Topic 2 - Capital Budgeting Decision

Financial Management: Core Concepts
Fourth Edition
Chapter 9
Capital Budgeting Decision
Models
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (1 of 2)
9.1 Explain capital budgeting and differentiate between short-
term and long-term budgeting decisions.
9.2 Explain the payback model and its two significant
weaknesses and how the discounted payback period
model addresses one of the problems.
9.3 Understand the net present value (NPV) decision model
and appreciate why it is the preferred criterion for
evaluating proposed investments.
Learning Objectives (2 of 2)
9.4 Calculate the most popular capital budgeting alternative
to the NPV, the internal rate of return (IRR); and explain
how the modified internal rate of return (MIRR) model
attempts to address the IRR’s problems.
9.5 Understand the profitability index (PI) as a modification of
the NPV model.
9.6 Compare and contrast the strengths and weaknesses of
each decision model in a holistic way.
9.1 Short-Term and Long-Term Decisions
(1 of 2)
• Long-term decisions versus short-term decisions

– longer time horizons,
– cost larger sums of money, and
– require a lot more information to be collected as part of their
analysis, than short-term decisions.
• Capital budgeting meets all three criteria
9.1 Short-Term and Long-Term Decisions
(2 of 2)
Three keys things to remember about capital budgeting

decisions include:
1. Typically a go or no-go decision on a product, service,
facility, or activity of the firm.
2. Requires sound estimates of the timing and amount of
cash flow for the proposal.
3. The capital budgeting model has a predetermined accept
or reject criterion.
9.2 (A) Payback Period (1 of 4)
• The length of time in which an investment pays back its
original cost.
• Payback period ← the cutoff period → and vice-versa.
• Thus, its main focus is on cost recovery or liquidity.
• The method assumes that all cash outflows occur right at
the beginning of the project’s life followed by a stream of
inflows.
• Also assumes that cash inflows occur uniformly over the
year.
• Thus if cost = $40,000; CF = $15,000 per year for 3 years;
PP = 2.67 years.
Example 1: Payback Period of a New Machine
• Let’s say that the owner of Perfect Images Salon is
considering the purchase of a new tanning bed.
• It costs $10,000 and is likely to bring in after-tax cash
inflows of $4,000 in the first year, $4,500 in the second year,
$10,000 in the third year, and $8,000 in the fourth year.
• The firm has a policy of buying equipment only if the
payback period is 2 years or less.
• Calculate the payback period of the tanning bed and state
whether the owner would buy it or not.
Example 1: Answer
Percent of Year
Year Cash flow Yet to be recovered Recovered/Inflow
0 (10,000) (10,000) Blank
1 4,000 (6,000) Blank
2 4,500 (1,500) Blank
3 10,000 0 (recovered) 15%
4 8,000 Not used in decision Blank
Payback period Blank
Reject, ➢ 2 years
= 2.15 years.
The payback period method has three major flaws:
1. It ignores all cash flow after the initial cash outflow has
been recovered.
2. It ignores the time value of money.
3. It ignores the riskiness of the cash flows.
9.2 (B) Discounted Payback Period (1 of 3)
• Calculates the time it takes to recover the initial investment
in current or discounted dollars.
• Incorporates time value of money by adding up the
discounted cash inflows at time 0, using the appropriate
hurdle or discount rate, and then measuring the payback
period.
• It is still flawed in that cash flows after the payback is
ignored.
Example 2: Calculate Discounted Payback Period
Calculate the discounted payback period of the tanning bed,
stated in Example 1 above, by using a discount rate of 10%.
Example 2: Answer
Year Cash flow Discounted CF Yet to be Percent of Year
recovered Recovered/Inflow
0 (10,000) (10,000) (10,000) Blank
1 4,000 3,636 (6,364) Blank

2 4,500 3,719 (2,645) Blank
3 10,000 7,513 4,869 35%
4 8,000 5,464 Not used in Blank
decision
Discounted Blank Blank Blank Blank
Payback
= 2.35 years
9.3 Net Present Value (NPV) (1 of 2)
• Discounts all the cash flows from a project back to time 0
using an appropriate discount rate, r:
CF1 CF2 CF3 CFn

