Capital Budgeting
Net Present Value Rule
Payback Period Rule
Discounted Payback Period Rule
Average Accounting Return
Internal Rate of Return
Profitability Index
Practice of Capital Budgeting
Incremental Cash Flow
Chapters 6 & 7 – MBA504
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Net Present Value (NPV) Rule
• Net Present Value (NPV) =
Total PV of future CF’s + Initial Investment
• Estimating NPV:
– 1. Estimate future cash flows: how much? and when?
– 2. Estimate discount rate
– 3. Estimate initial costs
• Minimum Acceptance Criteria: Accept if NPV > 0
• Ranking Criteria: Choose the highest NPV
Chapters 6 & 7 – MBA504
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Example
Assume you have the following information on Project X:
Initial outlay -$1,100
Required return = 10%
Annual cash revenues and expenses are as follows:
Year
1
2
Calculate its NPV.
Revenues
$1,000
2,000
Expenses
$500
1,000
Chapters 6 & 7 – MBA504
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The Payback Period Rule
• How long does it take the project to “pay back” its
initial investment?
• Payback Period = number of years to recover
initial costs
• Minimum Acceptance Criteria:
– set by management
• Disadvantages
– Ignores the time value of money
– Ignores cash flows after the payback period
– Biased against long-term projects
Chapters 6 & 7 – MBA504
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Initial outlay -$1,000
YearCash flow
1
2
3
$200
400
600
Accumulated
YearCash flow
1
2
3
Payback period =
Chapters 6 & 7 – MBA504
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Discounted Payback Period Rule
• How long does it take the project to “pay
back” its initial investment taking the time
value of money into account?
• By the time you have discounted the cash
flows, you might as well calculate the NPV.
Chapters 6 & 7 – MBA504
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Example
Initial outlay -$1,000
R = 10%
PV of
Cash flow
Cash flow
Year
1
2
3
4
Accumulated:
Year
1
2
3
4
$ 200
400
700
300
$ 182
331
526
205
discounted cash flow
$ 182
513
1,039
1,244
Discounted payback period is
Chapters 6 & 7 – MBA504
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Average Accounting Return Rule
Average Net Income
AAR 
Average Book Value of Investent
• Another attractive but fatally flawed approach.
• Ranking Criteria and Minimum Acceptance Criteria
set by management
• Disadvantages:
– Ignores the time value of money
– Uses an arbitrary benchmark cutoff rate
– Based on book values, not cash flows and market values
• Advantages:
– The accounting information is usually available
– Easy to calculate
Chapters 6 & 7 – MBA504
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Internal Rate of Return (IRR) Rule
• IRR: the discount that sets NPV to zero
• Minimum Acceptance Criteria:
– Accept if the IRR exceeds the required return.
• Ranking Criteria:
– Select alternative with the highest IRR
• Reinvestment assumption:
– All future cash flows assumed reinvested at the IRR.
Chapters 6 & 7 – MBA504
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Example
Consider the following project:
0
-$200
$50
$100
$150
1
2
3
The internal rate of return for this project is 19.44%
$50
$100
$150
NPV  0 


2
(1  IRR ) (1  IRR ) (1  IRR )3
Chapters 6 & 7 – MBA504
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NPV Payoff Profile for The Example
If we graph NPV versus discount rate, we can see the IRR as
the x-axis intercept.
NPV
$100.00
$71.04
$47.32
$27.79
$11.65
($1.74)
($12.88)
($22.17)
($29.93)
($36.43)
($41.86)
$120.00
$100.00
$80.00
$60.00
NPV
Discount Rate
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
$40.00
IRR = 19.44%
$20.00
$0.00
-1%
($20.00)
9%
19%
39%
29%
($40.00)
($60.00)
Discount rate
Chapters 6 & 7 – MBA504
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Problems with the IRR Approach
• Multiple IRRs.
• The Scale Problem.
• The Timing Problem.
Chapters 6 & 7 – MBA504
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Multiple IRRs
There are two IRRs for this project:
$200
NPV
0
-$200
$800
1
2
3
- $800
$100.00
Which one should
we use?
100% = IRR2
$50.00
$0.00
-50%
0%
($50.00)
50%
100%
0% = IRR1
($100.00)
($150.00)
Chapters 6 & 7 – MBA504
150%
200%
Discount rate
13
The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment
while the 50% return is on a $1,000
investment?
Chapters 6 & 7 – MBA504
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The Timing Problem (page 161)
$10,000
$1,000
$1,000
Project A
0
1
2
3
-$10,000
$1,000
$1,000
$12,000
Project B
0
1
2
3
-$10,000
The preferred project in this case depends on the discount
rate, not the IRR.
