Foundations of Finance

Tenth Edition, Global Edition

Chapter 10
Capital-Budgeting Techniques
and Practice

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Learning Objectives
10.1 Discuss the difficulty encountered in finding profitable
projects in competitive markets and the importance of
the search.
10.2 Determine whether a new project should be accepted
or rejected using the payback period, net present value,
the profitability index, and the internal rate of return.
10.3 Explain how the capital-budgeting decision process
changes when a dollar limit is placed on the capital
budget.
10.4 Discuss the problems encountered when deciding
among mutually exclusive projects.

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Finding Profitable Projects

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Capital Budgeting
• Meaning: The process of decision making with respect to
investments in fixed assets—that is, whether a proposed
project should be accepted or rejected.
• It is easier to “evaluate” profitable projects than to “find
them.”

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Source of Ideas for Projects
• R&D: Typically, a firm has a research and development
(R&D) department that searches for ways of improving
existing products or finding new projects.
• Other sources: Employees, competition, suppliers,
customers

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Capital-Budgeting Decision Criteria

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Capital-Budgeting Decision Criteria
• The Payback Period
• Net Present Value
• Profitability Index
• Internal Rate of Return

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The Payback Period
• Meaning: Number of years needed to recover the initial
cash outlay related to an investment
• Decision Rule: Project is considered feasible or desirable
if the payback period is less than or equal to the firm’s
maximum desired payback period. In general, shorter
payback period is preferred when comparing two projects.

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Payback Period Example 1
• Example: Project with an initial cash outlay of $10,000
with following free cash flows for 5 years.

Table 10.1 Payback Period Example

Blank Project A Project B

Initial cash outlay −$ 10,000 −$ 10,000
Annual free cash inflows Blank Blank
Year 1 $ 6,000 $ 5,000
2 4,000 5,000
3 3,000 0
4 2,000 0
5 1,000 0

Payback is 2 years.
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Trade-Offs
• Benefits
– Uses cash flows rather than accounting profits
– Easy to compute and understand
– Useful for firms that have capital constraints
• Drawbacks
– Ignores the time value of money
– Does not consider cash flows beyond the payback
period

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Discounted Payback Period (1 of 2)
• The discounted payback period is similar to the traditional
payback period except that it uses discounted free cash
flows rather than actual undiscounted cash flows.
• The discounted payback period is defined as the number
of years needed to recover the initial cash outlay from the
discounted free cash flows.

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Discounted Payback Period (2 of 2)

unrecovered amount at
number of years just prior the beginning of year
Discounted
to complete recovery payback is completed
payback = +
of the initial outlay using discounted free cash
period
discounted cash flows flow in year payback
is completed

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Table 10.2 Discounted Payback
Period Example Using a 17 Percent
Required Rate of Return

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Payback Period Example 2
• Table 10.2 shows the difference between traditional
payback and discounted payback methods.
• With undiscounted free cash flows, the payback period is
only 2 years, while with discounted free cash flows (at 17
percent), the discounted payback period is 3.07 years.

$74
Discounted payback period A = 3.0 + = 3.07 years
$1, 068

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Net Present Value (NPV)
• NPV is equal to the present value of all future free cash
flows less the investment’s initial outlay. It measures the
net value of a project in today’s dollars.

NPV = ( present value of all the future annual free cash flows ) − ( the initial cash outlay )
FCF1 FCF2 FCFn
= + + ... + − 10
(1 + k ) (1 + k ) (1 + k )
1 2 n

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NPV Example (1 of 2)
• Example: Project with an initial cash outlay of $40,000
with following free cash flows for 5 years and a required
rate of return of 12 percent.

