goal of maximizing
shareholder wealth.

The method estimates the amount by which the benefits or cash flows from a project
exceeds the cost of the project in present value terms.
A.
Valuation of Real Assets


Valuing real assets calls for the same steps as valuing financial assets.

Estimate future cash flows.

Determine the investor’s cost of capital or required rate of return.

Calculate the present value of the future cash flows.
However, there are some practical difficulties in following the process for real
assets.
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
First, cash flow estimates have to be prepared in-house and are not readily
available as they are for financial assets in legal contracts.

Second, estimates of required rates of return are more difficult than it is for
financial assets because no market data is available for real assets.
B.
NPV—The Basic Concept

The present value of a project is the difference between the present value of the
expected future cash flows and the initial cost of the project.

Accepting a positive NPV project leads to an increase in shareholder wealth,
while accepting a negative NPV project leads to a decline in shareholder wealth.

Projects that have an NPV equal to zero imply that management will be
indifferent between accepting and rejecting the project.
C.
Framework for Calculating NPV

The NPV technique uses the discounted cash flow technique.

Our goal is to compute the net cash flow (NCF) for each time period t, where NCFt =
(Cash inflows – Cash outflows) for the period t.

A five-step approach can be utilized to compute the NPV.
1. Determine the cost of the project.

Identify and add up all expenses related to the cost of the project.

While we are mostly looking at projects whose entire cost occurs at the start
of the project, we need to recognize that some projects may have costs
occurring beyond the first year also.

The cash flow in year 0 (NCF0) is negative, indicating a cost.
2. Estimate the project’s future cash flows over its expected life.
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
Both cash inflows (CIF) and cash outflows are likely in each year of the
project. Estimate the net cash flow (NCFt) = CIFt – COFt for each year of the
project.

Remember to recognize any salvage value from the project in its terminal
year.
3. Determine the riskiness of the project and the appropriate cost of capital.

The cost of capital is the discount rate used in determining the present value of
the future expected cash flows.

The riskier the project, the higher the cost of capital for the project.
4. Compute the project’s NPV.

Determine the difference between the present value of the expected cash flows
from the project and the cost of the project.
5. Make a decision.

Accept the project if it produces a positive NPV or reject the project if NPV is
negative.
D.
Concluding Comments on NPV

Beware of optimistic estimates of future cash flows.

Recognize that the estimates going into calculating NPV are estimates and not
market data. Estimates based on informed judgments are considered acceptable.

The NPV method of determining project viability is the recommended approach
for making capital investment decisions.

The NPV decision criteria can be summed up as follows:
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Summary of Net Present Value (NPV) Method
Decision Rule: NPV > 0: Accept the project.
NPV < 0: Reject the project.
Key Advantages
Key Disadvantages
1. Uses the discounted cash flow
1. Difficult to understand without an
valuation technique.
accounting and finance background.
2. Provides a direct measure of how much
a capital project will increase the value
of the firm.
3. Consistent with the goal of maximizing
shareholder wealth.
10.3
The Payback Period

It is one of the most widely used tools for evaluating capital projects.

The payback period represents the number of years it takes for the cash flows from a
project to recover the project’s initial investment.

A project is accepted if its payback period is below some prespecified threshold.

This technique can serve as a risk indicator—the more quickly you recover the cash,
the less risky is the project.
A.
Computing the Payback Period

To compute the payback period, we need to know the project’s cost and to
estimate its future net cash flows.

Equation 10.2 shows how to compute the payback period.
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PB  Years before cost recovery 

Remaining cost to recover
Cash flow during the year
There is no economic rationale that links the payback method to shareholder
wealth maximization.

If a firm has a number of projects that are mutually exclusive, the projects are
selected in order of their payback rank: projects with the lowest payback period
are selected first.
B.
How the Payback Period Performs

The payback period analysis can lead to erroneous decisions because the rule does
not consider cash flows after the payback period.

A rapid payback does not necessarily mean a good investment. See Exhibit
10.6—Projects D and E.
C.
The Discounted Payback Period

One weakness of the ordinary payback period is that it does not take into account
the time value of money.

The discounted payback period calculation calls for the future cash flows to be
discounted by the firm’s cost of capital.

The major advantage of the discounted payback is that it tells management how
long it takes a project to reach a positive NPV.

However, this method still ignores all cash flows after the arbitrary cutoff period,
which is a major flaw.
D.
Evaluating the Payback Rule

The standard payback period is widely used in business.
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
It provides a simple measure of an investment’s liquidity risk.

The greatest advantage of the payback period is its simplicity.

It ignores the time value of money.

It does not adjust or account for differences in the overall, or total, risk for a
project, which could include operating, financing, and foreign exchange risk.

The biggest weakness of either the standard or discounted payback methods is
their failure to consider cash flows after the payback.

The following table summarizes this capital budgeting technique.
Summary of Payback Method
Decision Rule: Payback period ≤ Payback cutoff point  Accept the project.
Payback period > Payback cutoff point  Reject the project.
Key Advantages
1. Easy to calculate and understand for
Key Disadvantages
1. Most common version does not account
people without strong finance
backgrounds.
for time value of money.
2. Does not consider cash flows past the
2. A simple measure of a project’s
liquidity.
payback period
3. Bias against long-term projects such as
research and development and new
product launches.
4. Arbitrary cutoff point.
10.4
The Accounting Rate of Return
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
It is sometimes called the book rate of return.

