Chapter 10
Capital
Budgeting
Decisions
Chapter 10 Outline
The Capital
Budgeting
Process
Evaluating
Investment
Projects
2
• What is capital budgeting?
• Where does value come from?
• Discounted cash flow and maximizing owners’
wealth
• The net present value method (NPV)
• The internal rate of return (IRR)
• Payback methods
• The profitability index
• What methods do companies really use?
The capital budgeting process
 A capital expenditure
is a company’s
investment in long-lived assets, which may be
tangible assets, such as property, plants, and
equipment, or intangible assets, such as
research and development, copyrights, brand
names, and franchise agreements.
 Tangible assets are hard, physical assets,
whereas intangible ones are more abstract; it
is easier for a company to borrow against
tangible assets than against intangible ones.
3
What is capital budgeting?
 Analysis
of potential additions to fixed
assets.
 Long-term decisions; involve large
expenditures.
 Necessary for a company’s future.
Steps to capital budgeting
Estimate cash flows (inflows & outflows).
Assess riskiness of the cash flows
Determine the appropriate cost of capital.
Apply a capital budgeting technique (e.g., NPV).
Make a decision.
Where does value come from?
A company that does not invest effectively will find itself
at a competitive disadvantage, which in the extreme will
affect its long-term survival.


6
In the short run, poor investment decisions will make a company
less attractive than those that have better prepared themselves for
the future.
Recall from economics that to earn more than a “normal” profit, a
company must have some type of comparative or competitive
advantage.
What profit?
 Normal profit
- the return on an investment
that compensates the investor for explicit and
implicit costs, where implicit costs include the
opportunity cost of the investor’s capital.
 Economic profit - the return on an investment
in excess of the normal profit. This is the
essence of creating value: generating
economic profits through capital investment.
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Value
A comparative advantage is the ability of a
company to produce a product at a lower
cost than its competitors.
 This includes the innate advantage that a
company has over other companies due to
access to resources, inputs, or markets.
 Examples of such access include ownership of
oil fields, mines, chemicals, land, or production
of inputs.
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Value
Competitive advantage - any strategy or
company action that reduces the competition
that the company experiences.



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These advantages include patents, copyrights, and
trademarks, which may keep competitors at bay, or
at least slow down imitations of products.
An example of competitive advantage is economies
of scale;
Another example of a competitive advantage is
when a government grants a monopoly to a
company.
Porter’s Five Forces
Michael Porter reframed these basic economic
principles by identifying five critical factors that
determine the attractiveness of an industry in
terms of the ability to generate economic profit,
often referred to as the five forces:
1.
2.
3.
4.
5.
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Entry barriers
The threat of substitutes
The bargaining power of buyers
The bargaining power of suppliers
Rivalry among existing competitors
Discounted cash flow (DCF) and
maximizing owners’ wealth
 DCF valuation involves
estimating future cash
flows and comparing their discounted values with
investment outlays required today.

In this way, they are technically identical to the
approaches used to evaluate bonds and stock.
 The
only practical difference is that whereas the
cash flows are fixed in valuing bonds and shares in
the sense that the analyst cannot change them, in
making capital investment decisions the analyst
can change the underlying cash flows by changing
the structure of the project.
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What is the difference between
independent and mutually exclusive
projects?
 Independent
projects – if the cash flows of
one are unaffected by the acceptance of
the other.
 Mutually exclusive projects – if the cash
flows of one affects the acceptance of the
other.
What is the difference between
normal and nonnormal cash flow
streams?
 Normal
cash flow stream – Cost (negative
CF) followed by a series of positive cash
inflows. One change of signs.
 Nonnormal cash flow stream – Two or
more changes of signs. Most common:
Cost (negative CF), then string of positive
CFs, then cost to close project. Nuclear
power plant, strip mine, etc.
Techniques for evaluating
cash flows
Net present
value
Internal rate
of return
Modified
internal rate
of return
Payback
periods
Profitability
index
Net present value
The net present value
The net present value (NPV) of an investment is the estimated
value added of a project, which we calculate as the sum of the
present value of all future after-tax incremental cash flows
generated by an initial cash outlay, less the present value of
the investment outlays.
The NPV is the present value of the expected cash flows net of the
costs needed to generate them.
where CFn = the estimated cash flow at time n, and CF0 = the initial
cash outlay, which is a negative cash flow.
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Sample projects
End of year cash flows
Year
Project A
Project B
0
-$100.00
-$100.00
1
$25.00
$0.00
2
$50.00
$0.00
3
$75.00
$155.00
Assume that the required rate of return for each project is 10%
Net Present Value (NPV)
 The
net present value is the sum of the
PVs of all cash inflows and outflows of a
project.
 The discount rate is the project’s cost of
capital, r.
N
NPV  
t 0
CFt
t
(1  r )
What is Project A’s NPV?
Year
Cash flow
Present value
of cash flow
0
-$100.00
-$100.000
1
$25.00
$22.727
2
$50.00
$41.322
3
$75.00
$56.349
NPV =
$20.398
Solving for NPV:
Financial calculator solution
HP10B
Enter CFs into the
calculator’s CF register.
CF0 = -100
CF1 = 25
CF2 = 50
CF3 = 75
Enter I/YR = 10, then
NPV
TI83/84
 Enter
CFs for period
1 through 3 in a list:
{25,50,75}, say L1
 Use NPV(.1,-100,L1)
Using Excel: Project A’s NPV
A
1
2
3
4
5
6
B
Year
Cash flow
0
-$100.00
1
$25.00
2
$50.00
3
$75.00
NPV
$20.398
=NPV(0.1,B3:B5)+B2
Rationale for the NPV Method
NPV
= PV of inflows – PV of outflows
= Added value
 If projects are independent, accept if the
project NPV > $0.
 If projects are mutually exclusive, accept
projects with the highest positive NPV,
those that add the most value.
NPV
NPV profiles
$60
$50
$40
$30
$20
$10
$0
-$10
-$20
-$30
Project A
Project B
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
Discount rate
The internal rate of return
Internal rate of return (IRR)
The internal rate of return (IRR) is the discount rate
that forces the present value of the inflows equal
to the present value of the outflows, and the NPV =
$0:
N
CFt
$0  
t
(1

