The Basics of Capital Budgeting: Should We Build This Plant?

Chapter 11:
THE BASICS OF
CAPITAL
BUDGETING
Should we
build this
plant?
Topic Overview
Project Types
Capital Budgeting Decision Criteria
Net Present Value (NPV)

Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Payback Period
Discounted Payback Period
Learning Objectives
Understand how to calculate and use the 5
capital budgeting decision techniques:, NPV,
IRR, MIRR, Payback, & Discounted Payback.
Understand the advantages and
disadvantages of each technique.
Understand which project to select when
there is a ranking conflict between NPV and
IRR.
Think about this as we cover Chapter 11

Capital Budgeting Decision Methods.
Which of the following investment opportunities

would you prefer?
#1) Give me $1 now and Ill give you $2 at the
end of class.
#2) Give me $100 now and Ill give you $150 at
the end of class.
WHAT IS CAPITAL BUDGETING?
Analysis of potential additions to fixed assets.

Long-term decisions; involve large
expenditures.
Very important to firms future.
Capital Budgeting Steps:
1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine k = WACC (adj.).
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
Types of Projects
Brand new line of business

Expansion of existing line of business
Replacement of existing asset
Independent vs. Mutually Exclusive
Normal vs. Non-normal
An Example of Mutually Exclusive

Projects:
BRIDGE VS. BOAT TO GET

PRODUCTS ACROSS A RIVER.
Normal vs. Nonnormal 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
NN
NN
NN
Our Case Study
We want to help Marge Simpson analyze the following

business opportunities by using the following cash flow
information. Assume Marge's cost of capital is 12%.
Time
Falafel-Full
How 'Bout A Pretzel?
0
1
2
3
4
(20,000)
15,000
15,000
13,000
3,000
(20,000)
2,000
2,500
3,000
50,000
Net Present Value (NPV)
NPV = PV of inflows minus Cost = Net gain in

wealth.
Acceptance of a project with a NPV > 0 will
add value to the firm.
Decision Rule:
Accept if NPV >0,

Reject if NPV < 0
NPV: Sum of the PVs of inflows and outflows.
CFt
NPV
.
t
t 0 1 k
Cost often is CF0 and is negative.
n
CFt
NPV
CF0 .
t
t 1 1 k
Marges NPVs: k = 12%

Time
0
1
2
3
4
NPV
Falafel-Full
PV(CF)
(20,000) (20,000)
15,000
13,393
15,000
11,958
13,000
9,253
3,000
1,907
16,510
PV(CF)
(20,000) (20,000)
2,000
1,786
2,500
1,993
3,000
2,135
50,000
31,776
17,690
Calculator Steps. Falafel-Full: CF0 = -20,000, C01 =

15,000, F01 = 2, C02 = 13,000, F02 = 1, C03 = 3,000.
NPV: I = 12, CPT NPV = 16,510
Pretzel: CF0 = -20,000, C01 = 2,000, C02 = 2,500,
C03 = 3,000, C04 = 50,000. NPV: I = 12, CPT NPV =
17,690
Excel and NPV:
Excels NPV function is goofed up. =NPV(k, range of

cash flows)
Assumes first cash flow in range occurs at t = 1.
See spreadsheet.
Solution to this spreadsheet problem: exclude CF0 (t =
0 cash flow) from NPV cell range and add CF0 (if CF0
is already negative) or subtract CF0 (if CF0 is positive)
from NPV function.
Marges NPV Decision
If projects are independent, Marge

should select both.
Both have positive NPV.
If the projects are mutually exclusive,

select How Bout A Pretzel?
Pretzel NPV > Falafel NPV.
Internal Rate of Return: IRR

0
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 k, solve for NPV.

n
CFt
NPV.
t
t 0 1 k
IRR: Enter NPV = 0, solve for IRR.
n
CFt
0.
t
t 0 1 IRR
Internal Rate of Return (IRR)
Internal Rate of Return is a projects 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 projects NPV
= 0.
Decision Rule: Accept if IRR > k (cost of capital).
Non-normal projects have multiple IRRs. Dont use
IRR to decide on non-normal projects.
Marges IRRs
Best to use calculator. Calculator Steps.

