Chapter 9
Capital Budgeting
Techniques
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Learning Outcomes
Chapter 9

Describe the importance of capital budgeting decisions and the general
process that is followed when making investment (capital budgeting)
decisions.

Describe how (a) the net present value (NPV) technique and (b) the
internal rate of return (IRR) technique are used to make investment
(capital budgeting) decisions.

Compare the NPV technique with the IRR technique, and discuss why the
two techniques might not always lead to the same investment decisions.

Describe how conflicts that might arise between NPV and IRR can be
resolved using the modified internal rate of return(MIRR) technique.

Describe other capital budgeting techniques
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What is Capital Budgeting?

The process of planning and evaluating
expenditures on assets whose cash flows are
expected to extend beyond one year
 Analysis of potential additions to fixed assets
 Long-term decisions; involve large expenditures
 Very important to firm’s future
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Generating Ideas for Capital Projects

A firm’s growth and its ability to remain
competitive depend on a constant flow of
ideas for new products, ways to make
existing products better, and ways to produce
output at a lower cost.

Procedures must be established for
evaluating the worth of such projects.
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Project Classifications




Replacement Decisions: whether to purchase capital
assets to take the place of existing assets to maintain or
improve existing operations
Expansion Decisions: whether to purchase capital
projects and add them to existing assets to increase
existing operations
Independent Projects: Projects whose cash flows are
not affected by decisions made about other projects
Mutually Exclusive Projects: A set of projects where the
acceptance of one project means the others cannot be
accepted
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The Post-Audit

Compares actual results with those predicted by
the project’s sponsors and explains why any
differences occurred

Two main purposes:
 To improve forecasts
 To improve operations
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Similarities between Capital Budgeting
and Asset Valuation

Estimate the cash flows expected from the project.

Evaluate the riskiness of cash flows.

Compute the present value of the expected cash flows to
obtain as estimate of the asset’s value to the firm.

Compare the present value of the future expected cash
flows with the initial investment.
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Net Present Value:
Sum of the PVs of Inflows and Outflows
 NPV
Decision Rule:
A project is acceptable if NPV > $0
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Net Cash Flows for Project S and Project L?
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What is Project S’s NPV?
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Rationale for the NPV method:
NPV = PV inflows - Cost
= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually exclusive projects
on basis of higher NPV.
Which adds most value?
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Using NPV method, which project(s)
should be accepted?
 If
Projects S and L are mutually exclusive,
accept S because
NPVS = 161.33 > NPVL = 108.67.

If S & L are independent,
accept both; NPV > 0.
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Calculating IRR
 IRR
Decision Rule: A project is acceptable if
IRR > r
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What is Project S’s IRR?
Financial Calculator Method

Enter the cash flows sequentially, and then
press the IRR button

For Project S, IRRS = 13.1%.

For Project L, IRRL = 11.4%.
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Rationale for the IRR Method

If IRR (project’s rate of return) > the firm’s
required rate of return, r, then some return is
left over to boost stockholders’ returns.
Example: r = 10%, IRR = 15%.
Profitable.
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Decisions on Projects S and L per IRR

If S and L are independent, accept both.
IRRS > IRRL > r = 10%.

If S and L are mutually exclusive, based on
IRR, Project S is more acceptable because
IRRS > IRRL.
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NPV Profiles for Project S and Project L
NPV Profiles for Project S and Project L
To Find the Crossover Rate:

Find cash flow differences between the projects.

Enter these differences in CF register, then press
IRR. Crossover rate = 8.11, rounded to 8.1%.

Can subtract S from L or vice versa.

If profiles don’t cross, one project dominates the
other.
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Two Reasons NPV Profiles Cross:

Size (scale) differences. Smaller project frees
up funds at t = 0 for investment. The higher
the opportunity cost, the more valuable these
funds, so high r favors small projects.

Timing differences. Project with faster
payback provides more CF in early years for
reinvestment.
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Reinvestment Rate Assumptions

NPV assumes reinvest at r.

IRR assumes reinvest at IRR.
 Reinvest
at opportunity cost, r, is more
realistic, so NPV method is best. NPV should
be used to choose between mutually
exclusive projects.
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Multiple IRRs


Suppose a project exists with the following
cash flow pattern:
Year
Cash Flow
0
$(1,600,000)
1
10,000,000
2
(10,000,000)
Two IRRs exist for this project.
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NPV Profile for Project M
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Modified Internal Rate of Return

A better indicator of relative profitability
 Better

for use in capital budgeting
MIRR Rule:
A project is acceptable if MIRR > r
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Traditional Payback Period

The length of time it takes to recover the
original cost of an investment from its
expected cash flows

Payback period =
 PB
Decision Rule: A project is acceptable if
PB < n* (years determined by the firm)
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Discounted Payback Period

The length of time it takes for a project’s
discounted (PV of) cash flows to repay the
cost of the investment

DPB Decision Rule: A project is acceptable if
DPB < Project’s useful life
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