The Basics of Capital Budgeting

I. Project Classifications
A. Replacement projects = expenditures to replace worn-out or damaged euipment
reuired in the production of profita!le products
B. Replacement" cost reduction = expenditures to replace ser#icea!le !ut o!solete
euipment and lower costs
C. $xpansion of existing products or mar%ets = expenditures to increase output of
existing products or to expand retail outlets or distri!ution facilities in mar%ets now
!eing ser#ed
&. $xpansion of new products or mar%ets = expenditures to produce new products or
to expand into new mar%ets
$. 'afet( and)or en#ironmental products = expenditures necessar( to compl( with
go#ernment orders* la!or agreements* or insurance polic( terms
+. ,ther = expenditures on office !uildings* par%ing lots* and executi#e aircraft
II. Capital Budgeting Techniues
A. Three wa(s to determine appropriate project* !e it either an expansion or
replacement project* independent projects or mutuall( exclusi#e projects
-. Pa(!ac% period
.. /et present #alue 0/P12
3. Internal rate of return 0IRR2
4. 5odified internal rate of return 05IRR2
B. $xample" After-tax* incremental cash flows of two projects
6ear Project A Project B
7 -84.*777 -849*777
- -4*777 .:*777
. -4*777 -.*777
3 -4*777 -7*777
4 -4*777 -7*777
9 -4*777 -7*777
C. Pa(!ac% period
-. &ef;n" amount of time reuired for a firm to reco#er its initial in#estment in
a project* as calculated from cash flows
Pa(!ac% period = num!er of (ears prior to full reco#er( < 0unreco#ered cost
at start of last (ear2)0cash flow during full reco#er( (ear2
.. 1iewed as unsophisticated capital !udgeting techniue
. Page -
3. &ecision rule" =et /> (ears = firm;s maximum accepta!le pa(!ac% period
a. Independent projects" Accept all projects whose pa(!ac% periods ?
/>
!. 5utuall( exclusi#e projects" Among those projects whose pa(!ac%
periods are ? />* choose the project with the shortest pa(!ac% period
4. The example"
a. Project A" The cash inflow of e#er( (ear = 8-4*777.
84.*777)-4*777= 3 = =@ Project A;s pa(!ac% period is 3 (ears
6ear 7 - . 3 4 9
Cash flow -84.*777 8-4*777 8-4*777 8-4*77
7
8-4*77
7
8-4*777
Cumulati#e cash flow -84.*777 -8.:*777 -8-4*777 87 8-4*77
7
8.:*777
Pa(!ac% period = 3 (ears
!. Project B" To get 849*777 = =@ /eed all the 8.:*777 of the -
st
(ear
08-A*777 left to go2* need all the 8-.*777 of the second (ear 089*777 left
to go2* need onl( 89*777 of the 8-7*777 earned during third (ear. To
prorate the time need after the second (ear " 89*777)8-7*777 = .9 (ear
= =@ Project B;s pa(!ac% period = ..9 (ears
6ear 7 - . 3 4 9
Cash flow -849*777 8.:*777 8-.*77
7
8-7*77
7
8-7*77
7
8-7*777
Cumulati#e cash flow -849*777 -8-A*777 -89*777 89*777 8-4*77
7
8.:*777
Pa(!ac% period = . (ears < 89*777)8-7*777 (ears = ..9 (ears
c. =et /> = 3.9 (ears
d. If independent projects" accept !oth projects !ecause 3 ? 3.9 and ..9 ?
3.9
e. If projects mutuall( exclusi#e" pic% project B as ..9 ? 3 ? 3.9
9. Pros and cons of the pa(!ac% method
a. The pros"
i. Bidel( used
ii. Computationall( simple
iii. Intuiti#e appeal
i#. 'ince it measures how uic% firm reco#ers initial in#estment*
gi#es implicit consideration to time #alue of mone(
#. B( pic%ing projects with pa(!ac% ? /> = =@ approach is ma(
reduce ris% and pa(!ac% period has some relation to ris%
exposure
!. The con"
a. /> a su!jecti#e predetermined measure
!. Pa(!ac% period not lin%ed to goal of shareholder wealth
maximiCation
. Page .
c. Approach doesn;t full( ta%e the time #alue of mone( into
account 0cash flows aren;t discounted to present #alue2
d. Pa(!ac% period approach ignores cash flows recei#ed after the
pa(!ac% period.
. Page 3
D. ,ne possi!le modification" &iscounted pa(!ac% at -7E cost of capital
a. =ength of time reuired for in#estment;s cash flows* discounted at the
cost of capital to co#er its cost
!. Project A"
6ear 7 - . 3 4 9
Cash flow -849*777 8-4*777 8-4*777 8-4*777 8-4*77
7
8-4*777
&iscounted cash flow -849*777 8-.*A.A 8--*9A7 8-7*9-: 8F*9D. 8:*DF3
Cumulati#e discounted cash flow -849*777 -83.*.A3 -8.7*A7. -8-7*-:4 -8D.. 8:*7A-
Pa(!ac% period = 4 < D..):DF3 = 4 < .7A = 4.7A
c. Project B
6ear 7 - . 3 4 9
Cash flow -849*777 8.:*777 8-.*77
7
8-7*77
7
8-7*77
7
8-7*777
&iscounted cash flow -849*777 8.9*499 8F*F-A 8A*9-3 8D*:37 8D*.7F
Cumulati#e discounted cash flow -849*777 -8-F*949 -8F*D.: -8.*--9 84*A-9 8-7*F.4
Pa(!ac% period = 3 < .--9)D:37 = 3 < 7.3- = 3.73-
d. If /> = 4"
i. If projects are independent" Accept Project B and reject
project A. 3.73- ? 4 ? 4.7A
ii. If projects are mutuall( exclusi#e" Accept Project B and reject
project A. 3.73- ? 4 ? 4.7A
&. /et present #alue 0/P12
-. &ef;n" sophisticated capital !udgeting techniue found !( su!tracting
project;s initial in#estment from present #alue of future cash flows 0which
where discounted at rate eual to firm;s cost of capital2
.. =et C+
t
!e the firm;s cash flow in (ear t. =et % !e the firm;s cost of capital.
/
t /-- / - .
7 7 t - . /-- /
t=-
C+ C+ C+ C+ C+
/P1 = - C+ = < < < < - C+
0- < r2 0-<r2 0-<r2 0-<r2 0-<r2