Falafel-Full: CF0 = -20,000, C01 = 15,000, F01
= 2, C02 = 13,000, F02 = 1, C03 = 3,000.
Press IRR, then CPT: IRR = 54.7%
Pretzel: CF0 = -20,000, C01 = 2,000, C02 =
2,500, C03 = 3,000, C04 = 50,000. Press IRR,
then CPT: IRR = 33.3%
k = 12%. If independent projects: select
both, IRRs > 12%. Mutually exclusive:
select Falafel; higher IRR.
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 Profiles
A graph which shows a projects NPV at different

interest rates (cost of capital).
Can illustrate ranking conflicts between NPV and IRR.
Below is a table of NPVs for Marges projects.
k
0%
5%
10%
12%
15%
25%
35%
55%
Falafel-Full
26,000
21,589
17,849
16,510
14,649
9,485
5,529
(68)

37,500
27,899
20,289
17,690
14,190
5,216
(874)
(8,201)
Marges Projects
NPV
Marge's NPV Profiles

40,000
30,000
20,000
10,000
0
-10,000 0%
-20,000
IRR(P)
IRR(F)
Falafel-Full
How 'Bout A
Pretzel?
10% 20%
30%
40% 50%
Cost of Capital (k)
60%
Determining NPV/IRR Conflict

Range
For each year, subtract one projects 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.
Marges crossover rate
Falafel-Full
How 'Bout A Pretzel? Fal - Pret
(20,000)
(20,000)
0 CF0
15,000
2,000 13,000 C01
15,000
2,500 12,500 C02
13,000
3,000 10,000 C03
3,000
50,000 (47,000) C04
IRR = Crossover Rate =
14.1%
Marge's NPV Profiles
NPV
Time
0
1
2
3
4
40,000
30,000
20,000
10,000
0
-10,000 0%
-20,000
IRR(P)
IRR(F)
Falafel-Full
How 'Bout A
Pretzel?
10% 20% 30% 40% 50% 60%

Cost of Capital (k)
At a cost of capital less than 14.1%, Pretzel has higher

NPV but lower IRR = Ranking Conflict.
At cost of capital greater than 14.1%, Falafel has the
higher NPV and IRR.
Two reasons NPV profiles cross:

1)
2)
Size (scale) differences. Smaller

project frees up funds at t = 0 for
investment. The higher the opp.
cost, the more valuable these funds,
so high k favors small projects.
Timing differences. Project with
faster payback provides more CF in
early years for reinvestment. If k is
high, early CF especially good, NPVS
> NPVL.
Which project is best for Marge?
Think back to my indecent proposal.

Which of the following investment
opportunities would you prefer?
#1) Give me $1 now and Ill give you $2 at
the end of class.
#2) Give me $100 now and Ill give you $150
at the end of class.
Reconciling Ranking Conflicts

absent capital rationing.
Shareholder Wealth Maximization:
Reinvestment Rate Assumption:

NPV assumes cash flows are reinvested at
companys cost of capital (i.e.: the investors
required rate of return).
IRR assumes cash flows are reinvested at IRR.
The NPV reinvestment rate assumption is more
realistic.
Result: Choose project with highest NPV when
NPV/IRR ranking conflict exists for mutually
exclusive projects.
Want to add more value to the firm than less.
Acme, Inc. Rocket-Powered Roller

Blade Project
Acme is considering the following project which would market

these roller blades to coyotes trying to catch road runners. Acme
expects a cash inflow in the year 1, but an outflow in the 2nd (last)
year of the project due to liability claims from injured cartoon
coyotes. Acmes opportunity cost of capital is 13%.
Year
0
Cash Flow
(5)
NPV = -1.95 IRR = 26.8%
1
30
2
(30)
Rocket-Powered Roller Blade NPV

Profile
NPV
4
-1
0%
50% 100% 150% 200% 250% 300% 350% 400% 450% 500% 550%
-6
At Acmes 13% opportunity cost of capital, the project has a

negative NPV even though the IRRs (~27% & 374%) are greater
than 13%.
Because of this conflict, dont use IRR to make decisions for nonnormal projects!
Why even mess with IRR?
Since we like NPV, why mess with something like IRR?

