Chapter 4

Chapter 11
The Basics of Capital Budgeting
Net Present Value (NPV)

Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Regular Payback
Discounted Payback
11-1
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What is capital budgeting?
• Analysis of potential additions to fixed assets.

• Long-term decisions; involve large expenditures.
• Very important to firm’s future.
11-2
Steps to Capital Budgeting
1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
11-3
What is the difference between independent
and mutually exclusive projects?
11-4
Net Present Value (NPV)
• Sum of the PVs of all cash inflows and outflows of a

project:
CFtN
NPV   t
t0 ( 1  r )
11-5
Example
Projects we’ll examine:

Cash Flow
Year L S CF
0 -100 -100 0
1 10 70 -60
2 60 50 10
3 80 20 60
CF is the difference between CFL and CFS. We’ll use
CF later.
11-6
What is Project L’s NPV?
WACC = 10%
Year CFt PV of CFt
0 -100 - $100.00
1 10 9.09
2 60 49.59
3 80 60.11
NPVL = $ 18.79
Excel: =NPV(rate,CF1:CFn) + CF0

Here, CF0 is negative.
11-7
What is Project S’ NPV?
WACC = 10%
Year CFt PV of CFt
0 -100 - $100.00
1 70 63.64
2 50 41.32
3 20 15.02
NPVS = $ 19.98
Excel: =NPV(rate,CF1:CFn) + CF0

Here, CF0 is negative.
11-8
NPV for Project L & S
11-9
Solving for NPV:
Financial Calculator Solution
Enter CFs into the calculator’s CFLO register.

CF0 = -100
CF1 = 10
CF2 = 60
CF3 = 80
Enter I/YR = 10, press NPV button to get NPVL = $18.78.
11-10
Rationale for the NPV Method
NPV = PV of inflows – Cost

= Net gain in wealth
• If projects are independent, accept if the project
NPV > 0.
• If projects are mutually exclusive, accept projects
with the highest positive NPV, those that add the
most value.
• In this example, accept S if mutually exclusive
(NPVS > NPVL), and accept both if independent.
11-11
Practice Session
WACC for both projects 10%
After-tax end of year

Initial Cost
cashflows Total Cash
Inflows
Year 0 1 2 3 4
Project A $1000 $500 $400 $300 $100 $1300
Project B $1000 $100 $300 $400 $675 $1475
Using NPV method, appraise the projects A & B

i.If they are independent projects
ii.If they are mutually exclusive projects
11-12
NPV for Project L & S
After-tax end of year

WACC = 10% Initial Cost
cashflows Total Cash
NPV = PV CF - Cost
Inflows
Year 0 1 2 3 4
DF @ 10% 1 0.909 0.826 0.751 0.683

Project A -1000 500 400 300 100 1300
PV Cashflows
(A)
-1000 454.5 330.4 225.3 68.3 1078.5 78.5
Project B -1000 100 300 400 675 1475
PV Cashflows 461.02
(B)
-1000 90.9 247.8 300.4
5
1100.125 100.125
11-13
Internal Rate of Return (IRR)
• IRR is the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:
N
CFt
0 t
t0 (1  IRR)
• Solving for IRR with a financial calculator:
IRR – discount rate
PV Cash Inflows = Initial cost
– Enter CFs in CFLO register. NPV= 0
– Press IRR; IRRL = 18.13% and
NPV = PV cash Inflows – Initial
IRRS = 23.56%. cost
• Solving for IRR with Excel:
=IRR(CF0:CFn,guess for rate)
11-14
How is a project’s IRR similar to a bond’s YTM?
• They are the same thing.
• Think of a bond as a project. The YTM on YTM is the rate of
return which is
the bond would be the IRR of the “bond” generated by a bond
project. over a period up to
its maturity.
• EXAMPLE: Suppose a 10-year bond with a
9% annual coupon and $1,000 par value If the future
cashflows of interest
sells for $1,134.20. and redemption price
– Solve for IRR = YTM = 7.08%, the annual are discounted using
YTM, PV of such
return for this project/bond. cashflows will be
– Market Value = PV Interest + PV equal to its actual
market price.
Redemption value
– 1134.20 = PV ($90) for 10 years + PV $1000
11-15
Rationale for the IRR Method
• If IRR > WACC, the project’s return exceeds its costs

and there is some return left over to boost
stockholders’ returns.
If IRR > WACC, accept project.
If IRR < WACC, reject project.
• If projects are independent, accept both projects,
as both IRR > WACC = 10%.
• If projects are mutually exclusive, accept S, because
IRRs > IRRL.
11-16
What is the payback period?
• The number of years required to recover a project’s

cost, or “How long does it take to get our money
back?”
• Calculated by adding project’s cash inflows to its
cost until the cumulative cash flow for the project
turns positive.
11-17
Calculating Payback
Project L’s Payback Calculation

