2.3 Capital Budgeting PDF

2.
3 Capital Budgeting Techniques
Chapter 12 & 13
Contents
2.3.1 Non-discounted Cash Flow Techniques 2.3.3 NPV-IRR Relationship
2.3.1.1 Payback Period 2.3.3.1 NPV Profile
2.3.1.2 Accounting Rate of 2.3.3.2 Crossover rate
Return 2.3.4 Capital Rationing and Project Selection
2.3.1.3 Payback Reciprocal 2.3.4.1 Lease vs. purchase
2.3.1.4 Bailout Payback 2.3.4.2 Project ranking
2.3.2 Discounted Cash Flow Techniques 2.3.4.3 Problems in project ranking
2.3.2.1 Net Present Value (NPV) 2.3.4.3.1 Size disparity
2.3.2.2 Present Value Index 2.3.4.3.2 Time disparity
2.3.2.3 Discounted Payback Period 2.3.4.3.3 Unequal lives
2.3.2.4 Internal Rate of Return (IRR) 2.3.4.3.3.1 Annualized NPV or
2.3.2.5 Modified IRR (MIRR) equivalent annual
annuity
2.3.4.3.3.2 Replacement
chain
Capital Budgeting Techniques
Preferred or ideal traits of a technique:

1. Easy application (simple calculations);
2. Considers cash flow;
3. Recognizes time value of money; AND
4. Leads to higher stock prices (maximization
of shareholder’s wealth)
• Non-discounted Cash Flow Techniques (Simple
methods)
1. Accounting Rate of Return
2. Payback Period
3. Payback Reciprocal Rate
4. Bailout Payback Period
• Discounted Cash Flow Techniques (Complex
methods)
5. Discounted Payback Period
6. Net Present Value
7. Profitability/ Present Value Index
8. Internal Rate of Return (IRR)
9. Modified IRR (MIRR)

methods)
2. Payback Period
methods)
Accounting Rate of Return (ARR)
• Calculation of a hurdle rate by dividing contribution to

net income by the either average investment or initial
investment
• Average Contribution to net income are estimated by

dividing total contribution to net income by project’s
life.
• Average initial investment = (Initial investment + SV)/2
• Decision rule: accept if equal or above the minimum
ARR set
Annuity: A piece of equipment costs P2M. The
equipment has a useful life of 5 years. The
investment generates sales revenue of P650,000
per year. Tax rate is 30%.
1. Assume the equipment is depreciated on a straight-
line basis with P200,000 salvage value, what is the
annual contribution to net income?
2. What is the average accounting rate of return (using
average investment)?
initial investment)?
Mixed Stream: A piece of equipment costs P2M. The
equipment has a useful life of 5 years. The
investment generates sales revenue as follows:
Year 1 570,000 Year 4 930,000
Year 2 675,000 Year 5 880,000
Year 3 700,000
Tax rate is 30%.
1. Assume the equipment is depreciated on a straight-
line basis with P200,000 salvage value, what is the
annual contribution to net income?
average investment)?
initial investment)?

methods)
2. Payback Period
methods)
Payback Period (PP)
• Number of years of future cash flows needed to recover the
initial investment in a proposed project
• For mixed stream, use cumulative cash flow to determine

the recovery year that is where cumulative cash flow is
equal or more than initial investment:
Unrecovered investment at start of
No. of years prior to
PPmixed stream= + recovery year*
recovery year
Net cash inflowrecovery year
*Unrecovered investment= Initial investment less cumulative cash flows of
years prior to recovery year
• Decision rule: accept if equal or less than maximum
acceptable payback period

methods)
2. Payback Period
methods)
Payback Reciprocal Rate (PRR)
• A variation of the payback period, stated in percentage,
which gives a quick estimate of the internal rate of
return on an investment
• Decision rule: accept if equal or greater than hurdle

rate or cost of capital
• Accurate as an estimated IRR only when (a) project life

