Capital Budgeting Techniques

Questions
• How should capital be allocated?
» Do I invest / launch a product / buy a building / scrap / outsource...
» Should I acquire / sell / accept offer for company or division?
» How should the capital budgeting process be organized?
• Which choices should I make?
» make or buy
» which distribution channel
» should I test market a product
 What is capital budgeting?

• Analysis of potential projects.

• Long‐term decisions; involve large
expenditures.
• Important to firm’s future.

Topic Overview
• Project Types
• Capital Budgeting Decision Criteria
– Payback Period
– Discounted Payback Period
– Net Present Value (NPV)
– Internal Rate of Return (IRR)
– Modified Internal Rate of Return (MIRR)
 Principles of Capital Budgeting
Technique

• All Cash flows should be considered

• The cash flows should be discounted at the
opportunity cost of funds
• The technique should select from a set of
mutually exclusive projects the one that
maximizes shareholder’s wealth
• Value additivity principle.

Independent and mutually

exclusive projects
Projects are:
independent, if the cash flows of one are
unaffected by the acceptance of the other.
mutually exclusive, if only one project can be
selected from a set of projects.
(if the cash flows of one can be adversely
impacted by the acceptance of the other).
 An Example of Mutually Exclusive
Projects:

BRIDGE VS. BOAT TO GET

PRODUCTS ACROSS A RIVER.

Normal vs. Non‐normal Projects

• Normal Project:
– Cost (negative CF) followed by a series of
positive cash inflows. One change of signs.
• Non‐normal Project:
– 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.
 Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN

Value Additivity Principle

• If we know the value of separate projects
accepted by management, then simply adding
their values will give us the value of the firm.
• V= VJ
 Capital Budgeting Techniques

• The payback method

• The accounting rate of return
• The net present value
• The internal rate of return

What is the payback period?

The number of years required to

recover a project’s cost or the
initial outlay on a project.
 Payback for Franchise L
(Long: Most CFs in out years)
0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

Franchise S (Short: CFs come quickly)

0 1 1.6 2 3

CFt -100 70 100 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM (i.e. opportunity
cost of funds)
2. Ignores CFs occurring after the
payback period.

Discounted Payback: Uses discounted

rather than raw CFs. Discount factor=1/(1+r)^t
0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.

 Payback simplified
(Example: Four mutually exclusive projects)
Years A B C D PV at 10%

0 ‐1000 ‐1000 ‐1000 ‐1000 1.00

1 100 (‐900) 0 (‐1000) 100 (‐900) 200 (‐800) 0.909

2 900 (0) 0 (‐1000) 200 (‐700) 300 (‐500) 0.826

3 100 300 (‐700) 300 (‐400) 500 (0) 0.751

4 ‐100 700 (0) 400 (0) 500 0.683

5 ‐400 1300 1250 600 0.621

In parentheses, cumulative CF are calculated. Payback periods (not counting the year of
investment):
A = 2 years
B = 4 years
C = 4 years
D = 3 years

Which one the management would choose?

The Accounting Rate of Return (ARR)

• The ARR is the average after tax profit divided
by the initial cash outlays. This is very similar
to ROA or ROI.
 The Net Present Value (NPV)
NPV: Sum of the PVs of inflows and outflows.
The cash flows are discounted at the
opportunity cost of capital.
n
CFt
NPV   .
t 0 1  r t

Cost often is CF0 and is negative.

n
CFt
NPV    CF0 .
t 1 1  r t

What’s Franchise L’s NPV?

Project L:
0 1 2 3
10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = 19.98
 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. Adds most value.

Using NPV method, which

franchise(s) should be accepted?

• If Franchise S and L are mutually

exclusive, accept S because NPVs >
NPVL .
• If S & L are independent, accept
both; NPV > 0.
 Exercise
• The cash flows of the projects A, B and C are given.
Calculate the payback period and NPV at 10%
discount rate. If A and B are mutually exclusive and C
is independent, which project or combination of
projects is preferred using a) the payback method or
b)the NPV method?
• What do you understand with respect to the value
additivity properties of the payback method?
Year A B C
0 ‐1 ‐1 ‐1
1 0 1 0
2 2 0 0
3 ‐1 1 3

Solution
Year PVIF A PV(A) B PV(B) C PV(C) A+C B+C
0 1.000 ‐1 ‐1.00 ‐1 ‐1.00 ‐1 ‐1.00 ‐2 ‐2
1 0.909 0 (‐1) 0 1(0) 0.91 0(‐1) 0 0 (‐2) 1 (‐1)
2 .826 2(1) 1.65 0 0 0 (‐1) 0 2 (0) 0 (‐1)
3 0.751 ‐1 ‐0.75 1 0.75 3 (2) 2.25 2 4 (3)
‐0.10 0.66 1.25

Payback periods (look at the change in sign of the Cum CFs in parentheses):
A=2 year
B=1 year
C=3 year
Since A and B are mutually exclusive, B would be preferable using both
techniques.

