Capital Budgeting

Decision Methods
“Everything is worth what its purchaser
will pay for it.”
—Publilius Syrus

In April of 2012, before Facebook’s initial public offering (IPO), it announced

it was acquiring Instagram, a photo sharing and editing mobile application
company, for $1 billion in cash and stock.
Facebook CEO Mark Zuckerberg seemed to be looking for a way
for Facebook to improve its photo sharing capabilities. Some analysts
believed at the time of this announcement that Facebook’s photo
capabilities were not as good as they could be. The company may
have been vulnerable to a competitor coming along with better photo
capabilities. This investment of $1 billion is widely seen as an attempt to
head off such competition.
Facebook’s investment in Instagram was a capital budgeting
decision. Zuckerberg and other Facebook executives must have
believed that the benefits from owning Instagram justified the $1 billion
cost. In this chapter we see how such capital budgeting projects are
evaluated.

Source: http://newsroom.bankofamerica.com/index.php?s=43&item=8255
http://hispanicbusiness.com/news/news_print.asp?id=158659

270
Chapter Overview Learning Objectives

We now look at the decision methods that analysts use to determine whether to After reading this chapter,
approve a given investment project and how they account for a project’s risk. you should be able to:
Investment projects such as DaimlerChrysler’s expansion project can fuel a firm’s
1. Explain the capital
success, so effective project selection often determines a firm’s value. The decision
budgeting process.
methods for choosing acceptable investment projects, then, are some of the most
important tools financial managers use. 2. Calculate the payback
We begin by looking at the capital budgeting process and four capital budgeting period, net present value,
decision methods: payback, net present value, internal rate of return, and modified internal rate of return,
and modified internal rate
internal rate of return. Then we discuss how to select projects when firms limit
of return for a proposed
their budget for capital projects, a practice called capital rationing. Finally, we look capital budgeting project.
at how firms measure and compensate for the risk of capital budgeting projects.
3. Describe capital rationing
and how firms decide
which projects to select.
The Capital Budgeting Process
4. Measure the risk of a
All businesses budget for capital projects—an airline that considers purchasing capital budgeting project.
new planes, a production studio that decides to buy new film cameras, or a 5. Explain risk-adjusted
pharmaceutical company that invests in research and development for a new discount rates.
drug. Capital budgeting is the process of evaluating proposed large, long-term
investment projects. The projects may be the purchase of fixed assets, investments
in research and development, advertising, or intellectual property. For instance,
Apple Computer’s development of the iPhone was a capital budgeting project.

271
272 Part III  Capital Budgeting and Business Valuation

Long-term projects may tie up cash resources, time, and additional assets. They can
also affect a firm’s performance for years to come. As a result, careful capital budgeting
is vital to ensure that the proposed investment will add value to the firm.
Before we discuss the specific decision methods for selecting investment projects,
we briefly examine capital budgeting basics: capital budgeting decision practices, types
of capital budgeting projects, the cash flows associated with such projects, and the stages
of the capital budgeting process.

Decision Practices
Financial managers apply two decision practices when selecting capital budgeting
projects: accept/reject and ranking. The accept/reject decision focuses on the question
of whether the proposed project would add value to the firm or earn a rate of return that
is acceptable to the company. The ranking decision lists competing projects in order of
desirability to choose the best one.
The accept/reject decision determines whether a project is acceptable in light of the
firm’s financial objectives. That is, if a project meets the firm’s basic risk and return
requirements, it will be accepted. If not, it will be rejected.
Ranking compares projects to a standard measure and orders the projects based on
how well they meet the measure. If, for instance, the standard is how quickly the project
pays off the initial investment, then the project that pays off the investment most rapidly
would be ranked first. The project that paid off most slowly would be ranked last.

Types of Projects
Firms invest in two categories of projects: independent projects and mutually exclusive
projects. Independent projects do not compete with each other. A firm may accept
none, one, some, or all from among a group of independent projects. Say, for example,
that a firm is able to raise funds for all worthwhile projects it identifies. The firm is
considering two new projects—a new telephone system and a warehouse. The telephone
system and the warehouse would be independent projects. Accepting one does not
preclude accepting the other.
In contrast, mutually exclusive projects compete against each other. The best project
from among a group of acceptable mutually exclusive projects is selected. For example,
if a company needed only one copier, one proposal to buy a XeroxTM copier and a second
proposal to buy a ToshibaTM copier would be two projects that are mutually exclusive.

Capital Budgeting Cash Flows

Although decision makers examine accounting information such as sales and expenses,
capital budgeting decision makers base their decisions on relevant cash flows associated
with a project. The relevant cash flows are incremental cash flows—cash flows that
will occur if an investment is undertaken but that won’t occur if it isn’t.
For example, imagine that you are an animator who helps create children’s films.
Your firm is considering whether to buy a computer to help you design your characters
more quickly. The computer would enable you to create two characters in the time it
now takes you to draw one, thereby increasing your productivity.
The incremental cash flows associated with the animation project are (1) the initial
investment in the computer and (2) the additional cash the firm will receive because you
will double your animation output for the life of the computer. These cash flows will
 Chapter 10  Capital Budgeting Decision Methods 273

occur if the new computer is purchased and will not occur if it is not purchased. These
are the cash flows, then, that affect the capital budgeting decision.
Estimating these incremental cash flows, the subject of Chapter 11, is a major
component of capital budgeting decisions, as we see in the next section.

Stages in the Capital Budgeting Process

The capital budgeting process has four major stages:

1. Finding projects
2. Estimating the incremental cash flows associated with projects
3. Evaluating and selecting projects
4. Implementing and monitoring projects
This chapter focuses on stage 3—how to evaluate and choose investment projects.
We assume that the firm has found projects in which to invest and has estimated the
projects’ cash flows effectively.

Capital Budgeting Decision Methods

The four formal capital budgeting decision methods we will examine are payback, net
present value, internal rate of return, and modified internal rate of return. Let’s begin
with the payback method.

The Payback Method Take Note

Capital budgeting
One of the simplest capital budgeting decision methods is the payback method. To use techniques are usually
it, analysts find a project’s payback period—the number of time periods it will take used only for projects
before the cash inflows of a proposed project equal the amount of the initial project with large cash outlays.
investment (a cash outflow). Small investment
decisions are usually
made by the “seat of
How to Calculate the Payback Period  To calculate the payback period, simply add up the pants.” For instance,
a project’s projected positive cash flows, one period at a time, until the sum equals the if your office supply
amount of the project’s initial investment. That number of time periods it takes for the of pencils is running
low, you order more.
positive cash flows to equal the amount of the initial investment is the payback period.
You know that the
To illustrate, imagine that you work for a firm called the AddVenture Corporation. cost of buying pencils
AddVenture is considering two investment proposals, Projects X and Y. The initial is justified without
investment for both projects is $5,000. The finance department estimates that the projects undergoing capital
will generate the following cash flows: budgeting analysis.

Cash Flows
For Initial End of End of End of End of
Investment Year 1 Year 2 Year 3 Year 4

Project X –$5,000 $2,000 $3,000 $ 500 $ 0

Project Y –$5,000 $2,000 $2,000 $ 1,000 $ 2,000
274 Part III  Capital Budgeting and Business Valuation

By analyzing the cash flows, we see that Project X has a payback period of two
years because the project’s initial investment of $5,000 (a cash flow of –$5,000) will
be recouped (by offsetting positive cash flows) at the end of year 2. In comparison,
Project Y has a payback of three years.

Payback Method Decision Rule  To apply the payback decision method, firms must
first decide what payback time period is acceptable for long-term projects. In our case,
if the firm sets two years as its required payback period, it will accept Project X but
reject Project Y. If, however, the firm allows a three-year payback period, then both
projects will be accepted if they are independent.

Problems with the Payback Method  The payback method is used in practice because
of its simplicity, but it has a big disadvantage in that it does not consider cash flows that
occur after the payback period. For example, suppose Project Y’s cash flows in year 4
were $10 million instead of $2,000. It wouldn’t make any difference. Project Y would
still be rejected under the payback method if the company’s policy were to demand a
payback of no more than two years. Failing to look beyond the payback period can lead
to poor business decisions, as shown.
Another deficiency of the payback method is that it does not consider the time value
of money. For instance, compare the cash flows of Projects A and B:

Cash Flows
For Initial End of End of
Investment Year 1 Year 2
Project A –$5,000 $3,000 $2,000
Project B –$5,000 $2,000 $3,000

Assuming the required payback period is two years, we see that both projects are
equally preferable—they both pay back the initial investment in two years. However,
time value of money analysis indicates that if both projects are equally risky, then Project
A is better than Project B because the firm will get more money sooner. Nevertheless,
timing of cash flows makes no difference in the payback computation.
Because the payback method does not factor in the time value of money, nor the
cash flows after the payback period, its usefulness is limited. Although it does provide
a rough measure of a project’s liquidity and can help to supplement other techniques,
financial managers should not rely on it as a primary decision method.

The Net Present Value (NPV) Method

The project selection method that is most consistent with the goal of owner wealth
maximization is the net present value method. The net present value (NPV) of a capital
budgeting project is the dollar amount of the change in the value of the firm as a result
of undertaking the project. The change in firm value may be positive, negative, or zero,
depending on the NPV value.
If a project has an NPV of zero, it means that the firm’s overall value will not change
if the new project is adopted. Why? Because the new project is expected to generate
exactly the firm’s required rate of return—no more and no less. A positive NPV means
that the firm’s value will increase if the project is adopted because the new project’s
 Chapter 10  Capital Budgeting Decision Methods 275

estimated return exceeds the firm’s required rate of return. Conversely, a negative NPV
means the firm’s value will decrease if the new project is adopted because the new
project’s estimated return is less than what the firm requires.

Calculating NPV  To calculate the net present value of a proposed project, we add the
present value of a project’s projected cash flows and then subtract the amount of the
initial investment.1 The result is a dollar figure that represents the change in the firm’s
value if the project is undertaken.

