Chapter 13

Capital
Capital Budgeting
Budgeting
Techniques
Techniques

© Pearson Education Limited 2004

Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
 Proposed
Proposed Project
Project Data
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 Tk10,000; Tk12,000; Tk15,000; Tk10,000; and
Tk7,000, respectively, for each of the Years 1 through 5. The initial
cash outlay will be Tk40,000.
• 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.
 1.
1. Project
Project Evaluation:
Evaluation:
Alternative
Alternative Methods
Methods

– Payback Period (PBP)

– Internal Rate of Return (IRR)
– Net Present Value (NPV)
– Profitability Index (PI)
 Payback
Payback Period
Period (PBP)
(PBP)
(a)
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K (d) 7 K
-b 10 K 22 K 37 K (c) 47 K 54 K
Cumulative Inflows
PBP is the period of time required for the cumulative expected cash
flows from an investment project to equal the initial cash outflow.

a – minimum whole year for recovery PBP = a + ( b - c ) / d

b – initial cash outflow = 3 + (40 - 37) / 10
c – maximum amount not crossing b = 3 + (3) / 10
d – portion of payment necessary for payback = 3.3 Years
 PBP
PBP Acceptance
Acceptance Criterion
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.]

If maximum PBP is set for 3 years?

No! The firm will receive back the initial cash outlay in
more than 3 years. [3.3 Years > 3 Year Max.]
 PBP
PBP Strengths
Strengths
and
and Weaknesses
Weaknesses
Strengths: Weaknesses:
– Easy to use and understand – Does not account
for TVM (time value of money)
– Can be used as a – Does not consider cash
measure of liquidity flows beyond the PBP
– Easier to forecast – Cutoff period is subjective
ST than LT flows
 Internal
Internal Rate
Rate of
of Return
Return (IRR)
(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

Tk10,000 Tk12,000Tk15,000 Tk10,000 Tk7,000

Tk40,000 = + + + +
(1+IRR) 1
(1+IRR) 2
(1+IRR) 3
(1+IRR) 4
(1+IRR)5

Find the interest rate (IRR) that causes the discounted cash
flows to equal Tk40,000.
 IRR
IRR Solution
Solution (Try
(Try 10%
10% and
and 15%)
15%)
Tk40,000 = Tk10,000(PVIF10%,1) + Tk12,000(PVIF10%,2)
+Tk15,000(PVIF10%,3) + Tk10,000(PVIF10%,4) + Tk 7,000(PVIF10%,5)
Tk40,000 = Tk10,000(.909) + Tk12,000(.826) + Tk15,000(.751) +
Tk10,000(.683) + Tk 7,000(.621)
Tk40,000 = Tk9,090 + Tk9,912 + Tk11,265 + Tk6,830 + Tk4,347
= Tk 41,444 [Rate is too low!!]

Tk40,000 = Tk10,000(PVIF15% ,1 ) + Tk12,000(PVIF15% ,2 ) +

Tk15,000(PVIF15% ,3 ) + Tk10,000(PVIF15% ,4 ) + Tk 7,000(PVIF15% ,5 )
Tk40,000 = Tk10,000(.870) + Tk12,000(.756) + Tk15,000(.658) +
Tk10,000(.572) + Tk 7,000(.497)
Tk40,000 = Tk8,700 + Tk9,072 + Tk9,870 + Tk5,720 + Tk3,479
= Tk 36,841 [Rate is too high!!]
 IRR
IRR Solution
Solution (Interpolate)
(Interpolate)
.10 Tk41,444
.05 X IRR Tk40,000 Tk1,444 Tk4,603
.15 Tk36,841

X Tk1,444
=
.05 Tk4,603
 IRR
IRR Solution
Solution
(Interpolate
(Interpolate [Trial
[Trial and
and Error])
Error])
.10 Tk41,444
.05 X IRR Tk40,000 Tk1,444 Tk4,603
.15 Tk36,841

X Tk1,444

.05
=
Tk4,603
 IRR
IRR Solution
Solution (Interpolate)
(Interpolate)
.10 Tk41,444
.05 X IRR Tk40,000 Tk1,444 Tk4,603
.15 Tk36,841

(Tk1,444)(0.05)
X= X = .0157
Tk4,603

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

 IRR
IRR Acceptance
Acceptance Criterion
Criterion
The management of Basket Wonders has determined that
the Hurdle (cutoff) 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 ]
 IRR
IRR Strengths
Strengths
and
and Weaknesses
Weaknesses
Strengths: Weaknesses:
– Accounts for – Assumes all cash
TVM flows reinvested at the IRR
– Considers all
cash flows – Difficulties with
– Less project rankings and Multiple
subjectivity IRRs
 Net
Net Present
Present Value
Value (NPV)
(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
 NPV
NPV Solution
Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this project is
13%.