Table 10.3 Ski-Doo’s Investment in New Machinery and Its Associated

Free Cash Flows

Blank Free Cash Flow

Initial outlay −$40,000
Inflow year 1 15,000
Inflow year 2 14,000
Inflow year 3 13,000
Inflow year 4 12,000
Inflow year 5 11,000
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NPV Example (2 of 2)

NPV = ( present value of all the future annual free cash flows ) − ( the initial cash outlay )
FCF1 FCF2 FCFn
= + + ... + − IO
(1 + k ) (1 + k ) (1 + k )
1 2 n

• PV of FCF = $47,675
• Subtracting the initial cash outlay of $40,000 leaves an
NPV of $7,675.
• Because NPV > 0, project is feasible.

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Table 10.4 Calculating the NPV of Ski-
Doo’s Investment in New Machinery

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Calculator Solution (Using a Texas
Instruments BA II Plus)

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NPV Trade-Offs
• Benefits
– Considers all cash flows
– Recognizes time value of money
• Drawbacks
– Requires detailed long-term forecast of cash flows
• NPV is generally considered to be the most theoretically
correct criterion for evaluating capital budgeting projects.

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The Profitability Index (PI)
(Benefit-Cost Ratio)
• The profitability index (PI) is the ratio of the present value
of the future free cash flows (FCF) to the initial outlay.
• It yields the same accept/reject decision as NPV.

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Profitability Index

present value of all the future annual free cash flows

PI =
initial cash outlay
FCF1 FCF2 FCFn
+ + ... +
(1 + k ) (1 + k ) (1 + k )
1 2 n

=
IO

• Decision Rule

PI  1 = accept;
PI  1 = reject

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Profitability Index Example
• A firm with a 10 percent required rate of return is considering investing
in a new machine with an expected life of 6 years. The initial cash
outlay is $50,000.

Table 10.5 The Cash Flows Associated with an Investment in New

Machinery

Blank Free Cash Flow

Initial outlay −$50,000
Inflow year 1 15,000
Inflow year 2 8,000
Inflow year 3 10,000
Inflow year 4 12,000
Inflow year 5 14,000
Inflow year 6 16,000
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Table 10.6 Calculating the PI of an
Investment in New Machinery

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NPV and PI
• When the present value of a project’s free cash inflows are
greater than the initial cash outlay, the project NPV will be
positive. PI will also be greater than 1.
• NPV and PI will always yield the same decision.

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Internal Rate of Return (IRR)
• IRR is the discount rate that equates the present value of a
project’s future net cash flows with the project’s initial cash
outlay (IO).

FCF1 FCF2 FCFn

• IO = + + ... +
(1 + IRR ) (1 + IRR ) (1 + IRR )
1 2 n

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Internal Rate of Return
• Decision Rule
– If IRR ≤ Required Rate of Return, accept
– If IRR < Required Rate of Return, reject

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Figure 10.1 An Example of the Net
Present Value Profile of a Project

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IRR and NPV
• If NPV is positive, IRR will be greater than the required
rate of return
• If NPV is negative, IRR will be less than required rate of
return
• If NPV = 0, IRR is the required rate of return.

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Multiple IRRs
• A normal cash flow pattern for project is negative initial
outlay followed by positive cash flows (−, +, +, + …)
• However, if the cash flow pattern is not normal (such as
−, +, −), there can be more than one IRR.
• Figure 10.2 is based on cash flows of −1,600, +10,000,
−10,000 in years 0, 1, 2.

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Figure 10.2 Multiple IRRs

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Modified IRR (MIRR)
• Primary drawback of the IRR relative to the net present
value is the reinvestment rate assumption made by the
internal rate of return. Modified IRR allows the decision
maker to directly specify the appropriate reinvestment rate.