Formula for Net Present Value (NPV), Algebraic Method

     
CF1 CF2 CFn
NPV =   +   + . . . +   − Initial Investment
 (1 + k )1   (1 + k )2   (1 + k ) n 

(10-1a)

where: CF = Cash flow at the indicated times

k = Discount rate, or required rate of return for the project
n = Life of the project measured in the number of time periods

To use financial tables to solve present value problems, write the NPV formula as
follows:

Formula for Net Present Value (NPV), Table Method

NPV = CF1(PVIFk, 1) + CF2(PVIFk, 2) + . . . + CFn(PVIFk, n) –
Initial Investment (10-1b)
where: PVIF = Present Value Interest Factor
k = Discount rate, or required rate of return for the project
n = Life of the project measured in the number of time periods

To use the TI BAII Plus financial calculator to solve for NPV, switch the calculator
to the spreadsheet mode, enter the cash flow values in sequence, then the discount rate,
depicted as I on the TI BAII Plus calculator, then compute the NPV.
For simplicity, we use only the algebraic equation and the financial calculator to
calculate NPV. If you prefer using financial tables, simply replace Equation 10-1a with
Equation 10-1b.2
To show how to calculate NPV, let’s solve for the NPVs of our two earlier projects,
Projects X and Y. First, note the following cash flows of Projects X and Y:

Cash Flows
For Initial End of End of End of End of
Investment Year 1 Year 2 Year 3 Year 4

Project X –$5,000 $2,000 $3,000 $ 500 $ 0

Project Y –$5,000 $2,000 $2,000 $ 1,000 $ 2,000

We use many of the time value of money techniques learned in Chapter 8 to calculate NPV.
1

2
If the future cash flows are in the form of an annuity, Equations 10-1a and 10-1b can be modified to take advantage of the
present value of annuity formulas discussed in Chapter 8, Equations 8-4a and 8-4b.
276 Part III  Capital Budgeting and Business Valuation

Assume the required rate of return for Projects X and Y is 10 percent. Now we have
all the data we need to solve for the NPV of Projects X and Y.
Applying Equation 10-1a and assuming a discount rate of 10 percent, the NPV of
Project X follows:

     
$2,000 $3,000 $500 n
NPV=   +   +   − $5,000
 (1 + .10 )1   (1 + .10 )2   (1 + .10 )3 

$2,000 $3,000 $500

= + + − $5,000
1.1 1.21 1.331

= $1,818.1818 + $2,479.3388 + $375.6574 − $5,000

= − $326.82
We may also find Project X’s NPV with the financial calculator at a 10 percent
discount rate as follows:

TI BAII PLUS Financial Calculator Solutions

Project X NPV

Keystrokes Display

CF0 = old contents

CF0 = 0.00
5000 CF0 = –5,000.00
2000 C01 = 2,000.00
F01 = 1.00
3000 C02 = 3,000.00
F02 = 1.00
500 C03 = 500.00
F03 = 1.00
I = 0.00
10 I = 10.00

NPV = –326.82

The preceding calculations show that at a 10 percent discount rate, an initial cash
outlay of $5,000, and cash inflows of $2,000, $3,000, and $500 at the end of years 1,
2, and 3, the NPV for Project X is –326.82.
To find the NPV of Project Y, we apply Equation 10-1a as follows:

       
$2,000 $2,000 $1,000 $2,000
NPV =   +   +  +  − $5,000
 (1 + .10 )1   (1 + .10 )2   (1 + .10 )3   (1 + .10 )4 
 Chapter 10  Capital Budgeting Decision Methods 277

$2,000 $2,000 $1,000 $2,000

= + + + − $5,000
1.1 1.21 1.331 1.4641

= $1,818.1818 + $1,652.8926 + $751.3148 + $1,366.0269 − $5,000

= $588.42

Using the financial calculator, we solve for Project Y’s NPV at a 10 percent discount
rate as follows:

TI BAII PLUS Financial Calculator Solutions

Project Y NPV

Keystrokes Display

CF0 = old contents

CF0 = 0.00
5000 CF0 = –5,000.00
2000 C01 = 2,000.00
2 F01 = 2.00
1000 C02 = 1,000.00
F02 = 1.00
2000 C03 = 2,000.00
F03 = 1.00
I = 0.00
10 I = 10.00

NPV = 588.42

Our calculations show that with a required rate of return of 10 percent, an initial
cash outlay of $5,000, and positive cash flows in years 1 through 4 of $2,000, $2,000,
$1,000, and $2,000, respectively, the NPV for Project Y is $588.42. If we compare Project
X’s NPV of –326.82 to Project Y’s NPV of $588.42, we see that Project Y would add
value to the business and Project X would decrease the firm’s value.

NPV Decision Rules  NPV is used in two ways: (1) to determine if independent projects
should be accepted or rejected (the accept/reject decision); and (2) to compare acceptable
mutually exclusive projects (the ranking decision). The rules for these two decisions are
• NPV Accept/Reject Decision—A firm should accept all independent projects having
NPVs greater than or equal to zero. Projects with positive NPVs will add to the value
of the firm if adopted. Projects with NPVs of zero will not alter the firm’s value but
(just) meet the firm’s requirements. Projects with NPVs less than zero should be
rejected because they will reduce the firm’s value if adopted. Applying this decision
rule, Project X would be rejected and Project Y would be accepted.
278 Part III  Capital Budgeting and Business Valuation

• NPV Ranking Decision—The project from the mutually exclusive list with the highest
positive NPV should be ranked first, the next highest should be ranked second, and
so on. Under this decision rule, if the two projects in our previous example were
mutually exclusive, Project Y would be ranked first and Project X second. (Not only
is Project X second in rank here, but it is unacceptable because it has a negative NPV.)

The NPV Profile  The k value is the cost of funds used for the project. It is the discount
rate used in the NPV calculation because the cost of funds for a given project is that
project’s required rate of return. The relationship between the NPV of a project and k is
inverse—the higher the k, the lower the NPV, and the lower the k, the higher the NPV.3
Because a project’s NPV varies inversely with k, financial managers need to know
how much the value of NPV will change in response to a change in k. If k is incorrectly
specified, what appears to be a positive NPV could in fact be a negative NPV and vice
versa—a negative NPV could turn out to be positive. Mutually exclusive project rankings
could also change if an incorrect k value is used in the NPV computations.4
To see how sensitive a project’s NPV value is to changes in k, analysts often create
an NPV profile. The NPV profile is a graph that shows how a project’s NPV changes
when different discount rate values are used in the NPV computation.
Building an NPV profile is straightforward. First, the NPV of the project is calculated
at a number of different discount rates. Then the results are plotted on the graph, with k
values on one axis and the resulting NPV values on the other. If more than one project
is included on the graph, the process is repeated for each project until all are depicted.
To illustrate, we will build an NPV profile of Projects X and Y. We will plot Project X
and then Project Y on the graph.
To begin, we first calculate the NPV of Project X with a number of different discount
rates. The different k values may be chosen arbitrarily. For our purposes, let’s use 0
percent, 5 percent, 10 percent, 15 percent, and 20 percent. The results of Project X’s
NPV calculations follow:
Discount Rate Project X NPV
0% $ 500.00
5% $ 57.77
10% –$ 326.82
Take Note 15% –$ 663.68
The NPV profile line is 20% –$ 960.65
curved, not straight. The
curve is steepest at low
Now Project X’s NPV values may be plotted on the NPV profile graph. Figure
discount rates and gets
more shallow at higher 10-1 shows the results.
rates. This shape occurs When the data points are connected in Figure 10-1, we see how the NPV of Project
because discounting X varies with the discount rate changes. The graph shows that with a k of about 5.7
is the inverse of the percent, the value of the project’s NPV is zero. At that discount rate, then, Project X
exponential compounding would provide the firm’s required rate of return, no more and no less.
phenomenon, as
Next, we add project Y to the NPV profile graph. We calculate the NPV of Project
described in Chapter 8.
Y at a number of different discount rates, 0 percent, 5 percent, 10 percent, 15 percent,
and 20 percent. The results follow:
3
We are assuming here that the project is a typical one, meaning that it has an initial negative cash flow, the initial investment,
followed by all positive cash flows. It is possible that if a project has negative cash flows in the future the relationship between
NPV and k might not be inverse.
The estimation of the cost of funds used for capital budgeting projects was covered in Chapter 9.
4
 Chapter 10  Capital Budgeting Decision Methods 279

$600
$500

$400

$200

$57.77
$0
Pr
oj
ec
tX
NPV

–$200

–$326.81
–$400
Figure 10-1 
NPV Profile of Project X
–$600
–$663.68 The NPV profile shows how
the NPV of project X varies
–$800 inversely with the discount
rate, k. Project X’s NPV is
–$960.65 highest ($500) when the
–$1,000
discount rate is zero. Its NPV
0% 5% 10% 15% 20%
is lowest (–$960.65) when the
Discount Rate discount rate is 20 percent.

Discount Rate Project Y NPV

0% $ 2,000.00
5% $ 1,228.06
10% $ 588.42
15% $ 52.44
20% –$ 401.23

Figure 10-2 shows these NPV values plotted on the NPV profile graph.
Notice in Figure 10-2 that Project Y’s NPV profile falls off more steeply than Project
X’s. This indicates that Project Y is more sensitive to changes in the discount rate than
Project X. Project X’s NPV becomes negative and, thus, the project is unacceptable when
the discount rate rises above about 6 percent. Project Y’s NPV becomes negative and,
thus, the project is unacceptable when the discount rate rises above about 16 percent.

Problems with the NPV Method  Although the NPV method ensures that a firm will
choose projects that add value to a firm, it suffers from two practical problems. First,
it is difficult to explain NPV to people who are not formally trained in finance. Few
nonfinance people understand phrases such as “the present value of future cash flows”
or “the change in a firm’s value given its required rate of return.” As a result, many
financial managers have difficulty using NPV analysis persuasively.
A second problem is that the NPV method results are in dollars, not percentages.
Many owners and managers prefer to work with percentages because percentages can
be easily compared with other alternatives; Project 1 has a 10 percent rate of return
compared with Project 2’s 12 percent rate of return. The next method we discuss, the
internal rate of return, provides results in percentages.
280 Part III  Capital Budgeting and Business Valuation

$2,000
$2,000
Project X
Project Y
$1,500
$1,228.06

$1,000

NPV $500 $588.42

$500

$52.44
$0
$57.77

Figure 10-2  NPV Profile –$326.81 –$401.23

of Projects X and Y –$500
–$663.68
The NPV file shows how the
NPVs of two capital budgeting –$960.65
–$1,000
projects, Projects X and
Y, vary inversely with the 0% 5% 10% 15% 20%
discount rate, k. Discount Rate

The Internal Rate of Return (IRR) Method

The Internal Rate of Return (IRR) is the estimated rate of return for a proposed
project, given the project’s incremental cash flows. Just like the NPV method, the IRR
method considers all cash flows for a project and adjusts for the time value of money.
However, the IRR results are expressed as a percentage, not a dollar figure.
When capital budgeting decisions are made using the IRR method, the IRR of the
proposed project is compared with the rate of return management requires for the project.
The required rate of return is often referred to as the hurdle rate. If the project’s IRR is
greater than or equal to the hurdle rate (jumps over the hurdle), the project is accepted.

Calculating Internal Rate of Return: Trial-and-Error Method  If the present value

of a project’s incremental cash flows were computed using management’s required
rate of return as the discount rate and the result exactly equaled the cost of the project,
then the NPV of the project would be zero. When NPV equals zero, the required rate of
return, or discount rate used in the NPV calculation, is the projected rate of return, IRR.
To calculate IRR, then, we reorder the terms in Equation 10-1a to solve for a discount
rate, k, that results in an NPV of zero.
The formula for finding IRR, Equation 10-2, follows:

Formula for IRR (10-2)

 CF   CF   CF 
NPV = 0 =  1  +  2  + ... +  n  − Initial Investment
 (1 + k )1   (1 + k )2   (1 + k )n 
 Chapter 10  Capital Budgeting Decision Methods 281

To find the IRR of a project using Equation 10-2, fill in the cash flows, the n values,
and the initial investment figure. Then choose different values for k (all the other values
are known) until the result equals zero. The IRR is the k value that causes the left-hand
side of the equation, the NPV, to equal zero.
To illustrate the process, let’s calculate the IRR for Project X. Recall that the cash
flows associated with Project X were as follows:

Cash Flows
For Initial
Investment Year 1 Year 2 Year 3 Year 4
Project X –$5,000 $2,000 $3,000 $500 $0

First, we insert Project X’s cash flows and the times they occur into Equation 10‑2.

     
$2,000 $3,000 $500
NPV = 0 =   +   +   − $5,000
 (1 + k )1   (1 + k )2   (1 + k )3 

Next, we try various discount rates until we find the value of k that results in an
NPV of zero. Let’s begin with a discount rate of 5 percent.
     