IRR)
t0
Solving for NPV:
financial calculator solution
HP10B
Enter CFs into the
calculator’s CF
register.
CF0 = -100
CF1 = 25
CF2 = 50
CF3 = 75
Then IRR
TI83/84
Enter CFs for period 1
through 3 in a list:
{25,50,75} STO L1
The IRR(-100,L1)
Using excel: project A
A
1
2
3
4
5
6
B
Year
Cash flow
0
-$100.00
1
$25.00
2
$50.00
3
$75.00
IRR
19.44%
What is the IRR of Project B?
=IRR(B2:B5)
Rationale for the IRR method
If IRR > project's cost of capital, the project’s
return exceeds its costs and there is some
return left over to boost stockholders’
returns.
 If IRR > project's cost of capital, accept project.
 If IRR < project's cost of capital, reject project.
Multiple IRRs
Consider a project with the following cash flows:
Cash
Year flows
0
-$100
1
$195
2
-$100
3
$100
4
-$100
• What is the IRR of this project?
• What happens when you try to solve this using
a calculator?
Profile
$4.00
$3.00
$2.00
$0.00
-$1.00
-$2.00
Two of the IRRs: 6.528% & 35.415%
-$3.00
-$4.00
-$5.00
-$6.00
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
24%
26%
28%
30%
32%
34%
36%
38%
40%
42%
44%
NPV
$1.00
Discount rate
Why are there multiple IRRs?
A
series of numbers that is being
compounded or discounted can have as
many roots as there are sign changes.
[Rene Descartes, 16th century philosopher]
 Are they useful? No. The IRRs in these
cases are not useful in decision-making.
Comparing the NPV and IRR Methods
 If projects are independent, the two methods
always lead to the same accept/reject
decisions.
 If projects are mutually exclusive …


If project's cost of capital > crossover rate, the
methods lead to the same decision and there is no
conflict.
If project's cost of capital < crossover rate, the
methods lead to different accept/reject decisions.
BOTTOM LINE: Do not use IRR when deciding
between or among mutually exclusive projects
Determining the cross-over rate
The cross-over rate is the rate at which the
two projects have the same NPV:
 Step 1: calculate the differences
in cash flows
 Step 2: calculate the IRR of these differences
Cash flows
Year
0
1
2
3
IRR
Project A Project B Differences
-$100.00 -$100.00
$0.00
$25.00
$0.00
$25.00
$50.00
$0.00
$50.00
$75.00 $155.00
-$80.00
19.44%
15.73%
4.94%
NPV profiles
$60
$50
$40
$30
$20
$10
$0
-$10
-$20
-$30
Project B
Cross-over 4.94%
IRRA = 19.44%
IRRB = 15.73%
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
21%
22%
23%
24%
25%
NPV
Project A
Discount rate
Reasons why NPV profiles cross
 Size (scale) differences
 The
smaller project frees up funds at t = 0 for
investment. The higher the opportunity cost,
the more valuable these funds, so a high
project's cost of capital favors small projects.
 Timing
 The
differences
project with faster payback provides more
CF in early years for reinvestment.
Reinvestment rate assumptions
 NPV
method assumes CFs are reinvested at the
project's cost of capital.
 IRR method assumes CFs are reinvested at IRR.
 Assuming CFs are reinvested at the opportunity cost of
capital is more realistic, so NPV method is the best. NPV
method should be used to choose between mutually
exclusive projects.
 Perhaps
a hybrid of the IRR that assumes cost of
capital reinvestment is needed.
The modified internal rate
of return
The MIRR
 The modified internal
rate of return, (MIRR)
is the discount rate that causes the PV of a
project’s terminal value (TV) to equal the PV
of costs. TV is found by compounding inflows
at project's cost of capital.
 We often assume that cash flows are
reinvested at the project's cost of capital, but
that is not always appropriate.