is more than twice the payback period and (b) cash
inflows are uniform

methods)
2. Payback Period
methods)
Bailout Payback Period (BPP)
• A variation of the payback period incorporating the salvage
value of the asset in the calculation
• Salvage value (on year of recovery) is combined with
cumulative cash flow to determine the payback period
• Use cumulative cash flow to determine the recovery year
where cumulative cash flow is equal or more than initial
investment:
(Unrecovered investment at start of
No. of years prior to recovery year* - SVrecovery year)
BPP= +
recovery year
*Unrecovered investment= Initial investment less cumulative
cash flows of years prior to recovery year

methods)
2. Payback Period
methods)
payback period (DPP)
• aka Break-even Time Period
• The number of years required for a project’s discounted
cash flows to recover the initial investment
• Use cumulative discounted cash flow to determine the
recovery year where cumulative discounted cash flow is
equal or more than initial investment:
Unrecovered investment at start of
No. of years prior to recovery year*
DPP= +
recovery year
*Unrecovered investment= Initial investment less cumulative
discounted cash flows of years prior to recovery year
PP, PRR, BPP and DPP
Compute for the PP, PRR, BPP and DPP of
the 10-year investment proposal below:
Initial investment P8,000,000
Annual Cash inflow 1,900,000
Salvage value as % of initial 60% at year 1 then decreases by
investment (yrs. 1-10) 5% for succeeding years
Cost of capital 15%
No. of years prior to (Unrecovered investment at start of recovery year* - SVrecovery year)
BPP= +
recovery year Net cash inflowrecovery year
No. of years prior to Unrecovered investment at start of recovery year*

DPP= +
recovery year Net cash inflowrecovery year
PP, PRR, BPP and DPP
UR Company has a new project with initial
investment of P2,000,000 and is expected to
provide after-tax operating cash inflows of
P500,000 in year 1, P900,000 in year 2, P1,200,000
in year 3 and P 800,000 in year 4. The salvage value
of the project for year 1-4 as follows: 1,250,000;
800,000; 500,000, 250,000, respectively. Compute
for (1) Payback period; (2) Payback reciprocal rate; (3)
Bailout payback period; and (4) Discounted payback
period, using 25% cost of capital

methods)
2. Payback Period
methods)
Net Present Value
• NPV is the difference in the present value of an

investment proposal’s future cash flows and the
initial cash outlay. This difference, if positive, is
the expected increase in value of the firm due to
the acceptance of the project
• Discounted at rate consistent with the project’s
risk.
• Decision rule: accept if equal or greater than P0

(nil)
NPV Rule and Shareholder Wealth
• If we apply NPV logic to our valuation topics
previously, we can create a connection
between stock prices and NPV

methods)
2. Payback Period
methods)
Profitability Index (PI)
• A variation of the NPV stated in ratio

• The ratio of the present value of the
expected future cash flows for an investment
proposal (discounted using the required rate
of return for the project) divided by the
project’s initial investment
• Decision rule: accept if equal or greater than

1.0

methods)
2. Payback Period
methods)
Internal Rate of Return (IRR)
• Aka discounted cash flow rate of return or time
adjusted rate of return
• The compound annual rate of return earned by an
investment
• Can be calculated using a financial calculator,
spreadsheet, graph or trial and error approach
The rate where Initial investment = PV of cashflows
• Therefore, it is the discount rate wherein NPV = 0
• We will use trial and error approach then
interpolate, range of answer will be provided
• Decision rule: accept if equal or greater than
hurdle rate or cost of capital
NPV-IRR relationship
• NPV Profile- Graph that depicts a project’s
NPVs for various discount rates.
NPV, PI and IRR
• Harry's Inc. is considering a project that has the
following cash flow and WACC data. What is the
project’s NPV, PI and IRR (20-22%)?
WACC 10%
Year 0 1 2 3 4 5
Cash flows -1M 300,000 200,000 400,000 400,000 500,000
• Conductor’s Inc. is evaluating a new etching

equipment. The equipment costs P3,750,000 and
will generate after-tax cash inflows of P660,500
per year for 7 years. Assume the firm has a 7% cost
of capital. Compute the equipment’s NPV, PI and
IRR (5-9%).
IRR: Multiple IRRs
• When project cash flows have multiple sign
changes, there can be multiple IRRs.
• Example: If we plot the NPV profile using
the data below:
Year Cash Flow (P in millions)
0 +100
1 -460
2 +791
3 -602.6
4 +171.6
NPV Profile with Multiple IRRs
IRR
the maximum number of IRRs equal the

number of sign changes in the CF stream
IRR: No Real Solution
• Sometimes projects do not have a real