$2,000 $3,000 $500
0 =   +   +   − $5,000
 (1 + .05)1   (1 + .05)2   (1 + .05)3 

 $2,000   $3,000   $500 

=  +  +  − $5,000
 1.05   
 1.1025   1.157625 

= $1,904.76 + $2,721.09 + $431.92 − $5,000

= $57.77

This is close, but not quite zero. Let’s try a second time, using a discount rate of
6 percent.
     
$2,000 $3,000 $500
0 =   +   +   − $5,000
 (1 + .06 )1   (1 + .06 )2   (1 + .06 )3 

 $2,000   $3,000   $500 

=  +  +  − $5,000
 1.06   
 1.1236   1.191016  Take Note
We could estimate the
= $1,886.79 + $2,669.99 + $419.81 − $5,000 IRR more accurately
through more trial and
= − $23.41 error. However, carrying
the IRR computation to
This is close enough for our purposes. We conclude the IRR for Project X is slightly several decimal points
may give a false sense of
less than 6 percent.
accuracy, as in the case
Although calculating IRR by trial and error is time-consuming, the guesses do not in which the cash flow
have to be made entirely in the dark. Remember that the discount rate and NPV are estimates are in error.
inversely related. When an IRR guess is too high, the resulting NPV value will be too
low. When an IRR guess is too low, the NPV will be too high.
282 Part III  Capital Budgeting and Business Valuation

Calculating Internal Rate of Return: Financial Calculator  Finding solutions to IRR

problems with a financial calculator is simple. After clearing previous values, enter the
initial cash outlay and other cash flows and compute the IRR value.
The TI BAII PLUS financial calculator keystrokes for finding the IRR for Project
X are shown next.

TI BAII PLUS Financial Calculator Solution IRR

Keystrokes Display

CF0 = old contents

CF0 = 0.00
5000 –5,000.00
2000 C01 = 2,000.00
F01 = 1.00
3000 C02 = 3,000.00
F02 = 1.00
500 C03 = 500.00
F03 = 1.00
IRR = 0.00

IRR = 5.71

We see that with an initial cash outflow of $5,000 and Project X’s estimated cash
inflows in years 1 through 3, the IRR is 5.71 percent.

IRR and the NPV Profile  Notice in Figure 10-2 that the point where Project X’s NPV
profile crosses the zero line is, in fact, the IRR (5.71 percent). This is no accident. When
the required rate of return, or discount rate, equals the expected rate of return, IRR, then
NPV equals zero. Project Y’s NPV profile crosses the zero line just below 16 percent. If
you use your financial calculator, you will find that the Project Y IRR is 15.54 percent.
If an NPV profile graph is available, you can always find a project’s IRR by locating
Take Note the point where a project’s NPV profile crosses the zero line.
If you are using a
financial calculator other IRR Decision Rule  When evaluating proposed projects with the IRR method, those
than the TI BAII PLUS,
the calculator procedure
that have IRRs equal to or greater than the required rate of return (hurdle rate) set by
will be similar but the management are accepted, and those projects with IRRs that are less than the required
keystrokes will differ. rate of return are rejected. Acceptable, mutually exclusive projects are ranked from
Be sure to check your highest to lowest IRR.
calculator’s instruction
manual.
 Chapter 10  Capital Budgeting Decision Methods 283

Benefits of the IRR Method  The IRR method for selecting capital budgeting projects
is popular among financial practitioners for three primary reasons:

1. IRR focuses on all cash flows associated with the project.

2. IRR adjusts for the time value of money.
3. IRR describes projects in terms of the rate of return they earn, which makes it
easy to compare them with other investments and the firm’s hurdle rate.

Problems with the IRR Method  The IRR method has several problems, however.
First, because the IRR is a percentage number, it does not show how much the value of
the firm will change if the project is selected. If a project is quite small, for instance,
it may have a high IRR but a small effect on the value of the firm. (Consider a project
that requires a $10 investment and returns $100 a year later. The project’s IRR is 900
percent, but the effect on the value of the firm if the project is adopted is negligible.)
If the primary goal for the firm is to maximize its value, then knowing the rate of
return of a project is not the primary concern. What is most important is the amount by
which the firm’s value will change if the project is adopted, which is measured by NPV.
To drive this point home, ask yourself whether you would rather earn a 100 percent
rate of return on $5 (which would be $5) or a 50 percent rate of return on $1,000 (which
would be $500). As you can see, it is not the rate of return that is important but the
dollar value. Why? Dollars, not percentages, comprise a firm’s cash flows. NPV tells
financial analysts how much value in dollars will be created. IRR does not.
A second problem with the IRR method is that, in rare cases, a project may have
more than one IRR, or no IRR. This is shown in detail in Appendix 10A.
The IRR can be a useful tool in evaluating capital budgeting projects. As with any
tool, however, knowing its limitations will enhance decision making.

Conflicting Rankings between the NPV and IRR Methods

As long as proposed capital budgeting projects are independent, both the NPV and IRR
methods will produce the same accept/reject indication. That is, a project that has a
positive NPV will also have an IRR that is greater than the discount rate. As a result,
the project will be acceptable based on both the NPV and IRR values. However, when
mutually exclusive projects are considered and ranked, a conflict occasionally arises.
For instance, one project may have a higher NPV than another project, but a lower IRR.
To illustrate how conflicts between NPV and IRR can occur, imagine that the
AddVenture Company owns a piece of land that can be used in different ways. On the
one hand, this land has minerals beneath it that could be mined, so AddVenture could
invest in mining equipment and reap the benefits of retrieving and selling the minerals.
On the other hand, the land has perfect soil conditions for growing grapes that could be
used to make wine, so the company could use it to support a vineyard.
Clearly, these two uses are mutually exclusive. The mine cannot be dug if there is
a vineyard, and the vineyard cannot be planted if the mine is dug. The acceptance of
one of the projects means that the other must be rejected.
284 Part III  Capital Budgeting and Business Valuation

Now let’s suppose that AddVenture’s finance department has estimated the cash
flows associated with each use of the land. The estimates are presented next:

Cash Flows for Cash Flows for

Time the Mining Project the Vineyard Project

t0 ($ 736,369 ) ($ 736,369 )
t1 $ 500,000 $ 0
t2 $ 300,000 $ 0
t3 $ 100,000 $ 0
t4 $ 20,000 $ 50,000
t5 $ 5,000 $ 200,000
t6 $ 5,000 $ 500,000
t7 $ 5,000 $ 500,000
t8 $ 5,000 $ 500,000

Note that although the initial outlays for the two projects are the same, the
incremental cash flows associated with the projects differ in amount and timing. The
Mining Project generates its greatest positive cash flows early in the life of the project,
whereas the Vineyard Project generates its greatest positive cash flows later. The
differences in the projects’ cash flow timing have considerable effects on the NPV and
IRR for each venture.
Assume AddVenture’s required rate of return for long-term projects is 10 percent. The
NPV and IRR results for each project given its cash flows are summarized as follows:

NPV IRR

Mining Project $ 65,727.39 16.05%

Vineyard Project $ 194,035.65 14.00%

These figures were obtained with our TI BAII PLUS calculator, in the same manner
as shown earlier in the chapter.
The NPV and IRR results show that the Vineyard Project has a higher NPV than the
Mining Project ($194,035.65 versus $65,727.39), but the Mining Project has a higher
IRR than the Vineyard Project (16.05 percent versus 14.00 percent). AddVenture is
faced with a conflict between NPV and IRR results. Because the projects are mutually
exclusive, the firm can only accept one.
In cases of conflict among mutually exclusive projects, the one with the highest
NPV should be chosen because NPV indicates the dollar amount of value that will be
added to the firm if the project is undertaken. In our example, then, AddVenture should
choose the Vineyard Project (the one with the higher NPV) if its primary financial goal
is to maximize firm value.

The Modified Internal Rate of Return (MIRR) Method

One problem with the IRR method that was not mentioned earlier is that the only way you
can actually receive the IRR indicated by a project is if you reinvest the intervening cash
flows in the project at the IRR. If the intervening cash flows are reinvested at any rate
lower than the IRR, you will not end up with the IRR indicated at the end of the project.
 Chapter 10  Capital Budgeting Decision Methods 285

For example, assume you have a project in which you invest $100 now and expect
to receive four payments of $50 at the end of each of the next four years:

t0 t1 t t3 t4

–100 +50 +50 +50 +50

The IRR of this investment, calculated using either the trial-and-error or financial-
calculator methods, is 34.9 percent. On the surface, this sounds like a fabulous
investment. But, as they say, don’t count your chickens before they hatch. If you can’t
reinvest each $50 payment at the IRR of 34.9 percent, forget it; you won’t end up with an
overall return of 34.9 percent. To see why, consider what would happen if, for example,
you simply put each $50 payment in your pocket. At the end of the fourth year you would
have $200 in your pocket. Now, using Equation 8-6, calculate the average annual rate
of return necessary to produce $200 in four years with a beginning investment of $100:

Actual return on the investment per Equation 8-6

 1
 200   4 
k =  − 1
 100 

= .189, or 18.9% (not 34.9%)

Despite the fact that the IRR of the investment was 34.9 percent, you only ended
up with an 18.9 percent annual return. The only way you could have obtained an annual
return of 34.9 percent was to have reinvested each of the $50 cash flows at 34.9 percent.
This is called the IRR reinvestment assumption.
To get around the IRR reinvestment assumption, a variation on the IRR procedure
has been developed, called the Modified Internal Rate of Return (MIRR) method.
The MIRR method calls for assuming that the intervening cash flows from a project are
reinvested at a rate of return equal to the cost of capital. To find the MIRR, first calculate
how much you would end up with at the end of a project, assuming the intervening cash
flows were invested at the cost of capital. The result is called the project’s terminal
value. Next, calculate the annual rate of return it would take to produce that end amount
from the beginning investment. That rate is the MIRR.
Here is the MIRR calculation for the project in our example, in which $100 is
invested at time zero, followed by inflows of $50 at the end of each of the next four
years. Let us assume for this example that the cost of capital is 10 percent.

Step 1: Calculate the project’s terminal value:

FV of Cash Flow at t4 if reinvested

@ 10% Cost of Capital
Time Cash Flow (per Equation 8-a)

t1 $50 FV = $50 x (1 + .10)3 = $ 66.55

t2 $50 FV = $50 x (1 + .10)2 = $ 60.50
t3 $50 FV = $50 x (1 + .10)1 = $ 55.00
t4 $50 FV = $50 x (1 + .10)0 = $ 50.00
Project’s Terminal Value: $ 232.05
286 Part III  Capital Budgeting and Business Valuation

Step 2: Calculate the annual rate of return that will produce the terminal value from
the initial investment:

Project’s Terminal Value: $232.05

PV of Initial Investment: $100
per Equation 8-6:
 1
 232.05   4 
MIRR =  − 1
 100 

= .234, or 23.4%

This is a much more realistic expectation than the 34.9 percent return from the
project indicated by the IRR method. Remember, any time you consider investing in
a project, you will not actually receive the IRR unless you can reinvest the project’s
intervening cash flows at the IRR. Calculate the MIRR to produce a more realistic
indication of the actual project outcome.
In this section we looked at four capital budgeting decision methods: the payback
method, the net present value method, the internal rate of return method, and the modified
internal rate of return method. We also investigated how to resolve conflicts between
NPV and IRR decision methods. Next, we turn to a discussion of capital rationing.

