Chapter 10: Capital Budgeting Techniques

Overview
This chapter is the first of two that deal with long-term investment decisions. This chapter covers
capital budgeting techniques and Chapter 11 deals with the basic principles of determining
relevant cash flows in capital budgeting. Both the sophisticated [net present value (NPV) and the
internal rate of return (IRR)] and unsophisticated (average rate of return and payback period)
capital budgeting techniques are presented here. Discussion centers on the calculation and
evaluation of the NPV and IRR in investment decisions, with and without a capital rationing
constraint. Several illustrations exist explaining why capital budgeting techniques will be useful
to you in your professional and personal lives.
Few Key points:
Capital expenditures are outlays made by the firm that are expected to produce benefits over the
long term (a period greater than one year). Not all capital expenditures are made for fixed assets.
An expenditure made for an advertising campaign may have long-term benefits. An operating
expenditure is an outlay resulting in benefits received within 1 year.
Once the relevant cash flows have been developed, they must be analyzed to determine whether
the projects are acceptable or to rank the projects in terms of acceptability in meeting the firms
goal. Managers reach their goal of maximizing shareholder wealth when they undertake all
investments wherein the present value of the cash inflows exceed the present value of cash
outflows.
The capital budgeting process consists of five steps:
1. Proposal generation. Proposals for new investment projects are made at all levels within a
business organization and are reviewed by finance personnel.
2. Review and analysis. Financial managers perform formal review and analysis to assess the
merits of investment proposals
3. Decision making. Firms typically delegate capital expenditure decision making on the basis
of dollar limits.
4. Implementation. Following approval, expenditures are made and projects implemented.
Expenditures for a large project often occur in phases.
5. Follow-up. Results are monitored and actual costs and benefits are compared with those that
were expected. Action may be required if actual outcomes differ from projected ones.
Independent versus Mutually Exclusive Projects
Independent projects are projects whose cash flows are unrelated to (or independent of) one
another; the acceptance of one does not eliminate the others from further consideration.

Mutually exclusive projects are projects that compete with one another, so that the acceptance of
one eliminates from further consideration all other projects that serve a similar function.
Unlimited Funds versus Capital Rationing
Unlimited funding is the financial situation in which a firm is able to accept all independent
projects that provide an acceptable return.
Capital rationing is the financial situation in which a firm has only a fixed number of dollars
available for capital expenditures, and numerous projects compete for these dollars.
Accept-Reject versus Ranking Approaches
An acceptreject approach is the evaluation of capital expenditure proposals to determine
whether they meet the firms minimum acceptance criterion.
A ranking approach is the ranking of capital expenditure projects on the basis of some
predetermined measure, such as the rate of return.
Methods to make a decision:
There are two types of techniques: 1) Non-discounting Technique and 2) Discounting Technique
Non-discounting technique is simple to apply and easy to understand but it suffers time value of
money criterion and therefore it is less reliable and also known as un sophisticated method of
choosing a long term investment. The most common method under this technique is payback
period method.
The payback period is the exact amount of time required to recover the firms initial investment
in a project. In the case of a mixed stream, the cash inflows are added until their sum equals the
initial investment in the project. In the case of an annuity, the payback is calculated by dividing
the initial investment by the annual cash inflow.
The weaknesses of using the payback period are (1) no explicit consideration of shareholders
wealth; (2) failure to take fully into account the time value of money; and (3) failure to consider
returns beyond the payback period and, hence, overall profitability of projects. [Note: If you
discount each cash flow at the time value of money and subtract that from the original
expenditure, you end up with a revised payback period, usually called the discounted payback
period. However, this technique still does not consider all of the cash flows.]

