Chapter 13

Capital Budgeting Techniques

13-1 Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI

After studying Chapter 13, you should be able to:

Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability. Understand the three major discounted cash flow (DCF) methods of project evaluation and selection internal rate of return (IRR), net present value (NPV), and profitability index (PI). Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. Define, construct, and interpret a graph called an NPV profile. Understand why ranking project proposals on the basis of IRR, NPV, and PI methods may lead to conflicts in ranking. Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or PI rankings. Understand how sensitivity analysis allows us to challenge the singlepoint input estimates used in traditional capital budgeting analysis. Explain the role and process of project monitoring, including progress reviews and post-completion audits.

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Capital Budgeting Techniques

Project Evaluation and Selection

Potential Difficulties

Capital Rationing
Project Monitoring

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Post-Completion Audit

Project Evaluation: Alternative Methods

Payback Period (PBP) Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI)

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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.
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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.
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Payback Period (PBP)

0
-40 K

1
10 K

2
12 K

3
15 K

4
10 K

5
7K

PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.
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Payback Solution (#1)

0
-40 K (-b)

1
10 K 10 K

2
12 K 22 K

3 (a)
15 K 37 K(c)

4
10 K(d) 47 K

5
7K 54 K

Cumulative Inflows

PBP

=a+(b-c)/d = 3 + (40 - 37) / 10 = 3 + (3) / 10 = 3.3 Years

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Payback Solution (#2)

0
-40 K -40 K

1
10 K -30 K

2
12 K -18 K

3
15 K -3 K

4
10 K 7K

5
7K 14 K

PBP
Cumulative Cash Flows

= 3 + ( 3K ) / 10K = 3.3 Years

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Note: Take absolute value of last negative cumulative cash flow 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.]
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PBP Strengths and Weaknesses

Strengths:

Weaknesses:

Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flows

Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective

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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 projects initial cash outflow.
CF1 CF2 + ICO = (1+IRR)1 (1+IRR)2
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+...+

CFn (1+IRR)n

IRR Solution
$10,000 $12,000 $40,000 = + + (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.
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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!!]
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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!!]
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IRR Solution (Interpolate)

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

$1,444 $4,603

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IRR Solution (Interpolate)

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

$1,444 $4,603

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IRR Solution (Interpolate)

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

X = ($1,444)(0.05) $4,603

X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

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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 ]
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IRRs on the Calculator

We will use the cash flow registry to solve the IRR for this problem quickly and accurately!

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Actual IRR Solution Using Your Financial Calculator

Steps in the Process
Step 1: Press Step 2: Press Step 3: For CF0 Press Step 4: Step 5: Step 6: Step 7: For C01 Press For F01 Press For C02 Press For F02 Press CF 2nd CLR Work -40000 Enter 10000 1 12000 1 15000 1 Enter Enter Enter Enter Enter Enter key keys keys

keys keys keys keys keys keys

Step 8: For C03 Press 13-21 Step 9: For F03 Press

Actual IRR Solution Using Your Financial Calculator

Steps in the Process (Part II)
Step 10:For C04 Press Step 11:For F04 Press Step 12:For C05 Press Step 13:For F05 Press Step 14: Step 15: Step 16: Press Press Press 10000 1 7000 1

Enter Enter Enter Enter

keys keys keys keys keys key key

IRR CPT

Result:
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Internal Rate of Return = 11.47%

IRR Strengths and Weaknesses

Strengths:

Weaknesses:

Accounts for TVM Considers all cash flows

Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs

Less subjectivity

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Net Present Value (NPV)

NPV is the present value of an investment projects net cash flows minus the projects initial cash outflow.
CF1 NPV = (1+k)1
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CF2 (1+k)2

CFn - ICO +...+ n (1+k)

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 + $40,000 4 5 (1.13) (1.13)

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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
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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 ]
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NPV on the Calculator

We will use the cash flow registry to solve the NPV for this problem quickly and accurately!
Hint: If you have not cleared the cash flows from your calculator, then you may skip to Step 15.
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Actual NPV Solution Using Your Financial Calculator

