The Basics of Capital Budgeting: MINI CASE Solution

You have just graduated from the MBA program of a large university, and one of your
favorite courses was “Today’s Entrepreneurs.” In fact, you enjoyed it so much you have
decided you want to “be your own boss.” While you were in the master’s program, your
grandfather died and left you $1 million to do with as you please. You are not an inventor
and you do not have a trade skill that you can market; however, you have decided that you
would like to purchase at least one established franchise in the fast-foods area, maybe two
(if profitable). The problem is that you have never been one to stay with any project for
too long, so you figure that your time frame is three years. After three years you will sell
off your investment and go on to something else.

You have narrowed your selection down to two choices; (1) Franchise L, Lisa’s Soups,
Salads, & Stuff and (2) Franchise S, Sam’s Fabulous Fried Chicken. The net cash flows
shown below include the price you would receive for selling the franchise in Year 3 and the
forecast of how each franchise will do over the three-year period. Franchise L’s cash flows
will start off slowly but will increase rather quickly as people become more health
conscious, while Franchise S’s cash flows will start off high but will trail off as other
chicken competitors enter the marketplace and as people become more health conscious
and avoid fried foods. Franchise L serves breakfast and lunch, while Franchise S serves
only dinner, so it is possible for you to invest in both franchises. You see these franchises as
perfect complements to one another: You could attract both the lunch and dinner crowds
and the health conscious and not so health conscious crowds without the franchises directly
competing against one another.

Here are the net cash flows (in thousands of dollars):

Expected Net Cash Flows

Year Franchise L Franchise S
0 ($100) ($100)
1 10 70
2 60 50
3 80 20

Depreciation, salvage values, net working capital requirements, and tax effects are all
included in these cash flows.

You also have made subjective risk assessments of each franchise, and concluded that
both franchises have risk characteristics that require a return of 10%. You must now
determine whether one or both of the franchises should be accepted.
a. What is capital budgeting?

Answer: Capital budgeting is the process of analyzing additions to fixed assets. Capital
budgeting is important because, more than anything else, fixed asset investment
decisions chart a company’s course for the future. Conceptually, the capital budgeting
process is identical to the decision process used by individuals making investment
decisions. These steps are involved:

1. Estimate the cash flows—interest and maturity value or dividends in the case of
bonds and stocks, operating cash flows in the case of capital projects.

2. Assess the riskiness of the cash flows.

3. Determine the appropriate discount rate, based on the riskiness of the cash flows
and the general level of interest rates. This is called the project cost of capital in
capital budgeting.

4. Evaluate the cash flows.

b. What is the difference between independent and mutually exclusive projects?

Answer: Projects are independent if the cash flows of one are not affected by the acceptance of
the other. Conversely, two projects are mutually exclusive if acceptance of one
impacts adversely the cash flows of the other; that is, at most one of two or more such
projects may be accepted. Put another way, when projects are mutually exclusive it
means that they do the same job. For example, a forklift truck versus a conveyor
system to move materials, or a bridge versus a ferry boat.

c. 1. Define the term net present value (NPV). What is each franchise’s NPV?

Answer: The net present value (NPV) is simply the sum of the present values of a project’s
cash flows:

N
CF
NPV =  (1  rt) t .
t 0

Mini Case: 10 - 2
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 Franchise L’s NPV is $18.79:

0 1 2 3
10%
| | | |
(100.00) 10 60 80
9.09
49.59
60.11
18.79 = NPVL

NPVs are easy to determine using a calculator with an NPV function. Enter the cash
flows sequentially, with outflows entered as negatives; enter the cost of capital; and
then press the NPV button to obtain the franchise’s NPV, $18.78 (note the penny
rounding difference). The NPV of Franchise S is NPVS = $19.98.

c. 2. What is the rationale behind the NPV method? According to NPV, which
franchise or franchises should be accepted if they are independent? Mutually
exclusive?

Answer: The rationale behind the NPV method is straightforward: if a project has NPV = $0,
then the project generates exactly enough cash flows (1) to recover the cost of the
investment and (2) to enable investors to earn their required rates of return (the
opportunity cost of capital). If NPV = $0, then in a financial (but not an accounting)
sense, the project breaks even. If the NPV is positive, then more than enough cash
flow is generated, and conversely if NPV is negative.
Consider Franchise L’s cash inflows, which total $150. They are sufficient (1) to
return the $100 initial investment, (2) to provide investors with their 10% aggregate
opportunity cost of capital, and (3) to still have $18.79 left over on a present value
basis. This $18.79 excess PV belongs to the shareholders—the debtholders’ claims
are fixed, so the shareholders’ wealth will be increased by $18.79 if Franchise L is
accepted. Similarly, shareholders gain $19.98 in value if Franchise S is accepted.
If Franchises L and S are independent, then both should be accepted, because they
both add to shareholders’ wealth, hence to the stock price. If the franchises are
mutually exclusive, then Franchise S should be chosen over L, because S adds more
to the value of the firm.

c. 3. Would the NPVs change if the cost of capital changed?