NPV = −CF0 + + + + + 9.1
(1 + r ) (1 + r ) (1 + r ) (1 + r )
1 2 3 n
accept if NPV  0 reject if NPV  0
• A positive NPV implies that the project is adding value to

the firm’s bottom line and therefore when comparing
projects, the higher the NPV the better.
9.3 Net Present Value (NPV) (2 of 2)
Example 3: Calculating NPV
Using the cash flows for the tanning bed given in Example 2
above, calculate its NPV and indicate whether the
investment should be undertaken or not.
Answer
NPV bed = −$10,000 + $4,000 ÷ (1.10) + $4,500 ÷ (1.10)2
+$10,000 ÷ (1.10)3 + $8,000 ÷ (1.10)4
= −$10,000 + $3,636.36 + $3719.01 + $7513.15 + $5,464.11
= $10,332.62
Since the NPV > 0, the tanning bed should be purchased.
9.3 (A) Mutually Exclusive Versus
Independent Projects (1 of 3)
NPV approach useful for independent as well as mutually exclusive
projects.
A choice between mutually exclusive projects arises when:
1. There is a need for only one project, and both projects can fulfill that
need.
2. There is a scarce resource that both projects need, and by using it in
one project, it is not available for the second.
NPV rule considers whether or not discounted cash inflows outweigh the
cash outflows emanating from a project.
Higher positive NPVs would be preferred to lower or negative NPVs.
Decision is clear-cut.
Example 4: Calculate NPV for Choosing Between Mutually Exclusive Projects
The owner of Perfect Images Salon has a dilemma. She wants to start offering
tanning services and has to decide between purchasing a tanning bed and a
tanning booth. In either case, she figures that the cost of capital will be 10%. The
relevant annual cash flows with each option are listed below:
Year Tanning Bed Tanning Booth

0 −10,000 −12,500
1 4,000 4,400
2 4,500 4,800
3 10,000 11,000
4 8,000 9,500
Can you help her make the right decision?
Example 4: Answer
Since these are mutually exclusive options, the one with the higher NPV
would be the best choice.
NPV bed = −$10,000 + $4,000 ÷ (1.10) + $4,500 ÷ (1.10)2
+$10,000 ÷ (1.10)3 + $8,000 ÷ (1.10)4
= −$10,000 + $3,636.36 + $3,719.01 + $7,513.15 +
$5,464.11
= $10,332.62
NPV booth = −$12,500 + $4,400 ÷ (1.10) + $4,800 ÷ (1.10)2
+$11,000 ÷ (1.10)3 + $9,500 ÷ (1.10)4
= −$12,500 + $4,000 + $3,966.94 + $8,264.46 + $6,488.63
= $10,220.03
Thus, the less expensive tanning bed with the higher NPV
(10,332.62 > 10,220.03) is the better option.
9.3 (B) Unequal Lives of Projects (1 of 7)
Firms often have to decide between alternatives that are:
• mutually exclusive,
• cost different amounts,
• have different useful lives, and
• require replacement once their productive lives run out.
In such cases, using the traditional NPV (single life analysis)
as the evaluation criterion can lead to incorrect decisions,
since the cash flows will change once replacement occurs.
Under the NPV approach, mutually exclusive projects with
unequal lives can be analyzed by using one of the following
two modified approaches:
1. Replacement chain method.
2. Equivalent annual annuity (EAA) approach
Example 5: Unequal Lives
Let’s say that there are two tanning beds available, one lasts
for 3 years while the other for 4 years.
The owner realizes that she will have to replace either of these
two beds with new ones when they are at the end of their
productive life, as she plans on being in the business for a long
time.
Using the cash flows listed below, and a cost of capital is 10%,
help the owner decide which of the two tanning beds she
should choose.
Example 5: Answer (continued)
Tanning Tanning
Year Bed A Bed B
0 −10,000 −5,750
1 4,000 4,000
2 4,500 4,500
3 10,000 9,000
4 8,000 --------
Example 5: Answer
Using the replacement chain method:
1. Calculate the NPV of each tanning bed for a single life
NPVbed a = −$10,000 + $4,000 ÷ (1.10) + $4,500 ÷ (1.10)2
+ $10,000 ÷ (1.10)3 + $8,000 ÷ (1.10)4
= −$10,000 + $3,636.36 + $3,719.01 + $7,513.15 + $5,464.11
= $10,332.62
NPVbed b = −$−5,750 + $4,000 ÷ (1.10) + $4,500 ÷ (1.10)2 + $9,000 ÷ (1.10)3
= −$5,750 + $3,636.36 + $3,719.01 + $6,761.83
= $8,367.21
Next, calculate the total NPV of each bed using three repetitions for A and 4 for B, i.e.,
we assume the Bed A will be replaced at the end of years 4, and 8; lasting 12 years,
while Bed B will be replaced in years 3, 6, and 9, also lasting for 12 years in total.
We assume that the annual cash flows are the same for
each replication.
Total NPV bed A = $10,332.62 + $10,332.62 ÷ (1.10)4 + $10,332.62 ÷ (1.1)8
Total NPV bed A = $10,332.62 + $7,057.32 + $4,820.24 = $22,210.18
Total NPV bed B = $8,367.21 + $8,367.21 ÷ (1.10)3 + $8,367.21 ÷ (1.1)6