Capital Rationing
Our discussion so far has shown that all independent projects with NPVs greater than
or equal to zero should be accepted. All such projects that are adopted will add value to
the firm. To act consistently with the goal of shareholder wealth maximization, then, it
seems that if a firm locates $200 billion worth of independent positive NPV projects,
it should accept all the projects. In practice, however, many firms place dollar limits
on the total amount of capital budgeting projects they will undertake. They may wish
to limit spending on new projects to keep a ceiling on business size. This practice of
setting dollar limits on capital budgeting projects is known as capital rationing.
If capital rationing is imposed, then financial managers should seek the combination of
projects that maximizes the value of the firm within the capital budget limit. For example,
suppose a firm called BeLimited does not want its capital budget to exceed $200,000.
Seven project proposals, Proposals A to G, are available, as shown in Table 10-1.
Note that all the projects in Table 10-1 have positive net present values, so they are
all acceptable. However, BeLimited cannot adopt them all because that would require
the expenditure of more than $200,000, its self-imposed capital budget limit.
Under capital rationing, BeLimited’s managers try different combinations of projects
seeking the combination that gives the highest NPV without exceeding the $200,000
limit. For example, the combination of Projects B, C, E, F, and G costs $200,000 and
yields a total NPV of $23,700. A better combination is that of Projects A, B, C, D, and F,
which costs $200,000 and has a total NPV of $30,600. In fact, this combination has the
highest total NPV, given the $200,000 capital budget limit (try a few other combinations
to see for yourself), so that combination is the one BeLimited should choose.
In this section, we explored capital rationing. In the following section, we will
examine how risk affects capital budgeting decisions.
 Chapter 10  Capital Budgeting Decision Methods 287

Table 10-1  BeLimited Project Proposals

Initial Cash Net Present

Project Outlay Value
A $20,000 $8,000
B $50,000 $7,200
C $40,000 $6,500
D $60,000 $5,100
E $50,000 $4,200
F $30,000 $3,800
G $30,000 $2,000

Risk and Capital Budgeting

Suppose you are a financial manager for AddVenture Corporation. You are considering
two capital budgeting projects, Project X (discussed throughout the chapter) and Project
X2. Both projects have identical future cash flow values and timing, and both have the
same NPV, if discounted at the same rate, k, and the same IRR. The two projects appear
equally desirable.
Now suppose you discover that Project X’s incremental cash flows are absolutely
certain, but Project X2’s incremental cash flows, which have the same expected value,
are highly uncertain. These cash flows could be higher or lower than forecast. In other
words, Project X is a sure thing and Project X2 appears to be quite risky. As a risk-averse
person, you would prefer Project X over Project X2.
Financial managers are not indifferent to risk. Indeed, the riskier a project, the less
desirable it is to the firm. To incorporate risk into the NPV and IRR evaluation techniques,
we use the standard deviation and coefficient of variation (CV) measures discussed in
Chapter 7. We begin by examining how to measure the risk of a capital budgeting project.
Then we explain how to include the risk measurement in the NPV and IRR evaluation.

Measuring Risk in Capital Budgeting

Financial managers may measure three types of risk in the capital budgeting process.
The first type is project-specific risk, or the risk of a specific new project. The second
type is firm risk, which is the impact of adding a new project to the existing projects of
the firm. The third is market (or beta) risk, which is the effect of a new project on the
stockholders’ nondiversifiable risk.
In this chapter we focus on measuring firm risk. To measure firm risk, we compare
the coefficient of variation (CV) of the firm’s portfolio before and after a project is
adopted. The before-and-after difference between the two CVs serves as the project’s
risk measure from a firm perspective. If the CAPM approach (discussed in Chapter 7)
is preferred, a financial manager could estimate the risk of a project by calculating the
project’s beta instead of the change in firm risk.

Computing Changes in the Coefficient of Variation  Let’s reconsider our earlier

example, Project X. Recall that the IRR of Project X was 5.71 percent. Now suppose
that after careful analysis, we determine this IRR is actually the most likely value from a
288 Part III  Capital Budgeting and Business Valuation

range of possible values, each with some probability of occurrence. We find the expected
value and standard deviation of Project X’s IRR distribution using Equations 7-1 and
7-2, respectively. We find that the expected value of the IRR distribution is 5.71 percent
and the standard deviation is 2.89 percent.
To see how adding Project X to the firm’s existing portfolio changes the portfolio’s
coefficient of variation (CV), we follow a five-step procedure.
Step 1: Find the CV of the Existing Portfolio. Suppose the expected rate of return
and standard deviation of possible returns of AddVenture’s existing portfolio
are 6 percent and 2 percent, respectively. Given this information, calculate the
CV of the firm’s existing portfolio using Equation 7-3:
Standard Deviation
CV =
Mean, or Expected Value

.02
=
.06
= .3333, or 33.33%

Step 2: Find the Expected Rate of Return of the New Portfolio (the Existing Portfolio
Plus the Proposed Project). Assume that the investment in Project X represents
10 percent of the value of the portfolio. In other words, the new portfolio after adding
Project X will consist of 10 percent Project X and 90 percent of the rest of the firm’s
assets. With these figures, solve for the expected rate of return of the new portfolio
using Equation 7-4. In the calculations, Asset A represents Project X and Asset B
represents the firm’s existing portfolio.

E(Rp) = (wa × E(Ra)) + (wb × E(Rb))

= (.10 × .0571) + (.90 × .06)
= .00571 + .05400
= .05971, or 5.971%

σp = w a2 σ 2a + w 2b σ 2b + 2w a w b ra,b σ a σ b

= (.102 )(0.02892 ) + (.902 )(0.022 ) + (2)(.10)(.90)(0.0)(.0289)(.02)

= (.01)(.000835) + (.81)(.0004) + 0

= .00000835 + .000324

= .000332352

= .0182, or 1.82%
Step 3: Find the Standard Deviation of the New Portfolio (the Existing Portfolio Plus
the Proposed Project). Calculate the standard deviation of the new portfolio using
Equation 7-5. Assume the degree of correlation (r) between project X (Asset A) and
the firm’s existing portfolio (Asset B) is zero. Put another way, there is no relationship
between the returns from Project X and the returns from the firm’s existing portfolio.
 Chapter 10  Capital Budgeting Decision Methods 289

Step 4: Find the CV of the New Portfolio (the Existing Portfolio Plus the Proposed
Project). To solve for the CV of the new portfolio with Project X included, we
use Equation 7-3, as follows:
Standard Deviation
CV=
Mean, or Expected value

.0182
=
.05971

= .3048, or 30.48%

Step 5: C
 ompare the CV of the Portfolio with and without the Proposed Project.
To evaluate the effect of Project X on the risk of the AddVenture portfolio, we
compare the CV of the old portfolio (without Project X) to the CV of the new
portfolio (with Project X). The coefficients follow:

CV of the Portfolio CV of the Portfolio Change

without Project X with Project X in CV
33.33% 30.48% –2.85

The CV of the firm’s portfolio dropped from 33.33 percent to 30.48 percent with
the addition of Project X. This 2.85 percentage point decrease in CV is the measure of
risk in Project X from the firm’s perspective.

Adjusting for Risk

Most business owners and financial managers are risk averse, so they want the capital
budgeting process to reflect risk concerns. Next, we discuss how to adjust for risk in the
capital budgeting process—risk-adjusted discount rates. The discount rate is the cost
of capital discussed in Chapter 9. A project’s risk-adjusted discount rate is the cost of
capital for that specific project.

Risk-Adjusted Discount Rates (RADRs)  One way to factor risk into the capital
budgeting process is to adjust the rate of return demanded for high- and low-risk projects.
Risk-adjusted discount rates (RADRs), then, are discount rates that differ according to
their effect on a firm’s risk. The higher the risk, the higher the RADR, and the lower
the risk, the lower the RADR. A project with a normal risk level would have an RADR
equal to the actual discount rate.
To find the RADR for a capital budgeting project, we first prepare a risk adjustment
table like the one in Table 10-2. We assume in Table 10-2 that the coefficient of variation,
CV, is the risk measure to be adjusted for. The CV is based on the probability distribution
of the IRR values.
Table 10-2 shows how the discount rates for capital budgeting projects might be
adjusted for varying degrees of risk. The discount rate of a project that decreased the
CV of the firm’s portfolio of assets by 2.5 percentage points, for example, would be
classified as a low-risk project. That project would be evaluated using a discount rate
two percentage points lower than that used on average projects.
This has the effect of making Project X a more desirable project. That is, financial
managers would calculate the project’s NPV using an average discount rate that is two
percentage points lower, which would increase the project’s NPV. If the firm uses the
290 Part III  Capital Budgeting and Business Valuation

Table 10-2  Risk-Adjustment Table

If Adoption of the
Proposed Capital
Budgeting Project Then Assign the And Adjust the
Would Change the CV Project to the Discount Rate for
of the Firm’s Portfolio IRR Following Risk the Project as
by the Following Amount: Category: Follows:
More than a 1 percent increase High risk +2%
Between a 1 percent decrease
and a 1 percent increase Average risk 0
More than a 1 percent decrease Low risk –2%

IRR method, financial managers would compare the project’s IRR to a hurdle rate two
Take Note percentage points lower than average, which would make it more likely that the firm
The data in Table 10-2 would adopt the project.
are only for illustration. RADRs are an important part of the capital budgeting process because they
In practice, the incorporate the risk–return relationship. All other things being equal, the more a project
actual amount of risk increases risk, the less likely it is that a firm will accept the project; the more a project
adjustment will depend
on the degree of risk
decreases risk, the more likely it is that a firm will accept the project.
aversion of the managers
and stockholders.
What’s Next
In this chapter we explored the capital budgeting process and decision methods. We
examined four capital budgeting techniques—the payback method, net present value
method, internal rate of return method, and modified internal rate of return method. We
also discussed capital rationing and how to measure and adjust for risk when making
capital budgeting decisions.
In the next chapter, we’ll investigate how to estimate incremental cash flows in
capital budgeting.

Summary
1. Explain the capital budgeting process.
Capital budgeting is the process of evaluating proposed investment projects. Capital
budgeting projects may be independent—the projects do not compete with each other—
or mutually exclusive—accepting one project precludes the acceptance of the other(s)
in that group.
Financial managers apply two decision practices when selecting capital budgeting
projects: accept/reject decisions and ranking decisions. The accept/reject decision is
the determination of which independent projects are acceptable in light of the firm’s
financial objectives. Ranking is a process of comparing projects to a standard measure
and ordering the mutually exclusive projects based on how well they meet the measure.
The capital budgeting process is concerned only with incremental cash flows; that is,
those cash flows that will occur if an investment is undertaken but won’t occur if it isn’t.
 Chapter 10  Capital Budgeting Decision Methods 291

2. C alculate the payback period, net present value, internal rate of return, and
modified internal rate of return for a proposed capital budgeting project.
The payback period is defined as the number of time periods it will take before the
cash inflows from a proposed capital budgeting project will equal the amount of the
initial investment. To find a project’s payback period, add all the project’s positive cash
flows, one period at a time, until the sum equals the amount of the initial cash outlay
for the project. The number of time periods it takes to recoup the initial cash outlay is
the payback period. A project is acceptable if it pays back the initial investment within
a time frame set by firm management.
The net present value (NPV) of a proposed capital budgeting project is the dollar
amount of the change in the value of the firm that will occur if the project is undertaken.
To calculate NPV, total the present values of all the projected incremental cash flows
associated with a project and subtract the amount of the initial cash outlay. A project
with an NPV greater than or equal to zero is acceptable. An NPV profile—a graph that
shows a project’s NPV at many different discount rates (required rates of return)— shows
how sensitive a project’s NPV is to changes in the discount rate.
The internal rate of return (IRR) is the projected percentage rate of return that a
proposed project will earn, given its incremental cash flows and required initial cash
outlay. To calculate IRR, find the discount rate that makes the project’s NPV equal to
zero. That rate of return is the IRR. A project is acceptable if its IRR is greater than or
equal to the firm’s required rate of return (the hurdle rate).
The IRR method assumes that intervening cash flows in a project are reinvested
at a rate of return equal to the IRR. This can result in overly optimistic expectations
when the IRR is high and the intervening cash flows can’t be reinvested at that rate. To
produce more realistic results, the Modified Internal Rate of Return (MIRR) method
was developed. The MIRR method calls for assuming that the intervening cash flows
from a project are reinvested at a rate of return equal to the cost of capital. To find the
MIRR, first calculate how much you would end up with at the end of a project, assuming
the intervening cash flows were invested at the cost of capital. The result is called the
project’s terminal value. Next, calculate the annual rate of return it would take to produce
that end amount from the beginning investment. That rate is the MIRR.