Example 1: XYZ Company is buying a new machine for $10,000 and its useful life is 4
years. Following are the cash flows of this investment.
Time

CFs

0 (initial investment)

$10,000

$5,000

$4,000

$3,000

$6,000

$3,000

Based on the above information, answer the following questions:

1. What is the approximate payback period?
2. What is the exact payback period?
3. Should XYZ invest in this investment if desired payback period is 3 years? Will XYZs
decision change if desired payback period is 2.30 years? Why?
Ans 1) XYZ should be able to recover its initial cost in 3 years. In other words, approximate
payback period is 3 years.
Ans 2) Exact payback period is between 2 and 3 years.
Cumulative PB amount in 2 years = $9,000
Cumulative PB amount in 3 years = $12,000

Exact Payback period = 2 yrs. +

Exact Payback Period = 2 yrs. +
Exact Payback = 2.33 years
Ans 3) XYZ should invest in this machine because actual payback period of 2.33 years is less
than desired payback period of 3 years.
Decision will change and XYZ should not invest if desired payback is 2.30 years because it will
take longer to recover initial investment than desired recovery period.

Practice Problem 1: Find the payback period of the following investment?

Time

CFs

0 (initial investment)

$40,000

$15,000

$5,000

$7,000

$15,000

$3,000

Will you accept this investment if required payback period is 4 years? Will your decision change
if required payback period is 3.20 years?
Answer:
Approximate payback period is between 3 and 4 years.
Exact payback period is 3.87 years.
Yes, this project should be accepted if the required payback period is 4 years, but we will reject
this investment if the required payback period is 3.20 years.

Discounting Technique:
A decision making method that uses time value of money concept, i.e. PV of future CFs is
estimated and then sum of those PVs is compared with the initial investment.
Discounting Technique Method 1: Net Present Value (NPV) Method:
NPV computes the present value of all relevant cash flows associated with a project. For
conventional cash flow, NPV takes the present value of all cash inflows over years 1 through n
and subtracts from that sum the initial investment at time zero. The formula for the NPV of a
project with conventional cash flows is:
NPV = present value of cash inflows - initial investment
Acceptance criterion for the NPV method is if NPV > 0, accept; if NPV < 0, reject. If the firm
undertakes projects with a positive NPV, the market value of the firm should increase by the
amount of the NPV.

Example 2: Use the information given in example 1 and estimate net present value of this
investment if required rate of return a) 8%, b) 35%.
What will be your decision about this investment based on NPV rule?
n

CFt
I0
t
t 1 (1 r )

NPV

NPV =

10,000

NPV = $16,892.41 - $10,000 = $6,892.41

Since NPV > 0 therefore this project should be accepted for investment.
Please pay attention, in the above equation, it is 5000 / (1.08)1 + 4000/ (1.08)2 + time is the
exponential term but somehow in the equation it seems like it is a multiplicative term.
NPV Calculator Function:
First clear all the previous work (memory).
Press 2nd press CF
Press 2nd press CE|C
Press 2nd press FV
Press 2nd press CPT
These four steps are required (the first one in bold has to be the first step) to clear all the previous
NPV (CF) related work.
Press CF and it will show CF0; type 10000 followed +|- then press ENTER followed by
It will show C01 type 5000 and press ENTER followed by and again
It will show C02 type 4000 and press ENTER followed by and again
It will show C03 type 3000 and press ENTER followed by and again
It will show C04 type 6000 and press ENTER followed by and again
It will show C05 type 3000 and press ENTER followed by and again
It will show C06
We dont have any CF for year 6 for this example so press CPT NPV
It will show I (the interest rate) type 8 and press ENTER followed by and CPT
It will give you answer $6,892.41
To clear the memory, you press CE|C to get 0 and then 2nd CF followed by 2nd CE|C followed by
2nd FV followed by 2nd CPT.

Redo the same problem at 35% required rate of return.

NPV =

10,000

NPV = $9,593.27 - $10,000 = -$406.73

Since NPV is less than zero at 35% required rate of return therefore this investment should be
rejected.
Note: Students can get the same answer by using financial calculator.

Practice Problem 2: Do practice problem 1 given above and find NPV at 3% required rate of
return and then at 5% required rate of return. What will be your decision under two conditions?
Answer:
At 3%, the NPV is $1,597.21 and the project should be accepted for investment.
At 5%, the NPV is -$441.16 and the project should be rejected for investment.

Discounting Technique Method 2: Internal Rate of Return (IRR) Method

The IRR on an investment is the discount rate that would cause the investment to have a NPV of
zero. It is found by solving the NPV equation given below for the value of k that equates the
present value of cash inflows with the initial investment.
n

CFt
I0
t
t 1 (1 r )

NPV

If a projects IRR is greater than the firms cost of capital, the project should be accepted;
otherwise, the project should be rejected. If the project has an acceptable IRR, the value of the
firm should increase. Unlike the NPV, the amount of the expected value increase is not known.