Answer: The NPV of a project is dependent on the cost of capital used. Thus, if the cost of
capital changed, the NPV of each franchise would change. NPV declines as r
increases, and NPV rises as r decreases.

d. 1. Define the term internal rate of return (IRR). What is each franchise’s IRR?
Answer: The internal rate of return (IRR) is the discount rate that forces the NPV of a project
to equal zero:

0 1 2 3
IRR
| | | |
CF0 CF1 CF2 CF3
PVCF1
PVCF2
PVCF3
0 = SUM OF PVs = NPV.

Expressed as an equation, we have:

N
CF
IRR:  (1  IRR
t
)t
= $0 = NPV.
t 0

Note that the IRR equation is the same as the NPV equation, except that to find the
IRR the equation is solved for the particular discount rate, IRR, which forces the
project’s NPV to equal zero (the IRR) rather than using the cost of capital (r) in the
denominator and finding NPV. Thus, the two approaches differ in only one respect:
in the NPV method, a discount rate is specified (the project’s cost of capital) and the
equation is solved for NPV, while in the IRR method, the NPV is specified to equal
zero and the discount rate (IRR) that forces this equality is found.

Franchise L’s IRR is 18.1%:

0 1 2 3
18.1%
| | | |
-100.00 10 60 80
8.47
43.02
48.57
$ 0.06 ≈ $0 if IRRL = 18.1% is used as the discount rate.

Therefore, IRRL ≈ 18.1%.

Mini Case: 10 - 4
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 A financial calculator is extremely helpful when calculating IRRs. The cash flows
are entered sequentially, and then the IRR button is pressed. For Franchise S, IRRS ≈
23.6%. Note that with many calculators, you can enter the cash flows into the cash
flow register, also enter r = I/YR, and then calculate both NPV and IRR by pressing
the appropriate buttons.

d. 2. How is the IRR on a project related to the YTM on a bond?

Answer: The IRR is to a capital project what the YTM is to a bond. It is the expected rate of
return on the project, just as the YTM is the promised rate of return on a bond.

d. 3. What is the logic behind the IRR method? According to IRR, which franchises
should be accepted if they are independent? Mutually exclusive?

Answer: IRR measures a project’s profitability in the rate of return sense: If a project’s IRR
equals its cost of capital, then its cash flows are just sufficient to provide investors
with their required rates of return. An IRR greater than r implies an economic profit,
which accrues to the firm’s shareholders, while an IRR less than r indicates an
economic loss, or a project that will not earn enough to cover its cost of capital.
Projects’ IRRs are compared to their costs of capital, or hurdle rates. Since
Franchises L and S both have a hurdle rate of 10%, and since both have IRRs greater
than that hurdle rate, both should be accepted if they are independent. However, if
they are mutually exclusive, Franchise S would be selected, because it has the higher
IRR.

d. 4. Would the franchises’ IRRs change if the cost of capital changed?

Answer: IRRs are independent of the cost of capital. Therefore, neither IRRS nor IRRL would
change if r changed. However, the acceptability of the franchises could change—L
would be rejected if r were above 18.1%, and S would also be rejected if r were above
23.6%.

e. 1. Draw NPV profiles for Franchises L and S. At what discount rate do the profiles
cross?

Answer: The NPV profiles are plotted in the figure below.

Note the following points:

1. The Y-intercept is the project’s NPV when r = 0%. This is $50 for L and $40 for
S.

2. The X-intercept is the project’s IRR. This is 18.1% for L and 23.6% for S.
 3. NPV profiles are curves rather than straight lines. To see this, note that these
profiles approach cost = -$100 as r approaches infinity.

4. From the figure below, it appears that the crossover rate is between 8% and 9%.
The precise value is approximately 8.7%. One can calculate the crossover rate by
(1) going back to the data on the problem, finding the cash flow differences for
each year, (2) entering those differences into the cash flow register, and (3)
pressing the IRR button to get the crossover rate, 8.68% ≈ 8.7%.

r NPVL NPVS
0% $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5

Mini Case: 10 - 6
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e. 2. Look at your NPV profile graph without referring to the actual NPVs and IRRs.
Which franchise or franchises should be accepted if they are independent?
Mutually exclusive? Explain. Are your answers correct at any cost of capital
less than 23.6%?