NPV = Tk10,000+ Tk12,000

+
Tk15,000
+
(1.13)1 (1.13)2 (1.13)3
Tk10,000 Tk7,000
4 + 5 - Tk40,000
(1.13) (1.13)
 NPV
NPV Solution
Solution
NPV = Tk10,000(PVIF13%,1) + Tk12,000(PVIF13%,2) +
Tk15,000(PVIF13%,3) + Tk10,000(PVIF13%,4) + Tk
7,000(PVIF13%,5) - Tk40,000
NPV = Tk10,000(.885) + Tk12,000(.783) +
Tk15,000(.693) + Tk10,000(.613) + Tk
7,000(.543) - Tk40,000
NPV = Tk8,850 + Tk9,396 + Tk10,395 +
Tk6,130 + Tk3,801 - Tk40,000
= - Tk1,428
 NPV
NPV Acceptance
Acceptance Criterion
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 ]
 NPV
NPV Strengths
Strengths
and
and Weaknesses
Weaknesses
Strengths: Weaknesses:
– Cash flows – May not include
assumed to be managerial
reinvested at the options embedded in the
hurdle rate. project. See Chapter 14.
– Accounts for TVM.
– Considers all
cash flows.
 Profitability
Profitability Index
Index (PI)
(PI)
PI is the ratio of the present value of a project’s
future net cash flows to the project’s initial cash
outflow.

Method #1:
CF1 CF2 CFn
PI = + +...+ ICO
(1+k)1 (1+k)2 (1+k)n
<< OR >>
Method #2:
PI = 1 + [ NPV / ICO ]
 PI
PI Acceptance
Acceptance Criterion
Criterion
PI = Tk38,572 / Tk40,000
= .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 ]
 PI
PI Strengths
Strengths
and
and Weaknesses
Weaknesses

Strengths: Weaknesses:
– Same as NPV – Same as NPV
– Allows – Provides only relative
comparison of different profitability
scale projects – Potential Ranking
Problems
 Evaluation Summary

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
 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.
 Potential
Potential Problems
Problems
Under
Under Mutual
Mutual Exclusivity
Exclusivity
Ranking of project proposals may create
contradictory results.

A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
 A.
A. Scale
Scale Differences
Differences
Compare a small (S) and a large (L)
project.

NET CASH FLOWS

END OF YEAR Project S Project L
0 -Tk100 -Tk100,000
1 0 0
2 Tk400 Tk156,250
 Scale
Scale Differences
Differences
Calculate the PBP, IRR, NPV@10%, and
PI@10%.

Which project is preferred? Why?

Project IRR NPV PI

S 100% Tk 231 3.31

L 25% Tk29,132 1.29
 B.
B. Cash
Cash Flow
Flow Pattern
Pattern
Let us compare a decreasing cash-flow (D) project and an increasing
cash-flow (I) project.

NET CASH FLOWS

END OF YEAR Project D Project I
0 -Tk1,200 -Tk1,200
1 1,000 100
2 500 600
3 100 1,080
 Cash
Cash Flow
Flow Pattern
Pattern

Calculate the IRR, NPV@10%, and

PI@10%.

Which project is preferred?

Project IRR NPV PI
D 23% Tk198 1.17
I 17% Tk198 1.17
 600 Examine
Examine NPV
NPV Profiles
Profiles
Plot NPV for each
Net Present Value (Tk)

project at various
Project I discount rates.
400

NPV@10%
200

IRR

Project D
0
-200

0 5 10 15 20 25
Discount Rate (%)
 600
Net Present Value (Tk)
Fisher’s
Fisher’s Rate
Rate of
of Intersection
Intersection

At k<10%, I is best! Fisher’s Rate of

Intersection
-200 0 200 400

At k>10%, D is best!

0 5 10 15 20 25
Discount Rate (Tk)
 C.
C. Project
Project Life
Life Differences
Differences
Let us compare a long life (X) project and a short life (Y)
project.

NET CASH FLOWS

END OF YEAR Project X Project Y
0 -Tk1,000 -Tk1,000
1 0 2,000
2 0 0
3 3,375 0
 Project
Project Life
Life Differences
Differences
Calculate the PBP, IRR, NPV@10%, and
PI@10%.

Which project is preferred? Why?

Project IRR NPV PI

X 50% Tk1,536 2.54

Y 100% Tk 818 1.82