0 1 2 3
CFt -100 10 60 80
Cumulative -100 -90 -30 50
30 80
11-18
Strengths and Weaknesses of Payback
• Strengths
– Provides an indication of a project’s risk and liquidity.
– Easy to calculate and understand.
• Weaknesses
– Ignores the time value of money.
– Ignores CFs occurring after the payback period.
11-19
Discounted Payback Period
Uses discounted cash flows rather than raw CFs.
0 10% 1 2 3
CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years
11-20
Practice Session
Evaluate the projects A & B using payback period and

discounted payback period technique of capital
budgeting (WACC=10%)
0 1 2 3
(Project A) CFt -1000 200 750 600
0 1 2 3
(Project B) CFt -1000 800 250 350
11-21
Capital Budgeting
IRR PBP NPV
PBP < life of the

Independent IRR>WACC project NPV>0
Accept
Mutually Highest IRR Highest Positive

exclusive (IRR>WACC) Least PBP NPV
11-22
Practice Session
WACC = 15% Initial Cost After-tax end of year cashflows
Year 0 1 2 3 4
Project A -10000 2500 4000 5300 1900
Project B -10000 1700 3000 6400 3500
Help the company choosing the project using NPV, IRR , PBP & Discounted PBP, when
projects are
a.Mutually exclusive
b.Independent
WACC=15%
(A) NPV=230.34; IRR=13.87%; PBP=2.66; DPBP=3.05
(B)NPV= - 44.06; IRR=14.81; PBP=2.83; DPBP=3.14
WACC=10%
(A) NPV=858.21; IRR=13.87%; PBP=2.66; DPBP=3.05
(B)NPV= 1223.76 ; IRR=14.81; PBP=2.83; DPBP=3.14
11-23
What is the difference between normal and
nonnormal cash flow streams?
11-24
Multiple IRRs
NPV
IRR2 = 400%
450
0 WACC
100 400
IRR1 = 25%
-800
11-25
Why are there multiple IRRs?
• At very low discount rates, the PV of CF2 is large and

negative, so NPV < 0.
• At very high discount rates, the PV of both CF 1 and
CF2 are low, so CF0 dominates and again NPV < 0.
• In between, the discount rate hits CF 2 harder than
CF1, so NPV > 0.
• Result: 2 IRRs.
11-26
Reinvestment Rate Assumptions
• NPV method assumes CFs are reinvested at the

WACC.
• IRR method assumes CFs are reinvested at IRR.
• Assuming CFs are reinvested at the opportunity cost
of capital is more realistic, so NPV method is the
best. NPV method should be used to choose
between mutually exclusive projects.
• Perhaps a hybrid of the IRR that assumes cost of
capital reinvestment is needed.
11-27
Since managers prefer the IRR to the NPV method, is
there a better IRR measure?
• Yes, MIRR is the discount rate that causes the PV of

a project’s terminal value (TV) to equal the PV of
costs. TV is found by compounding inflows at
WACC.
• MIRR assumes cash flows are reinvested at the
WACC.
11-28
Calculating MIRR
0 1 2 3
10%
-100.0 10.0 60.0 80.0
10%
10% 66.0
12.1
MIRR = 16.5%
-100.0 158.1
PV outflows TV inflows
$158.1
$100 =
(1 + MIRRL)3
MIRRL = 16.5%
Excel: =MIRR(CF0:CFn,Finance_rate,Reinvest_rate)
We assume that both rates = WACC.
11-29
Why use MIRR versus IRR?
• MIRR assumes reinvestment at the opportunity cost

= WACC. MIRR also avoids the multiple IRR
problem.
• Managers like rate of return comparisons, and
MIRR is better for this than IRR.
11-30
Find Project P’s NPV and IRR
Project P has cash flows (in 000s): CF 0 = -$800, CF1 =

$5,000, and CF2 = -$5,000.
0 1 2
WACC = 10%
-800 5,000 -5,000
• Enter CFs into calculator CFLO register.