Steps in the Process
Step 1: Press Step 2: Press Step 3: For CF0 Press Step 4: Step 5: Step 6: Step 7: For C01 Press For F01 Press For C02 Press For F02 Press CF 2nd CLR Work -40000 Enter 10000 1 12000 1 15000 1 Enter Enter Enter Enter Enter Enter key keys keys

keys keys keys keys keys keys

Step 8: For C03 Press 13-29 Step 9: For F03 Press

Actual NPV Solution Using Your Financial Calculator

Steps in the Process (Part II)
Step 10:For C04 Press Step 11:For F04 Press Step 12:For C05 Press Step 13:For F05 Press Step 14: Step 15: Step 17: Press Press Press 10000 1 7000 1

Enter Enter Enter Enter

keys keys keys keys keys key

NPV 13 CPT Enter

Step 16: For I=, Enter

keys key

Result:
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Net Present Value = -$1,424.42

NPV Strengths and Weaknesses

Strengths:

Weaknesses:

Cash flows assumed to be reinvested at the hurdle rate. Considers all cash flows.

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Accounts for TVM.

May not include managerial options embedded in the project. See Chapter 14.

Net Present Value Profile

Net Present Value

$000s 15
10 5

Sum of CFs

Plot NPV for each discount rate.

IRR NPV@13%

0
-4 0 3 6 9 12 Discount Rate (%) 15

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Creating NPV Profiles Using the Calculator

Hint: As long as you do not clear the cash flows from the registry, simply start at Step 15 and enter a different discount rate. Each resulting NPV will provide a point for your NPV Profile!
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Profitability Index (PI)

PI is the ratio of the present value of a projects future net cash flows to the projects initial cash outflow.
Method #1:

CF1 PI = (1+k)1

CF2 CFn +...+ 2 (1+k) (1+k)n

<< OR >>

ICO

Method #2: 13-34

PI = 1 + [ NPV / ICO ]

PI Acceptance Criterion
PI = $38,572 / $40,000 = .9643 (Method #1, 13-34) 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 ]
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PI Strengths and Weaknesses

Strengths:

Weaknesses:

Same as NPV

Same as NPV

Allows comparison of different scale projects

Provides only relative profitability

Potential Ranking Problems

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Evaluation Summary
Basket Wonders Independent Project

Method Project Comparison Decision PBP IRR NPV PI

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3.3 11.47% -$1,424 .96

3.5 13% $0 1.00

Accept Reject Reject Reject

Other Project Relationships

Dependent

-- A project whose acceptance depends on the acceptance of one or more other projects. Mutually Exclusive -- A project whose acceptance precludes the acceptance of one or more alternative projects.
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Potential Problems Under Mutual Exclusivity

Ranking of project proposals may create contradictory results. A. Scale of Investment
B. Cash-flow Pattern

C. Project Life
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A. Scale Differences
Compare a small (S) and a large (L) project.
END OF YEAR 0 1 2
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NET CASH FLOWS Project S Project L

-$100 0 $400 -$100,000 0 $156,250

Scale Differences
Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why?
Project IRR NPV PI

S L
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100% 25%

231

3.31 1.29

$29,132

B. Cash Flow Pattern

Let us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project.
NET CASH FLOWS Project D Project I -$1,200 1,000 500 100 -$1,200 100 600 1,080

END OF YEAR 0 1 2 3
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Cash Flow Pattern

Calculate the IRR, NPV@10%, and PI@10%. Which project is preferred?
Project D
I
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IRR 23%
17%

NPV $198
$198

PI 1.17
1.17

Examine NPV Profiles

600 Net Present Value ($)

400

Project I

Plot NPV for each project at various discount rates. NPV@10%

IRR Project D

-200

0 0

200

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10 15 20 Discount Rate (%)

25

Fishers Rate of Intersection

Net Present Value ($) 600 -200 0 200 400 At k<10%, I is best! Fishers Rate of Intersection

At k>10%, D is best!

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10 15 20 Discount Rate ($)

25

C. Project Life Differences

Let us compare a long life (X) project and a short life (Y) project.
NET CASH FLOWS Project X Project Y -$1,000 0 0 3,375 -$1,000 2,000 0 0

END OF YEAR 0 1 2 3
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Project Life Differences

Calculate the PBP, IRR, NPV@10%, and PI@10%. Which project is preferred? Why?
Project X Y
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IRR 50% 100%

NPV $1,536 $ 818

PI 2.54 1.82

Another Way to Look at Things

1. Adjust cash flows to a common terminal year if project Y will NOT be replaced.
Compound Project Y, Year 1 @10% for 2 years.

