Chapter No.02.

Capital Budgeting
Techniques (Ch.13
in book)
13-1
 Capital Budgeting
Techniques

 Project Evaluation and Selection

 Potential Difficulties
 Capital Rationing
 Project Monitoring
 Post-Completion Audit

13-2
 Project Evaluation:
Alternative Methods

 Payback Period (PBP)

 Internal Rate of Return (IRR)
 Net Present Value (NPV)
 Profitability Index (PI)

13-3
 Proposed Project Data

Julie Miller is evaluating a new project

for her firm, Basket Wonders (BW).
She has determined that the after-tax
cash flows for the project will be
$10,000; $12,000; $15,000; $10,000;
and $7,000, respectively, for each of
the Years 1 through 5. The initial
cash outlay will be $40,000.
13-4
 Independent Project
For this project, assume that it is
independent of any other potential
projects that Basket Wonders may
undertake.
Independent -- A project whose
acceptance (or rejection) does not
prevent the acceptance of other
projects under consideration.
13-5
 Payback Period (PBP)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

PBP is the period of time

required for the cumulative
expected cash flows from an
investment project to equal
the initial cash outflow.
13-6
 Payback Solution (#1)

0 1 2 3 (a) 4 5

-40 K (-b) 10 K 12 K 15 K 10 K(d) 7K

10 K 22 K 37 K(c) 47 K 54 K

Cumulative
Inflows PBP =a+(b-c)/d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years
13-7
 Payback Solution (#2)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K
-40 K -30 K -18 K -3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K
Cumulative = 3.3 Years
Cash Flows
Note: Take absolute value of last
negative cumulative cash flow
13-8 value.
 PBP Acceptance Criterion
The management of Basket Wonders
has set a maximum PBP of 3.5
years for projects of this type.
Should this project be accepted?

Yes! The firm will receive back the

initial cash outlay in less than 3.5
years. [3.3 Years < 3.5 Year Max.]

13-9
 Internal Rate of Return (IRR)

IRR is the discount rate that equates the

present value of the future net cash
flows from an investment project with
the project’s initial cash outflow.

CF1 CF2 CFn

ICO = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n

13-10
 IRR Solution

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the

discounted cash flows to equal $40,000.
13-11
 IRR Solution (Try 10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +

$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
13-12
 IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +

$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
13-13
 IRR Solution (Interpolate)

.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X $1,444
.05 = $4,603

13-14
 IRR Solution (Interpolate)

.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X $1,444
.05 = $4,603

13-15
 IRR Solution (Interpolate)

.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X = ($1,444)(0.05) X = .0157
$4,603
IRR = .10 + .0157 = .1157 or 11.57%
13-16
 IRR Acceptance Criterion
The management of Basket Wonders
has determined that the hurdle rate
is 13% for projects of this type.
Should this project be accepted?

No! The firm will receive 11.57% for

each dollar invested in this project at
a cost of 13%. [ IRR < Hurdle Rate ]
13-17
 Net Present Value (NPV)

NPV is the present value of an

investment project’s net cash
flows minus the project’s initial
cash outflow.

CF1 CF2 CFn

NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k) n

13-18
 NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)

13-19
 NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428
13-20
 NPV Acceptance Criterion
The management of Basket Wonders
has determined that the required
rate is 13% for projects of this type.
Should this project be accepted?

No! The NPV is negative. This means

that the project is reducing shareholder
wealth. [Reject as NPV < 0 ]
13-21
 Profitability Index (PI)

PI is the ratio of the present value of

a project’s future net cash flows to
the project’s initial cash outflow.
CF1 CF2 CFn
PI = + +...+ ICO
(1+k)1 (1+k) 2 (1+k)n
<< OR >>

PI = 1 + [ NPV / ICO ]
13-22
 PI Acceptance Criterion
PI = $38,572 / $40,000
= .9643 (Method #1, 13-33)

Should this project be accepted?

