Principles of Managerial Finance

Fifteenth Edition, Global Edition

Chapter 10
Capital Budgeting
Techniques

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10.1 Overview of Capital Budgeting
• Capital Budgeting
– The process of evaluating and selecting long-term
investments that contribute to the firm’s goal of maximizing
owners’ wealth
• Motives for Capital Expenditure
– Capital Expenditure
 An outlay of funds by the firm that the firm expects to produce
benefits over a period of time greater than 1 year
– Operating Expenditure
 An outlay of funds by the firm resulting in benefits received
within 1 year

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10.1 Overview of Capital Budgeting
• Capital Budgeting Process
– Consists of five distinct but interrelated steps: proposal
generation, review and analysis, decision making,
implementation, and follow-up
• Steps in the Process
– 1. Proposal Generation
 Managers at all levels in a business make proposals for new
investment projects that are reviewed by finance personnel
 Proposals that require large outlays receive greater scrutiny
than less costly ones
– 2. Review and Analysis
 Financial managers perform formal review and analysis to
assess the merits of investment proposals
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10.1 Overview of Capital Budgeting
• Steps in the Process
– 3. Decision Making
 Firms typically delegate capital expenditure decisions on the
basis of dollar limits
 Generally, the board of directors or a team of very senior
executives must authorize expenditures beyond a certain
amount
 Often, plant managers have authority to make decisions
necessary to keep the production line moving

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10.1 Overview of Capital Budgeting
• Steps in the Process
– 4. Implementation
 Following approval, firms make expenditures and implement
projects; expenditures for a large project often occur in phases
– 5. Follow-up
 Managers monitor results and compare actual costs and
benefits to the projections that they originally used to justify
making the investment
 Managers may take actions to expand, contract, or shut down
investments when actual outcomes differ from projected ones

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10.1 Overview of Capital Budgeting
• Basic Terminology
– Independent versus Mutually Exclusive Projects
 Independent Projects
– Projects whose cash flows are unrelated to (or
independent of) one another; accepting or rejecting one
project does not change the desirability of other projects
 Mutually Exclusive Projects
– Projects that compete with one another so that the
acceptance of one eliminates from further consideration all
other projects that serve a similar function

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10.1 Overview of Capital Budgeting
• Basic Terminology
– Unlimited Funds versus Capital Rationing
 Unlimited Funds
– The financial situation in which a firm is able to accept all
independent projects that provide an acceptable return
 Capital Rationing
– The financial situation in which a firm has only a fixed
number of dollars available for capital expenditures and
numerous projects compete for these dollars

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10.1 Overview of Capital Budgeting
• Basic Terminology
– Accept–Reject versus Ranking Approaches
 Accept–Reject Approach
– The evaluation of capital expenditure proposals to
determine whether they meet the firm’s minimum
acceptance criterion
 Ranking Approach
– The ranking of capital expenditure projects on the basis of
some predetermined measure, such as how much value
the project creates for shareholders

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10.1 Overview of Capital Budgeting
• Capital Budgeting Techniques
– To ensure that the investment projects a firm selects have
the best chance of increasing the value of the firm, financial
managers need tools to help them evaluate the merits of
individual projects and to rank competing investments
– A number of techniques are available for performing such
analyses
– The best techniques take into account the time value of
money as well as the tradeoff between risk and return
– Project evaluation methods that fail to account for money’s
time value or for risk may not lead to shareholder value
maximization

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10.1 Overview of Capital Budgeting
• Capital Budgeting Techniques
– Bennett Company’s Relevant Cash Flows
 We will use one basic problem to illustrate all the techniques
described in this chapter
 The problem concerns Bennett Company, a medium-sized
metal fabricator that is currently contemplating two projects
with conventional cash flow patterns
 Project A requires an initial investment of $420,000, and
project B requires an initial investment of $450,000
 The projected cash flows for the two projects appear in Table
10.1 and on the timelines in Figure 10.1

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Table 10.1 Capital Expenditure Data for
Bennett Company
Blank Project A Project B
Initial investment −$420,000 −$450,000
Year Operating cash inflows
1 $140,000 $280,000
2 140,000 120,000
3 140,000 100,000
4 140,000 100,000
5 140,000 100,000

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Figure 10.1 Bennett Company’s Projects
A and B