+$8,367.21 ÷ (1.1)9
Total NPV bed B = $8,367.21 + $6,286.41 + $4,723.07 + $3,548.51 = $22,925.20
Decision: Bed B with its higher total NPV should be chosen.
Equivalent annual annuity (EAA)
• We simply convert each project’s NPV into an equivalent
annual annuity (EAA) as shown in Equation below, by
using the PV of an annuity equation or calculator function,
and choose the one with the higher EAA.
PVIFA
Using the EAA method:
EAA bed A = NPVA ÷ (PVIFA,10%,4)
= $10,332.62 ÷ (3.1698)
= $3,259.56
EAA bed B = NPV B ÷ (PVIFA,10%,3)

= $8,367.21 ÷ (2.48685)
= $3,364.58
Decision: Bed B’s EAA = $3,364.58 > Bed A’s

EAA = $3,259.56 → Accept Bed B
9.3 (C) Net Present Value Example:
Equation and Calculator Function (1 of 5)
Two ways to solve for NPV given a series of cash flows
1. We can use equation 9.1, manually solve for the present
values of the cash flows, and sum them up as shown in
the examples above; or
2. We can use a financial calculator such as the Texas
Instruments Business Analyst II or TI-83 and input the
necessary values using either the CF key (BA-II) or the
NPV function (TI-83).
Example 6: Solving NPV Using Equation/Calculator
A company is considering a project which costs $750,000 to
start and is expected to generate after-tax cash flows as
follows:
Year 1: $125,000
Year 2: $175,000
Year 3: $200,000
Year 4: $225,000
Year 5: $250,000
If the cost of capital is 12%, calculate its NPV.
Example 6: Answer
Equation method:
$125, 000 $175, 000 $200, 000

NPV = −$750, 000 + + +
(1 + 0.12) (1 + 0.12) (1 + 0.12)3
1 2
$225, 000 $250, 000

+ +
(1 + 0.12 ) (1 + 0.12 )
4 5
NPV = −$750, 000 + $111, 607 + $139,509 + $142,356 + $142,992

+ $141,857
= −$71, 679
Calculator method:
Calculator method:
9.3 (C) Net Present ValueTI-BAII
Example:
Plus: We enter the respective cash fl
TI-BAII Plus: We enter the respective ca
Equation and Calculator Function
key
key (4 of 5)
Example 6: Answer
Calculator method:
TI-BAII Plus: We enter the
respective case flows
sequentially using the CF key
Then we press the NPV key, enter the discoun
Then
arrow we press
as follows to the NPV
get the key, enter
following the dis
result:
Then we press the NPV key, arrow as follows to get the following resu
enter the discount rate, I, and

press the down arrow as
follows to get the following
result.
TI-83 method:
We use the NPV function (available under the FINANCE
mode) as follows:
NPV(discount rate, CF0, {CF1,CF2,…CFn} and press the ENTER key
NPV(12, −750,000, {125,000, 175,000, 200,000, 225,000, 250,000}
ENTER
Output = −71,679.597
Note: The discount rate is entered as a whole number i.e.,

12 for 12% and a comma should separate each of the
inputs, with a { } bracket used for cash flows 1 through n.
9.4 Internal Rate of Return (1 of 3)
• The internal rate of return (IRR) is the discount rate which
forces the sum of all the discounted cash flows from a
project to equal 0, as shown below:
CF1 CF2 CF3 CFn

$0 = CF0 + + + + + 9.3
(1 + r ) (1 + r ) (1 + r ) (1 + r )
1 2 3 n
The decision rule that would be applied is as follows:

• IRR > discount rate → NPV > 0 → accept project
• The IRR is measured as a percent while the NPV is
measured in dollars.
Example 7: Calculating IRR with a Financial Calculator
Using the cash flows for the tanning bed given in Example 1
above calculate its IRR and state your decision.
CF0 = −$10,000; CF1 = $4,000; CF2 = $4,500;
CF3 = $10,000; CF4 = $8,000
I or discount rate = 10%
Example 7: Answer
TI-83 inputs are as follows:
Using the Finance mode, select IRR function and enter the
inputs as follows:
• IRR(−CF0,{CF1,CF2,CF3,CF4} ENTER
• IRR(−10,000, {4,000, 4,500, 10,000, 8,000} ENTER
• → 44.932% = IRR > 10% → Accept it!
9.4 (A.1) Appropriate Discount Rate or
Hurdle Rate (1 of 3)
• Discount rate or hurdle rate is the minimum acceptable
rate of return that should be earned on a project given its
riskiness.
• For a firm, it would typically be its weighted average cost of
capital (covered in later chapters).
• Sometimes, it helps to draw an NPV profile
– i.e. A graph plotting various NPVs for a range of incremental
discount rates, showing at which discount rates the project would
be acceptable and at which rates it would not.
Table 9.2 NPVs for Copier A with Varying Risk Levels
The point where the NPV line cuts the X-axis is the IRR of the project, i.e.,
the discount rate at which the NPV = 0. Thus, at rates below the IRR, the
project would have a positive NPV and would be acceptable and vice-versa.
Figure 9.3 Net present value profile of Copier A.
9.4 (A.2) Problems with the Internal Rate of
Return
• In most cases, NPV decision = IRR decision
– That is, if a project has a positive NPV, its IRR will exceed its
hurdle rate, making it acceptable. Similarly, the highest NPV
project will also generally have the highest IRR.
However, there are some cases when the IRR method leads
to ambiguous decisions or is problematic. In particular, we
can have two problems with the IRR approach:
1. Multiple IRRs; and
2. An unrealistic reinvestment rate assumption.
9.4 (A.3) Multiple Internal Rates of Return
(1 of 2)
Projects which have non-normal cash flows (as shown below)
i.e., multiple sign changes during their lives often end up with
multiple IRRs.
$7,500 $7,500 $7,500 $7,500 $20, 000
$0 = −$11, 000 + + + + −
(1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r )
1 2 3 4 5
Figure 9.4 Pay me

later franchise
company multiple
internal rates of
return.
9.4 (A.3) Multiple Internal Rates of Return
(2 of 2)
• Typically happens when a project has non-normal cash

flows, i.e. the cash inflows and outflows are not all clustered
together, i.e., all negative cash flows in early years followed
by all positive cash flows later or vice-versa.
• If the cash flows have multiple sign changes during the
project’s life, it leads to multiple IRRs and therefore
ambiguity as to which one is correct.
• In such cases, the best thing to do is to draw an NPV profile
and select the project if it has a positive NPV at our required
discount rate and vice-versa.
9.4 (A.4) Reinvestment & Crossover Rates
(1 of 6)
• Another problem with the IRR approach is that it inherently

assumes that the cash flows are being reinvested at the
IRR, which if unusually high, can be highly unrealistic.
• In other words, if the IRR was calculated to be 40%, this

would mean that we are implying that the cash inflows
from a project are being reinvested at a rate of return of
40%, for the IRR to materialize.
(2 of 6)
• A related problem arises when in the case of mutually

exclusive projects we have either significant cost
differences, and/or significant timing differences, leading to
the NPV profiles crossing over.
(3 of 6)
Figure 9.5 Mutually exclusive projects and their

crossover rates.
Notice that Project B’s IRR is higher than Project A’s IRR, making it the preferred choice
based on the IRR approach.
However, at discount rates lower than the crossover rate, Project A has a higher NPV than
Project B, making it more acceptable since it is adding more value.
(4 of 6)
If the discount rate is exactly equal to the crossover rate both

projects would have the same NPV.
To the right of the crossover point, both methods would

select Project B.
The fact that at certain discount rates, we have conflicting

decisions being provided by the IRR method vis-à-vis the
NPV method is the problem.
So, when in doubt go with the project with the highest NPV, it
will always be correct.
(5 of 6)
Example 8: Calculating the Crossover Rate of Two
Projects
Listed below are the cash flows associated with two mutually
exclusive projects A and B. Calculate their crossover rate.
Year A B (A−B)
0 −10,000 −7,000 −3,000
1 5,000 9,000 −4,000
2 7,000 5,000 2,000
3 9,000 2,000 7,000
IRR 42.98% 77.79% 12.04%
First calculate the yearly differences in the cash flows, i.e., (A−B). Next,
calculate the IRR of the cash flows in each column, e.g. for IRR(A−B).
(6 of 6)
Example 8: Answer
→IRR(10, {−3,000, −4,000, 2,000, 7,000} →12.04%
→IRRA = 42.98%; IRRB = 77.79%; IRR(A−B) = 12.04%
Now, to check this calculate the NPVs of the two projects at:
0%, 10%, 12.04%, 15%, 42.98%, and 77.79%.
I NPVA NPVB
0% $11,000.00 $9,000.00
10% $7,092.41 $6,816.68
12.04% $6,437.69 $6,437.69
15.00% $5,558.48 $5,921.84
42.98% $0.00 $2,424.51
77.79% ($3,371.48) $0.00
From 0% to 12.04%, NPVA > NPVB
For I >12.04%, NPVB > NPVA
NPV profiles cross-over at 12.04%
7.2 The Internal Rate of Return Rule (1 of 2)
• Internal Rate of Return (IRR) Investment Rule