A+C = 2 years at NPV=1.15

B+C = 3 years at NPV=1.91

If C is combined, the results change if we use payback criteria. A+C is preferred.

NPV does not violate VA. B+C is preferred.
 Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = cost. This is the same
as forcing NPV = 0.

NPV: Enter r, solve for NPV.

n
CF t

t0 1  r t
 NPV .

IRR: Enter NPV = 0, solve for IRR.

n CFt
 t  0.
t  0 1  IRR
 NPV

IRR

Discount Rate

What’s Franchise L’s IRR?

0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Use IRR function in excel
IRRL = 18.13%. IRRS = 23.56%.
Find IRR if CFs are constant:
0 1 2 3
IRR = ?

-100 40 40 40

IRR = 9.70%.

Rationale for the IRR Method

If IRR > WACC, then the project’s

rate of return is greater than its
cost-- some return is left over to
boost stockholders’ returns.

Example: WACC = 10%, IRR = 15%.

Profitable.
 Internal Rate of Return (IRR)

• Internal Rate of Return is a project’s expected rate of

return on its investment.
• IRR is the interest rate where the PV of the inflows equals
the PV of the outflows.
• In other words, the IRR is the rate where a project’s NPV
= 0.
• Decision Rule: Accept if IRR > k (cost of capital).
• Non‐normal projects have multiple IRRs. Don’t use IRR
to decide on non‐normal projects.

Decisions on Projects S and L per

IRR

• If S and L are independent, accept both.

IRRs > r = 10%.
• If S and L are mutually exclusive, accept S
because IRRS > IRRL .
 Comparison of NPV & IRR

• For normal independent projects, both

methods give same accept/reject decision.
– NPV > 0 yields IRR > k in order to lower NPV to 0.
• However, the methods can rank mutually
exclusive projects differently.
• What to do, then?

NPV and IRR always lead to the same

accept/reject decision for independent
projects:
NPV ($)
IRR > r r > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.

r (%)
IRR
 Construct NPV Profiles
NPVL and NPVS at different discount rates:

r NPVL NPVS
0 50 40
5 33 29
10 19 20
15 7 12
20 (4) 5

NPV ($) r NPVL NPVS

60
0 50 40
50 5 33 29
Crossover 10 19 20
40
Point = 8.7% 15 7 12
30
20 (4) 5
20 S
IRRS = 23.6%
10 L
0 Discount Rate (%)
0 5 10 15 20 23.6
-10
IRRL = 18.1%
 Mutually Exclusive Projects

NPV r < 8.7: NPVL> NPVS , IRRS > IRRL

CONFLICT
L r > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT

S IRRS

r 8.7 r %
IRRL

Determining NPV/IRR Conflict Range

• For each year, subtract one project’s cash flows

from the other.
• If there is a change of signs of these cash flow
differences, a ranking conflict exists.
• Find IRR of these cash flow differences to find rate
where the two projects have the same NPV =
crossover rate.
• At a cost of capital less than this crossover rate, a
ranking conflict between NPV and IRR exists.
 Two Reasons NPV Profiles Cross

1. 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.
2. Timing differences. Project with faster
payback provides more CF in early
years for reinvestment. If r is high,
early CF especially good, NPVS > NPVL.

Value Additivity
• IRR can violate the value additivity principle.
• Consider, project 1 and 2 are mutually exclusive and
project 3 is an independent project.
• If the value additivity hold then we should be able to
choose the better of the two mutually exclusive project
without having to consider the independent project.

Year Project 1 Project 2 Project 3 1+3 2+3 Discount

0 -100 -100 -100 -200 -200 1
1 0 225 450 450 6750.909
2 550 0 0 550 0 .826
NPV 354.35 104.53 309.05 663.35 413.64
IRR 135% 125% 350% 213% 238%

NPV @ 10% : Project 1 and 1+3 ; IRR : Project 1 and 2+3

• IRR rule
– between 1 and 2, we would select 1
– Between combination, we would select 2&3 over 1&3
– Prefers project 1 in isolation but project 2 in combination
with independent project
– Does not obey the value‐additivity principle.
• NPV rule
– Project 1 is best either by itself or in combination with
project3.
– The combinations of 1&3 or 2&3 are simply the sums of
the NPVs of the separate projects.
– If NPV is adopted, the value of firm is the sum of the
values of separate projects.