A rate of return or interest rate is more intuitive for
outsiders and easier to understand.
But IRR assumes an unrealistic reinvestment rate an
leads to multiple IRRs for non-normal projects.
Solution: Modified Internal Rate of Return (MIRR).
Modified Internal Rate of Return,

MIRR
The interest rate where the FV of a projects inflows

(TV) are discounted to equal the PV of a projects
outflows.
Assumes cash inflows are reinvested at the projects
cost of capital (k).
PV(outflows) = TV/(1+MIRR)n, where
TV = SCIFt(1+k)n-t, and
PV(outflows) = SCOFt/(1+k)t
Where CIF = annual cash inflow, and COF = annual cash

outflow.
Steps to finding MIRR.
Find TV of inflows by finding FV of each annual inflow

to the end of the projects life at the cost of capital.
Find PV of outflows at the cost of capital today.
Then find interest rate over the n years of the project
that equates the TV (=FV) to the PV of the
outflows(=PV).
Decision rule same as IRR: Compare MIRR to cost of
capital.
The MIRR for Marges projects.

Tim e Falafel- Fu ll FV at y r 4 at 1 2 %
0
1
2
3
4
(20,000)
15,000
15,000
13,000
3,000
TV =
21,074
18,816
14,560
3,000
57,450
How 'Bou t A Pretzel? FV at y r 4 at 1 2 %
(20,000)
2,000
2,500
3,000
50,000
TV =
2,810
3,136
3,360
50,000
59,306
Falafel-Full: -20,000 = PV, 57,450 = FV, 4 = N, 0 = PMT, CPT I/Y

= 30.2% = MIRR
How Bout A Pretzel: -20,000 = PV, 59,306 = FV, 4 = N, 0 =
PMT, CPT I/Y = 31.2% = MIRR
Accept both projects if independent since MIRRs are greater
than the 12% cost of capital. Prefer pretzel if mutually
exclusive.
CF Worksheet solution to MIRR

Find NPV of inflows only first, then find FV of this single
PV.
YR
FALAFEL ACIF
CF WORK
0
0
CF0 = 0
1
15,000
C01 = 15,000
2
15,000
F01 = 2
3
13,000
C02 = 13,000 F02 =1
4
3,000
C03 = 3,000 F03 = 1
NPV: I = 12, CPT NPV = 36,510
-36,510 =PV, 12 = I/Y, 4 = N, 0 = PMT, CPT FV =
57,450. Now 20,000 = PV, MIRR: CPT I/Y = 30.2%
MIRR if more than one outflow

ACME Rocket Roller
Blades
YR
CF
0
-5
1
+30
2
-30
Cost of capital = 13%
FV of inflows at yr 2 =
30(1.13) = 33.9
PV of outflows today (yr
0) = -5 30/(1.13)2 =
-28.49
-28.49 = PV, 33.9 = FV,
0 = PMT, 2 = N, CPT I/Y
= 9.1%
MIRR less than 13%
consistent with negative
NPV
Payback Period (PB)
Measures how long it takes to recovers a projects cost

(CF0 = initial outlay).
Easy to calculate and a good measure of a projects
risk and liquidity.
Decision Rule: Accept if PB < some maximum period
of time.
If cash inflows are equal each year (in the form of an
annuity), PB = CF0/Annual CF
Otherwise: see our continuing example.
Marges Payback (Assume Marges

max is 2 years)
Time
Falafel-Full
0
1
2
3
4
(20,000)
15,000
15,000
13,000
3,000
Cumulative CF How 'Bout A Pretzel? Cumulative CF
(20,000)
(5,000)
10,000
23,000
26,000
(20,000)
2,000
2,500
3,000
50,000
PB = Years Before Full Recovery of Initial Cost +

(Unrecovered CF0)/(Cash inflow during year)
Falafel PB = 1 + 5,000/15,000 = 1.33
Pretzel PB = 3 + 12,500/50,000 = 3.25
Marge should choose Falafel using Payback
Period.
(20,000)
(18,000)
(15,500)
(12,500)
37,500
Problems with Payback
Ignores time value of money!