• Enter I/YR = 10.
• NPV = -$386.78.
• IRR = ERROR Why?
11-31
When to use the MIRR instead of the IRR? Accept
Project P?
• When there are nonnormal CFs and more than one

IRR, use MIRR.
– PV of outflows @ 10% = -$4,932.2314.
– TV of inflows @ 10% = $5,500.
– MIRR = 5.6%.
• Do not accept Project P.
– NPV = -$386.78 < 0.
– MIRR = 5.6% < WACC = 10%.
11-32
NPV Profiles
• A graphical representation of project NPVs at

various different costs of capital.
WACC NPV L NPV S

0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5
11-33
Independent Projects
NPV and IRR always lead to the same accept/reject

decision for any given independent project.
NPV ($)
IRR > r r > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.
r = 18.1%
IRRL = 18.1% r (%)

11-34
Mutually Exclusive Projects
NPV If r < 8.7%: NPVL > NPVS

IRRS > IRRL
L CONFLICT
If r > 8.7%: NPVS > NPVL ,
IRRS > IRRL
NO CONFLICT
S
%
r 8.7 r
IRRL IRRs
11-35
Finding the Crossover Rate
• Find cash flow differences between the projects.

See Slide 11-7.
• Enter the CFs in CFj register, then press

 IRR. Crossover rate = 8.68%, rounded to 8.7%.
• If profiles don’t cross, one project dominates the

other.
11-36
Reasons Why NPV Profiles Cross
• Size (scale) differences: the smaller project frees up

funds at t = 0 for investment. The higher the
opportunity cost, the more valuable these funds, so
a high WACC favors small projects.
• Timing differences: the project with faster payback
provides more CF in early years for reinvestment. If
WACC is high, early CF especially good, NPV S > NPVL.
11-37
Practice session
11-38
NPV Method
NPV Advantages NPV Disadvantages
Incorporates time value of Accuracy depends on
money. quality of inputs.
Not useful for comparing

projects of different sizes,
Simple way to determine if
as the largest projects
a project delivers value.
typically generate highest
returns.
May omit hidden costs such

Considers a company's cost
as opportunity costs and
of capital.
organizational costs.
Accounts for inherent

Purely quantitative in
uncertainty of projections
nature and does not
by most heavily discounting
consider qualitative factors.
far-future estimates.
11-39

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Chapter 11

The Basics of Capital Budgeting

Net Present Value (NPV)

• Analysis of potential additions to fixed assets.

1. Estimate CFs (inflows & outflows).

• Sum of the PVs of all cash inflows and outflows of a

Projects we’ll examine:

Excel: =NPV(rate,CF1:CFn) + CF0

Excel: =NPV(rate,CF1:CFn) + CF0

Enter CFs into the calculator’s CFLO register.

Enter I/YR = 10, press NPV button to get NPVL = $18.78.

NPV = PV of inflows – Cost

WACC for both projects 10%

After-tax end of year

Using NPV method, appraise the projects A & B

After-tax end of year

DF @ 10% 1 0.909 0.826 0.751 0.683

Project B -1000 100 300 400 675 1475

• IRR is the discount rate that forces PV of

• If IRR > WACC, the project’s return exceeds its costs

• The number of years required to recover a project’s

Project L’s Payback Calculation

Uses discounted cash flows rather than raw CFs.

Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years

Evaluate the projects A & B using payback period and

(Project A) CFt -1000 200 750 600

(Project B) CFt -1000 800 250 350

IRR PBP NPV

PBP < life of the

Mutually Highest IRR Highest Positive

WACC = 15% Initial Cost After-tax end of year cashflows

• At very low discount rates, the PV of CF2 is large and

• NPV method assumes CFs are reinvested at the

• Yes, MIRR is the discount rate that causes the PV of

• MIRR assumes reinvestment at the opportunity cost

Project P has cash flows (in 000s): CF 0 = -$800, CF1 =

-800 5,000 -5,000

• Enter CFs into calculator CFLO register.

• When there are nonnormal CFs and more than one

• A graphical representation of project NPVs at

WACC NPV L NPV S

NPV and IRR always lead to the same accept/reject

IRRL = 18.1% r (%)

NPV If r < 8.7%: NPVL > NPVS

• Find cash flow differences between the projects.

• Enter the CFs in CFj register, then press

• If profiles don’t cross, one project dominates the

• Size (scale) differences: the smaller project frees up

Not useful for comparing

May omit hidden costs such

Accounts for inherent

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