The Basics of Capital Budgeting: Evaluating Cash Flows

Chapter 10
The Basics of Capital Budgeting:

Evaluating Cash Flows
10-1 a. Capital budgeting is the whole process of analyzing projects and deciding whether
they should be included in the capital budget. This process is of fundamental
importance to the success or failure of the firm as the fixed asset investment decisions
chart the course of a company for many years into the future. The payback, or
payback period, is the number of years it takes a firm to recover its project
investment. Payback may be calculated with either raw cash flows (regular payback)
or discounted cash flows (discounted payback). In either case, payback does not
capture a project’s entire cash flow stream and is thus not the preferred evaluation
method. Note, however, that the payback does measure a project’s liquidity, and
hence many firms use it as a risk measure.
b. Mutually exclusive projects cannot be performed at the same time. We can choose
either Project 1 or Project 2, or we can reject both, but we cannot accept both
projects. Independent projects can be accepted or rejected individually.
c. The net present value (NPV) and internal rate of return (IRR) techniques are
discounted cash flow (DCF) evaluation techniques. These are called DCF methods
because they explicitly recognize the time value of money. NPV is the present value
of the project’s expected future cash flows (both inflows and outflows), discounted at
the appropriate cost of capital. NPV is a direct measure of the value of the project to
shareholders. The internal rate of return (IRR) is the discount rate that equates the
present value of the expected future cash inflows and outflows. IRR measures the
rate of return on a project, but it assumes that all cash flows can be reinvested at the
IRR rate. The profitability index is the ratio of the present value of future cash flows
to the project’s initial cost. It shows the relative profitability of any project. A
profitability index greater than 1 is equivalent to a positive NPV project.
d. The modified internal rate of return (MIRR) assumes that cash flows from all projects
are reinvested at the cost of capital as opposed to the project’s own IRR. This makes
the modified internal rate of return a better indicator of a project’s true profitability.
e. An NPV profile is the plot of a project’s NPV versus its cost of capital. The
crossover rate is the cost of capital at which the NPV profiles for two projects
intersect indicating that at that point their NPVs are equal.
f. Capital projects with nonnormal cash flows have a large cash outflow either
sometime during or at the end of their lives. A common problem encountered when
evaluating projects with nonnormal cash flows is multiple IRRs. A project has
normal cash flows if one or more cash outflows (costs) are followed by a series of
cash inflows.
g. The mathematics of the NPV method imply that project cash flows are reinvested at
the cost of capital while the IRR method assumes reinvestment at the IRR. Since
project cash flows can be replaced by new external capital that costs r, the proper
reinvestment rate assumption is the cost of capital, and thus the best capital budget
decision rule is NPV.
h. A replacement chain is a method of comparing mutually exclusive projects that have

unequal lives. Each project is replicated such that they will both terminate in a
common year. If projects with lives of 3 years and 5 years are being evaluated, the 3-
year project would be replicated 5 times and the 5-year project replicated 3 times;
thus, both projects would terminate in 15 years. Not all projects maximize their NPV
if operated over their engineering lives and therefore it may be best to terminate a
project prior to its potential life. The economic life is the number of years a project
should be operated to maximize its NPV, and is often less than the maximum
potential life. Capital rationing occurs when a firm’s management limits its capital
expenditures to an amount less than would be required to fund the optimal capital
budget. The equivalent annual annuity method is an alternative method of comparing
mutually exclusive projects that have unequal lives. This method converts the annual
cash flows under the alternative investments into a constant cash flow stream whose
NPV is equal to the NPV of the initial stream.
10-2 Projects requiring greater investments or that have greater risk should be given detailed
analysis the capital budgeting process.
10-3 The NPV is obtained by discounting future cash flows, and the discounting process
actually compounds the interest rate over time. Thus, an increase in the discount rate has
a much greater impact on a cash flow in Year 5 than on a cash flow in Year 1.
10-4 This question is related to Question 10-3 and the same rationale applies. With regard to
the second part of the question, the answer is no; the IRR rankings are constant and
independent of the firm’s cost of capital.
10-5 The NPV and IRR methods both involve compound interest, and the mathematics of
discounting requires an assumption about reinvestment rates. The NPV method assumes
reinvestment at the cost of capital, while the IRR method assumes reinvestment at the
IRR. MIRR is a modified version of IRR which assumes reinvestment at the cost of
capital.
10-6 Generally, the failure to employ common-life analysis in such situations will bias the
NPV against the shorter project because it "gets no credit" for profits beyond its initial
life, even though it could possibly be "renewed" and thus provide additional NPV.
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ASSIGNMENTS:
SELF-TEST PROBLEM: PAGE 395 – 396: ST-1
PROBLEMS: PAGE 396 – 398: QUESTION 10-1 UNTIL 10-13
DUE: 28 JUNE 2020: BEFORE 12 MIDNIGHT

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Chapter 10

The Basics of Capital Budgeting:

h. A replacement chain is a method of comparing mutually exclusive projects that have

SELF-TEST PROBLEM: PAGE 395 – 396: ST-1

PROBLEMS: PAGE 396 – 398: QUESTION 10-1 UNTIL 10-13

DUE: 28 JUNE 2020: BEFORE 12 MIDNIGHT

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