Reconciling Ranking Conflicts

• Shareholder Wealth Maximization:

– Market determined opportunity cost of capital is the one managers
should use.
• Reinvestment Rate Assumption:
– NPV assumes cash flows can be reinvested at company’s cost of
capital (i.e. investors’ required rate of return).
– In other words, the projects have the same risk (why?), and
therefore their cash flows should be discounted at the same rate.
– IRR assumes cash flows are reinvested at IRR. (therefore, 2nd rule is
violated)
– The NPV reinvestment rate assumption is more realistic.
• Result: Choose project with highest NPV when NPV/IRR ranking conflict
exists for mutually exclusive projects.
Normal Cash Flow Project:
Cost (negative CF) followed by a
series of positive cash inflows.
One change of signs.

Nonnormal Cash Flow Project:

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.

Project: NPV and IRR?

0 1 2
r = 10%

-1,600 10,000 -10,000

NPV = -773.55
IRR = ERROR. Why?
The IRR is incorrect because there
are 2 IRRs. Nonnormal CFs--two sign
changes. Here’s a picture:

NPV NPV Profile

IRR2 = 400%
1000
0 r
100 400
IRR1 = 25%
-1600

Logic of Multiple IRRs

1. At very low discount rates, the PV of

CF2 is large & negative, so NPV < 0.
2. At very high discount rates, the PV of
both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
3. In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
4. Result: 2 IRRs.
 Economic interpretation of multiple root problem and
therefore obtaining “correct” IRR
Think of the project as an investment, with the firm putting money into it
twice: ‐1,600 is initial investment and ‐10,000 is the second investment.
NPV is negative but IRR exceed the opportunity cost of capital.
• Assume that the positive CFs are lent at r. Also, the firm expects to earn
IRR on the CFs it puts into the project. Mathematically, the value at the
end of first period should be
1600(1+IRR)
• The future value of firm is the difference between the investment return
and the amount lent from the project.
[10,000‐1,600(1+IRR)](1+k)
• Finally, the firm invests ‐10,000 at the end of second period. This is set
equal to the future value of the project
10,000= [10,000‐1,600(1+IRR)](1+k)
• Solve for IRR as k=10%. IRR=‐43.18%
• Same result as NPV: Reject the project

Managers like rates‐‐prefer IRR to

NPV comparisons. Can we give
them a better IRR?
Yes, MIRR( Modified Internal Rate of Return
(MIRR)). is the discount rate which
causes the PV of a project’s terminal
value (TV) to equal the PV of costs.
TV is found by compounding inflows
at WACC.
Thus, MIRR assumes cash inflows are
reinvested at WACC.
 How MIRR is different from IRR?
• MIRR does not require the assumption that
the project cash flows are reinvested at the
IRR; rather, it factors in a discrete
reinvestment rate into the model.
• Decision rule: projects with MIRR greater the
project's hurdle rate should be accepted;
while in case of mutually exclusive projects,
the project with higher MIRR should be
preferred

Why use MIRR versus IRR?

MIRR correctly assumes reinvestment

at opportunity cost = WACC. MIRR
also avoids the problem of multiple
IRRs.
MIRR makes it possible to isolate the
rate of return on money invested in
the project which can be thought of as
the IRR.
 MIRR for Franchise L (r = 10%)
0 1 2 3
10%

-100.0 10.0 60.0 80.0

10%
66.0
10%
12.1
MIRR =
158.1
16.5%
-100.0 $158.1 TV inflows
$100 =
(1+MIRRL)3
PV outflows
MIRRL = 16.5%

Modified Internal Rate of Return,

MIRR
• The interest rate where the FV of a project’s
inflows (TV) are discounted to equal the PV of a
project’s outflows.
• Assumes cash inflows are reinvested at the
project’s cost of capital (k).
• PV(outflows) = TV/(1+MIRR)n, where
• TV = CIFt(1+k)n‐t, and
• PV(outflows) = COFt/(1+k)t
– Where CIF = annual cash inflow, and COF = annual cash
outflow.
 When there are nonnormal CFs and
more than one IRR, use MIRR:

0 1 2

-5 30 -30

FV (INFLOWS) PV (INFLOWS)
-5 0 5
30 33
-30 0 24.79338843
TV 33 NPV (INFLOWS) 29.79338843
MIRR 5.24%

Accept Project P?

NO. Reject because MIRR = 5.6% < r =

10%.

Also, if MIRR < r, NPV will be negative:

NPV = -$2.52
 Summary of Capital Budgeting
Methods

• Want a method that uses the time value of money with all
project cash flows: NPV, IRR & MIRR.
• IRR can give erroneous decision for non‐normal projects.
• Overall, NPV is the best and preferred method.
– It obeys the value‐additivity principle
– Correctly discounts at WACC
– It is precisely the same thing as maximizing the
shareholders’ wealth.