– Take any investment where the IRR exceeds the cost
of capital
– Turn down any investment whose IRR is less than the
cost of capital
7.2 The Internal Rate of Return Rule (2 of 2)
• The IRR Investment Rule will give the same answer as the
NPV rule in many, but not all, situations.
• In general, the IRR rule works for a stand-alone project if
all of the project’s negative cash flows precede its positive
cash flows.
– In Figure 7.1, whenever the cost of capital is below the
IRR of 14%, the project has a positive NPV, and you
should undertake the investment.
Applying the IRR Rule (1 of 10)
• In other cases, the IRR rule may disagree with the NPV
rule and thus be incorrect.
– Situations where the IRR rule and NPV rule may be in
conflict:
▪ Delayed Investments
▪ Nonexistent IRR
▪ Multiple IRRs
Pitfall 1: Delayed Investments (1 of 4)
• Assume you have just retired as the CEO of a successful
company. A major publisher has offered you a book deal.
The publisher will pay you $1 million upfront if you agree to
write a book about your experiences. You estimate that it
will take three years to write the book. The time you spend
writing will cause you to give up speaking engagements
amounting to $500,000 per year. You estimate your
opportunity cost to be 10%.
• Should you accept the deal?
– Calculate the IRR
Blank NPER RATE PV PMT FV Excel Formula
Given 3 Blank 1,000,000 −500,000 0 Blank
Solve for 1 Blank 23.38% Blank Blank Blank =RATE(3,500000,1
000000,0)
– The IRR is greater than the cost of capital

– Thus, the IRR rule indicates you should accept the deal
Financial Calculator Solution (3 of 4)
• Should you accept the deal?
500, 000 500, 000 500, 000

NPV = 1, 000, 000 − − 2
− 3
= −$243, 426
1.1 1.1 1.1
• Since the NPV is negative, the NPV rule indicates you

should reject the deal.
Figure 7.2 NPVof Star’s $1 Million Book
Deal
When the benefits of an investment occur before the costs,

the NPV is an increasing function of the discount rate.
Pitfall 2: Multiple IRRs (1 of 4)
• Suppose Star informs the publisher that it needs to
sweeten the deal before he will accept it. The publisher
offers $550,000 advance and $1,000,000 in four years
when the book is published.
• Should he accept or reject the new offer?
• The cash flows would now look like
• The NPV is calculated as

500, 000 500, 000 500, 000 1, 000, 000
NPV = 550, 000 − − 2
− 3
−
1+ r (1 + r ) (1 + r ) (1 + r ) 4
• By setting the NPV equal to zero and solving for r, we find
the IRR.
• In this case, there are two IRRs: 7.164% and 33.673%.
• Because there is more than one IRR, the IRR rule cannot
be applied.
Figure 7.3 NPVof Star’s Book Deal with
Royalties
• As seen in Figure 7.3, between 7.164% and 33.673%, the
book deal has a negative NPV.
• Since your opportunity cost of capital is 10%, you should
reject the deal.
Pitfall 3: Nonexistent IRR
• Finally, Star is able to get the publisher to increase his
advance to $750,000, in addition to the $1 million when the
book is published in four years.
• With these cash flows, no IRR exists; there is no discount
rate that makes NPV equal to zero.
Figure 7.4 NPVof Star’s Final Offer
No IRR exists because the NPV is positive for all values of

the discount rate. Thus the IRR rule cannot be used.
Common Mistake
• IRR Versus the IRR Rule
– While the IRR rule has shortcomings for making
investment decisions, the IRR itself remains useful. IRR
measures the average return of the investment and the
sensitivity of the NPV to any estimation error in the
cost of capital.
9.4 (B) Modified Internal Rate of Return
(MIRR) (1 of 5)
• Despite several shortcomings, managers like to use IRR since it is
expressed as a % rather than in dollars.
• The MIRR was developed to get around the unrealistic reinvestment
rate criticism of the traditional IRR.
• Under the MIRR, all cash outflows are assumed to be reinvested at the
firm’s cost of capital or hurdle rate, which makes it more realistic.
• We calculate the future value of all positive cash flows at the terminal
year of the project, the present value of the cash outflows at time 0;
using the firm’s hurdle rate; and then solve for the relevant rate of
return that would be implied using the following equation:
1/ n
 FV 
MIRR =   −1
 PV 
(MIRR) (2 of 5)
Figure 9.7 Future value of cash inflows reinvested at the
internal rate of return.
(MIRR) (3 of 5)
Figure 9.8 Future value of cash inflows reinvested at 13%.
(MIRR) (4 of 5)
Example 9: Calculating MIRR
Using the cash flows given in Example 8 above, and a