TVinflows
PVoutflows =
(1 + MIRR )
n

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Modified IRR
• Accept if MIRR ≥ required rate of return
• Reject if MIRR < required rate of return

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MIRR Example (1 of 3)
• Project having a 3-year life and a required rate of return of
10 percent with the following free cash flows:

Blank Free Cash Flows

Initial outlay −$6,000
Year 1 2,000
Year 2 3,000
Year 3 4,000

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MIRR Example (2 of 3)
• Step 1: Determine the PV of the project’s free cash
outflows; $6,000 is already at the present.
• Step 2: Determine the terminal value of the project’s free
cash inflows. To do this, use the project’s required rate of
return to calculate the FV of the project’s three cash
inflows. They turn out to be $2,420 + $3,300 + $4,000 =
$9,720 for the terminal value.

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Figure 10.3 Calculating the MIRR

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MIRR Example (3 of 3)
• Step 3: Determine the discount rate that equates the PV of
the terminal value and the PV of the project’s cash
outflows. MIRR = 17.446%
• Decision: MIRR is greater than required rate of return, so
accept.

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Capital Rationing

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Capital Rationing (1 of 2)
• Capital rationing refers to situation where there is a limit on
the dollar size of the capital budget. This may be due to
the following:
– Temporary adverse conditions in the market
– Shortage of qualified personnel to direct new projects
– Other factors, such as not being willing to take on
excess debt to finance new projects

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Capital Rationing (2 of 2)
• How to select? Select a set of projects with the
highest NPV—subject to the capital constraint.
• Note, using NPV may preclude accepting the highest
ranked project in terms of PI or IRR.

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Figure 10.4 Projects Ranked by the
IRR

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Table 10.7 Capital Rationing:
Choosing Among Five Indivisible
Projects
Initial Profitability Net Present
Project
Outlay Index Value
A $200,000 2.4 $280,000
B 200,000 2.3 260,000
C 800,000 1.7 560,000
D 300,000 1.3 90,000
E 300,000 1.2 60,000

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Ranking Mutually Exclusive Projects

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Ranking Mutually Exclusive
Projects
• Size disparity
• Time disparity
• Unequal life

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Size Disparity
• This occurs when we examine mutually exclusive projects
of unequal size.
• Example: Consider the following cash flows for two 1-year
projects, A and B, with required rates of return of 10
percent.
– Initial Outlay: A = $200; B = $1,500
– Inflow: A = $300; B = $1,900

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Table 10.8 The Size-Disparity Ranking
Problem

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Size-Disparity Ranking Problem (1 of 2)

Blank Project A Project B

NPV $72.73 $227.28
PI 1.36 1.15
IRR 50% 27%

• Ranking Conflict
– Using NPV, Project B is better.
– Using PI and IRR, Project A is better.

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Size-Disparity Ranking Problem (2 of 2)
• Which technique to use to select the project?
• Use NPV whenever there is size disparity. If there is no
capital rationing, project with the largest NPV will be
selected. When capital rationing exists, rank and select set
of projects based on NPV.

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Unequal-Lives Problem (1 of 2)
• This occurs when we are comparing two mutually
exclusive projects with different life spans.
• To compare projects, we compute the equivalent annual
annuity (EAA).

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Unequal-Lives Problem (2 of 2)
• Example: If you have two projects, A and B, with equal
investment of $1,000, required rate of return of 10 percent,
and following cash flows in years 1–3 (for project A) and 1–
6 (for project B)
– Project A = $500 each in years 1–3
– Project B = $300 each in years 1–6

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Figure 10.5 Unequal Lives Ranking
Problem

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Figure 10.6 Replacement Chain
Illustration: Two Project A’s Back to
Back

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Computing EAA
• Calculate the project’s NPV:
– A = $243.43 and B = $306.58
• Calculate EAA = NPV/annual annuity factor
– A = $97.89
– B = $70.39
• Project A is better.

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Key Terms
• Capital budgeting
• Capital rationing
• Discounted payback period
• Equivalent annual annuity (E A A)
• Internal rate of return (I R R)
• Modified internal rate of return (M I R R)
• Mutually exclusive projects
• Net present value (N P V)
• Net present value profile
• Payback period
• Profitability index (P I) or benefit-cost ratio

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