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10.2 Payback Period
• Payback Period
– The time it takes an investment to generate cash inflows
sufficient to recoup the initial outlay required to make the
investment
• Decision Criteria
– If the payback period is less than the maximum acceptable
payback period, accept the project
– If the payback period is greater than the maximum
acceptable payback period, reject the project

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Example 10.1
We can calculate the payback period for Bennett Company’s
projects A and B, using the data in Table 10.1. For project A, which
is an annuity, the payback period is 3.0 years ($420,000 initial
investment ÷ $140,000 annual cash inflow). Because project B
generates a mixed stream of cash inflows, the calculation of its
payback period is not as clear-cut. In year 1, the firm will recover
$280,000 of its $450,000 initial investment. By the end of year 2,
$400,000 ($280,000 from year 1 + $120,000 from year 2) will have
been recovered. At the end of year 3, $500,000 will have been
recovered. Only 50% of the year-3 cash inflow of $100,000 is
needed to complete the payback of the initial $450,000. The
payback period for project B is therefore 2.5 years (2 years + 50%
of year 3).

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Example 10.1
If Bennett’s maximum acceptable payback period were 2.75 years,
project A would be rejected and project B would be accepted. If the
maximum acceptable payback period were 2.25 years, both projects
would be rejected. If the projects were being ranked, B would be
preferred over A because it has a shorter payback period. Note,
however, that no matter what payback period Bennett requires, it is
unclear from payback analysis which investment will do the most to
increase shareholder wealth. All we can say is that project B
recoups the initial investment more rapidly than does project A.

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10.2 Payback Period
• Pros and Cons of Payback Analysis
– Large firms sometimes use the payback approach to
evaluate small projects (or as one of several metrics used to
judge a larger project’s merits), and small firms use it to
evaluate most projects
– The payback method’s popularity results from its simplicity
and intuitive appeal
– By measuring how quickly the firm recovers its initial
investment, the payback period also gives at least some
consideration to the timing of cash flows

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10.2 Payback Period
• Pros and Cons of Payback Analysis
– Likewise, the payback approach offers a crude way to adjust
for project risk if managers require a faster payback on
riskier endeavors
– The major weakness of the payback period is that the
appropriate payback period is merely a subjectively
determined number
 No firm connection exists between the payback period and the
goal of shareholder wealth maximization

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Table 10.2 Relevant Cash Flows and Payback
Periods for DeYarman Enterprises’ Projects
Blank Project Gold Project Silver
Initial investment −$50,000 −$50,000
Year Operating cash inflows
1 $ 5,000 $40,000
2 5,000 2,000
3 40,000 8,000
4 10,000 10,000
5 10,000 10,000
Payback period 3 years 3 years

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Example 10.4
Rashid Company, a software developer, has two investment
opportunities, X and Y. Data for X and Y appear in Table
10.3. The payback period for project X is 2 years; for project
Y, it is 3 years. Strict adherence to the payback approach
suggests that project X is preferable to project Y. However, if
we look beyond the payback period, we see that project X
returns only an additional $1,200 ($1,000 in year 3 + $100 in
year 4 + $100 in year 5), whereas project Y returns an
additional $7,000 ($4,000 in year 4 + $3,000 in year 5). On
the basis of this information, project Y appears preferable to
X. The payback approach ignored the cash inflows occurring
after the end of the payback period.

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Table 10.3 Calculation of the Payback Period for
Rashid Company’s Two Alternative Investment
Projects
Blank Project X Project Y
Initial investment −$10,000 −$10,000
Year Operating cash inflows
1 $5,000 $3,000
2 5,000 4,000
3 1,000 3,000
4 100 4,000
5 100 3,000
Payback period 2 years 3 years

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10.3 Net Present Value (NPV)
• Net Present Value (NPV)
– A capital budgeting technique that measures an
investment’s value by calculating the present value of its
cash inflows and outflows
– NPV = Present Value of Cash Inflows – Initial Investment

n
CFt
NPV    CF0 (10.1)
t 1 (1  r )
t

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10.3 Net Present Value (NPV)
• Net Present Value (NPV)
– Not every investment opportunity has this kind of standard cash
flow pattern
– Sometimes firms receive money up front and have to pay out
cash in later years
– Other times a project requires several years of cash outflows
before inflows begin
– Therefore, a more general equation for an investment’s NPV is
n
CFt
NPV   (10.1a)
t 0 (1  r )t