discount rate of 10%; calculate the MIRRs for Projects A and
B. Which project should be accepted? Why?
Year A B (A−B)
0 −10,000 −7,000 −3,000
1 5,000 9,000 −4,000
2 7,000 5,000 2,000
3 9,000 2,000 7,000
IRR 42.98% 77.79% 12.04%
(MIRR) (5 of 5)
Example 9: Answer
Project A:
PV of cash outflows at time 0 = $10,000
FV of cash inflows at year 3, @10% = 5,000 × (1.1)2 + $7,000 × (1.1)1 + $9,000
→$6,050 + $7,700 + $9,000 = $22,750
MIRRA = (22,750 ÷ 10,000)1÷3 −1 = 31.52%
Project B:
PV of cash outflows at time 0 = $7,000
FV of cash inflows at year 3, @10% = $9,000 × (1.1)2 + $5,000 × (1.1)1 + $2,000
→$10,890 + $5,500 + $2,000 = $18,390
MIRRB = (18,390 ÷ 7,000)1÷3 − 1 = 37.98%
So, accept Project B since its MIRR is higher.
9.5 Profitability Index (1 of 2)
• If faced with a constrained budget choose projects that
give us the best “bang for our buck.”
The Profitability Index can be used to calculate the ratio of
the PV of benefits (inflows) to the PV of the cost of a project
as follows:
NPV + cost
PI with standard cash flow =
cost
• In essence, it tells us how many dollars we are getting per

dollar invested.
9.5 Profitability Index (2 of 2)
Example 10: PI Calculation
Using the cash flows listed in Example 8, and a discount rate of 10%,
calculate the PI of each project Which one should be accepted, if they
are mutually exclusive? Why?
Year A B
0 −10,000 −7,000
1 5,000 9,000
2 7,000 5,000
3 9,000 2,000
NPV@10% $7,092.41 $6,816.68
Answer
PIA = (NPV + cost) ÷ cost = ($17,092.41 ÷ $10,000) = $1.71
PIB = (NPV + cost) ÷ cost = ($13,816.68 ÷ $7,000) = $1.97
Project B, higher PI
9.6 Overview of Six Decision Models (1 of 4)
1. Payback period
– simple and fast, but economically unsound.
– ignores all cash flow after the cutoff date.
– ignores the time value of money and riskiness of cash flows.
2. Discounted payback period

– incorporates the time value of money.
– still ignores cash flow after the cutoff date.
3. Net present value (NPV)

– economically sound.
– properly ranks projects across various sizes, time horizons, and
levels of risk, without exception for all independent projects.
4. Internal rate of return (IRR)
– provides a single measure (return).
– has the potential for errors in ranking projects.
– can also lead to an incorrect selection when there are two
mutually exclusive projects or incorrect acceptance or rejection of
a project with more than a single IRR.
5. Modified internal rate of return (MIRR)

– corrects for most of, but not all, the problems of IRR and gives the
solution in terms of a return.
– the reinvestment rate may or may not be appropriate for the future
cash flows, however.
6. Profitability index (PI)
– incorporates risk and return.
– but the benefits-to-cost ratio is actually just another way of
expressing the NPV.
Table 9.4 Summary of Six Decision Models
9.6 (A) Capital Budgeting Using a
Spreadsheet (1 of 3)
NPV, MIRR, and IRR can be easily solved once data is
entered into a spreadsheet.
For NPV we enter the following → NPV(rate, CF1:CFn) + CF0
Note: for the NPV we have to add in the cash outflow in
year 0 (CF0), at the end, i.e., to the PV of CF1…CFn
For IRR we enter the following → IRR(CF0:CFn)
For MIRR →MIRR(CF0:CFn, discount rate, reinvestment
rate); where the discount rate and the reinvestment rate
would typically be the same, i.e., the cost of capital of the
firm.
Additional Problems with Answers
Problem 1
Computing Payback Period and Discounted Payback Period.
Regions bank is debating between two the purchase of two software
systems; the initial costs and annual savings of which are listed
below. Most of the directors are convinced that given the short
lifespan of software technology, the best way to decide between the
two options is on the basis of a payback period of 2 years or less.
Compute the payback period of each option and state which one
should be purchased.
One of the directors states, “I object! Given our hurdle rate of 10%,
we should be using a discounted payback period of 2 years or less.”
Accordingly, evaluate the projects on the basis of the DPP and state
your decision.
Problem 1 (Answer) (1 of 2)
Year Software Option A PVCF@10% Software Option B PVCF@10%
0 ($1,875,000) $ (1,875,000.00) ($2,000,000) $ (2,000,000.00)
1 $1,050,000 $954,545.45 1,250,000 $1,136,363.64
2 $900,000 $743,801.65 $800,000 $661,157.02
3 $450,000 $338,091.66 $600,000 $450,788.88
Payback period of Option A = 1 year + (1,875,000 − 1,050,000) ÷ 900,000