Answer: The NPV profiles show that the IRR and NPV criteria lead to the same accept/reject
decision for any independent project. Consider Franchise L. It intersects the X-axis
at its IRR, 18.1%. According to the IRR rule, L is acceptable if r is less than 18.1%.
Also, at any r less than 18.1%, L’s NPV profile will be above the X-axis, so its NPV
will be greater than $0. Thus, for any independent project, NPV and IRR lead to the
same accept/reject decision.
Now assume that L and S are mutually exclusive. In this case, a conflict might
arise. First, note that IRRS = 23.6% > 18.1% = IRRL. Therefore, regardless of the
size of r, Franchise S would be ranked higher by the IRR criterion. However, the
NPV profiles show that NPVL > NPVS if r is less than 8.7%. Therefore, for any r
below the 8.7% crossover rate, say r = 7%, the NPV rule says choose L, but the IRR
rule says choose S. Thus, if r is less than the crossover rate, a ranking conflict occurs.

f. What is the underlying cause of ranking conflicts between NPV and IRR?

Answer: For normal projects’ NPV profiles to cross, one project must have both a higher
vertical axis intercept and a steeper slope than the other. A project’s vertical axis
intercept typically depends on (1) the size of the project and (2) the size and timing
pattern of the cash flows—large projects, and ones with large distant cash flows,
would generally be expected to have relatively high vertical axis intercepts. The
slope of the NPV profile depends entirely on the timing pattern of the cash flows—
long-term projects have steeper NPV profiles than short-term ones. Thus, we
conclude that NPV profiles can cross in two situations: (1) when mutually exclusive
projects differ in scale (or size) and (2) when the projects’ cash flows differ in terms
of the timing pattern of their cash flows (as for Franchises L and S).
g. Define the term modified IRR (MIRR). Find the MIRRs for Franchises L and S.

Answer: MIRR is the discount rate that equates the present value of the terminal value of the
inflows, compounded at the cost of capital, to the present value of the costs. Here is
the setup for calculating Franchise L’s modified IRR:

0 1 2 3
r = 10%
| | | |
PV of Costs = (100.00) 10 60 80.00
66.00
12.10
TV of Inflows = 158.10
MIRR = ?
PV of TV = 100.00

$158.10
$100 = .
(1  MIRR ) 3

N
N
COF
 CIFt (1  r) Nt
 (1  r)t t
TV t 1
PV costs = = = .
(1  MIRR ) N
t 0 (1  MIRR ) N

After you calculate the TV, enter N = 3, PV = -100, PMT = 0, FV = 158.1, and then
press I/YR to get the answer, MIRRL = 16.5%. We could calculate MIRRS similarly:
MIRRS = 16.9%. Thus, Franchise S is ranked higher than L. This result is consistent
with the NPV decision.

h. What does the profitability index (PI) measure? What are the PI’s for
Franchises S and L?

Answer: The PI is equal to the present value of all future cash flows divided by the initial cost.
It measures the “bang for the buck.”

PIS = $119.98 / $100 = 1.1998.

PIL = $118.78 / $100 = 1.1878.

Mini Case: 10 - 8
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website, in whole or in part.
i. 1. What is the payback period? Find the paybacks for Franchises L and S.

Answer: The payback period is the expected number of years required to recover a project’s
cost. We calculate the payback by developing the cumulative cash flows as shown
below for Franchise L (in thousands of dollars):

Expected NCF
Year Annual Cumulative
0 ($100) ($100)
1 10 (90)
2 60 (30) Payback is
3 80 50 between t = 2
and t = 3

0 1 2 3
r = 10%
| | | |
-100 10 60 80
-90 -30 +50

Franchise L’s $100 investment has not been recovered at the end of Year 2, but it has
been more than recovered by the end of Year 3. Thus, the recovery period is between
2 and 3 years. If we assume that the cash flows occur evenly over the year, then the
investment is recovered $30/$80 = 0.375 ≈ 0.4 into Year 3. Therefore, PaybackL =
2.4 years. Similarly, PaybackS = 1.6 years.

i. 2. What is the rationale for the payback method? According to the payback
criterion, which franchise or franchises should be accepted if the firm’s
maximum acceptable payback is 2 years, and if Franchises L and S are
independent? If they are mutually exclusive?

Answer: Payback represents a type of “breakeven” analysis: The payback period tells us when
the project will break even in a cash flow sense. With a required payback of 2 years,
Franchise S is acceptable, but Franchise L is not. Whether the two projects are
independent or mutually exclusive makes no difference in this case.
i. 3. What is the difference between the regular and discounted payback periods?