3. Describe capital rationing and how firms decide which projects to select.
The practice of placing dollar limits on the total size of the capital budget is called capital
rationing. Under capital rationing, the firm will select the combination of projects that
yields the highest NPV without exceeding the capital budget limit.

4. Measure the risk of a capital budgeting project.

To measure the risk of a capital budgeting project, we determine how the project would
affect the risk of the firm’s existing asset portfolio. We compare the coefficient of
variation of possible returns of the firm’s asset portfolio with the proposed project and
without it. The difference between the two coefficients of variation is the measure of
the risk of the capital budgeting project.

5. Explain risk-adjusted discount rates.

To compensate for the degree of risk in capital budgeting, firms may adjust the discount
rate for each project according to risk. The more risk is increased, the higher the discount
rate. The more risk is decreased, the lower the discount rate. Rates adjusted for the risk
of projects are called risk-adjusted discount rates (RADRs).
292 Part III  Capital Budgeting and Business Valuation

Equations Introduced in This Chapter

Equation 10-1a. NPV Formula, Algebraic Method:

 CF   CF   CF 
NPV=  1  +  2  + ... +  n  − Initial Investment
 (1 + k )1   (1 + k )2   (1 + k )n 

where: CF = Cash flow at the indicated times

k = Discount rate, or required rate of return for the project
n = Life of the project measured in the number of time periods

Equation 10-1b. NPV Formula, Table Method:

NPV = CF1(PVIFk, 1) + CF2(PVIFk, 2) + . . . + CFn(PVIFk, n) – Initial Investment

where: PVIF = Present Value Interest Factor

k = Discount rate, or required rate of return for the project
n = Life of the project measured in the number of time periods

Equation 10-2. Formula for IRR Using Equation 10-1a:

 CF   CF   CF 
NPV = 0 =  1  +  2  + ... +  n  − Initial Investment
 (1 + k )1   (1 + k )2   (1 + k )n 

where: k = the IRR value

Fill in cash flows (CFs) and periods (n). Then choose values for k by trial and error
until the NPV equals zero. The value of k that causes the NPV to equal zero is the IRR.

Self-Test
ST-1. What is the NPV of the following project? ST-6.  ssume you have decided to reinvest your
A
portfolio in zero-coupon bonds. You like
Initial investment $50,000
zero‑coupon bonds because they pay off a known
Net cash flow at the end of year 1 $20,000
amount, $1,000 at maturity, and involve no other
Net cash flow at the end of year 2 $40,000
cash flows other than the purchase price. Assume
Discount rate 11%
your required rate of return is 12 percent. If you
buy some 10-year zero-coupon bonds for $400
ST-2. What is the IRR of the project in ST-1?
each today, will the bonds meet your return
ST-3.  ou’ve been assigned to evaluate a project for your
Y requirements? (Hint: Compute the IRR of the
firm that requires an initial investment of $200,000, investment given the cash flows involved.)
is expected to last for 10 years, and is expected
ST-7. J oe, the cut-rate bond dealer, has offered to sell you
to produce after-tax net cash flows of $44,503
some zero-coupon bonds for $300. (Remember,
per year. If your firm’s required rate of return is
zero-coupon bonds pay off $1,000 at maturity
14 percent, should the project be accepted?
and involve no other cash flows other than the
ST-4. What is the IRR of the project in ST-3? purchase price.) If the bonds mature in 10 years
and your required rate of return for cut-rate bonds
ST-5. What is the MIRR of the project in ST-3? is 20 percent, what is the NPV of Joe’s deal?
 Chapter 10  Capital Budgeting Decision Methods 293

Review Questions
1. How do we calculate the payback period for a 8. Explain how to resolve a ranking conflict between
proposed capital budgeting project? What are the the net present value and the internal rate of
main criticisms of the payback method? return. Why should the conflict be resolved as you
2. How does the net present value relate to the value explained?
of the firm? 9. Explain how to measure the firm risk of a capital
3. What are the advantages and disadvantages of the budgeting project.
internal rate of return method? 10. Why is the coefficient of variation a better risk
4. Provide three examples of mutually exclusive measure to use than the standard deviation when
projects. evaluating the risk of capital budgeting projects?
5. What is the decision rule for accepting or rejecting 11. Explain why we measure a project’s risk as the
proposed projects when using net present value? change in the CV.
6. What is the decision rule for accepting or rejecting 12. Explain how using a risk-adjusted discount rate
proposed projects when using internal rate of improves capital budgeting decision making
return? compared with using a single discount rate for all
projects.
7. What is capital rationing? Should a firm practice
capital rationing? Why?

Build Your Communication Skills

CS-1. A
 rrange to have a person who has no training After the projects have been described, have
in finance visit the class on the next day after the CEO ask each team for its recommendation
the net present value (NPV) evaluation method about which project to adopt. The CEO may also
has been covered. Before the visitor arrives, listen to input from the class at large.
choose two teams who will brief the visitor
When the debate is complete, have the CEO
on the results of their evaluation of a capital
select one of the projects (based on the class’s
budgeting project. The visitor will play the
recommendations). Then critique the class’s
role of the CEO of the firm. The CEO must
recommendations.
choose one capital budgeting project for the
firm to undertake. The CEO will choose the CS-2. D
 ivide the class into groups of two members
project based on the recommendations of each. Have each pair prepare a written
Team A and Team B. description (closed book) of how to measure
Now have each team describe the following the risk of a capital budgeting project. When
projects: the explanations are complete, select a
volunteer from each group to present their
Team A Team B findings to the class.
Solar Energy Fresh Water
Satellite Extraction Project
(a plan to beam (a plan to extract
energy down drinking water
from orbit) from the sea)
Initial Investment $40 million $ 40 million
NPV $10 million $ 8 million
IRR 12% 18%
294 Part III  Capital Budgeting and Business Valuation

Problems
Payback 10-1. You are investing in a new business known informally as Zombiebook.
The initial investment is $5 million. Future cash flows are projected
to be $2 million at the end of years one, two, three, and four. A different
business in which you are considering investing is called Angry
Rabbits. It too would cost $5 million. Future cash flows for Angry
Rabbits are projected to be $1 million at the end of years one, two,
and three, followed by a positive cash flow of $20 million at the end
of year 4. Compute the payback period for Zombiebook and for Angry
Rabbits. On the basis of the two payback computations, which of the
two companies would you choose? Does this choice cause you any
concern?
NPV and IRR 10-2. An heiress has a rich grandfather who set up a trust that will pay her
$5 million per year for 20 years beginning on her 25th birthday. Assume her
25th birthday is 4 years from now. Further assume that you are a wealthy
investor and this heiress is anxious to get her hands on some serious
cash. You are offered the opportunity to purchase the rights to receive the
promised cash flows from the trust.
a. If you were to pay $80 million today for the right to receive these cash
flows promised to the heiress, what is the net present value (NPV) of
this investment, assuming a 10% discount rate is appropriate?
b. What is the internal rate of return (IRR) of this $80 million investment?

Payback 10-3. Three separate projects each have an initial cash outlay of $10,000. The cash
flow for Peter’s Project is $4,000 per year for three years. The cash flow
for Paul’s Project is $2,000 in years 1 and 3, and $8,000 in year 2. Mary’s
Project has a cash flow of $10,000 in year 1, followed by $1,000 each year
for years 2 and 3.
a. Use the payback method to calculate how many years it will take for each
project to recoup the initial investment.
b. Which project would you consider most liquid?

Net Present Value 10-4. You have just paid $20 million in the secondary market for the winning
Powerball lottery ticket. The prize is $2 million at the end of each year for
the next 25 years. If your required rate of return is 8 percent, what is the net
present value (NPV) of the deal?

Internal Rate 10-5. What is the internal rate of return (IRR) of the Powerball deal in question 4?
of Return

Modified Internal 10-6.  What is the modified internal rate of return (MIRR) of the Powerball deal in
Rate of Return question 4?
 Chapter 10  Capital Budgeting Decision Methods 295

10-7. RejuveNation needs to estimate how long the payback period would be for Payback Period
their new facility project. They have received two proposals and need to
decide which one is best. Project Weights will have an initial investment of
$200,000 and generate positive cash flows of $100,000 at the end of year 1,
$75,000 at the end of year 2, $50,000 at the end of year 3, and $100,000 at
the end of year 4. Project Waters will have an initial investment of $300,000
and will generate positive cash flows of $200,000 at the end of year 1 and
$150,000 at the end of years 2, 3, and 4. What is the payback period for
Project Waters? What is the payback period for Project Weights? Which
project should RejuveNation choose?

10-8. Calculate the NPV of each project in problem 10-5 using RejuveNation’s NPV
cash flows and a 8 percent discount rate.

10-9.  The Bedford Falls Bridge Building Company is considering the purchase NPV and IRR
of a new crane. George Bailey, the new manager, has had some past
management experience while he was the chief financial officer of the local
savings and loan. The cost of the crane is $17,291.42, and the expected
incremental cash flows are $5,000 at the end of year 1, $8,000 at the end of
year 2, and $10,000 at the end of year 3.
a. Calculate the net present value if the required rate of return is 9 percent.
b. Calculate the internal rate of return.
c. Should Mr. Bailey purchase this crane?

10-10. Lin McAdam and Lola Manners, managers of the Winchester Company, do NPV
not practice capital rationing. They have three independent projects they
are evaluating for inclusion in this year’s capital budget. One is for a new
machine to make rifle stocks. The second is for a new forklift to use in the
warehouse. The third project involves the purchase of automated packaging
equipment. The Winchester Company’s required rate of return is 13 percent.
The initial investment (a negative cash flow) and the expected positive net
cash flows for years 1 through 4 for each project follow:

Expected Net Cash Flow

Rifle Stock Packaging
Year Machine Forklift Equipment

0 $(9,000 ) $(12,000 ) $(18,200 )

1 2,000 5,000 0
2 5,000 4,000 5,000
3 1,000 6,000 10,000
4 4,000 2,000 12,000

a. Calculate the net present value for each project.

b. Which project(s) should be undertaken? Why?
296 Part III  Capital Budgeting and Business Valuation

NPV and IRR 10-11. The Trask Family Lettuce Farm is located in the fertile Salinas Valley of
California. Adam Trask, the head of the family, makes all the financial
decisions that affect the farm. Because of an extended drought, the family
needs more water per acre than what the existing irrigation system can
supply. The quantity and quality of lettuce produced are expected to increase
when more water is supplied. Cal and Aron, Adam’s sons, have devised
two different solutions to their problem. Cal suggests improvements to the
existing system. Aron is in favor of a completely new system. The negative
cash flow associated with the initial investment and expected positive net
cash flows for years 1 through 7 for each project follow. Adam has no other
alternatives and will choose one of the two projects. The Trask Family
Lettuce Farm has a required rate of return of 8 percent for these projects.