Year
CF

0
-$1,000

1
$0 IRR* = 34.26%

2
$0

3
$2,420

Results:
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NPV = $818

*Lower IRR from adjusted cash-flow stream. X is still Best.

Replacing Projects with Identical Projects

2.
0 -$1,000

Use Replacement Chain Approach (Appendix B) when project Y will be replaced.

1 $2,000 -1,000 2 3

$2,000 -1,000

$2,000

-$1,000
Results:
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$1,000
IRR = 100%

$1,000

$2,000

NPV* = $2,238.17

*Higher NPV, but the same IRR. Y is Best.

Capital Rationing
Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period.
Example: Julie Miller must determine what investment opportunities to undertake for Basket Wonders (BW). She is limited to a maximum expenditure of $32,500 only for this capital budgeting period.
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Available Projects for BW

Project
A B C D E F G H
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ICO
$ 500 5,000 5,000 7,500 12,500 15,000 17,500 25,000

IRR
18% 25 37 20 26 28 19 15 $

NPV
50 6,500 5,500 5,000 500 21,000 7,500 6,000

PI
1.10 2.30 2.10 1.67 1.04 2.40 1.43 1.24

Choosing by IRRs for BW

Project
C F E B

ICO
$ 5,000 15,000 12,500 5,000

IRR
37% 28 26 25

NPV
$ 5,500 21,000 500 6,500

PI
2.10 2.40 1.04 2.30

Projects C, F, and E have the three largest IRRs.

The resulting increase in shareholder wealth is $27,000 with a $32,500 outlay.

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Choosing by NPVs for BW

Project
F G B

ICO
$15,000 17,500 5,000

IRR
28% 19 25

NPV
$21,000 7,500 6,500

PI
2.40 1.43 2.30

Projects F and G have the two largest NPVs.

The resulting increase in shareholder wealth is $28,500 with a $32,500 outlay.
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Choosing by PIs for BW

Project
F B C D G

ICO

IRR
28% 25 37 20 19

NPV
$21,000 6,500 5,500 5,000 7,500

PI
2.40 2.30 2.10 1.67 1.43

$15,000 5,000 5,000 7,500 17,500

Projects F, B, C, and D have the four largest PIs. The resulting increase in shareholder wealth is $38,000 with a $32,500 outlay.
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Summary of Comparison
Method Projects Accepted PI NPV F, B, C, and D F and G Value Added $38,000 $28,500

IRR

C, F, and E

$27,000

PI generates the greatest increase in shareholder wealth when a limited capital budget exists for a single period.
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Single-Point Estimate and Sensitivity Analysis

Sensitivity Analysis: A type of what-if uncertainty analysis in which variables or assumptions are changed from a base case in order to determine their impact on a projects measured results (such as NPV or IRR).

Allows us to change from single-point (i.e., revenue, installation cost, salvage, etc.) estimates to a what if analysis Utilize a base-case to compare the impact of individual variable changes E.g., Change forecasted sales units to see impact on the projects NPV

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Post-Completion Audit
Post-completion Audit
A formal comparison of the actual costs and benefits of a project with original estimates.

Identify any project weaknesses

Develop a possible set of corrective actions

Provide appropriate feedback

Result: Making better future decisions!

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Multiple IRR Problem*

Let us assume the following cash flow pattern for a project for Years 0 to 4: -$100 +$100 +$900 -$1,000

How many potential IRRs could this project have? Two!! There are as many potential IRRs as there are sign changes.
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* Refer to Appendix A

NPV Profile -- Multiple IRRs

75
Net Present Value ($000s) 50 25 0 Multiple IRRs at k = 12.95% and 191.15%

-100
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40

80 120 160 Discount Rate (%)

200

NPV Profile -- Multiple IRRs

Hint: Your calculator will only find ONE IRR even if there are multiple IRRs. It will give you the lowest IRR. In this case, 12.95%.

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