Answer: Discounted payback is similar to payback except that discounted cash flows are used.

Setup for Franchise L’s discounted payback, assuming a 10% cost of capital:

Expected Net Cash Flows

Cash Discounted Cumulative
Year Flows Cash Flows Cash Flows
0 ($100) ($100.00) ($100.00)
1 10 9.09 (90.91)
2 60 49.59 (41.32)
3 80 60.11 18.79

Discounted PaybackL = 2 + ($41.32/$60.11) = 2.69 = 2.7 years.

Versus 2.4 years for the regular payback.

i. 4. What is the main disadvantage of discounted payback? Is the payback method

of any real usefulness in capital budgeting decisions?

Answer: Regular payback has 3 critical deficiencies: (1) It ignores the time value of money,
(2) it ignores the cash flows that occur after the payback period, and (3) it does not
provide a specific acceptance rule. Discounted payback does consider the time value
of money, but it still fails to consider cash flows after the payback period and it does
not provide a specific acceptance rule; so it still has basic flaws. In spite of these
deficiencies, many firms today still calculate the discounted payback and give some
weight to it when making capital budgeting decisions. However, payback is not
generally used as the primary decision tool. Rather, it is used as a rough measure of a
project’s liquidity and riskiness.

Mini Case: 10 - 10
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j. As a separate project (Project P), you are considering sponsoring a pavilion at
the upcoming World’s Fair. The pavilion would cost $800,000, and it is expected
to result in $5 million of incremental cash inflows during its 1 year of operation.
However, it would then take another year, and $5 million of costs, to demolish
the site and return it to its original condition. Thus, Project P’s expected net
cash flows look like this (in millions of dollars):

Year Net Cash Flows

0 ($0.8)
1 5.0
2 (5.0)

The project is estimated to be of average risk, so its cost of capital is 10%.

j. 1. What are normal and nonnormal cash flows?

Answer: Normal cash flows begin with a negative cash flow (or a series of negative cash
flows), switch to positive cash flows, and then remain positive. They have only one
change in sign. (Note: normal cash flows can also start with positive cash flows,
switch to negative cash flows, and then remain negative.) Nonnormal cash flows
have more than one sign change. For example, they may start with negative cash
flows, switch to positive, and then switch back to negative.
Projects with normal cash flows have outflows, or costs, in the first year (or years)
followed by a series of inflows. Projects with nonnormal cash flows have one or
more outflows after the inflow stream has begun. Here are some examples:

Inflow (+) Or Outflow (–) In Year

0 1 2 3 4 5
Normal – + + + + +
– – + + + +
– – – + + +

Nonnormal – + + + + –
– + + – + –
+ + + – – –

j. 2. What is Project P’s NPV? What is its IRR? Its MIRR?

Answer: Here is the time line for the cash flows, and the NPV:

0 1 2
10%
| | |
-800,000 5,000,000 -5,000,000

NPVP = -$386,776.86.
 We can find the NPV by entering the cash flows into the cash flow register, entering
I/YR = 10, and then pressing the NPV button. However, calculating the IRR presents
a problem. With the cash flows in the register, press the IRR button. An HP-10B
financial calculator will give the message “error-soln.” This means that Project P has
multiple IRRs. An HP-17B will ask for a guess. If you guess 10%, the calculator
will produce IRR = 25%. If you guess a high number, such as 200%, it will produce
the second IRR, 400%1. The MIRR of Project P = 5.6%, and is found by computing
the discount rate that equates the terminal value ($5.5 million) to the present value of
cost ($4.93 million).

1
Looking at the figure below, if you guess an IRR to the left of the peak NPV rate, the lower IRR will
appear. If you guess IRR > peak NPV rate, the higher IRR will appear.

Mini Case: 10 - 12
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website, in whole or in part.
j. 3. Draw Project P’s NPV profile. Does Project P have normal or nonnormal cash
flows? Should this project be accepted?

Answer: You could put the cash flows in your calculator and then enter a series of r values, get
an NPV for each, and then plot the points to construct the NPV profile. We used a
spreadsheet program to automate the process and then to draw the profile. Note that
the profile crosses the X-axis twice, at 25% and at 400%, signifying two IRRs.
Which IRR is correct? In one sense, they both are—both cause the project’s NPV to
equal zero. However, in another sense, both are wrong—neither has any economic or
financial significance.
Project P has nonnormal cash flows; that is, it has more than one change of signs
in the cash flows. Without this nonnormal cash flow pattern, we would not have the
multiple IRRs.
Since Project P’s NPV is negative, the project should be rejected, even though
both IRRs (25% and 400%) are greater than the project’s 10% cost of capital. The
MIRR of 5.6% also supports the decision that the project should be rejected.
k. In an unrelated analysis, you have the opportunity to choose between the
following two mutually exclusive projects, Project T (which lasts for two years)
and Project F (which lasts for four years):

Expected Net Cash Flows

Year Project T Project F
0 ($100,000) ($100,000)
1 60,000 33,500
2 60,000 33,500
3 — 33,500
4 — 33,500

The projects provide a necessary service, so whichever one is selected is expected

to be repeated into the foreseeable future. Both projects have a 10% cost of
capital.

k. 1. What is each project’s initial NPV without replication?