= 1.92 years
Payback period of Option B = 1 year + (2,000,000 − 1,250,000) ÷ 800,000

= 1.9375 years
Based on the payback period, Option A should be chosen
For the discounted payback period, we first discount the
cash flows at 10% for the respective number of years and
then add them up to see when we recover the investment.
DPP A = −1,875,000 + 954,545.45 + 743,801.65 = −176,652.9 still to
be recovered in year 3
DPP A = 2 + (176,652.9 ÷ 338,091.66) = 2.52 years
DPP B = −2,000,000 + 1, 136,363.64 + 661,157.02 = −202,479.34
still to be recovered in year 3
DPP B = 2 + (202,479.34 ÷ 450,788.88) = 2.45 years.
Based on the discounted payback period and a 2 year

cutoff, neither option is acceptable.
Problem 2
Computing Net Present Value—Independent projects:
Locey Hardware is expanding its product line and its
production capacity. The costs and expected cash flows of
the two projects are given below. The firm typically uses a
discount rate of 15.4%.
a. What are the NPVs of the two projects?
b. Which of the two projects should be accepted (if any) and
why?
Problem 2 (Answer)
Year Product Line Production
Expansion Capacity Expansion
0 $ (2,450,000) $ (8,137,250)
1 $500,000 $1,250,000
2 $825,000 $2,700,000
3 $850,000 $2,500,000
4 $875,000 $3,250,000
5 $895,000 $3,250,000
NPV @15.4% = $86,572.61 $20,736.91

Decision: Both NPVs are positive, and the projects are independent,
so assuming that Locey Hardware has the required capital, both
projects are acceptable.
Problem 3
KLS Excavating needs a new crane. It has received two
proposals from suppliers.
Proposal A costs $900,000 and generates cost savings of $325,000
per year for 3 years, followed by savings of $200,000 for an
additional 2 years.
Proposal B costs $1,500,000 and generates cost savings of

$400,000 for 5 years.
If KLS has a discount rate of 12%, and prefers using the IRR
criterion to make investment decisions, which proposal
should it accept?
Problem 3 (Answer)
Year Crane A Crane B
0 $ (900,000) $ (1,500,000)
1 $325,000 $400,000
2 $325,000 $400,000
3 $325,000 $400,000
4 $200,000 $400,000
5 $200,000 $400,000
Required rate Blank 12%
of return
Blank Blank Blank
IRR 17.85% 10.42%
Decision Accept Crane A →IRR>12%
Problem 4
Using MIRR.
The New Performance Studio is looking to put on a new
opera.
They figure that the set-up and publicity will cost $400,000.
The show will go on for 3 years and bring in after-tax net
cash flows of $200,000 in year 1; $350,000 in year 2;
−$50,000 in year 3.
If the firm has a required rate of return of 9% on its
investments, evaluate whether the show should go on using
the MIRR approach.
The forecasted after-tax net cash flows are as follows:
Year After-tax cash flow
0 −$400,000
1 200,000
2 350,000
3 −$50,000
The formula for MIRR is as follows:

1/ n
 FV 
MIRR =   −1
 PV 
Where : FV = Compounded value of cash inflows at end of project’s life
(year 3) using realistic reinvestment rate (9%);
PV = Discounted value of all cash outflows at year 0;
N = number of years until the end of the project’s life = 3.
FV3 = $200,000 × (1.09)2 + $350,000 × (1.09)1
= $237,620 + $381,500 = $619,120
PV0 = $400,000 + $50,000 ÷ (1.09)3

= $438,609.17
MIRR = (619,120 ÷ $438,609.17)1÷3 − 1

= (1.411552)1÷3 − 1 = 12.18%
The show must go on, since the MIRR = 12.18% > Hurdle
rate = 9%.
Problem 5
Using multiple methods with mutually exclusive projects:
The Upstart Corporation is looking to invest one of two mutually
exclusive projects, the cash flows for which are listed below. Their
director is really not sure about the hurdle rate that he should use when
evaluating them and wants you to look at the projects’ NPV profiles to
better assess the situation and make the right decision.
Year A B
0 −454,000 ($582,000)
1 $130,000 $143,333
2 $126,000 $168,000
3 $125,000 $164,000
4 $120,000 $172,000
5 $120,000 $122,000
To get some idea of the range of discount rates we
should include in the NPV profile, it is a good idea to
first compute each project’s IRR and the crossover rate,
i.e., the IRR of the cash flows of Project B−A as shown
below:
Year A B B−A
0 (454,000) ($582,000) ($128,000)
1 $130,000 $143,333 $13,333
2 $126,000 $168,000 $168,000
3 $125,000 $164,000 $39,000
4 $120,000 $172,000 $52,000
5 $120,000 $122,000 $2000
IRR 0.116 0.102 0.052
So, it’s clear that the NPV profiles will cross-over at a
discount rate of 5.2%.
Project A has a higher IRR than Project B, so at discount

