Capital Budgeting Techniques

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Agenda
NPV Rule & and Stand-Alone Projects

IRR
MIRR
Payback Rule
Book rate of Return
Profitability Index
Numerical

Techniques Used
Survey Data on CFO Use of Investment Evaluation Techniques
NPV, 75%

IRR, 76%

Payback, 57%

Book rate of
return, 20%
Profitability
Index, 12%
0%

20%

40%

60%

80%

100%

Source - Graham and Harvey, The Theory and Practice of Finance: Evidence from the
Field, Journal of Financial Economics 61 (2001), pp. 187-243.
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Techniques Used
Two approaches:
Discounting: takes time value of money into consideration
Non-discounting: simple and still of value

NPV Rule
Why use NPV rule to evaluate projects
Accepting positive NPV projects increases value
of the firm
NPV uses cash flows (CF)
NPV uses not just CF but all the CFs of the
project
NPV discounts the cash flows appropriately
(opportunity cost of capital)

NPV Rule
Net Present Value (NPV) =
Total PV of future CFs + Initial Investment
Estimating NPV
Estimate future cash flows - how much? and when?
Estimate rate
Estimate initial costs

Minimum Acceptance Criteria: Accept if NPV > 0

Ranking Criteria: Choose the highest NPV
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NPV Rule
Consider the following two options:
1. Invest the $100 in a riskless project and pay out $107,
1 year from now as dividends
2. Pay out the $100 today

The opportunity cost is 6%

Consider the options from the firms angle and the
shareholders angle refer to your text for greater
details

NPV Rule & Stand-Alone Projects

Consider a take-it-or-leave-it investment decision
involving a single, stand-alone project for FFF Co
The project costs $250 million and is expected to
generate cash flows of $35 million per year, starting at
the end of the first year and lasting forever
What is the NPV of the project?

NPV Rule & Stand-Alone Projects Sensitivity

At 10% cost of capital (opportunity cost, discount
rate) the NPV is 100 million
At 14%, the NPV is equal to 0, thus the projects
IRR is 14%

For FFF, if their cost of capital is more than 14%,

the NPV would be negative
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NPV Rule & Stand-Alone Projects

400.00
350.00
300.00
250.00
200.00
150.00
100.00

14%

50.00
(50.00) 6%

8.50%

11.00%

13.50%

16.00%

18.50%

21.00%

23.50%

(100.00)
(150.00)

In general, the difference between the actual cost of

capital (r) and the IRR is the maximum amount of
estimation error in the cost of capital estimate that can
exist without altering the original decision
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NPV Rule
Why is NPV widely used

Uses cash flows (not accounting numbers)

Uses ALL cash flows of the project
Discounts ALL cash flows appropriately
Reinvestment assumption: the NPV rule assumes
that all cash flows can be reinvested at the
discount rate

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NPV Rule
Sometimes alternative investment rules may give
the same answer as the NPV rule, but at other
times they may disagree.
When the rules conflict, the NPV decision rule should
generally be followed.

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NPV Rule
Consider the following example

XYZ company has the following cash flows for a

project
Year
0
1
2
3

CF
(5,550,000)
5,000,000
4,000,000
(3,000,000)

Plot the NPV profile

What is the IRR
If the cost of capital is 12%, would you accept it
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Internal Rate of Return (IRR)

IRR is the discount that sets NPV to zero or
It is the discount rate that will equate the present
value of the outflows with the present value of the
inflows
The IRR is the projects intrinsic rate of return
Minimum Acceptance Criteria
Accept if the IRR exceeds the required return

Ranking Criteria
Select alternative with the highest IRR

Reinvestment assumption
All future cash flows assumed reinvested at the IRR
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Internal Rate of Return (IRR)

Disadvantages

Does not distinguish between investing and borrowing

IRR may not exist
There may be multiple IRR
Mutually exclusive projects (scale and timing of CF)

Advantages
Easy to understand and communicate

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Internal Rate of Return (IRR)

Situations where the IRR rule and NPV rule may be
in conflict
Delayed Investments (Are we borrowing or lending)
Nonexistent IRR
Multiple IRRs
Mutually exclusive projects (timing and scale)

Implicit in the IRR calculation is that that discount

rates are stable during the term of the project This implies that all funds are reinvested at the
IRR (which may not be the case)
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Internal Rate of Return (IRR)

Consider the following example

You can purchase a turbo powered machine tool

gadget for $6,500. The investment will generate
$3,500 and $5,500 in cash flows for two years,
respectively. What is the IRR on this investment?

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Internal Rate of Return (IRR)

Delayed Investments
Assume you have just retired as the CEO of a
successful company - A major publisher has offered
you a book deal
The publisher will pay you $1.0 million upfront if you
agree to write a book about your experiences
You estimate that it will take three years to write the
book
Assume that the time you spend writing will cause you
to give up speaking engagements amounting to
$500,000 per year
You estimate your opportunity cost to be 10%
Should you accept the deal?
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Internal Rate of Return (IRR)

Nonexistent IRR
Assume now that you are offered $500,000 per year if
you agree to go on a speaking tour for the next three
years
If you lecture, you will not be able to write the book
(however, as of now there is no book deal)
Compute the IRR and NPV

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Internal Rate of Return (IRR)

Multiple IRRs
Now assume the lecture deal is still in
discussion with a tentative offer and you decide
to negotiate with the book publisher
You inform the publisher that they need to
increase the offer before you will accept it
The publisher then agrees to make royalty
payments of $20,000 per year forever, starting a
year after the book is published in three years
Should you accept or reject the new offer?