What are the investment opportunities?
The MIRR calculation
Calculate the future value of all inflows, using the
reinvestment rate as the compound rate
Calculate the present value of all outflows,
discounting at the required rate of return
Solve for the rate that causes the
PVoutflows = FVinflows
Why use MIRR versus IRR?
 MIRR
assumes reinvestment at a more
realistic reinvestment rate.
 MIRR avoids the multiple IRR problem.
 Managers like rate of return comparisons,
and MIRR is better for this than IRR.
MIRR & financial calculators
 There is no built-in program for
MIRR in
financial calculators.
 Using most financial calculators requires the
calculation of the FV for each inflow and then
the summing of these FVs. Then use the PV,
FV and n to solve for i.
 Trick to find TV:


Calculate the NPV of the cash inflows (not outflows)
at the reinvestment rate (be sure to use 0 for CF0).
Calculate the FV of this NPV using the reinvestment
rate.
Example: Project A
Assume that the reinvestment rate is 0%.
Year
0
1
2
3
Project A Future value of Present value of
cash flows cash inflows
cash outflows
-$100.00
-$100.00
$25.00
$25.00
$50.00
50.00
$75.00
75.00
Sum
$150.00
-$100.00
MIRR
14.471%
Example: Project A, continued
Assume that the reinvestment rate is 5%.
Project A Future value of Present value of
Year
cash flows
cash inflows
cash outflows
0
-$100.00
-$100.00
1
$25.00
$27.56
2
$50.00
52.50
3
$75.00
75.00
Sum
$155.06
-$100.00
MIRR
15.745%
Example: Project A, continued
Assume that the reinvestment rate is 10%.
Project A cash Future value of Present value of
Year
flows
cash inflows
cash outflows
0
-$100.00
-$100.00
1
$25.00
$30.25
2
$50.00
55.00
3
$75.00
75.00
Sum
$160.25
-$100.00
MIRR
17.022%
Using Excel: Project A
6% reinvestment rate and 10% cost of capital
A
1
2
3
4
5
6
Year
0
1
2
3
MIRR
B
Cash flow
-$100.00
$25.00
$50.00
$75.00
16.00%
=MIRR(C40:C43,0.1,0.06)
Payback methods
Payback period
 Payback
period - number of years required
to fully recover the initial cash outlay
associated with a capital expenditure
 Shorter payback periods are better, and
usually this decision criterion is
implemented by choosing a cutoff date
and rejecting projects whose payback
period is longer than the cutoff period.
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Discounted payback period
The discounted payback period alleviates
the first shortcoming of the payback period
by accounting for the time value of money.
 It is defined
as the number of years required to
fully recover the initial cash outlay in terms of
discounted cash flows.
 Shorter periods are better, and projects with
discounted payback periods before the cutoff
date will be accepted.
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Other issues
Capital rationing
 Capital
rationing is the presence of a limit
on the capital budget.
 When there is capital rationing, our goal is
to select projects that maximize the total
net present value, subject to constraints.
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Comparing evaluation techniques
51
Comparing evaluation
techniques (continued)
52
What methods do companies
really use?
Evaluation Criteria Used by Companies
53
Summary
 There are alternative approaches to evaluating
capital investment projects.
 The net present value method requires the
calculation of the value added from the
project.
 The internal rate of return is the yield on the
project, which we derive by solving for the
discount rate resulting in a zero net present
value.
54
Summary
 The modified
internal rate of return is
return on a project assuming the
reinvestment of project cash flows at a
specific rate.
 The profitability index is the ratio of the
present value of inflows to the present
value of outflows.
 Paybacks methods (payback period and
discounted payback) are used to gauge the
liquidity of a project.
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Practice problems
Problem 1
What is the modified internal rate of return
for Project B if the reinvestment rate is 0%?
10%?
Problem 2
Calculate the NPV, the IRR, cross-over rate,
and the MIRR for projects C & D, assuming a
project cost of capital and reinvestment rate
Cash flows
of 8%:
Year
0
1
2
3
Project C Project D
-$100.00 -$100.00
$80.00
$0.00
$40.00
$0.00
$20.00
$160.00
Which project would you choose and why?
The end