Capital Budgeting
Professor Trainor
11-1
Capital Budgeting Decision
Techniques
Payback period: most commonly used
Discounted Payback, not as common
Net present value (NPV): best technique
theoretically; difficult to calculate realistically
Internal rate of return (IRR): widely used with
strong intuitive appeal.
Modified IRR can be used if several neg. cash flows
Profitability index (PI): related to NPV
11-2
A Capital Budgeting Process
Should:
Account for the time value of money;
Account for risk;
Focus on cash flow;
Rank competing projects appropriately, and
Lead to investment decisions that maximize
shareholders’ wealth. 11-3
Payback Period
The payback period is the amount of time required
for the firm to recover its initial investment.
• If the project’s payback period is less than the
maximum acceptable payback period, accept
the project.
• If the project’s payback period is greater than
the maximum acceptable payback period,
reject the project.
Management determines maximum acceptable
payback period. 11-4
Global Wireless
Global Wireless is a worldwide provider of wireless
telephony devices.
Global Wireless evaluating major expansion of its
wireless network in two different regions:
• Western Europe expansion
• A smaller investment in Southeast U.S. to establish a
toehold
Western Europe ($ millions) Southeast U.S. ($ millions)
Initial outlay -$250 Initial outlay -$50
Year 1 inflow $35 Year 1 inflow $18
Year 2 inflow $80 Year 2 inflow $22
Year 3 inflow $130 Year 3 inflow $25
Year 4 inflow $160 Year 4 inflow $30
Year 5 inflow $175 Year 5 inflow $32
11-5
Calculating Payback Periods for
Global Wireless Projects
Management selects a 2.75 years payback period.
Western Europe project has initial outflow of -$250
million,
• But cash inflows over first 3 years only $245 million.
• Global Wireless would reject Western Europe project.
• Southeast U.S. project: initial outflow of -$50
million
• Cash inflows over first 2 years cumulate to $40
million.
• Project recovers initial outflow after 2.40 years.
• Total inflow in year 3 is $25 million. We estimate that
the projects generates $10 million in year 3 in 0.40
years ($10 million $25 million).
• Global Wireless would accept the project. 11-6
Pros and Cons of Payback
Method
Advantages of payback method:
• Computational simplicity
• Easy to understand
• Focus on cash flow
Disadvantages of payback method:
• Does not account properly for time value of money
• Does not account properly for risk
• Cutoff period is arbitrary
11-7
• Does not lead to value-maximizing decisions
Discounted Payback Period
Discounted payback accounts for time value.
• Apply discount rate to cash flows during
payback period.
• Still ignores cash flows after payback period
Global Wireless uses an 18% discount rate.
PV Factors Southeast U.S.
Western Europe
Item project
(18%) project ($million)
($million)
PV Year 1 inflow 0.8475 $29.7 $15.2
PV Year 2 inflow 0.7182 $57.4 $15.8
PV Year 3 inflow 0.6086 $79.1 $15.2
Cumulative PV -- $166.2 $46.2
Accept / reject -- Reject Reject
11-8
Net Present Value
The present value of a project’s cash inflows and
outflows
Discounting cash flows accounts for the time value of
money.
Choosing the appropriate discount rate accounts for
risk.
CF1 CF2 CF3 CFN
NPV CF0 ...
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) N
Accept projects if NPV > 0. 11-9
Net Present Value
CF1 CF2 CF3 CFN
NPV CF0 ...
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) N
A key input in NPV analysis is the discount rate.
r represents the minimum return that the project
must earn to satisfy investors.
r varies with the risk of the firm and/or the risk of
the project.
11-10
Calculating NPVs for Global
Wireless Projects
Assuming Global Wireless uses 18% discount rate,
NPVs are:
Western Europe project: NPV = $75.3 million
35 80 130 160 175
NPVWestern Europe $75.3 250
(1.18) (1.18) 2 (1.18)3 (1.18) 4 (1.18)5
Southeast U.S. project: NPV = $25.7 million
18 22 25 30 32
NPVSoutheast U .S . $25.7 50
(1.18) (1.18) 2 (1.18)3 (1.18) 4 (1.18)5
Should Global Wireless invest in one project or both?