No! The PI is less than 1.00. This

means that the project is not profitable.
[Reject as PI < 1.00 ]
13-23
 Evaluation Summ l8ary

Basket Wonders Independent Project

Method Project Comparison Decision
PBP 3.3 3.5 Accept
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
13-24
 Problem No.01

Lobers, Inc., has two investment proposals, which have

the following characteristics:

PROJECT A PROJECT B

PROFIT NET CASH PROFIT NET CASH

PERIOD COST AFTER TAXES FLOW COST AFTER TAXES
FLOW

0 $9,000 $12,000
1 $1,000 $5,000 $1,000 $5,000
2 1,000 4,000 1,000 5,000
3 1,000 3,000 4,000 8,000

Required: For each project, compute its payback period,.

13-25
 PROBLEM NO.02
The following are exercises on internal rates of return:
a. An investment of $1,000 today will return $2,000 at the end of
10 years. What is its internal rate of return?
b. An investment of $1,000 will return $500 at the end of each of
the next 3 years. What is its internal rate of return?
c. An investment of $1,000 today will return $900 at the end of 1
year, $500 at the end of 2 years, and $100 at the end of 3 years.
What is its internal rate of return?
d. An investment of $1,000 will return $130 per year forever.
What is its internal rate of return?

13-26
 PROBLEM NO.03
Two mutually exclusive projects have projected cash flows as follows:

END OF YEAR

0 1 2 3 4

Project A ($2,000 ) $1,000 $1,000 $1,000 $1,000

Project B ($2,000) 0 0 0 6,000
Required:
a. Determine the internal rate of return for each project.
b. Determine the net present value for each project at discount rates of 0, 5, 10,
20, 30, and 35 percent.

13-27
 PROBLEM NO.04
Zaire Electronics can make either of two investments at time 0. Assuming a
required rate of return of 14 percent, determine for each project (a) the
payback period, (b) the net present value, (c) the profitability index, and (d)
the internal rate of return. Assume under MACRS the asset falls in the five-
year property class and that the corporate tax rate is 34 percent. The initial
investments required and yearly savings before depreciation and taxes are
shown below:

PROJECT NVESTMENT END OF YEAR

0 1 2 3 4 5 6 7

A ($28,000 ) $8,000 $8,000 $8,000 $8,000 $8,000 $8,000 $8,000

B (20,000 |) 5,000 5,000 6,000 6,000 7,000 7,000 7,000

13-28
 PROBLEM NO.05
Thoma Pharmaceutical Company may buy DNA testing
equipment costing $60,000. This equipment is expected to
reduce labor costs of clinical staff by $20,000 annually. The
equipment has a useful life of five years but falls in the three-
year property class for cost recovery (depreciation) purposes.
No salvage value is expected at the end. The corporate tax rate
for Thoma is 38 percent (combined federal and state), and its
required rate of return is 15 percent. (If profits after taxes on the
project are negative in any year, the firm will offset the loss
against other firm income for that year.) On the basis of this
information,

Required: what is the net present value of the project? Is it

acceptable?
13-29
 PROBLEM NO.06
The Lake Tahow Ski Resort is comparing a half dozen capital improvement projects. It has allocated
$1 million for capital budgeting purposes. The following proposals and associated profitability
indexes have been determined. The projects themselves are independent of one another.
PROFITABILITY
PROJECT AMOUNT INDEX

1. Extend ski lift 3 $500,000 1.22

2. Build a new sports shop 150,000 0.95
3. Extend ski lift 4 350,000 1.20
4. Build a new restaurant 450,000 1.18
5. Build addition to housing complex 200,000 1.19
6. Build an indoor skating rink 400,000 1.05

Required:
a. If strict capital rationing for only the current period is assumed, which of
the investments should be undertaken?
b. Is this an optimal strategy?

13-30
 MACRS depreciation
percentages
PROPERTY CLASS
YEAR YEAR 3- YEAR 5- YEAR 7- YEAR 10-
1 33.33% 20.00% 14.29% 10.00%
2 44.45 32.00 24.49 18.00
3 14.81 19.20 17.49 14.40
4 7.41 11.52 12.49 11.52
5 11.52 8.93 9.22
6 5.76 8.92 7.37
7 8.93 6.55
8 4.46 6.55
9 6.56
10 6.55
11 3.28
Totals 100.00% 100.00% 100.00% 100.00%
13-31