Chapters 6 & 7 – MBA504
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Mutually Exclusive vs. Independent Project
• Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring an
accounting system.
– RANK all alternatives and select the best one.
• Independent Projects: accepting or rejecting one
project does not affect the decision of the other
projects.
– Must exceed a MINIMUM acceptance criteria.
Chapters 6 & 7 – MBA504
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Which project is good?
Net present value
Year
0
160
140
120
100
80
60
40
20
0
1
2
3
4
Project A:
– $350
50
100
150
200
Project B:
– $250
125
100
75
50
Crossover Point
– 20
– 40
– 60
– 80
– 100
Discount rate
0
2%
6%
10%
14%
IRR A
18%
22%
26%
IRR B
Chapters 6 & 7 – MBA504
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HOW TO FIND CROSS POINT
PROJECT A
PROJECT B
A-B
-350
50
100
150
200
-250
125
100
75
50
-100
-75
0
75
150
12.91%
IRR(A3: A7)
17.80%
IRR(B3: B7)
8.07%
IRR(C3: C7)
Chapters 6 & 7 – MBA504
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Decision Rule
• If required rate of return < crossover return,
take the project with lower IRR
• If required rate of return > crossover return,
take the project with higher IRR
• Don’t think a project with higher IRR is
always good
• Projects with higher NPV is always good
Chapters 6 & 7 – MBA504
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Profitability Index (PI) Rule
•
•
•
•
Total PV of Future Cash Flows
PI 
Initial Investent
Minimum Acceptance Criteria: Accept if PI > 1
Ranking Criteria: Select alternative with highest PI
Disadvantages: Problems with mutually exclusive investments
Advantages:
– May be useful when available investment funds are
limited
– Easy to understand and communicate
– Correct decision when evaluating independent projects
Chapters 6 & 7 – MBA504
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Practice of Capital Budgeting
• Varies by industry:
– Some firms use payback, others use accounting
rate of return.
• The most frequently used technique for
large corporations is IRR or NPV.
Chapters 6 & 7 – MBA504
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Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for
the following two projects. Assume the required
return is 10%.
Year
0
1
2
3
Project A
-$200
$200
$800
-$800
Chapters 6 & 7 – MBA504
Project B
-$150
$50
$100
$150
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Incremental Cash Flows
•
•
•
•
•
•
•
Cash flows matter—not accounting earnings.
Sunk costs don’t matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like cannibalism and erosion matter.
Taxes matter: we want incremental after-tax cash flows.
Inflation matters.
Chapters 6 & 7 – MBA504
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Cash Flows—Not Accounting Earnings
• Consider depreciation expense.
• You never write a check made out to
“depreciation”.
• Much of the work in evaluating a
project lies in taking accounting
numbers and generating cash flows.
Chapters 6 & 7 – MBA504
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Incremental Cash Flows
• Sunk costs are not relevant
– Just because “we have come this far” does not mean that
we should continue to throw good money after bad.
• Opportunity costs do matter. Just because a project
has a positive NPV that does not mean that it should
also have automatic acceptance. Specifically if
another project with a higher NPV would have to be
passed up we should not proceed.
Chapters 6 & 7 – MBA504
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Incremental Cash Flows
• Side effects matter (page 180)
– Erosion
– Synergy
Chapters 6 & 7 – MBA504
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Estimating Cash Flows
• Cash Flows from Operations
– Recall that:
Operating Cash Flow = EBIT – Taxes + Depreciation
• Net Capital Spending
– Don’t forget salvage value (after tax, of course).
• Changes in Net Working Capital
– Recall that when the project winds down, we enjoy a
return of net working capital.
Chapters 6 & 7 – MBA504
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The Baldwin Company: An Example
(page 181)
Costs of test marketing (already spent): $250,000.
Current market value of proposed factory site (which we own): $150,000.
Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5year life). Salvage value of 30,000.
Increase in net working capital: $10,000. Production (in units) by year during
5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000.
Price during first year is $20; price increases 2% per year thereafter.
Production costs during first year are $10 per unit and increase 10% per year
thereafter.
Annual inflation rate: 5%
Tax rate is 34 percent
Working Capital: initially $10,000 changes with sales.
Chapters 6 & 7 – MBA504
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Key Issues
• Dis-regard sunk costs
• Consider incremental cash flow – additional cash
flows
• Figure out revenue, cost, depreciation, tax, capital
spending, addition to net work capital
• Refer to this example when you take advanced
corporate finance to deal with capital budgeting or
meet this kind of problem in your work
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