rates higher than 5.2%, it would be the better investment
and vice-versa (higher NPV and IRR), but if the firm can
raise funds at a rate lower than 5.2%, then Project B will
be better, since its NPV would be higher.
To check this let’s compute the NPVs of the two projects

at 0%, 3%, 5.24%, 8%, 10.2%, and 11.6%...
Rate NPV(A) NPV(B)
0.00% 167,000 187,333
3.00% 115,505 123,656
5.24% 81,353 81,353
8.00% 43,498 34,393
10.2441% 15,811 0
11.624% 0 −19,323
Note that the two projects have equal NPVs at the cross-
over rate of 5.24%. At rates below 5.24%, Project B’s
NPVs are higher; whereas at rates higher than 5.24%,
Project A has the higher NPV.
Figure 9.1 Initial Cash Outflow and Future
Cash Inflow of Copiers A and B
Table 9.1 Discounted Cash Flow of Copiers
A and B
Figure 9.2 Net Present Value of a Low-Tech
Packaging Machine
Table 9.3 Project Rankings Based on the
Internal Rate of Return and the Net Present
Value
Figure 9.6 Crossover Rate for Two Projects
Table 9.5 Corporate Use of Different
Decision Models: What Capital Budgeting
Decision Models Do You Use?
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Financial Management: Core Concepts

• Long-term decisions versus short-term decisions

• Capital budgeting meets all three criteria

Three keys things to remember about capital budgeting

1 4,000 3,636 (6,364) Blank

CF1 CF2 CF3 CFn

accept if NPV  0 reject if NPV  0

• A positive NPV implies that the project is adding value to

Year Tanning Bed Tanning Booth

Can you help her make the right decision?

Total NPV bed A = $10,332.62 + $7,057.32 + $4,820.24 = $22,210.18

Total NPV bed B = $8,367.21 + $8,367.21 ÷ (1.10)3 + $8,367.21 ÷ (1.1)6

Total NPV bed B = $8,367.21 + $6,286.41 + $4,723.07 + $3,548.51 = $22,925.20

Decision: Bed B with its higher total NPV should be chosen.

EAA bed B = NPV B ÷ (PVIFA,10%,3)

Decision: Bed B’s EAA = $3,364.58 > Bed A’s

If the cost of capital is 12%, calculate its NPV.

$125, 000 $175, 000 $200, 000

$225, 000 $250, 000

NPV = −$750, 000 + $111, 607 + $139,509 + $142,356 + $142,992

enter the discount rate, I, and

Note: The discount rate is entered as a whole number i.e.,

CF1 CF2 CF3 CFn

The decision rule that would be applied is as follows:

Figure 9.4 Pay me

• Typically happens when a project has non-normal cash

• Another problem with the IRR approach is that it inherently

• In other words, if the IRR was calculated to be 40%, this

• A related problem arises when in the case of mutually

Figure 9.5 Mutually exclusive projects and their

If the discount rate is exactly equal to the crossover rate both

To the right of the crossover point, both methods would

The fact that at certain discount rates, we have conflicting

• Internal Rate of Return (IRR) Investment Rule

– The IRR is greater than the cost of capital

500, 000 500, 000 500, 000

• Since the NPV is negative, the NPV rule indicates you

When the benefits of an investment occur before the costs,

• The NPV is calculated as

No IRR exists because the NPV is positive for all values of

Using the cash flows given in Example 8 above, and a

• In essence, it tells us how many dollars we are getting per

2. Discounted payback period

3. Net present value (NPV)

5. Modified internal rate of return (MIRR)

Payback period of Option A = 1 year + (1,875,000 − 1,050,000) ÷ 900,000

Payback period of Option B = 1 year + (2,000,000 − 1,250,000) ÷ 800,000

Based on the payback period, Option A should be chosen

Based on the discounted payback period and a 2 year

NPV @15.4% = $86,572.61 $20,736.91

Proposal B costs $1,500,000 and generates cost savings of

The formula for MIRR is as follows:

PV0 = $400,000 + $50,000 ÷ (1.09)3

MIRR = (619,120 ÷ $438,609.17)1÷3 − 1

Project A has a higher IRR than Project B, so at discount

To check this let’s compute the NPVs of the two projects

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