Expected Net Cash Flow

Year Cal’s Project Aron’s Project

0 $(100,000 ) $(300,000 )
1 22,611 63,655
2 22,611 63,655
3 22,611 63,655
4 22,611 63,655
5 22,611 63,655
6 22,611 63,655
7 22,611 63,655

a. Calculate the net present value for each project.

b. Calculate the internal rate of return for each project.
c. Which project should Adam choose? Why?
d. Is there a conflict between the decisions indicated by the NPVs and
the IRRs?

IRR and MIRR 10-12. Buzz Lightyear has been offered an investment in which he expects to
receive payments of $4,000 at the end of each of the next 10 years in return
for an initial investment of $10,000 now.
a. What is the IRR of the proposed investment?
b. What is the MIRR of the proposed investment? Assume a cost capital
of 10%.
c. Why is the MIRR thought of as a more realistic indication of a project’s
potential than the IRR?

Payback, NPV, 10-13. Dave Hirsh publishes his own manuscripts and is unsure which of two
and IRR new printers he should purchase. He is a novelist living in Parkman,
Illinois. Having slept through most of his Finance 300 course in college,
he is unfamiliar with cash flow analysis. He enlists the help of the finance
professor at the local university, Dr. Gwen French, to assist him. Together
they estimate the following expected initial investment (a negative cash flow)
and net positive cash flows for years 1 through 3 for each machine. Dave
only needs one printer and estimates it will be worthless after three years of
heavy use. Dave’s required rate of return for this project is 8 percent.
 Chapter 10  Capital Budgeting Decision Methods 297

Expected Net Cash Flow

Year Cal’s Project Aron’s Project

0 $(2,000 ) $(2,500 )
1 900 1,500
2 1,100 1,300
3 1,300 800

a. Calculate the payback period for each printer.

b. Calculate the net present value for each printer.
c. Calculate the internal rate of return for each printer.
d. Which printer do you think Dr. French will recommend? Why?
e. Suppose Dave’s required rate of return were 16 percent. Does the decision
about which printer to purchase change?

10-14. Matrix.com has designed a virtual-reality program that is indistinguishable NPV, IRR, and
from real life to those experiencing it. The program will cost $20 million to MIRR
develop (paid up front), but the payoff is substantial: $1 million at the end
of year 1, $2 million at the end of year 2, $5 million at the end of year 3, and
$6 million at the end of each year thereafter, through year 10. Matrix.com’s
weighted average cost of capital is 15 percent. Given these conditions, what
are the NPV, IRR, and MIRR of the proposed program?

10-15. Project A has an initial investment of $11,000, and it generates positive cash Independent
flows of $4,000 each year for the next six years. Project B has an initial and Mutually
investment of $17,000, and it generates positive cash flows of $4,500 each Exclusive Projects
year for the next six years. Assume the discount rate, or required rate of
return, is 13 percent.
a. Calculate the net present value of each project. If Project A and Project B
are mutually exclusive, which one would you select?
b. Assume Projects A and B are independent. Based on NPV, which one(s)
would you select?
c. Calculate the internal rate of return for each project.
d. Using IRR for your decision, which project would you select if Project
A and Project B were mutually exclusive? Would your answer change if
these two projects were independent instead of mutually exclusive?
e. Project C was added to the potential capital budget list at the last minute
as a mutually exclusive alternative to Project B. It has an initial cash
outlay of $17,000, and it generates its only positive cash flow of $37,500
in the sixth year. Years 1 through 5 have $0 cash flow. Calculate Project
C’s NPV. Which alternative, Project B or C, would you choose?
f. Now calculate the IRR of Project C and compare it with Project B’s IRR.
Based solely on the IRRs, which project would you select?
g. Because Projects B and C are mutually exclusive, would you recommend
that Project B or Project C be added to the capital budget for this year?
Explain your choice.
298 Part III  Capital Budgeting and Business Valuation

NPV, and IRR 10-16. Joanne Crale is an independent petroleum geologist. She is taking advantage
of every opportunity to lease the mineral rights of land she thinks lies over
oil reserves. She thinks there are many reservoirs with oil reserves left
behind by major corporations when they plugged and abandoned fields
in the 1960s. Ms. Crale knows that with today’s technology, production
can be sustained at much lower reservoir pressures than was possible in
the 1960s. She would like to lease the mineral rights from George Hansen
and Ed McNeil, the landowners. Her net cost for this current oil venture
is $5 million. This includes costs for the initial leasing and three planned
development wells. The expected positive net cash flows for the project
are $1.85 million each year for four years. On depletion, she anticipates
a negative cash flow of $250,000 in year 5 because of reclamation and
disposal costs. Because of the risks involved in petroleum exploration,
Ms. Crale’s required rate of return is 10 percent.
a. Calculate the net present value for Ms. Crale’s project.
b. Calculate the internal rate of return for this project.
c. Would you recommend the project?

NPV Profile 10-17. Silkwood Power Company is considering two projects with the following
Analysis predicted cash flows:

Hydroelectric Geothermal
Upgrade Upgrade

Initial Investment CFs ($100,000 ) ($100,000 )

End of year 1 CFs 20,000 80,000
End of year 2 CFs 30,000 40,000
End of year 3 CFs 40,000 30,000
End of year 4 CFs 90,000 10,000

a. Construct a chart showing the NPV profiles of both projects.

b. Which project(s) would be accepted if the company’s cost of capital were
6 percent?
c. Which project(s) would be accepted if the company’s cost of capital were
15 percent?
d. At what cost of capital would Silkwood value each project equally?
e. At what cost of capital would the hydroelectric project become
unacceptable?
f. At what cost of capital would the geothermal project become unacceptable?

10-18. The product development managers at World Series Innovations are about to
Challenge recommend their final capital budget for next year. They have a self-imposed
Problem budget limit of $100,000. Five independent projects are being considered.
Vernon Simpson, the chief scientist and CEO, has minimal financial analysis
experience and relies on his managers to recommend the projects that will
increase the value of the firm by the greatest amount. Given the following
summary of the five projects, which ones should the managers recommend?
 Chapter 10  Capital Budgeting Decision Methods 299

Initial Cash Net Present

Projects Outlay Value

Chalk Line Machine ($10,000 ) $4,000

Gel Padded Glove ($25,000 ) $3,600
Insect Repellent ($35,000 ) $3,250
Titanium Bat ($40,000 ) $2,500
Recycled Base Covers ($20,000 ) $2,100

10-19. A project you are considering has an initial investment of $5,669.62. It has Various Capital
positive net cash flows of $2,200 each year for three years. Your required Budgeting Issues
rate of return is 10 percent.
a. Calculate the net present value of this project.
b. Would you undertake this project if you had the cash available?
c. What would the discount rate have to be before this project’s NPV would
be positive? Construct an NPV profile with discount rates of 0 percent, 5
percent, and 10 percent to answer this question.
For more, see
d. What other method might you use to determine at what discount rate the 6e Spreadsheet Templates
net present value would become greater than 0? for Microsoft Excel

10-20. The internal rate of return (IRR) of a capital investment, Project B, is Expected IRR
expected to have the following values with the associated probabilities for an
economic life of five years. Calculate the expected value, standard deviation,
and coefficient of variation of the IRR distribution.

IRR Probability of Occurrence

0% 0.05
1% 0.10
3% 0.20
6% 0.30
9% 0.20
11% 0.10
12% 0.05

10-21. Four capital investment alternatives have the following expected IRRs and Capital
standard deviations. Budgeting Risk

Standard
Project Expected IRR Deviation
A 14% 2%
B 16% 6%
C 11% 5%
D 14% 4%

If the firm’s existing portfolio of assets has an expected IRR of 13 percent with a
standard deviation of 3 percent, identify the lowest- and the highest-risk projects
in the preceding list. You may assume the correlation coefficient of returns from
each project relative to the existing portfolio is .50 and the investment in each
project would constitute 20 percent of the firm’s total portfolio.
300 Part III  Capital Budgeting and Business Valuation

Capital Budgeting 10-22. Assume that a company has an existing Portfolio A, with an expected IRR
Risk and RADRs of 10 percent and standard deviation of 2 percent. The company is considering
adding a Project B, with expected IRR of 11 percent and standard deviation of
3 percent, to its portfolio. Also assume that the amount invested in Portfolio A
is $700,000 and the amount to be invested in Project B is $200,000.
a. If the degree of correlation between returns from Portfolio A and Project
B is .90 (r = +.9), calculate:
1. the coefficient of variation of Portfolio A
For more, see
2. the expected IRR of the new combined portfolio
6e Spreadsheet Templates
for Microsoft Excel 3. the standard deviation of the new combined portfolio
4. the coefficient of variation of the new combined portfolio
b. What is the change in the coefficient of variation as a result of adopting
Project B?
c. Assume the firm classifies projects as high risk if they raise the
coefficient of variation of the portfolio 2 percentage points or more,
as low risk if they lower the coefficient of variation of the portfolio
2 percentage points or more, and as average risk if they change the
coefficient of variation of the portfolio by less than 2 percent in either
direction. In what risk classification would Project B be?
d. The required rate of return for average-risk projects for the company in this
problem is 13 percent. The company policy is to adjust the required rate of
return downward by 3 percent for low-risk projects and to raise it 3 percent for
high-risk projects (average-risk projects are evaluated at the average required
rate of return). The expected cash flows from Project B are as follows:

CF of Initial Investment ($200,000)

end of year 1 55,000
end of year 2 55,000
end of year 3 55,000
end of year 4 100,000

Calculate the NPV of Project B when its cash flows are discounted at:
1. the average required rate of return
2. the high-risk discount rate
3. the low-risk discount rate

Risk in Capital 10-23. D

 orothy Gale is thinking of purchasing a Kansas amusement park, Glinda’s
Budgeting Gulch. She already owns at least one park in each of the surrounding states
and wants to expand her operations into Kansas. She estimates the IRR from
the project may be one of a number of values, each with a certain probability
of occurrence. Her estimated IRR values and the probability of their
occurrence follow.