Example 3: Find IRR of the data given in example 1. Will you accept or reject this
investment if required rate of return (cost of capital) is 10%?
It is very time-consuming and hard to estimate IRR without using a financial calculator.
Basically, IRR is a rate of return at which NPV = 0. In other words, we have to rely on trial and
error method to find that unique r at which Initial Investment equals Sum of PVs of future
CFs.
By using calculator:
IRR = 32.63%
IRR is greater than required rate of return therefore this project will be accepted.
IRR Calculator function: It is exactly similar to that of NPV except you need to press IRR
in the end instead of NPV.
First clear all the previous work (memory).
Press 2nd press CF
Press 2nd press CE|C
Press 2nd press FV
Press 2nd press CPT
These four steps are required (the first one in bold has to be the first step) to clear all the previous
CF related work.
Press CF and it will show CF0; type 10000 followed +|- then press ENTER followed by
It will show C01 type 5000 and press ENTER followed by and again
It will show C02 type 4000 and press ENTER followed by and again
It will show C03 type 3000 and press ENTER followed by and again
It will show C04 type 6000 and press ENTER followed by and again
It will show C05 type 3000 and press ENTER followed by and again
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It will show C06

We dont have any CF for year 6 for this example so press IRR followed by CPT and you will
see 32.63 on the screen.
To clear the memory, you press CE|C to get 0 and then 2nd CF followed by 2nd CE|C followed by
2nd FV followed by 2nd CPT.

Practice Problem 3: Redo the practice problem 1 given above and find IRR.
Answer: 4.55%.

The NPV and IRR always provide consistent accept/reject decisions. That means if a project
has positive NPV then its IRR will always be greater than the required rate of return. These
measures, however, may not agree with respect to ranking the projects. In other words, if good
projects are already selected, i.e. projects that give positive NPV and/or IRR > Required Rate of
Return and the question is to rank them in order then you may find NPV and IRR give different
ranking of those projects. The NPV may conflict with the IRR due to different cash flow
characteristics of the projects. The greater the difference between timing and magnitude of cash
inflows, the more likely it is that rankings will conflict.
A NPV profile is a graphic representation of the NPV of a project at various discount rates. The
NPV profile may be used when conflicting rankings of projects exist by depicting each project as
a line on the profile and determining the point of intersection. If the intersection occurs at a
positive discount rate, any discount rate below the intersection will cause conflicting rankings,
whereas any discount rates above the intersection will provide consistent rankings. Conflicts in
project rankings using NPV and IRR result from differences in the magnitude and timing of cash
flows. Projects with similar-sized investments having low early-year cash inflows tend to be
preferred at lower discount rates.
At high discount rates, projects with the higher early-year cash inflows are favored, as later-year
cash inflows tend to be severely penalized in present value terms.