This method computes the return on a capital project using accounting numbers—the
project’s net income (NI) and book value (BV) rather than cash flow data.

The most common definition is the one given in Equation 10.3:
ARR 

Average NI
Average BV
It has a number of major flaws as a tool for evaluating capital expenditure decisions.

First, the ARR is not a true rate of return. ARR simply gives us a number based
on average figures from the income statement and balance sheet.

It ignores the time value of money.

There is no economic rationale that links a particular acceptance criterion to the
goal of maximizing shareholders’ wealth.
10.5
Internal Rate of Return

The IRR is an important and legitimate alternative to the NPV method.

The NPV and IRR techniques are similar in that both depend on discounting the cash
flows from a project.

When we use the IRR, we are looking for the rate of return associated with a project
so we can determine whether this rate is higher or lower than the firm’s cost of
capital.

The IRR is the discount rate that makes the NPV to equal zero.
A.
Calculating the IRR

The IRR is an expected rate of return, much like the yield to maturity calculation
that was made on bonds.
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
B.
We will need to apply the same trial-and-error method to compute the IRR.
When the IRR and NPV Methods Agree

The two methods will always agree when the projects are independent and the
projects’ cash flows are conventional.

After the initial investment is made (cash outflow), all the cash flows in each
future year are positive (inflows).
C.
When the IRR and NPV Methods Disagree

The IRR and NPV methods can produce different accept/reject decisions if a
project either has unconventional cash flows or the projects are mutually
exclusive.
1. Unconventional Cash Flows

Unconventional cash flows could follow several different patterns.
 A positive initial cash flow followed by negative future cash flows.
 Future cash flows from a project could include both positive and negative
cash flows.
 A cash flow stream that looks similar to a conventional cash flow stream
except for a final negative cash flow.

In these circumstances, the IRR technique can provide more than one solution.
This makes the result unreliable and should not be used in deciding about
accepting or rejecting a project.
2. Mutually Exclusive Projects

When you are comparing two mutually exclusive projects, the NPVs of the
two projects will equal each other at a certain discount rate. This point at
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which the NPVs intersect is called the crossover point. Depending on whether
the required rate of return is above or below this crossover point, the ranking
of the projects will be different. While it is easy to identify the superior
project based on the NPV, one cannot do so based on the IRR. Thus, ranking
conflicts can arise.

A second situation arises when you compare projects with different costs.
While IRR gives you a return based on the dollar invested, it does not
recognize the difference in the size of the investments. NPV does!
D.
Modified Internal Rate of Return (MIRR)

A major weakness of the IRR compared to the NPV method is the reinvestment
rate assumption.

IRR assumes that the cash flows from the project are reinvested at the IRR,
while the NPV assumes that they are invested at the firm’s cost of capital.

This optimistic assumption in the IRR method leads to some projects being
accepted when they should not be.

An alternative technique is the modified internal rate of return (MIRR). Here,
each operating cash flow is reinvested at the firm’s cost of capital.

The compounded values are summed up to get the project’s terminal value.

The MIRR is the interest rate that equates the project’s cost to the terminal value
at the end of the project.

E.
Equation 10.5 shows how to calculate the MIRR.
IRR versus NPV: A Final Comment
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
While the IRR has an intuitive appeal to managers because the output is in the
form of a return, the technique has some critical problems.

On the other hand, decisions made based on the project’s NPV are consistent with
the goal of shareholder wealth maximization. In addition, the result shows
management the dollar amount by which each project is expected to increase the
value of the firm.

For these reasons, the NPV method should be used to make capital budgeting
decisions.

The following table summarizes the IRR decision-making criteria.
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Review of Internal Rate of Return (IRR)
Decision Rule: IRR > Cost of capital  Accept the project.
IRR < Cost of capital  Reject the project.
Key Advantages
1. Intuitively easy to understand.
2. Based on the discounted cash flow
technique.
Key Disadvantages
1. With nonconventional cash flows, IRR
approach can yield no or multiple answers.
2. A lower IRR can be better if a cash inflow is
followed by cash outflows.
3. With mutually exclusive projects, IRR can
lead to incorrect investment decisions.
10.6
Capital Budgeting in Practice
Practitioners’ Methods of Choice
A.

Exhibit 10.12 summarizes surveys of practitioners on the capital budgeting
methods of choice.

In the late 1950s, less than 20 percent of managers used the NPV or IRR methods.

By 1981, over 65 percent of financial managers surveyed used the IRR, but only
16.5 percent of managers used the NPV.

In a recent study of Fortune 1000 managers, 85 percent of managers used the
NPV while 77 percent used the IRR. Surprisingly, over 50 percent of managers
used the payback method.
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B.
Ongoing and Postaudit Reviews

Management should systematically review the status of all ongoing capital
projects and perform postaudits on all completed capital projects.

In a postaudit review, management compares the actual results of a project with
what was projected in the capital budgeting proposal.

A postaudit examination would determine why the project failed to achieve its
expected financial goals.

Managers should also conduct ongoing reviews of capital projects in progress.

The review should challenge the business plan, including the cash flow
projections and the operating cost assumptions.

Management must also evaluate people responsible for implementing a capital
project.
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