IRR solution.
• try Cash flow 0 = P100, Cash flow 1 = -
P200 and Cash Flow 2 = P150
• There is no real number that will make
NPV=0, so no real IRR.
• Project is acceptable based on NPV. Using
r =10%, project has positive NPV of
P42.15.
methods)
2. Payback Period
methods)
Modified IRR (MIRR)
• The compound annual rate of return earned by an
investment whose cash flows have been moved through
time so as to eliminate the problem of multiple IRRs
• Method (1) discount all negative cashflow to time zero
then compute IRR
• Method (2) discount all negative cashflow to time zero
then compound all positive cashflow to project’s
termination known as terminal value (TV) and apply the
following formula:
• Decision rule: accept if equal or greater than hurdle

rate or cost of capital
IRR and MIRR
• Manheim Candles is considering a project
with the following incremental cash flows.
Assume a discount rate of 11%.
Year Cash Flow
0 (55,000)
1 (12,000)
2 75,000
3 (52,000)
4 83,000
Calculate the project’s MIRR using method 1
(14-16%) and method 2 (14-16%)
Comparison of Techniques
Ideal/ Preferred ARR PB NPV PI IRR

Easy application ✗ ✗ ✗
Cash Flow ✗ *
Time Value ✗ ✗
Higher Stock Price ✗ ✗ ✗ ✗
*not fully since it ignores cashflow after cutoff

• NPV is the most theoretically correct model
to use since it measures how much wealth a
project creates (or destroys)
• Despite this, financial managers uses IRR as

often as NPV due to general disposition of
business people to think in terms of rates of
returns rather than actual peso returns,
smaller firms normally uses payback period
due to its simplicity
Independent vs. Mutually Exclusive
Independent projects- projects whose cash flows are

unrelated to one another; hence, the acceptance of one
does not eliminate the others from further consideration
Mutually exclusive projects- projects that compete with

one another so that the acceptance of one eliminates
from further consideration all other projects that serve a
similar function (e.g. substitutes)
Accept-reject or ranking approach
a) Unlimited funds- financial situation in which a firm is
able to accept all independent projects that provide an
acceptable return
• Accept-reject approach- the evaluation of projects
to determine whether they meet the firm’s minimum
acceptance criterion
b) Capital rationing- financial situation in which a firm has
only a fixed number of pesos available for capital
expenditures and numerous projects compete for these
pesos
• Ranking approach- ranking projects on the basis of
some predetermined measure, such as the rate of
return; then select highest to lowest up to the point
that the capital budget is exhausted
Ranking Projects
Galaxy Satellite Co. is attempting to select the best group
of independent projects competing for the firm’s fixed
capital budget of P10,000,000. Any unused portion of
this budget will earn less than its 20 percent cost of
capital. A summary of key data about the proposed
projects follows.
Conflicting rankings
• Conflicts in ranking given by NPV and IRR

• NPV, IRR and PI do not always agree when
evaluating or ranking competing projects.
• Problems in project ranking maybe due to:

1. Scale or size disparity
2. Time disparity
3. Unequal lives (NPV only)
 Results from differences in implicit assumption concerning the
reinvestment of intermediate cash inflows- NPV assumes
intermediate cash flows are reinvested at the cost of capital, while IRR
assumes that they are reinvested at the IRR.
Conflicts Between NPV and IRR:
The Scale Problem
Project IRR NPV (18%)
Western Europe 27.8% P75.3 M
Southeast U.S. 36.7% P25.7 M
• The Southeast U.S. project has a higher

IRR, but doesn’t increase shareholders’
wealth as much as the Western Europe
project.
The Scale Problem
• The scale of the Western Europe
expansion is roughly five times that of
the Southeast U.S. project.
• Even though the Southeast U.S.
investment provides a higher rate of
return, the opportunity to make the
much larger Western Europe investment
is more attractive.
• PI also suffers from the Scale Problem
The Timing Problem
Product Development Marketing Campaign
(in millions) (in millions)
Initial outlay -1000 -1000
1 0 450
2 50 350
3 100 300
4 200 200
5 1500 100
IRR 14.1% 15.9%