Answer: The NPVs, found with a financial calculator, are calculated as follows:

Input the following: CF0 = -100000, CF1 = 60000, NJ = 2, and I/YR = 10 to solve for
NPVT = $4,132.23 ≈ $4,132.

Input the following: CF0 = -100000, CF1 = 33500, NJ = 4, and I/YR = 10 to solve for
NPVF = $6,190.49 ≈ $6,190.

However, if we make our decision based on the initial NPVs, we would be biasing
the decision against the shorter project. Since the projects are expected to be
replicated, if we initially choose Project T, it would be repeated after 2 years.
However, the initial NPVs do not reflect the replication cash flows.

Mini Case: 10 - 14
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website, in whole or in part.
k. 2. What is each project’s equivalent annual annuity?

Answer: We begin with the NPVs found in the previous step. We then find the annuity
payment stream that has the same present value as follows:

For Project T, input the following: N = 2, I/YR = 10, PV = −4,132.23, FV = 0, and

solve for PMT = EAA = $2,380.95.

For Project F, input the following: N = 4, I/YR = 10, PV = −6,190.49, FV = 0, and

solve for PMT = EAA = $1,952.92.

Project T is preferred because it has a higher EAA.

k. 3. Now apply the replacement chain approach to determine the projects’ extended
NPVs. Which project should be chosen?

Answer: The simple replacement chain approach assumes that the projects will be replicated
out to a common life. Since Project T has a 2-year life and F has a 4-year life, the
shortest common life is 4 years.

Project F’s common-life NPV is its initial NPV:

Common-Life NPVF = $6,190.

However, Project T would be replicated in Year 2, and if we assume that the

replicated project’s cash flows are identical to the first set of cash flows, then the
replicated NPV is also $4,132, but it arrives in Year 2. We can put Project T’s cash
flow situation on a time line:

0 1 2 3 4
10%
| | | | |
4,132 4,132
3,415
7,547

Here we see that T’s common-life NPV is NPVT = $7,547.

Thus, when compared over a 4-year common life, Project T has the higher NPV,
hence it should be chosen. Project T would have the higher NPV over any common
life.
k. 4. Now assume that the cost to replicate Project T in 2 years will increase to
$105,000 because of inflationary pressures. How should the analysis be handled
now, and which project should be chosen?

Answer: If the cost of Project T is expected to increase, the replication project is not identical
to the original, and the EAA approach cannot be used. In this situation, we would put
the cash flows on a time line as follows:

0 r = 10% 1 2 3 4
| | | | |
-100,000 60,000 60,000 60,000 60,000
-105,000
- 45,000

Common-Life NPVT = $3,415.

With this change, the common-life NPV of Project T is less than that for Project F,
and hence Project F should be chosen.

l. You are also considering another project which has a physical life of 3 years;
that is, the machinery will be totally worn out after 3 years. However, if the
project were terminated prior to the end of 3 years, the machinery would have a
positive salvage value. Here are the project’s estimated cash flows:

Initial Investment End-of-Year

And Operating Net Salvage
Year Cash Flows Value
0 ($5,000) $5,000
1 2,100 3,100
2 2,000 2,000
3 1,750 0

Using the 10% cost of capital, what is the project’s NPV if it is operated for the
full 3 years? Would the NPV change if the company planned to terminate the
project at the end of Year 2? At the end of Year 1? What is the project’s
optimal (economic) life?

Mini Case: 10 - 16
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Answer: Here are the time lines for the 3 alternative lives:

No termination:
0 1 2 3
10%
| | | |
-5,000 2,100 2,000 1,750
0
1,750
NPV = -$123.

Terminate after 2 years:

0 1 2
10%
| | |
-5,000 2,100 2,000
2,000
4,000
NPV = $215.

Terminate after 1 year:

0 1
10%
| |
-5,000 2,100
3,100
5,200
NPV = -$273.

We see (1) that the project is acceptable only if operated for 2 years, and (2) that a
project’s engineering life does not always equal its economic life.
Mini Case: 10 - 18
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website, in whole or in part.