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10.3 Net Present Value (NPV)
• Decision Criteria
– If the NPV is greater than $0, accept the project
– If the NPV is less than $0, reject the project

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Table 10.1 Capital Expenditure Data for
Bennett Company
Blank Project A Project B
Initial investment −$420,000 −$450,000
Year Operating cash inflows
1 $140,000 $280,000
2 140,000 120,000
3 140,000 100,000
4 140,000 100,000
5 140,000 100,000

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 FV
NPVProject A PV 
1  i n
Bennett discounts project cash flows at 10%.
Initial
($420,000)
Investment
Operating Cash Net Present Value
Year
Inflows (NPV)
1 $140,000 $140,000 / (1+0.1)1 = $127,272.73
2 $140,000 $140,000 / (1+0.1)2 = $115,702.48
3 $140,000 $140,000 / (1+0.1)3 = $105,184.07
4 $140,000 $140,000 / (1+0.1)4 = $95,621.88
5 $140,000 $140,000 / (1+0.1)5 = $86,928.99
Total PV $530,710.15

NPV = $530,710.15 - $420,000 = $110,710.15

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 NPVProject A
Bennett discounts project cash flows at 10%.
  1 
1   n 
  1  i   
PVAnnuity  CF  
i
 
 
 
  1 
1   5 
  1  0.1  
Total PV  $140,000 
0 .1
 
 
 
Total PV  $530,710.15
NPV = $530,710.15 - $420,000 = $110,710.15
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 FV
NPVProject B PV 
1  i n
Bennett discounts project cash flows at 10%.
Initial
($450,000)
Investment
Operating Cash Net Present Value
Year
Inflows (NPV)
1 $280,000 $280,000 / (1+0.1)1 = $254,545.45
2 $120,000 $120,000 / (1+0.1)2 = $99,173.55
3 $100,000 $100,000 / (1+0.1)3 = $75,131.48
4 $100,000 $100,000 / (1+0.1)4 = $68,301.35
5 $100,000 $100,000 / (1+0.1)5 = $62,092.13
Total PV $559,243.97

NPV = $559,243.97 - $450,000 = $109,243.97

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Example 10.5
We can illustrate the NPV approach by using the Bennett
Company data presented in Table 10.1. Figure 10.2 shows
the calculation of the NPV for projects A and B, assuming
that Bennett discounts project cash flows at 10%. These
calculations result in net present values for projects A and B
of $110,710 and $109,244, respectively. Both projects are
acceptable because the net present value of each is greater
than $0. If the projects were being ranked, however, project
A would be considered superior to B because its net present
value is higher than that of B.

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Example 10.5
Calculator use We can use the cash flow
register CF and preprogrammed NPV
function in a financial calculator to perform
the NPV calculation. The keystrokes for
project A begin with entering the
investment amount as a cash outflow at
time 0, CF0 = −420,000, then entering the
first annuity cash inflow, CF1 = 140,000,
and then indicating the frequency of the
annuity’s cash inflow, F01 = 5. After
entering the discount rate, I/Y = 10,
compute the NPV.

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Example 10.5
The keystrokes for project B—the mixed
stream—appear in the left margin.
Because the last three cash inflows for
project B are the same (CF3 = CF4 = CF5
= 100,000), after inputting the first of
these cash inflows, CF3, we merely input
its frequency, F03 = 3.
The calculated NPVs for projects A and
B of $110,710 and $109,244,
respectively, agree with the NPVs
already cited.

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Example 10.5
Spreadsheet use The following Excel screenshot illustrates
how to calculate the NPVs using a spreadsheet.