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Internal Rate of Return (IRR)

When do you have multiple IRRs?
Generally when the cash flows change direction
you have multiple IRRs

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Internal Rate of Return (IRR)

Mutually exclusive projects
IRR sometimes ignores the magnitude and timing
of the projects cash flows
The following two projects illustrate that problem
$10,000

$1,000

$1,000

Project A
0

-$10,000
$1,000

$1,000

$12,000

Assume cost
of capital is
8%

Project B
0

-$10,000
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Internal Rate of Return (IRR)

In such a case the crossover rate is important and the
discount rate to be used
Steps
Compute IRR (A)
Compute IRR (B)
NPV (A)
NPV (B)
Compute the incremental CF ensure the first one is
negative to the extent possible
Compute the crossover rate/IRR of the incremental CF
Compute the NPV of the incremental project CF at the cost
of capital
Choose A or B
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Internal Rate of Return (IRR)

Shortcomings of the Incremental IRR Rule
The incremental IRR may not exist
Multiple incremental IRRs could exist
You must ensure that the incremental cash flows are initially
negative and then become positive
The incremental IRR rule assumes that the riskiness of the
two projects is the same

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Internal Rate of Return (IRR)

Scale (example 5.2 pg 174-175)
Two options to a project: small budget or long
budget
Small Budget
Large Budget

CF (0)
-10m
-25m

CF (1)
40m
65m

NPV at 25%
22m
27m

IRR
300%
160%

You want to go by the NPV rule and choose the large

budget project but your manager says convince me
why is the IRR rule may not be appropriate given that
that small budget project has a higher IRR. What do
you do, given that the discount rate is 25%?
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Internal Rate of Return (IRR)

Scale

If a projects size is doubled, its NPV will double

This is not the case with IRR
In such cases, the IRR rule cannot be used to
compare projects of different scales

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Internal Rate of Return (IRR)

Consider the following example

Friends
Business

Your
Laundromat

Initial Investment

$1,000

$1,000

Cash FlowYear 1

$1,100

$400

Annual Growth Rate

-10%

-20%

Cost of Capital

12%

12%

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Internal Rate of Return (IRR)

What if the laundromat project is 20 times larger assume
you can scale it up easily but not the friends business

The NPV would be 20 times larger but the IRR

remains the same at 20%

Now what would be your decision?

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IRR using interpolation

Consider the following cash flows. The hurdle rate
is 25%. Compute the IRR and based on the IRR
what is your decision?

0
1
2
3
4
5

-2700
1100
1600
850
1100
900
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Internal Rate of Return (IRR)

Percentage Return Versus Impact on Value
Would you prefer a 200% return on $2 or a 10%
return on $2 million?
The former investment makes only $4, while the
latter opportunity makes $200,000
The IRR is a measure of the average return, but
NPV is a measure of the total dollar impact on value

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Modified Internal Rate of Return (MIRR)

Let PV = PV of the cash outflows (discounted appropriately)
Let TV = FV of all cash inflows (compounded appropriately)
The compounding and discounting is at the cost of
capital
Then MIRR is obtained by solving the following
equation
PV = TV/(1+MIRR)N
Advantage cash flows are reinvested at the cost of
capital
The issue with multiple rates would not exist
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Modified Internal Rate of Return (MIRR)

Consider the following example

ABC Ltd. is evaluating a project that has an initial

investment of 1200 and the following cash flow
stream

1
2
3
4
200 100 -300 500

5
700

The cost of capital (opportunity cost) is 12.0% Should ABC Ltd. accept the project using the MIRR
rule
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Modified Internal Rate of Return (MIRR)

Consider the XYZ Co. example from before
Compute the MIRR
Does the decision change?

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Payback Rule
How long does it take the project to pay back its
initial investment
Payback Period = number of years to recover
initial costs
Minimum Acceptance Criteria:
set by management

Ranking Criteria:
set by management

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Payback Rule
Disadvantages
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback
criteria may not have a positive NPV
Advantages
Easy to understand
Biased toward liquidity
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Payback Rule
Consider the following example

Suppose that FFF company requires all projects to

have a payback period of 5 years or less would
they undertake the project we discussed?

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Payback Rule
Consider the following problem

Projects A, B, and C each have an expected

life of 5 years
Given the initial cost and annual cash flow
information below, what is the payback period
for each project?
A

Cost

$75

$110

$150

Cash Flow

$20

$25

$30
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Payback Rule
Consider the following example

Infoline Online has the following cash flows for a period

of four years. What is the payback period

Year
0
1
2
3
4

CF
(5,450,000)
1,508,000
1,773,100
1,897,910
2,753,941
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Payback Rule
To incorporate the Time value of money there is a
modification of the payback rule called the
discounted payback rule.
How long does it take the project to pay back its
initial investment taking the time value of money
into account
By the time you have discounted the cash flows, you might as well
calculate the NPV!