Conflicting rankings of projects frequently emerge from NPV and IRR as a result of differences
in the reinvestment rate assumption, as well as the magnitude and timing of cash flows. NPV
assumes reinvestment of intermediate cash inflows at the more conservative cost of capital; IRR
assumes reinvestment at the projects IRR. On a purely theoretical basis, NPV is preferred over
IRR because NPV assumes the more conservative reinvestment rate and does not exhibit the
mathematical problem of multiple IRRs that often occurs when IRRs are calculated for
nonconventional cash flows. In practice, the IRR is more commonly used because it is consistent
with the general preference of business professionals for rates of return, and corporate financial
analysts can identify and resolve problems with the IRR before decision makers use it.
The reinvestment rate assumption refers to the rate at which reinvestment of intermediate cash
flows theoretically may be achieved under the NPV or the IRR methods. The NPV method
assumes the intermediate cash flows are reinvested at the discount rate, whereas the IRR method
assumes intermediate cash flows are reinvested at the IRR. On a purely theoretical basis, the
NPVs reinvestment rate assumption is superior because it provides a more realistic rate, the
firms cost of capital, for reinvestment. The cost of capital is generally a reasonable estimate of
the rate at which a firm could reinvest these cash inflows. The IRR, especially one well
exceeding the cost of capital, may assume a reinvestment rate the firm cannot achieve. In
practice, the IRR is preferred due to the general disposition of business people toward rates of
return rather than pure dollar returns.
As described above, NPV method is the superior (most preferred) method. In case of conflict of
ranking, we always prefer NPV method because NPV method is most consistent with the
objective of maximizing firms value (shareholders wealth) plus you will get only one NPV for
any project whereas IRR may give you multiple IRRs especially when cash flows are nonconventional, i.e. future CFs are both positive and negative. Put it simply, if a stream of CFs has
initial investment (a negative CF) followed by all positive future CFs then it is called a
conventional stream of CFs and you will get only one IRR. On the other hand, if a stream of cash
flows has initial investment followed by a few positive CFs and then negative CF then you may
end up with two IRRs because sign changes twice in that stream of CFs.
Real Options are opportunities embedded in real assets that are part of the capital budgeting
process. Managers have the option of implementing some of these opportunities to alter the cash
flow and risk of a given project. Examples of real options include:
Abandonmentthe option to abandon or terminate a project prior to the end of its planned
life.
Flexibilitythe ability to adopt a project that permits flexibility in the firms production
process, such as being able to reconfigure a machine to accept various types of inputs.
Growththe option to develop follow-on projects, expand markets, expand or retool plants,
and so on, that would not be possible without implementation of the project that is being
evaluated.
Timingthe ability to determine the exact timing of when various action of the project will
be undertaken.

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Strategic NPV incorporates the value of the real options associated with the project while
traditional NPV includes only the identifiable relevant cash flows. Using strategic NPV could
alter the final accept/reject decision. It is likely to lead to more accept decisions since the value
of the options is added to the traditional NPV as shown in the following equation.
NPVstrategic = NPVtraditional - Value of real options
Capital rationing is a situation where a firm has only a limited amount of funds available for
capital investments. In most cases, implementation of the acceptable projects would require more
capital than is available. Capital rationing is common for a firm, since unfortunately most firms
do not have sufficient capital available to invest in all acceptable projects. In theory, capital
rationing should not exist because firms should accept all projects with positive NPVs or IRRs
greater than the cost of capital. However, most firms operate with finite capital expenditure
budgets and must select the best from all acceptable projects, taking into account the amount of
new financing required to fund these projects.
The internal rate of return approach and the net present value approach to capital rationing both
involve ranking projects on the basis of IRRs. Using the IRR approach, a cut-off rate and a
budget constraint are imposed. The NPV first ranks projects by IRR and then takes into account
the present value of the benefits from each project in order to determine the combination with the
highest overall net present value. The benefit of the NPV approach is that it guarantees a
maximum dollar return to the firm, whereas the IRR approach does not.
Risk, in terms of cash inflows from a project, is the variability of expected cash flows, hence the
expected returns, of the given project. The breakeven cash inflowthe level of cash inflow
necessary in order for the project to be acceptablemay be compared with the probability of that
inflow occurring. When comparing two projects with the same breakeven cash inflows, the
project with the higher probability of occurrence is less risky.
There are several behavioral approaches to deal with project risk.
a. Scenario analysis uses a number of possible inputs (cash inflows) to assess their impact
on the firms net present value (NPV). Scenario analysis can be used to evaluate the
impact on return of simultaneous changes in a number of variables, such as cash
inflows, cash outflows, and the cost of capital, resulting from differing assumptions
relative to economic and competitive conditions. In capital budgeting, the NPVs are
frequently estimated for the pessimistic, most likely, and optimistic cash flow estimates.
By subtracting the pessimistic outcome NPV from the optimistic outcome NPV, a range
of NPVs can be determined.
b. Decisions trees are graphic illustrations diagramming investment decision options and
payoffs.
A key to this approach is identification of the probability of each outcomes occurrence.
c. Simulation is a statistically based approach using random numbers to simulate various
cash flows associated with the project, calculating the NPV or internal rate of return
(IRR) on the basis of these cash flows, and then developing a probability distribution of
each projects rate of returns based on NPV or IRR criterion.

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