Capital Budgeting
Techniques
13-1
13-2
Capital Budgeting
Techniques
13-3
Potential Difficulties
Capital Rationing
Project Monitoring
Post-Completion Audit
Project Evaluation:
Alternative Methods
13-4
Independent Project
For
-40 K
10 K
12 K
15 K
4
10 K
5
7K
Cumulative
Inflows
13-8
10 K
10 K
12 K
22 K
PBP
3 (a)
15 K
37 K(c)
4
10 K(d)
47 K
=a+(b-c)/d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years
5
7K
54 K
-40 K
10 K
12 K
15 K
10 K
-40 K
-30 K
-18 K
-3 K
7K
PBP
Cumulative
Cash Flows
13-9
5
7K
14 K
= 3 + ( 3K ) / 10K
= 3.3 Years
PBP Strengths
and Weaknesses
Strengths:
Weaknesses:
Can be used as a
measure of
liquidity
Easier to forecast
ST than LT flows
Cutoff period is
subjective
13-11
+...+
CFn
(1+IRR)n
IRR Solution
$10,000
$12,000
$40,000 =
+
+
(1+IRR)1 (1+IRR)2
$15,000
$10,000
$7,000
+
+
(1+IRR)3
(1+IRR)4 (1+IRR)5
.10
IRR $40,000
.15
X
.05
13-16
$41,444
$36,841
$1,444
$4,603
$1,444
$4,603
.10
IRR $40,000
.15
X
.05
13-17
$41,444
$36,841
$1,444
$4,603
$1,444
$4,603
.10
$41,444
$1,444
IRR $40,000
.15
$4,603
$36,841
X = ($1,444)(0.05)
$4,603
X = .0157
13-20
CF
2nd
CLR Work
-40000 Enter
key
keys
keys
Step 4:
Step 5:
Step 6:
Step 7:
10000
1
12000
1
Enter
Enter
Enter
Enter
15000
1
Enter
Enter
keys
keys
keys
keys
keys
keys
13-22
10000
1
7000
1
Enter
Enter
Enter
Enter
keys
keys
keys
keys
Step 14:
Step 15:
Press
Press
IRR
keys
key
Step 16:
Press
CPT
key
Result:
IRR Strengths
and Weaknesses
Strengths:
Accounts for
TVM
Considers all
cash flows
13-23
Less
subjectivity
Weaknesses:
Difficulties with
project rankings and
Multiple IRRs
CF2
(1+k)2
CFn
- ICO
+...+
n
(1+k)
NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1
(1.13)2
(1.13)3
$10,000 $7,000
+
$40,000
4
5
(1.13)
(1.13)
13-25
NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428
13-26
CF
2nd
CLR Work
-40000 Enter
key
keys
keys
Step 4:
Step 5:
Step 6:
Step 7:
10000
1
12000
1
Enter
Enter
Enter
Enter
15000
1
Enter
Enter
keys
keys
keys
keys
keys
keys
13-30
10000
1
7000
1
Step 14:
Step 15:
Press
Press
Enter
Enter
Enter
Enter
keys
key
NPV
Enter
keys
keys
keys
keys
13
keys
Step 17:
Press
CPT
Result:
key
NPV Strengths
and Weaknesses
Weaknesses:
Strengths:
Cash flows
assumed to be
reinvested at the
hurdle rate.
Considers all
cash flows.
13-31
$000s
15
Sum of CFs
10
5
IRR
NPV@13%
0
-4
0
13-32
6
9
12
Discount Rate (%)
15
CF1
PI =
(1+k)1
CF2
CFn
+...+
2
(1+k)
(1+k)n
<< OR >>
Method #2:
13-34
PI = 1 + [ NPV / ICO ]
ICO
PI Acceptance Criterion
PI
= $38,572 / $40,000
= .9643 (Method #1, 13-34)
PI Strengths
and Weaknesses
Strengths:
Weaknesses:
Same as NPV
Same as NPV
Allows
comparison of
different scale
projects
Provides only
relative profitability
Potential Ranking
Problems
13-36
Evaluation Summary
Basket Wonders Independent Project
13-37
PBP
3.3
3.5
Accept
IRR
11.47%
13%
Reject
NPV
-$1,424
$0
Reject
PI
.96
1.00
Reject
Other Project
Relationships
Dependent
-- A project whose
acceptance depends on the
acceptance of one or more other
projects.
Mutually Exclusive -- A project
whose acceptance precludes the
acceptance of one or more
alternative projects.
13-38
Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may
create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
13-39
A. Scale Differences
Compare a small (S) and a
large (L) project.
END OF YEAR
13-40
-$100
-$100,000
$400
$156,250
Scale Differences
Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?
Project
IRR
100%
25%
13-41
NPV
PI
231
3.31
$29,132
1.29
END OF YEAR
13-42
0
1
-$1,200
1,000
-$1,200
100
500
600
100
1,080
13-43
IRR
NPV
PI
23%
$198
1.17
17%
$198
1.17
13-44
600
400
Project I
200
NPV@10%
IRR
Project D
0
-200
10
15
20
Discount Rate (%)
25
13-45
At k<10%, I is best!
Fishers Rate of
Intersection
At k>10%, D is best!
10
15
20
Discount Rate ($)
25
END OF YEAR
13-46
0
1
-$1,000
0
-$1,000
2,000
3,375
13-47
Project
IRR
NPV
PI
50%
$1,536
2.54
100%
$ 818
1.82
Another Way to
Look at Things
1.
Year
CF
-$1,000
$0
$0
Results:
IRR* = 34.26%
3
$2,420
NPV = $818
Replacing Projects
with Identical Projects
2.
-$1,000
-$1,000
Results:
$2,000
-1,000
$1,000
IRR = 100%
$2,000
-1,000
$2,000
$1,000
$2,000
NPV* = $2,238.17
Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for
this capital budgeting period.
13-50
ICO
$
500
5,000
5,000
7,500
12,500
15,000
17,500
25,000
IRR
18%
25
37
20
26
28
19
15
NPV
PI
50
6,500
5,500
5,000
500
21,000
7,500
6,000
1.10
2.30
2.10
1.67
1.04
2.40
1.43
1.24
ICO
IRR
NPV
PI
$ 5,000
15,000
12,500
5,000
37%
28
26
25
$ 5,500
21,000
500
6,500
2.10
2.40
1.04
2.30
ICO
$15,000
17,500
5,000
IRR
NPV
PI
28%
19
25
$21,000
7,500
6,500
2.40
1.43
2.30
ICO
IRR
NPV
PI
$15,000
5,000
5,000
7,500
17,500
28%
25
37
20
19
$21,000
6,500
5,500
5,000
7,500
2.40
2.30
2.10
1.67
1.43
Summary of Comparison
Method Projects Accepted
Value Added
PI
F, B, C, and D
$38,000
NPV
F and G
$28,500
IRR
C, F, and E
$27,000
Single-Point Estimate
and Sensitivity Analysis
Sensitivity Analysis: A type of what-if
uncertainty analysis in which variables or
assumptions are changed from a base case in
order to determine their impact on a projects
measured results (such as NPV or IRR).
13-56
Post-Completion Audit
Post-completion Audit
A formal comparison of the actual costs and
benefits of a project with original estimates.
* Refer to Appendix A
75
50
25
0
-100
13-59
Multiple IRRs at
k = 12.95% and 191.15%
40
80
120
160
Discount Rate (%)
200
13-60