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Payback Rule
Use the Infoline example from before and
assuming a discount rate of 12% compute the
discounted payback

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Profitability Index
NPV
Profitabil ity Index
Investment
If PI > 0 accept, <0 reject
Ranking Criteria - Select alternative with highest PI
Disadvantages
Problems with mutually exclusive investments wherein NPV
and PI have differences
Advantages
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
Helps in optimal combination of projects to undertake

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Profitability Index
BCR PVCI
PVCO

This is also known as benefitscost ratio

NET BCR (PI) =(PVB-I)/I=BCR-1

Decision Rules:
BCR
>1
=1
<1

NBCR(PI)
>0
=0
<0

Rule
Accept
Indifferent
Reject

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Profitability Index
When resources are limited, the profitability index
(PI) provides a tool for selecting among various
project combinations and alternatives
A set of limited resources and projects can yield
various combinations

The highest weighted average PI can indicate which

projects to select

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Profitability Index

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Profitability Index
In some situations the profitability Index does not give an
accurate answer
Suppose in Example 6.4 that NetIt has an additional small
project with a NPV of only $100,000 that requires 3 engineers
what happens

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Profitability Index
Consider the following example

You only have RS.300,000 to invest, Which do we

select?
Proj
A
B
C
D

NPV Invest
276
200
151.25 125
213.5
175
211.5
150

PI
1.38
1.21
1.22
1.41

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Profitability Index
Compute Weighted average PI, and choose the highest WAPI
Options only A, BC, BD

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Book Rate of Return

Also known as Average Accounting Return Rule
Average net income (project earning) divided by average
book value over project life (or average book value of the
investment)
Another simple non-cash flow approach
Ranking Criteria and Minimum Acceptance Criteria set by
management
Disadvantages
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market
values
Advantages
The accounting information is usually available
Easy to calculate
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Book Rate of Return

Consider the following example
A manufacturer is considering building a new production plant
in a new town. It will require an initial capital investment of
$12 million and the plant will be depreciated on a straightline basis over the next four years of its use. The new
project will generate incremental net income of $1,100,000,
$1,350,000, $1,200,000 and $2,100,000 over each of the
next four years for the company. What is the average
accounting return (AAR) for this project?

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Numerical 1
The firm for which you work must choose between the
following two mutually exclusive projects - The appropriate
discount rate for the projects is 10 percent
Project A
Project B

C0
-1000
-500

C1
1000
500

C2
500
400

PI
0.32
0.57

NPV
322.31
285.12

The firm chooses to undertake A. At a luncheon for the

shareholders, the managers of a pension fund that owns a
substantial amount of the firms stock asked you why the firm
chose project A instead of project B when B is more profitable.
How would you justify your firms action? Are there any
circumstances under which the pension fund managers
argument could be correct?
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Numerical 2
Orchid Biotech Company is evaluating several development projects for
experimental drugs. Although the cash flows are difficult to forecast, the
company has come up with the estimates of the initial capital requirements
and NPVs for the projects as shown below. Given a wide variety of staffing
needs, the company has also estimated the number of research scientists
requirements for each development project (all cost values are given in
millions of dollar)
Suppose that orchid has a total
capital budget of $60 million.
Initial
#
How should it prioritize these
Capital
Scientists
NPV
Project
projects?
I
II
III
!V
V

10.00
15.00
15.00
20.00
30.00

2
3
4
3
10

10.10
19.00
22.00
25.00
60.20

Suppose that orchid currently

has 12 research scientists and
does not anticipate to be able
to hire any more in the future.
How should Orchid prioritize
these projects?
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Numerical 3
Consider the following 2 mutually exclusive projects
0
1
2
3
4

A
(300,000)
20,000
50,000
50,000
390,000

B
(40,000)
19,000
12,000
18,000
10,500

Assuming that your opportunity cost is 15%, which projects would you choose
a. Using the payback criterion? Why?
b. Discounted payback criterion? Why?
c. NPV criterion? Why?
d. Using the IRR criterion? Why?
e. Using the Profitability criterion? Why?
f. Based on your answers in (a) (e) above, which project will you finally
choose? Why?
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Numerical 5
Your firm is considering two mutually exclusive
projects A and B. Project A involves an initial outlay
of Rs.100m and will generate an expected cash
inflow of Rs.25 m per year for 6 years. Project B
involves an initial outlay of Rs.50 m and will
generate an expected cash inflow of Rs.13 m per
year for 6 years. Both projects have a similar risk
and the firms cost of capital is 12%
a) Calculate the NPV and IRR of each project
b) Calculate the NPV and IRR of the incremental
(differential) project
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Summary
Discounted CF techniques
NPV
IRR
MIRR
PI
Payback Criteria
Payback
Discounted Payback
Accounting Criterion
AAR/Book Rate of Return

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Thank You!

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