Chapter 9Capital Budgeting Techniques

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Learning OutcomesChapter 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 yearAnalysis of potential additions to fixed

assetsLong-term decisions; involve large

expendituresVery 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 forecastsTo 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

What is Project S’s IRR?

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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.

NPV Profiles for Project S and Project L

NPV Profiles for Project S and Project L

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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