For more, see

6e Spreadsheet Templates
for Microsoft Excel
 Chapter 10  Capital Budgeting Decision Methods 301

Glinda’s Gulch
Possible IRR Value Probability
2% .125
5% .20
9% .35
13% .20
16% .125

Now Dorothy wants to estimate the risk of the project. Assume she has asked
you to do the following for her:
a. Calculate the mean, or expected, IRR of the project.
b. Calculate the standard deviation of the possible IRRs.
c. Assume the expected IRR of Dorothy’s existing portfolio of parks is 8
percent, with a standard deviation of 2 percent. Calculate the coefficient
of variation of Dorothy’s existing portfolio.
d. Calculate the expected IRR of Dorothy’s portfolio if the Glinda’s Gulch
project is adopted. For this calculation assume that Dorothy’s new portfolio
will consist of 80 percent existing parks and 20 percent new Glinda’s Gulch.
e. Again assuming that Dorothy’s new portfolio will consist of 80 percent
existing parks and 20 percent new Glinda’s Gulch, calculate the standard
deviation of Dorothy’s portfolio if the Glinda’s Gulch project is added.
Because Glinda’s Gulch is identical to Dorothy’s other parks, she
estimates the returns from Glinda’s Gulch and her existing portfolio are
perfectly positively correlated (r = +1.0).
f. Calculate the coefficient of variation of Dorothy’s new portfolio with
Glinda’s Gulch.
g. Compare the coefficient of variation of Dorothy’s existing portfolio
with and without the Glinda’s Gulch project. How does the addition of
Glinda’s Gulch affect the riskiness of the portfolio?

10-24. Four capital investment alternatives have the following expected IRRs and Risk in Capital
standard deviations. Budgeting

Standard
Project Expected IRR Deviation
A 18% 9%
B 15% 5%
C 11% 3%
D 8% 1%
For more, see
6e Spreadsheet Templates
The firm’s existing portfolio of projects has an expected IRR of 12 percent and
for Microsoft Excel
a standard deviation of 4 percent.
302 Part III  Capital Budgeting and Business Valuation

a. Calculate the coefficient of variation of the existing portfolio.

b. Calculate the coefficient of variation of the portfolio if the firm invests
10 percent of its assets in Project A. You may assume that there is no
correlation between the returns from Project A and the returns from the
existing portfolio (r = 0). (Note: In order to calculate the coefficient
of variation, you must first calculate the expected IRR and standard
deviation of the portfolio with Project A included.)
c. Using the same procedure as in b and given the same assumptions,
calculate the coefficient of variation of the portfolio if it includes, in turn,
Projects B, C, and D.
d. Which project has the highest risk? Which has the lowest risk?
Firm Risk 10-25. A firm has an existing portfolio of projects with a mean, or expected, IRR of
15 percent. The standard deviation of this estimate is 5 percent. The existing
portfolio is worth $820,000. The addition of a new project, PROJ1, is being
considered. PROJ1’s expected IRR is 18 percent with a standard deviation
of 9 percent. The initial investment for PROJ1 is expected to be $194,000.
The returns from PROJ1 and the existing portfolio are perfectly positively
correlated (r = +1.0).
For more, see
a. Calculate the coefficient of variation for the existing portfolio.
6e Spreadsheet Templates b. If PROJ1 is added to the existing portfolio, calculate the weight
for Microsoft Excel (proportion) of the existing portfolio in the combined portfolio.
c. Calculate the weight (proportion) of PROJ1 in the combined portfolio.
d. Calculate the standard deviation of the combined portfolio. Is the standard
deviation of the combined portfolio higher or lower than the standard
deviation of the existing portfolio?
e. Calculate the coefficient of variation of the combined portfolio.
f. If PROJ1 is added to the existing portfolio, will the firm’s risk increase or
decrease?
Risk in Capital 10-26. VOTD Pharmaceuticals is considering the mass production of a new
Budgeting sleeping pill. Neely O’Hara, VOTD’s financial analyst, has gathered all
the available information from the finance, production, advertising, and
marketing departments and has estimated that the yearly net incremental
cash flows will be $298,500. She estimates the initial investment for this
project will be $2 million. The pills are expected to be marketable for 10
years, and Neely does not expect that any of the investment costs will be
recouped at the end of the 10-year period. VOTD’s required rate of return
For more, see
for average-risk projects is 8 percent. Two percent is added to the required
6e Spreadsheet Templates rate of return for high-risk projects.
for Microsoft Excel a. Calculate the net present value of the project if VOTD management
considers it to be average risk.
b. A lot of uncertainty is associated with the potential competition of new drugs
that VOTD’s competitors might introduce. Because of this uncertainty,
VOTD management has changed the classification of this project to high risk.
Calculate the net present value at the risk-adjusted discount rate.
 Chapter 10  Capital Budgeting Decision Methods 303

c. Assuming the risk classification does not change again, should this
project be adopted?
d. What will the yearly net incremental cash flow have to be to have a
positive NPV when using the high-risk discount rate?

10-27. Aluminum Building Products Company (ABPC) is considering investing in Comprehensive

either of the two mutually exclusive projects described as follows: Problem
Project 1. Buying a new set of roll-forming tools for its existing roll-
forming line to introduce a new cladding product. After its
introduction, the product will need to be promoted. This means
that cash inflows from additional production will start some
time after and will gradually pick up in subsequent periods.
Project 2. Modifying its existing roll-forming line to increase productivity
of its available range of cladding products. Cash inflows from For more, see
additional production will start immediately and will reduce 6e Spreadsheet Templates
for Microsoft Excel
over time as the products move through their life cycle.
Sarah Brown, project manager of ABPC, has requested that you do the necessary
financial analysis and give your opinion about which project ABPC should
select. The projects have the following net cash flow estimates:

Year Project 1 Project 2

0 ($200,000) ($200,000)
1 0 90,000
2 0 70,000
3 20,000 50,000
4 30,000 30,000
5 40,000 10,000
6 60,000 10,000
7 90,000 10,000
8 100,000 10,000

Both these projects have the same economic life of eight years and average
risk characteristics. ABPC’s weighted average cost of capital, or hurdle rate,
is 7.2 percent.
a. Which project would you recommend Ms. Brown accept to maximize
value of the firm? (Hint: Calculate and compare NPVs of both projects.)
b. What are the IRRs of each project? Which project should be chosen using
IRR as the selection criterion?
c. Draw the NPV profiles of both projects. What is the approximate discount
rate at which both projects would have the same NPV? What is that NPV?
d. Does the selection remain unaffected for i) WACC > 5.4 percent; ii)
WACC > 8.81 percent; and iii) WACC > 14.39 percent?
e. Further market survey research indicates that both projects have lower-
than-average risk and, hence, the risk-adjusted discount rate should be 5
percent. What happens to the ranking of the projects using NPV and IRR
as the selection criteria? Explain the conflict in ranking, if any.
f. Answer questions a, d, and e, assuming the projects are independent of
each other.
304 Part III  Capital Budgeting and Business Valuation

Answers to Self-Test
ST-1. The NPV of the project can be found using Equation 10-1a as follows:

   
$20,000 $40,000
NPV =   +   − $50,000
 (1 + .11)1   (1 + .11)2 

 $20,000   $40,000 
=  +  − $50,000
 1.11    1.2321 

= $18,018 + $32,465 − $50,000

= $483
ST-2. T
 o find the IRR, we solve for the k value that results in an NPV of zero in
the NPV formula (Equation 10-1a) by trial and error:
Try using k = 11%:

   
$20,000 $40,000
0 =   +   − $50,000
 (1 + .11)1   (1 + .11)2 

 $20,000   $40,000 
=  +  − $50,000
 1.11    1.2321 

= $18,018 + $32,465 − $50,000

= $483
The result does not equal zero. Try again using a slightly higher discount rate:
Second, try using k = 11.65%:

   
$20,000 $40,000
0 =   +   − $50,000
 (1 + .1165)1   (1 + .1165)2 

 $20,000   $40,000 
=  +  − $50,000
 1.1165   1.24657225 

= $17,913 + $32,088 − $50,000

= $1
Close enough. The IRR of the project is almost exactly 11.65 percent.

ST-3. T
 he NPV of the project must be calculated to see if it is greater or less than
zero. Because the project in this problem is an annuity, its NPV can be found
most easily using a modified version of Equation 10-1b as follows:

NPV = PMT(PVIFAk, n) – Initial Investment

We include this problem (and some others that follow) to show you that
Equations 10-1a and 10-1b can be modified to take advantage of the present
value of an annuity formulas covered in Chapter 8, Equations 8-4a and 8-4b.
 Chapter 10  Capital Budgeting Decision Methods 305

The problem could also be solved using the basic forms of Equations 10-1a
and 10-1b, but those would take longer.
In this problem, the initial investment is $200,000, the annuity payment is
$44,503, the discount rate, k, is 14 percent, and the number of periods, n, is 10.

NPV = $44,503(PVIFA14%, 10) – $200,000

= $44,503(5.2161) – $200,000
= $232,132 – $200,000
= $32,132

Because the NPV is positive, the project should be accepted.

ST-4. T
 he IRR is found by setting the NPV formula to zero and solving for the
IRR rate, k. In this case, there are no multiple cash flows, so the equation
can be solved algebraically. For convenience we use Equation 10-1b
modified for an annuity:

(
0 = $44,503 PVIFA k%, 10 ) − $200,000

(
$200,000 = $44,503 PVIFA k%, 10 )
$200,000
= PVIFA k%, 10
$44,503

4.49408 = PVIFA k%, 10

Finding the PVIFA in Table IV in the Appendix, we see that 4.4941 (there are
only four decimal places in the table) occurs in the year 10 row in the 18 percent
column. Therefore, the IRR of the project is 18 percent.

ST-5. T
 o calculate the MIRR, first calculate the project’s terminal value. Next,
calculate the annual rate of return it would take to produce that end amount
from the beginning investment. That rate is the MIRR.

For the project in ST-3:

S tep 1: Calculate the project’s terminal value. Note—The terminal value
could be calculated by adding up the future values of each indi-
vidual cash flow, as was done on the MIRR explanation on pages
284–286. In this case, however, that would be a lengthy procedure
because there are 10 cash flows. Recognizing that the cash flows
are an annuity, we can make use of the future value of an annuity
formula, Equation 8-3a, to calculate the terminal value:

È (1+ .14)10 - 1 ˘
FV = $44,503 Í ˙
ÍÎ .14 ˙˚

FV = $44.503 [19.3372951 ]

FV = Projectʼs Terminal Value = $860,568

306 Part III  Capital Budgeting and Business Valuation

Step 2: Calculate the annual rate of return that will produce the terminal
value from the initial investment.
Project’s Terminal Value: $860,568
PV of Initial Investment: $200,000
per Equation 8-6:
 1
 860,568   10 
MIRR =  − 1
 200,000 

MIRR = .1571, or 15.71%

ST-6. T
 here are only two cash flows in this problem, a $400 investment at time 0
and the $1,000 payoff at the end of year 10. To find the IRR, we set the NPV
formula to zero, fill in the two cash flows and periods, and solve for the IRR
rate, k, that makes the right-hand side of the equation equal zero. Equation
10-1b is more convenient to use in this case:

(
0 = $1,000 PVIFk%, 10 ) − $400

(
$400 = $1,000 PVIFk%, 10 )
$400
= PVIFk%, 10
$1,000

.4000 = PVIFk%, 10

If we find the PVIF in Table II inside the book cover, we see that .4000 occurs
in the year 10 row between the 9 percent and 10 percent columns. Therefore,
the IRR of the project is between 9 percent and 10 percent. (The exact value of
the IRR is 9.596 percent). Because your required rate of return in this problem
was 12 percent, the bonds would not meet your requirements.

ST-7. S
 olve for the NPV using Equation 10-1a or b. Equation 10-1a would be
the more convenient version for this problem. The cash flows are a $300
investment at time 0 and a $1,000 future value (FV) in 10 years. The
discount rate is 20 percent.