NPV (@10%) 184.44 122.44
• The product development proposal generates a higher

NPV, whereas the marketing campaign proposal offers a
higher IRR.
The Timing Problem
Crossover rate
Crossover rate (or Fischer-intersection)- is the cost of capital at which

the net present values of two projects are equal.
The Timing Problem
Product Development Marketing Campaign
(in millions) (in millions)
Initial outlay -1000 -1000
1 0 450
2 50 350
3 100 300
4 200 200
5 1500 100
IRR 14.1% 15.9%

NPV (@10%) 184.44 122.44
NPV @ 12.4738% 68.15 68.15

NPV @ 15% -36.33 17.28
• If the cost of capital is greater than the crossover rate, then
the IRR and the NPV criteria will not result in a conflict
between the projects. The marketing campaign project will
rank higher by both criteria.
Problem on unequal lives
• 2 solutions:
1. Compute annualized net present value or equivalent
annual cost
2. Use of replacement chain
• Annualized NPV has same calculation
with equivalent annual cost (EAC)
1. Compute NPV of each project for their respective lifetimes
2. Compute annual expenditure/ income (annuity) to equal to NPV of of each
project
3. Select the highest annuity if net inflow or project with lowest annuity if net
outflow
• King Corp. is considering replacing its old
printer. The firm has two options to choose
from: Printer 113 and Printer 864. The NPV of
Printers 113 and 864 at 10% cost of capital
are (55,000) and (28,000), respectively.
Printers 113 and 864’s useful lives are 8 and 3
years, respectively.
• Compute for the equivalent annual cost of
each printers to determine which one to
purchase as a replacement.
• Replacement chain- computing for NPV

over a longer time horizon until both
projects will have the same replacement
year
– 1. Time horizon = project 1 life x project 2
life
– 2. Compute for the NPV of project 1 & 2 over
the time horizon determined
– 3. Select the project with higher positive
NPV or lower negative NPV
• Thompson Manufacturing must choose between two

types of furnaces to install. Model A has a 6-year life,
and an NPV of P15,000. Model B has a 3-year life,
and an NPV of P10,500. The relevant discount rate is
10%.
• Which model should be chosen?
Year 0 1 2 3 4 5 6
Model A 15,000
Model B 10,500
10,500
Lease vs. purchase analysis
• Lease vs. purchase decision- : whether to lease the