L
3. r = discount rate = reuired return = cost of capital = opportunit( cost =
minimum return that must !e earned on project to lea#e firm;s mar%et #alue
unchanged
4. &ecision rule"
a. Independent projects" Accept all projects with /P1 @ 7
!. 5utuall( exclusi#e projects" choose project with largest positi#e /P1
9. The example" =et r = -7E
a. $xcel formula" /P10discount rate* C+
-
* . . . * C+
/
2 G C+
7
!. Project A"
A - . 3 4 9
8-4*777 8-4*777 8-4*777 8-4*777 8-4*777
/P1 =-84.*777< < < < < =8--*7A-
0-.-72 0-.-72 0-.-72 0-.-72 0-.-72
c. Project B
. Page 4
B - . 3 4 9
8.:*777 8-.*777 8-7*777 8-7*777 8-7*777
/P1 =-849*777< < < < < =8-7*F.4
0-.-72 0-.-72 0-.-72 0-.-72 0-.-72
d. &ecision rule"
i. If A and B are independent projects" pic% !oth projects.
8--*7F- @ 7 and 8-7*7.4 @ 7
ii. If Projects A and B are mutuall( exclusi#e" Pic% project A
!ecause 8--*7F- @ 8-7*F.4 @ 7
$. Internal Rate of Return 0IRR2
-. &ef;n" 'ophisticated capital !udgeting techniue. It is that discount rate
where the net present #alue of the project is eual to Cero. It is the discount
rate that euates the present #alue of the future cash flows with the initial
in#estment.
.. =et IRR = the internal rate of return. IRR is the discount rate that sol#es the
following euation"
/
t /-- / - .
7 7 t - . /-- /
t=-
C+ C+ C+ C+ C+
- C+ = < < < < - C+ = 87
0- < IRR2 0- < IRR2 0- < IRR2 0- < IRR2 0- < IRR2
L