 
$1,000
NPV =   − $300
 (1 + .20 )10 

 $1,000 
=  − $300
 6.191736 

= $161.51 − $300

= − $138.49
 Chapter 10  Capital Budgeting Decision Methods 307

Appendix 10A
Wrinkles in Capital Budgeting
In this appendix we discuss three situations that change the capital budgeting decision
process. First, we examine nonsimple projects, projects that have a negative initial cash
flow, in addition to one or more negative future cash flows. Next, we explore projects
that have multiple IRRs. Finally, we discuss how to compare mutually exclusive projects
with unequal project lives.

Nonsimple Projects
Most capital budgeting projects start with a negative cash flow—the initial investment—
at t0, followed by positive future cash flows. Such projects are called simple projects.
Nonsimple projects are projects that have one or more negative future cash flows after
the initial investment.
To illustrate a nonsimple project, consider Project N, the expected cash flows for
a nuclear power plant project. The initial investment of $500 million is a negative cash
flow at t0, followed by positive cash flows of $25 million per year for 30 years as electric
power is generated and sold. At the end of the useful life of the project, the storage of
nuclear fuel and the shutdown safety procedures require cash outlays of $100 million at
the end of year 31. The timeline depicted in Figure 10A-1 shows the cash flow pattern:
With a 20 percent discount rate, an initial investment of $500 million, a 30-year
annuity of $25 million, and a shutdown cash outlay of $100 million in year 31, the NPV
of Project N follows (in millions), per Equation 10-1a:

 1 
1 − 
 (1 + .20 )
30


$100

NPVn = $25   −   − $500
( ) 
.20  1 + .20
31
 
 
 

 $100 
= ($25 × 4.9789364 ) −  − $500
 284.8515766 

= $124.47341 − $.35106 − $500

= − $375.8776

We find that at a discount rate of 20 percent, Project N has a negative net present
value of minus $375.88, so the firm considering Project N should reject it.

–$500 25 25 25 25 –100 Figure 10A-1  Cash

Flow Timeline for Project N
t0 t1 t2 t3 t30 t31 (in millions)
308 Part III  Capital Budgeting and Business Valuation

Multiple IRRs
Take Note
The $25 million annual Some projects may have more than one internal rate of return. That is, a project may
payment for 30 years have several different discount rates that result in a net present value of zero.
constitutes an annuity,
Here is an example. Suppose Project Q requires an initial cash outlay of $160,000
so we were able to
adapt Equation 10-1a and is expected to generate a positive cash flow of $1 million in year 1. In year 2, the
by using the present project will require an additional cash outlay in the amount of $1 million. The cash
value of annuity formula, flows for Project Q are shown on the timeline in Figure 10A-2.
Equation 8-4a. We find the IRR of Project Q by using the trial-and-error procedure, Equation 10-2.
When k = 25 percent, the NPV is zero.

   
$1,000,000 $1,000,000
0 =   −   − $160,000
 (1 + .25)1   (1 + .25)2 

 $1,000,000   $1,000,000 
=  −  − $160,000
 1.25   1.5625 

= $800,000 − $640,000 − $160,000

= $0

Because 25 percent causes the NPV of Project Q to be zero, the IRR of the project
must be 25 percent. But wait! If we had tried k = 400%, the IRR calculation would
look like this:
   
$1,000,000 $1,000,000
0 =   −   − $160,000
 (1 + 4.00 )1   (1 + 4.00 )2 

 $1,000,000   $1,000,000 
=  −  − $160,000
 5.00   25.00 

= $200,000 − $40,000 − $160,000

= $0
Because 400 percent results in an NPV of zero, 400 percent must also be the IRR
of the Project Q. Figure 10A-3 shows the net present value profile for Project Q. By
examining this graph, we see how 25 percent and 400 percent both make the net present
value equal to zero.
As the graph shows, Project Q’s net present value profile crosses the horizontal axis
(has a zero value) in two different places, at discount rates of 25 percent and 400 percent.
Project Q had two IRRs because the project’s cash flows changed from negative to
positive (from t0 to t1) and then from positive to negative at (from t1 to t2). It turns out
that a nonsimple project may have (but does not have to have) as many IRRs as there
are sign changes. In this case, two sign changes resulted in two internal rates of return.

t0 t1 t2
Cash flows:
Figure 10A-2  Cash
–$160,000 $1,000,000 –$1,000,000
Flow Timeline for Project Q
 Chapter 10  Capital Budgeting Decision Methods 309

Net Present Value (in thousands of dollars) 100

50

–50

–100

Figure 10A‑3 
–150 Net Present Value Profile
for Project Q
The net present value profile
–200 for project Q crosses the zero
0 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 2.75 3 3.25 3.5 3.75 4 4.25 4.5 4.75 5 line twice, showing that two
Discount Rate IRRs exist.

Whenever we have two or more IRRs for a project, the IRR method is not a useful
decision-making tool. Remember the IRR accept/reject decision rule: Firms should
accept projects with IRRs higher than the discount rate and reject projects with IRRs
lower than the discount rate. With more than one discount rate, decision makers will
not know which IRR to use for the accept/reject decision. In projects that have multiple
IRRs, then, switch to the NPV method.

Mutually Exclusive Projects with Unequal

Project Lives
When mutually exclusive projects have different expected useful lives, selecting among
the projects requires more than comparing the projects’ NPVs. To illustrate, suppose
you are a business manager considering a new business telephone system. One is the
Cheap Talk System, which requires an initial cash outlay of $10,000 and is expected
to last three years. The other is the Rolles Voice System, which requires an initial cash
outlay of $50,000 and is expected to last 12 years. The Cheap Talk System is expected
to generate positive cash flows of $5,800 per year for each of its three years of life. The
Rolles Voice System is expected to generate positive cash flows of $8,000 per year for
each of its 12 years of life. The cash flows associated with each project are summarized
in Figure10A-4.
310 Part III  Capital Budgeting and Business Valuation

Cheap Talk
t0 t1 t2 t3
Figure 10A-4  Cash
Flows for the Cheap –$10 +$5.8 +$5.8 +$5.8
Talk and Rolles Voice
Communications System
(in thousands) Rolles
This figure shows the cash t0 t1 t2 t3 t4 t5 t6 t7 t8 t9 t10 t11 t12
flows for two projects with
unequal lives, Project Cheap
Talk and Project Rolles Voice. –$50 +$8 +$8 +$8 +$8 +$8 +$8 +$8 +$8 +$8 +$8 +$8 +$8

To decide which project to choose, we first compute and compare their NPVs.
Assume the firm’s required rate of return is 10 percent. We solve for the NPVs as follows:
1. NPV of Cheap Talk.

 1 
1 − 3 

NPVCT

= $5,800 
(1 + .10)  − $10,000
.10 
 
 
 

= ($5,800 × 2.48685) − $10,000

= $14.424 − $10,000

= $4,424

2. NPV of Rolles Voice.

 1 
1 − 
 (1 + .10 )
12

NPVRolles = $8,000 
.10  − $50,000
 
 
 

= ($8,000 × 6.81369 ) − $50,000

= $54,510 − $50,000

= $4,510

We find that Project Cheap Talk has an NPV of $4,424, compared with Project
Rolles’ NPV of $4,510. We might conclude based on this information that the Rolles
Voice System should be selected over the Cheap Talk system because it has the higher
NPV. However, before making that decision, we must assess how Project Cheap Talk’s
NPV would change if its useful life were 12 years, not three years.
 Chapter 10  Capital Budgeting Decision Methods 311

Comparing Projects with Unequal Lives

Two possible methods that allow financial managers to compare projects with unequal
lives are the replacement chain approach and the equivalent annual annuity (EAA)
approach.

The Replacement Chain Approach

The replacement chain approach assumes each of the mutually exclusive projects can be
replicated, until a common time period has passed in which the projects can be compared.
The NPVs for the series of replicated projects are then compared to the project with the
longer life. An example illustrates this process. Project Cheap Talk could be repeated four
times in the same time span as the 12-year Rolles Voice project. If a business replicated
project Cheap Talk four times, the cash flows would look as depicted in Figure 10A-5.
The NPV of this series of cash flows, assuming the discount rate is 10 percent, is
(in thousands) $12,121. Each cash flow, be it positive or negative, is discounted back
the appropriate number of years to get the NPV of the four consecutive investments in
the Cheap Talk system.
The NPV of $12,121 for Cheap Talk system is the sum of the NPVs of the four
repeated Cheap Talk projects, such that the project series would have a life of 12 years,
the same life as the Rolles Voice System Project. We are now comparing apples to
apples. Cheap Talk’s replacement chain NPV is $12,121, whereas the NPV of Project
Rolles Voice is $4,510 over the same 12-year period. If a firm invested in project Cheap
Talk four successive times, it would create more value than investing in one project
Rolles Voice.

The Equivalent Annual Annuity (EAA)

The equivalent annual annuity (EAA) approach converts the NPVs of the mutually
exclusive projects into their equivalent annuity values. The equivalent annual annuity is
the amount of the annuity payment that would give the same present value as the actual
future cash flows for that project. The EAA approach assumes that you could repeat
the mutually exclusive projects indefinitely as each project came to the end of its life.
The equivalent annuity value (EAA) is calculated by dividing the NPV of a project by
the present value interest factor for an annuity (PVIFA) that applies to the project’s life span.

Formula for an Equivalent Annual Annuity (EAA)

NPV
EAA =
PVIFA k, n (10A-1)

where: k = Discount rate used to calculate the NPV

n = Life span of the project

Cheap Talk
t0 t1 t2 t3 t4 t5 t6 t7 t8 t9 t10 t11 t12
Figure 10A-5  Cash
Flows for the Cheap Talk
+$5.8 +$5.8 +$5.8 +$5.8 +$5.8 +$5.8 +$5.8 +$5.8 +$5.8 +$5.8 +$5.8 +$5.8 System Repeated 4 times
–$10 –$10 –$10 –$10 (in thousands)
312 Part III  Capital Budgeting and Business Valuation

The NPVs of Cheap Talk ($4,424) and Rolles Voice ($4,510) were calculated earlier,
assuming a required rate of return of 10 percent. With the project’s NPV and the discount
rate, we calculate each project’s EAA, per Equation 10A-1, as follows:
1. EAA of Project Cheap Talk:

$4,424
EAA CT =
2.48685

= $1,778.96

2. EAA of Project Rolles

$4,510
EAA Rolles =
6.81369

= $661.90

The EAA approach decision rule calls for choosing whichever mutually exclusive
project has the highest EAA. Our calculations show that Project Cheap Talk has an EAA
of $1,778.96 and Project Rolles Voice System has an EAA of $661.90. Because Project
Cheap Talk’s EAA is higher than Project Rolles’s, Project Cheap Talk should be chosen.
Take Note
Both the replacement chain and the EAA approach assume that mutually exclusive
Note that the unequal
projects can be replicated. If the projects can be replicated, then either the replacement
lives problem is only an
issue when the projects chain or the equivalent annual annuity methods should be used because they lead to
under consideration the same correct decision. Note in our case that the EAA method results in the same
are mutually exclusive. project selection (Project Cheap Talk) as the replacement chain method. If the projects
If the projects were cannot be replicated, then the normal NPVs should be used as the basis for the capital
independent, we would budgeting decision.
adopt both.

Equations Introduced in This Appendix

Equation 10A-1. The Formula for an Equivalent Annual Annuity:

NPV
EAA =
PVIFA k, n

where: k = Discount rate used to calculate the NPV

n = Life span of the project