Ignores cash flows beyond payback period.
The Discounted Payback Period addresses the
first problem.
Disc. PB tells how long it takes to recover
capital and financing costs for a project.
Discount rate = cost of capital.
Marges Discounted Payback

Time Falafel-Full
0
1
2
3
4
PV(CF)
(20,000) (20,000)
15,000 13,393
15,000 11,958
13,000
9,253
3,000
1,907
Cumulative PV(CF) How 'Bout A Pretzel?
(20,000)
(6,607)
5,351
14,604
16,510
PV(CF) Cumulative PV(CF)
(20,000) (20,000)
2,000
1,786
2,500
1,993
3,000
2,135
50,000 31,776
(20,000)
(18,214)
(16,221)
(14,086)
17,690
PB = Years Before Full Discounted Recovery of Initial

Cost + (Unrecovered Initial Cost)/(Disc. CF during
year)
Falafel DPB = 1 + 6,607/11,958 = 1.55
Pretzel DPB = 3 + 14,086/31,776 = 3.44
Discounted Payback stills ignores cash flows
beyond the discounted payback period.
Summary of Capital Budgeting

Methods
Want a method the uses the time value of

money with all project cash flows: NPV, IRR &
MIRR.
IRR can give erroneous decision for nonnormal projects.
Overall, NPV is the best and preferred method.

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Chapter 11:

Net Present Value (NPV)

Think about this as we cover Chapter 11

Which of the following investment opportunities

WHAT IS CAPITAL BUDGETING?

Analysis of potential additions to fixed assets.

Capital Budgeting Steps:

1. Estimate CFs (inflows & outflows).

5. Accept if NPV > 0 and/or IRR > WACC.

Brand new line of business

An Example of Mutually Exclusive

BRIDGE VS. BOAT TO GET

Normal vs. Nonnormal Projects

Cost (negative CF) followed by a series of

Two or more changes of signs.

Inflow (+) or Outflow (-) in Year

Our Case Study

We want to help Marge Simpson analyze the following

How 'Bout A Pretzel?

Net Present Value (NPV)

NPV = PV of inflows minus Cost = Net gain in

Accept if NPV >0,

NPV: Sum of the PVs of inflows and outflows.

Marges NPVs: k = 12%

How 'Bout A Pretzel?

Calculator Steps. Falafel-Full: CF0 = -20,000, C01 =

Excel and NPV:

Excels NPV function is goofed up. =NPV(k, range of

Marges NPV Decision

If projects are independent, Marge

Both have positive NPV.

If the projects are mutually exclusive,

Pretzel NPV > Falafel NPV.

Internal Rate of Return: IRR

IRR is the discount rate that forces

NPV: Enter k, solve for NPV.

Internal Rate of Return (IRR)

Internal Rate of Return is a projects expected rate of

Best to use calculator. Calculator Steps.

Comparison of NPV & IRR

For normal independent projects, both

NPV > 0 yields IRR > k in order to lower NPV to

However, the methods can rank mutually

A graph which shows a projects NPV at different

How 'Bout A Pretzel?

Marge's NPV Profiles

Cost of Capital (k)

Determining NPV/IRR Conflict

For each year, subtract one projects cash

Marges crossover rate

Marge's NPV Profiles

10% 20% 30% 40% 50% 60%

At a cost of capital less than 14.1%, Pretzel has higher

Two reasons NPV profiles cross:

Size (scale) differences. Smaller

Which project is best for Marge?

Think back to my indecent proposal.

Reconciling Ranking Conflicts