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Figure 10.2 Calculation of NPVs for Bennett
Company’s Capital Expenditure Alternatives

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10.3 Net Present Value (NPV)
• NPV and the Profitability Index
– For a project that has an initial cash outflow followed by
cash inflows, the profitability index (PI) is simply equal to the
present value of cash inflows divided by the absolute value
of the initial cash outflow:

n
CFt
 (1  r ) t
PI  t 1 (10.2)
CF0

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10.3 Net Present Value (NPV)
• NPV and the Profitability Index
– A PI greater than 1.0 implies that the present value of cash
inflows is greater than the (absolute value of the) initial cash
outflow, so a profitability index greater than 1.0 corresponds
to a net present value greater than 0
– In other words, the NPV and PI methods will always come to
the same conclusion regarding whether a particular
investment is worth doing or not

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Example 10.6
We can refer back to Figure 10.2, which shows the present value
of cash inflows for projects A and B, to calculate the PI for each of
Bennett’s investment options:
PIA = $530,710 ÷ $420,000 = 1.26
PIB = $559,244 ÷ $450,000 = 1.24
According to the profitability index, both projects are acceptable
(because PI > 1.0 for both), which shouldn’t be surprising because
we already know that both projects have positive NPVs.
Furthermore, in this particular case, the NPV rule and the PI both
indicate that project A is preferred over project B. It is not always
true that the NPV and PI methods will rank projects in exactly the
same order. Different rankings can occur when alternative projects
require initial outlays that have very different magnitudes.
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10.3 Net Present Value (NPV)
• NPV and Economic Value Added
– Economic Value Added (EVA), a registered trademark of the
consulting firm Stern Stewart & Co., is another close cousin
of the NPV method
– Whereas the NPV approach calculates the value of an
investment over its entire life, the EVA approach gives
managers a tool to measure an investment’s performance
on a year-by-year basis
– The EVA method begins the same way that NPV does: by
calculating a project’s net cash flows

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10.3 Net Present Value (NPV)
• NPV and Economic Value Added
– However, the EVA approach subtracts from those cash flows
a charge that is designed to capture the return that the firm’s
investors demand on the project
– That is, the EVA calculation asks whether a project
generates positive cash flows above and beyond what
investors demand
– If so, the project is worth undertaking

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10.3 Net Present Value (NPV)
• NPV and Economic Value Added
– The EVA method determines whether a project earns a pure
economic profit
– Pure Economic Profit
 A profit above and beyond the normal competitive rate of
return in a line of business

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Example 10.7
Suppose that a certain project costs $1,000,000 up front, but
after that it will generate net cash inflows each year (in
perpetuity) of $120,000. To calculate the NPV of this project,
we would simply discount the cash flows and add them up. If
the firm’s cost of capital is 10%, the project’s NPV is
NPV = −$1,000,000 + ($120,000 ÷ 0.10) = $200,000

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Example 10.7
To calculate the investment’s economic value added in any
particular year, we start with the annual $120,000 cash flow.
Next, we assign a charge that accounts for the return that
investors demand on the capital invested by the firm in the
project. In this case, the firm invested $1,000,000, and
investors expect a 10% return. This means that the project’s
annual capital charge is $100,000 ($1,000,000 × 10%), and
its EVA is $20,000 per year:

EVA  project cash flow –  cost of capital    invested capital 
 $120,000 – $100,000  $20,000

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Example 10.7
In other words, this project earns more than its cost of capital each
year, so the project is clearly worth doing. To calculate the EVA for
the project over its entire life, we would simply discount the annual
EVA figures using the firm’s cost of capital. In this case, the project
produces an annual EVA of $20,000 in perpetuity. Discounting at
10% gives a project EVA of $200,000 ($20,000 ÷ 0.10), identical to
the NPV. In this example, both the NPV and EVA methods reach the
same conclusion, namely, that the project creates $200,000 in value
for shareholders. If the cash flows in our example had fluctuated
through time rather than remaining fixed at $120,000 per year, an
analyst would calculate the investment’s EVA every year and then
discount those figures to the present, using the firm’s cost of capital.
If the resulting figure is positive, the project generates a positive EVA
and is worth doing.

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10.4 Internal Rate of Return (IRR)
• Internal Rate of Return (IRR)
– The discount rate that equates the NPV of an investment
opportunity with $0 (because the present value of cash
inflows equals the initial investment); it is the rate of return
that the firm will earn if it invests in the project and receives
the given cash inflows
n
CFt
$0    CF0 (10.3)
t 1 (1  IRR)t
 Recognizing that projects may have cash inflows or outflows in
any time period (including period 0), we can define the IRR
more generally as
n
CFt
$0   (10.3a)
t  0 (1  IRR )
t

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10.4 Internal Rate of Return (IRR)
• Decision Criteria
– If the IRR is greater than the cost of capital, accept the
project
– If the IRR is less than the cost of capital, reject the project