3. &ecision rule" let r = the firm;s cost of capital

a. Independent projects" Accept an( project whose IRR @ r.
!. 5utuall( exclusi#e projects" Among those projects with an IRR @ r*
choose the project with the largest IRR.
4. $xcel formula" IRR0!eginning cell"last cell* guess2
$nter (earl( cash flows in order from initial in#estment to terminal cash
flow. The !eginning cell of the arra( contains the initial in#estment* while
the last cell contains cash flows of the last (ear of the project. Huess is a
fraction to initiate the con#ergence to the solution.
9. $xample"
a. Project A - - IRR = -F.:DE
. 3 4 9
8-4*777 8-4*777 8-4*777 8-4*777 8-4*777
-84.*777 < < < < < =87
0-.-F:D2 0-.-F:D2 0-.-F:D2 0-.-F:D2 0-.-F:D2
!. Project B - - IRR = .-.D9E
. 3 4 9
8.:*777 8-.*777 8-7*777 8-7*777 8-7*777
-849*777 < < < < < =87
0-..-D92 0-..-D92 0-..-D92 0-..-D92 0-..-D92
c. &ecision rules" =et r = -7E
i. Independent projects" 'ince IRR
A
= -F.:DE @ -7.77E and
IRR
B
= .-.D9E @ -7.77E accept !oth projects A and B
ii. 5utuall( exclusi#e projects" Pic% project B !ecause IRR
B
@
IRR
A
@ r or .-.D9E @ -F.:DE @ -7.77E. In this case* there is
a conflict in the choices recommended !( /P1 and IRR.
According to /P1* project A should !e accepted* while
according to IRR* project B is preferred.
III. The possi!ilities of conflicting ran%ings using /P1 and IRR
A. $xamine the net present #alue profiles
-. /et present #alue profile = graph depicting project;s /P1 for #arious
discount rates
. Page 9
.. +igure - is the /P1 profiles for the example
. Page D
+igure -
NPV Pro f iles
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%
Di sc ount Ra t e ( %)
Project A
Project B
3. Conflicting decisions" Independent #s mutuall( exclusi#e projects
a. Refer to figure " IRR
A
= %
4
* IRR
B
= %
D
Cross o#er rate where /P1
A
= /P1
B
= %
.
!. Refer to +igure . on next page. Assume projects A and B are
independent.
Cost of Capital /P1 Approach IRR Approach /P1 and IRR AgreeI
%
-
Accept AJ Accept B Accept AJ Accept B 6es
%
.
Accept AJ Accept B Accept AJ Accept B 6es
%
3
Accept AJ Accept B Accept AJ Accept B 6es
%
4
Reject AJ Accept B Reject AJ Accept B 6es
%
9
Reject AJ Accept B Reject AJ Accept B 6es
%
D
Reject AJ Reject B Reject AJ Reject B 6es
%
A
Reject AJ Reject B Reject AJ Reject B 6es
Conclude" Bhen projects are independent* /P1 and IRR approach
alwa(s agree.
c. Refer to +igure . on next page. /ow assume projects A and B are
mutuall( exclusi#e.
Cost of Capital /P1 Approach IRR Approach /P1 and IRR AgreeI
%
-
Accept AJ Reject B Reject AJ Accept B /o
%
.
Accept either A or B Reject AJ Accept B /o
%
3
Reject AJ Accept B Reject AJ Accept B 6es
%
4
Reject AJ Accept B Reject AJ Accept B 6es
%
9
Reject AJ Accept B Reject AJ Accept B 6es
%
D
Reject AJ Reject B Reject AJ Reject B 6es
%
A
Reject AJ Reject B Reject AJ Reject B 6es
Conclude" +or mutuall( exclusi#e projects* if % ? the crosso#er rate*
then the recommendations of the /P1 and IRR approaches will
disagree. If % @ the crosso#er rate then the recommendations of the
two approaches agree.
. Page A
+igure .
d. Bhich approach is !etterI
i. /P1 approach is theoreticall( correct. The /P1 approach
assumes cash flows are rein#ested at the firm;s cost of capital.
Kowe#er* the IRR assumes the firm;s cash flows are
rein#ested at the IRR which is greater than the firm;s cost of
capital. Because the cost of capital is a more realistic estimate
of the rate at which the firm could rein#est intermediate cash
flows* use of the /P1 is theoreticall( prefera!le with its more
conser#ati#e and realistic rein#estment rate of the cost of
capital.
ii. 'ur#e(s show financial managers prefer IRR. 5anagers tend
to tal% more a!out rates of return than actual dollar returns.
5anagers comforta!le with return data* the( express interest
rates and profita!ilit( in percentage rates. /P1 seems less
intuiti#e as it doesn;t measure !enefits relati#e to amount
in#ested.
. Page :
B. 5ultiple IRR
-. /ormal cash flows
a. A project has normal cash flows if it has one or more outflows 0costs2
followed !( a series of cash inflows
!. $xamples"
i. - < < < < <
ii. - - - < < < < <
.. /onnormal cash flows
a. A project has nonnormal cash flows if a cash outflow occurs
sometime after the inflows ha#e commenced.
!. $xamples"
i. - < < < < -
ii. - < < < - < < <
3. Le( result" If a project has nonnormal cash flows* it can ha#e multiple IRRs.
a. A project has nonnormal cash flows if a cash outflow occurs
sometime after the inflows ha#e commenced.
!. $xample" Assume r = -.E
6ear 7 - .
Cash flow -8477*777 8FD7*77
7
-89A.*777
&iscounted cash flow 0r=-.E2 -8477*777 8:9A*-4
3
-8499*FF9
Cumulati#e discounted cash flow -8477*777 849A*-4
3
8-*-4:
i. P1 = 8-*-4: M Accept project
ii. +ind IRR. 'ol#e following euation
- .
8FD7*777 -89A.*777
-8477*777 < < =7
0- < IRR2 0- < IRR2
4770-<IRR2
.
-FD70-<IRR2<9A.=7
477NIRR
.
< .0IRR2 < -O -FD70- < IRR2 < 9A. = 7
4770IRR
.
2--D70IRR2<-. =7
-770IRR
.
2-47IRR<3 = 7 M
.
-0-472 P 0-472 - 40-772032
IRR =
.0-772
+ind two IRR" -7E and 37E
iii. 'ee Ta!le - and +igure 3 on next page
. Page F
Multiple IRR
-$20,000.00
-$15,000.00
-$10,000.00
-$5,000.00
$0.00
0 0.1 0.2 0.3 0.4 0.5 0.6
r
P
V
PV
Table 1
r PV
0.00-$12,000.00
0.02 -$8,612.07
0.04 -$5,769.23
0.06 -$3,417.59
0.08 -$1,508.92
0.10 $0.00
0.12 $1,147.96
0.14 $1,969.84
0.16 $2,497.03
0.18 $2,757.83
0.20 $2,777.78
0.22 $2,579.95
0.24 $2,185.22
0.26 $1,612.50
0.28 $878.91
0.30 $0.00
0.32 -$1,010.10
0.34 -$2,138.56
0.36 -$3,373.70
0.38 -$4,704.89
0.40 -$6,122.45
0.42 -$7,617.54
0.44 -$9,182.10
0.46-$10,808.78
0.48-$12,490.87
0.50-$14,222.22
0.52-$15,997.23
0.54-$17,810.76
0.56-$19,658.12
+igure -
. Page -7
C. 5odified internal rate of return = 5IRR
-. 5IRR = discount rate at which the present #alue of a project;s cost is eual
to the present of its terminal #alue* where the terminal #alue is found as the
sum of the future #alues of the cash inflows* compounded at the firm;s cost of
capital
.. /otation
a. C,+
t
= cash outflow in (ear t
!. CI+
t
= cash inflow in (ear t
c. 5IRR = modified internal rate of return
d. 5IRR euates present #alue of terminal #alue to present #alue of costs
terminal #alue = T1 =
/
/-t
t
t=7
CI+ 0-<r2

