Capital Budgeting

FIN 502: Managerial Finance

George W. Gallinger
Associate Professor of Finance
W. P. Carey School of Business
Arizona State University
Typical Capital Budgeting
System

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Illustration of Sustainable
Growth

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Calculating Accounting Rate
of Return

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Calculating Payback Period

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Calculating Discounted
Payback Period

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Calculating NPV

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Calculating NPV…

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 Use Nominal or Real WACC?

 Nominal return reflects the actual dollar return; real return

measures the increase in purchasing power gained by
holding a certain investment

(1 + nominal rate) = (1 + inflation rate) ×(1 + real rate),

1 + nom 
or, real rate =   −1
 1 + inf 
 Common in capital budgeting is the use of market rates of
return at the time of the analysis
 Market interest rates have embedded an assumption about
inflation
 Use nominal cash flows to reflect the same inflation rate as
that embedded in discount rate.
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Risk-Return Tradeoff for
Projects
 Projects plotting above
the security market line
(SML) have rates of
return in excess of their
required market rates
 Positive NPVs
 Projects plotting below
the SML have rates of
return less than their
required market rates
 Negative NPVs
 Projects plotting on the
SML earn their market
rates
 Zero NPVs.

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Calculating IRR

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Illustration for Calculating IRR

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 IRR & Required Risk-Adjusted
Rate
 Appropriate rates for
comparing project
returns are those falling
on the upward sloping
market risk-return trade-
off curve
 Not the firm’s horizontal
cost of capital line,
WACC
 WACC is only
appropriate for
evaluating projects with
risk comparable to the
level of risk of the firm
 “Carbon copy” projects.

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Size Problem

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Cash Flow Pattern Problems

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Multiple IRR Solutions

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Undervaluation of Later Cash
Flows

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Calculating the Profitability
Index

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 Comparison of Project
Rankings
 Project B is better
than project A
 Project B continues
to earn cash flows
longer
 Project D is more
desirable than
project C
 Although both
projects generate
the same amount
of cash flows,
project D does it
earlier
 Unanswered
question:
 Is Project D better
than
W. P. project
Carey B?MBA Program
Executive Slide 19
Sunk Costs

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Salvage Value Comparisons

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Calculating Initial Investment

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Calculating Annual Operating
Cash Flows

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Alternatively, Calculating Annual
Operating Cash Flows…

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Calculating Terminal Cash
Flows

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Salvage Value: Present vs.
Future

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Another Topic:
Competing Projects
 Assume projects
 Mutually exclusive
 On-going
 Different economic lives
 How do you select the correct
project?

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Example
 There are times when application of the NPV
rule can lead to the wrong decision
 Consider a factory which must have an air
cleaner
 The equipment is mandated by law, so there is no
“doing without”
 There are two choices:
 The “Cadillac cleaner” costs $4,000 today, has
annual operating costs of $100 and lasts for 10
years
 The “cheaper cleaner” costs $1,000 today, has
annual operating costs of $500 and lasts for 5 years
 Which one should we choose?
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 Example …
 At first glance, the cheap cleaner has the
“better” NPV (r = 10%):
10
$100
NPVCadillac = −$4,000 − ∑ t
= −4,614.46
t =1 (1.10)
5
$500
NPVcheap = −$1,000 − ∑ t
= −2,895.39
t =1 (1.10)

 Overlooks the fact that the Cadillac cleaner lasts twice as

long
 When we incorporate project life, the Cadillac cleaner is
actually cheaper.
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 Example …
 The Cadillac cleaner time line of cash flows:
-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100

0 1 2 3 4 5 6 7 8 9 10
10
$100
NPVCadillac = −$4,000 − ∑ t
= −4,614.46
t =1 (1.10)

 The “cheaper cleaner” time line of cash flows over ten

years:
-$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500

0 1 2 3 4 5 6 7 8 9 10
5
$500 $1,000 10 $500
NPVcheap = −$1,000 − ∑ t
− 5
−∑ t
= −$4,693.20
t =1 (1.10) (1.10) t =6 (1.10)
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 Investments of Unequal Lives
 Replacement Chain
 Repeat the projects forever, find the PV of that
perpetuity
 Assumption: Both projects can and will be repeated
 Matching Cycle
 Repeat projects until they begin and end at the
same time—like we just did with the air cleaners
 Compute NPV for the “repeated projects”
 The Equivalent Annual Annuity (EAA) Method.

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 Equivalent Annual Cost
Method
 Equivalent Annual Annuity Method
 Provides the value of the level payment annuity that
has the same PV as the original set of cash flows
 NPV = EAA × ArT
 For example, the EAA for the Cadillac air cleaner is
$750.98
10 10
$100 $750.98
∑ (1.10) ∑ (1.10)
Annuity Table
− $4,000 − t
= −4,614.46 = t 10%, 10 years
= 6.1446
t =1 t =1

The EAA for the cheaper air cleaner is $763.80,

which confirms our earlier decision to reject it.
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Another Example:
Calculating EAA

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 Human Face of Capital
Budgeting
 NPV of a project  based on assumptions
 Managers must be aware of optimistic bias in these
assumptions made by supporters of the project
 Companies need control measures to remove
bias
 Analysis done by a group independent of individual or
group proposing the project
 Analysts must have a sense of what is reasonable
when forecasting a project’s profit margin and its
growth potential
 Another side of determining which projects
receive funding – storytelling
 Best analysts not only provide numbers to highlight a
W.good
P. Careyinvestment, but also can explain why this
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investment makes sense.
The End

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