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10.4 Internal Rate of Return (IRR)
• Calculating the IRR
– With most financial calculators, you merely punch in all cash
flows as if to calculate an NPV and then depress IRR to find
the internal rate of return
– Spreadsheets also have preprogrammed functions that
allow you to calculate a project’s IRR very quickly

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Example 10.8
We can demonstrate the internal rate of return (IRR)
approach by using the Bennett Company data presented in
Table 10.1. Algebraically, the IRR for project A is the number
that solves this equation:
$140,000 $140,000 $140,000 $140,000 $140,000
0  420,000     
(1  IRR) (1  IRR) (1  IRR) (1  IRR) (1  IRR)5
1 2 3 4

Again, we are looking for the discount rate that makes the
NPV of project A’s cash flows equal to zero. One way to
solve this equation is to use a trial-and-error approach, trying
different values for the IRR until reaching a solution.
Likewise, the IRR for project B is the discount rate that
makes the NPV of that project’s cash flows equal zero.
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Example 10.8
Figure 10.3 uses timelines to depict the
framework for finding the IRRs for Bennett’s
projects A and B. We can see in the figure that
the IRR is the unknown discount rate that
causes the NPV to equal $0.
Calculator use To find the IRR using the
preprogrammed function in a financial calculator,
the keystrokes for each project are the same as
those shown on slides 31 and 32 for the NPV
calculation, except that you don’t enter a value
for I/Y or compute NPV. Instead, once the cash
flows have been entered, you push CPT and
IRR as shown here.
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Example 10.8
Comparing the IRRs of projects A and B given in Figure 10.3
to Bennett Company’s 10% cost of capital, we can see that
both projects are acceptable because the return on each
project is greater than the cost of capital:
IRRA = 19.9% > 10.0%
IRRB = 21.7% > 10.0%
Comparing the two projects’ IRRs, Bennett’s managers rank
project B over project A because project B delivers a higher
IRR (IRRB = 21.7% > IRRA = 19.9%). If these projects are
mutually exclusive, meaning that Bennett can choose one
project or the other but not both, the IRR decision technique
would recommend project B.
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Example 10.8
Spreadsheet use The internal rate of return also can be
calculated as shown on the following Excel spreadsheet.

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Figure 10.3 Calculation of IRRs for Bennett
Company’s Capital Expenditure Alternatives

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10.5 Comparing NPV and IRR Techniques
• Net Present Value Profiles
– Graph that depicts projects’ NPVs calculated at different
discount rates

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Example 10.10
To prepare net present value profiles for Bennett Company’s
two projects, A and B, the first step is to develop a number of
“discount rate–net present value” coordinates. Three
coordinates are easy to obtain for each project; they are at a
discount rate of 0%, at a discount rate of 10% (the cost of
capital, r), and the IRR. The net present value at a 0%
discount rate is the sum of all the cash inflows minus the
initial investment. Using the data in Table 10.1 and assuming
a 0% discount rate, we get
For project A:
$140,000  $140,000  $140,000  $140,000  $140,000  $420,000  $280,000

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Example 10.10
For project B:
($280,000  $120,000  $100,000  $100,000  $100,000)  $450,000  $250,000

The net present values for projects A and B at the 10% cost
of capital are $110,710 and $109,244, respectively (from
Figure 10.2). Because the IRR is the discount rate for which
net present value equals zero, the IRRs (from Figure 10.3) of
19.9% for project A and 21.7% for project B result in $0
NPVs. Table 10.4 summarizes the three sets of coordinates
for each of the projects.

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Example 10.10
Of course, it is easy to generate more coordinates by simply
calculating the NPV for each project at other discount rates.
Plotting all of those coordinates results in the net present value
profiles for projects A (the blue curve) and B (the red curve) shown
in Figure 10.4. The figure reveals three important facts:
1. The IRR of project B is greater than that of project A, so managers
using the IRR method to rank projects will choose B over A if both
projects are acceptable.
2. The NPV of project A is sometimes higher and sometimes lower than
that of project B, depending on the discount rate; thus, the NPV
method will not consistently rank A above B or vice versa. The NPV
ranking will depend on the firm’s cost of capital.
3. When the cost of capital is approximately 10.7%, projects A and B
have identical NPVs.
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Example 10.10
The cost of capital for Bennett Company is 10%; at that rate,
project A has a higher NPV than project B (the blue line is
above the red line in Figure 10.4 when the discount rate is
10%). Therefore, the NPV and IRR methods rank the two
projects differently. If Bennett’s cost of capital were a little
higher, say 12%, the NPV method would rank project B over
project A and there would be no conflict in the rankings
provided by the NPV and IRR approaches.