11-11
Pros and Cons of Using NPV as
Decision Rule
NPV is the “gold standard” of investment decision
rules.
Key benefits of using NPV as decision rule:
• Focuses on cash flows, not accounting earnings
• Makes appropriate adjustment for time value of money
• Can properly account for risk differences between
projects
Though best measure, NPV has some drawbacks:
• Lacks the intuitive appeal of payback, and
• Doesn’t capture managerial flexibility (option value) well.
11-12
Internal Rate of Return
Internal rate of return (IRR) is the discount rate that
results in a zero NPV for the project:
CF1 CF2 CF3 CFN
NPV 0 CF0 ....
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) N
• IRR found by computer/calculator or manually by
trial and error.
The IRR decision rule is:
• If IRR is greater than the cost of capital, accept
the project.
• If IRR is less than the cost of capital, reject the
project. 11-13
Calculating IRRs for Global
Wireless Projects
Global Wireless will accept all projects with at least
18% IRR.
Western Europe project: IRR (rWE) = 27.8%
35 80 130 160 175
0 250
(1 rWE ) (1 rWE ) 2
(1 rWE ) 3
(1 rWE ) 4
(1 rWE )5
Southeast U.S. project: IRR (rSE) = 36.7%
18 22 25 30 32
0 50
(1 rSE ) (1 rSE ) 2
(1 rSE ) 3
(1 rSE ) 4
(1 rSE )5
11-14
Advantages and Disadvantages of
IRR
Advantages of IRR:
• Properly adjusts for time value of money
• Uses cash flows rather than earnings
• Accounts for all cash flows
• Project IRR is a number with intuitive appeal
Disadvantages of IRR
• “Mathematical problems”: multiple IRRs, no real solutions
• Scale problem
• Timing problem 11-15
Multiple IRRs
NPV ($)
NPV>0
IRR
NPV>0
Discount
NPV<0 NPV<0
rate
IRR
When project cash flows have multiple sign changes,
there can be multiple IRRs.
With multiple IRRs, which do we compare with the
cost of capital to accept/reject the project?11-16
No Real Solution
Sometimes projects do not have a real IRR solution.
Modify Global Wireless’s Western Europe project to
include a large negative outflow (-$355 million) in
year 6.
• There is no real number that will make NPV=0,
so no real IRR. However, can use something
called modified IRR.
Project is a bad idea based on NPV. At r =18%,
project has negative NPV, so reject!
11-17
Conflicts Between NPV and
IRR
NPV and IRR do not always agree when ranking
competing projects.
The scale problem:
Project IRR NPV (18%)
Western Europe 27.8% $75.3 mn
Southeast U.S. 36.7% $25.7 mn
• Southeast U.S. project has higher IRR, but
doesn’t increase shareholders’ wealth as much as
Western Europe project.
11-18
The Timing Problem
Long-term
NPV IRR = 15%
project
Short-term
IRR = 17%
project
Discount
rate
13% 15% 17%
• The NPV of the long-term project is more sensitive to the
discount rate than the NPV of the short-term project is.
• Long-term project has higher NPV if the cost of capital is
less than 13%. Short-term project has higher NPV if the
cost of capital is greater than 13%.
11-19
Profitability Index
Calculated by dividing the PV of a project’s cash
inflows by the PV of its outflows:
CF1 CF2 CFN
...
(1 r ) (1 r ) 2
(1 r ) N
PI
CF0
Decision rule: Accept project with PI > 1.0, equal to NPV > 0
Project PV of CF (yrs1-5) Initial Outlay PI
Western Europe $325.3 million $250 million 1.3
Southeast U.S. $75.7 million $50 million 1.5
• Both projects’ PI > 1.0, so both acceptable if
independent.
Like IRR, PI suffers from the scale problem.
11-20