assets or to purchase them,
• Apply Net Present Value in evaluating the leasing and
purchasing alternatives
STEP 1- Compute for after-tax cash flows for each year
under lease alternative
STEP 2- Compute for after-tax cash flows for each year
under purchase alternative
STEP 3- Calculate present value of cash flows for both
alternatives using applicable cost of capital
STEP 4- Choose alternative with lower present value of
cash outflows
Lease vs. Purchase
Bessy Aviation is considering leasing or purchasing a
small aircraft to transport executives between
manufacturing facilities and the main administrative
headquarters. The firm is in the 30% tax bracket and its
cost of debt is 10%. The estimated after-tax cash flows
for the lease and purchase alternatives are given below:
End of Year Lease Purchase
0 0 -1,050,000
1 -144,000 -36,000
2 -144,000 -36,000
3 -144,000 -36,000
4 -144,000 -36,000
5 -144,000 557,000
Advantages and Disadvantages
of Leasing over Purchasing
• Advantages • Disadvantages
1. Avoid cost of obsolescence 1. Return to the lessor is high
2. Avoid restrictive covenants 2. Salvage value of the asset is
3. Financing flexibility (for low-cost realized by lessor
assets infrequently acquired) 3. Prohibited from making
4. Increase liquidity (sale-leaseback) improvements without prior
5. Lease payment on land is tax approval
deductible 4. Lease payments are still due
6. Better financial ratios (operating even if the asset becomes
lease) obsolete
7. 100% financing
8. Lower claim in case of bankruptcy
Contents
2.3.1 Non-discounted Cash Flow Techniques
2.3.3 NPV-IRR Relationship
2.3.1.1 Payback Period
2.3.3.1 NPV Profile
2.3.1.2 Accounting Rate of
2.3.3.2 Crossover rate
Return
2.3.4 Capital Rationing and Project Selection
2.3.1.3 Payback Reciprocal
2.3.4.1 Lease vs. purchase
2.3.1.4 Bailout Payback
2.3.4.2 Project ranking
2.3.2 Discounted Cash Flow Techniques
2.3.4.3 Problems in project ranking
2.3.2.1 Net Present Value (NPV)
2.3.4.3.1 Size disparity
2.3.2.2 Present Value Index
2.3.4.3.2 Time disparity
2.3.2.3 Discounted Payback Period
2.3.4.3.3 Unequal lives
2.3.2.4 Internal Rate of Return (IRR)
2.3.4.3.3.1 Annualized NPV or
2.3.2.5 Modified IRR (MIRR)
equivalent annual
annuity
2.3.4.3.3.2 Replacement
chain
Key Takeaway
• The simplest techniques do not always lead firms to make the
best investment decisions
• At NPV=0, IRR= cost of capital and PI=1.0
• At negative NPV, there is no discounted payback period
• MIRR resolve the multiple IRR problem
• Theoretically, the best decision technique is NPV.
• NPV assumes cash flow are reinvested at cost of capital while
IRR assumes it is reinvested at IRR
• NPV, IRR and PI often give the same accept-reject decisions
but do not necessarily rank projects the same due to:
1. Scale or size disparity
2. Time disparity
3. Unequal lives
Questions?
End of 2.3
Seatwork
Swerling Company is considering a project with the following cash
flows.
Year Cash Flow
0 (P25,000)
1 P 5,500
2 P 6,000
3 P 7,500
4 P 8,000
5 P 9,500
The company’s required rate of return is 9%.
Compute for NPV, PI, IRR with range of 10-14%, PP, DPB, and PRR
Answer to SW
• NPV – P2,729.08
• PI – 1.11
• IRR (10%-14%) – 12.74%
• Payback period – 3.75 years
• Discounted payback – 4.56 years
• Reciprocal payback rate- 26.67%

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2.

3 Capital Budgeting Techniques

Preferred or ideal traits of a technique:

• Non-discounted Cash Flow Techniques (Simple

• Calculation of a hurdle rate by dividing contribution to

• Average Contribution to net income are estimated by

• Non-discounted Cash Flow Techniques (Simple

• For mixed stream, use cumulative cash flow to determine

• Non-discounted Cash Flow Techniques (Simple

• Decision rule: accept if equal or greater than hurdle

• Accurate as an estimated IRR only when (a) project life

• Non-discounted Cash Flow Techniques (Simple

• Non-discounted Cash Flow Techniques (Simple

No. of years prior to Unrecovered investment at start of recovery year*

• Non-discounted Cash Flow Techniques (Simple

• NPV is the difference in the present value of an

• Decision rule: accept if equal or greater than P0

• Non-discounted Cash Flow Techniques (Simple

• A variation of the NPV stated in ratio

• Decision rule: accept if equal or greater than

• Non-discounted Cash Flow Techniques (Simple

• Conductor’s Inc. is evaluating a new etching

the maximum number of IRRs equal the

• Sometimes projects do not have a real

• Decision rule: accept if equal or greater than hurdle

Ideal/ Preferred ARR PB NPV PI IRR

Higher Stock Price ✗ ✗ ✗ ✗

*not fully since it ignores cashflow after cutoff

• Despite this, financial managers uses IRR as

Independent projects- projects whose cash flows are

Mutually exclusive projects- projects that compete with

• Conflicts in ranking given by NPV and IRR

• Problems in project ranking maybe due to:

Project IRR NPV (18%)

Western Europe 27.8% P75.3 M

Southeast U.S. 36.7% P25.7 M

• The Southeast U.S. project has a higher

IRR 14.1% 15.9%

• The product development proposal generates a higher

Crossover rate (or Fischer-intersection)- is the cost of capital at which

IRR 14.1% 15.9%

NPV @ 12.4738% 68.15 68.15

• Replacement chain- computing for NPV

• Thompson Manufacturing must choose between two

• Lease vs. purchase decision- : whether to lease the

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