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Table 10.4 Discount Rate–NPV
Coordinates for Projects A and B
Blank Net present value
Discount rate Project A Project B
0% $280,000 $250,000
10 110,710 109,244
19.9 0 —
21.7 — 0

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Figure 10.4 NPV Profiles

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10.5 Comparing NPV and IRR Techniques
• Conflicting Rankings
– Conflicts in the ranking given a project by NPV and IRR,
resulting from differences in the magnitude and timing of cash
flows
– Reinvestment Assumption
 One underlying cause of conflicting rankings is different implicit
assumptions about the reinvestment of intermediate cash
inflows
 The NPV calculation implicitly assumes that the firm can
reinvest intermediate cash inflows at the cost of capital
 The IRR approach, however, assumes that the firm reinvests
intermediate cash inflows at a rate equal to the project’s IRR
 Intermediate Cash Inflows
– Cash inflows received prior to the termination of a project
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10.5 Comparing NPV and IRR Techniques
• Conflicting Rankings
– Timing of the Cash Flow
 Another reason the IRR and NPV methods may provide
different rankings for investment options has to do with
differences in the timing of cash flows
 Figure 10.1 shows the upfront investment required by each
investment is similar, but after that, the timing of each project’s
cash flows is quite different
 Because so much of project B’s cash flows arrive early in its
life (especially compared to the timing for project A), the NPV
of project B will not be particularly sensitive to changes in the
discount rate
 Project A’s NPV, in contrast, will fluctuate more as the discount
rate changes
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Table 10.7 Ranking Projects A and B
Using IRR and NPV Methods
Method Project A Project B
IRR ✓
NPV
if r < 10.7% ✓
if r > 10.7% ✓

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10.5 Comparing NPV and IRR Techniques
• Conflicting Rankings
– Magnitude of the Initial Investment
 Suppose that someone offered you the following two
investment options
 You could invest $2 today and receive $3 tomorrow, or you
could invest $1,000 today and receive $1,100 tomorrow
 The first investment provides a return (an IRR) of 50% in just 1
day, a return that surely would surpass any reasonable hurdle
rate
 But after making this investment, you’re only better off by $1

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10.5 Comparing NPV and IRR Techniques
• Conflicting Rankings
– Magnitude of the Initial Investment
 On the other hand, the second choice offers a return of 10% in
a single day
 That’s far less than the first opportunity, but earning 10% in a
single day is still a very high return
 In addition, if you accept this investment, you will be $100
better off tomorrow than you were today

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10.5 Comparing NPV and IRR Techniques
• Which Approach Is Better?
– Theoretical View
 On a theoretical basis, NPV is the better approach to capital
budgeting for several reasons
 Most importantly, the NPV measures how much wealth a
project creates (or destroys if the NPV is negative) for
shareholders

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10.5 Comparing NPV and IRR Techniques
• Which Approach Is Better?
– Theoretical View
 For an investment project, the NPV calculation always
provides a single answer, but sometimes the IRR calculation
has more than one solution
– Multiple IRRs
• More than one IRR resulting from a capital budgeting
project with a nonconventional cash flow pattern; the
maximum number of IRRs for a project is equal to the
number of sign changes in its cash flows

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10.5 Comparing NPV and IRR Techniques
• Which Approach Is Better?
– Practical View
 Evidence suggests that despite the theoretical superiority of
NPV, financial managers use the IRR approach just as often as
the NPV method
 The appeal of the IRR technique is due to the general
disposition of business people to think in terms of rates of
return rather than actual dollar returns

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Matter of Fact
Which Methods Do Companies Actually Use?
Researchers surveyed chief financial officers (CFOs) about
what methods they used to evaluate capital investment
projects. One interesting finding was that many companies
use more than one of the approaches we’ve covered in this
chapter. The most popular approaches by far were IRR and
NPV, used by 76% and 75% (respectively) of the CFOs
responding to the survey. These techniques enjoy wider use
in larger firms, with the payback approach more common in
smaller firms.

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