P1 cost =
/
t
t
t=7
C,+
0-<r2

5IRR is that interest rate that sol#es the following euation"

/
/-t
t /
t t=7
t /
t=7
CI+ 0- < r2
C,+
=
0- < r2 0- < 5IRR2

e. &ecision rule" Accept project if 5IRR @ cost of capital = r

f. $xample" Return to pre#ious example of Projects A and B
6ear Project A Project B
7 -84.*777 -849*777
- -4*777 .:*777
. -4*777 -.*777
3 -4*777 -7*777
4 -4*777 -7*777
9 -4*777 -7*777
i. Project A
4 3 .
T1=8-4*7770-.-72 <8-4*7770-.-72 <8-4*7770-.-72 <8-4*7770-.-72<8-4*777=8:9*4A-.47
P1 of costs = 84.*777
9
8:9*4A-.47
84.*777 =
0- < 5IRR2
M -9..AE
ii. Project B
4 3 .
T1=8.:*7770-.-72 <8-.*7770-.-72 <8-7*7770-.-72 <8-7*7770-.-72 <8-7*777=8F7*7DD.:7
P1 of costs = 849*777
. Page --
9
8F7*7DD.:7
849*777 =
0- < 5IRR2
M -4.:FE
iii. &ecision" If projects are independent M Accept !oth since
5IRR @ r
4. /ote
a. 5IRR sol#es multiple IRR pro!lem* can ne#er !e more than one
5IRR. Compare it to cost of capital.
!. Is 5IRR good for choosing !etween mutuall( exclusi#e projectsI
i. In general* no.
ii. Conflicts ma( occur if projects differ in length M In this case
use /P1

. Page -.