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10

Capital Budgeting:
Introduction and Techniques
Chapter Objectives
By the end of this chapter you should be able to:
imply put, investment
1. Introduce TVM concepts to investment analysis
decisions have a
2. Develop project evaluation models
greater impact on a
businesss future than
3. Compare NPV to IRR
any other decision it
4. Select projects under capital rationing
makes. Businesses that
invest profitably make
money and provide a fair return for their owners. Those that fail to invest
profitably are unlikely to survive in the competitive business world. Businesses must invest constantly. Vail Associates, the ski resort operator,
invested $1 million in 1996 in a snowmobile and horseback riding center. Beaver Creek ski area invested $20 million in a retail complex. Both
were hoping to attract an increasingly elusive ski customer. Were these
wise investments? No matter how sophisticated the analysis, a firm is seldom sure. However, we can develop methods that increase the chance
that investments yield more than they cost.
The purpose of this chapter is to investigate methods for evaluating
investment decisions. We will use many of the tools developed so far in
this text. For example, we must adjust an investments cash flows to take
into account the time value of money. Additionally, we must be able to
adjust for the risk of those cash flows.
We begin this discussion by defining capital budgeting.

260
Finance: Investments, Institutions, and Management, Second Edition, by Stanley G. Eakins. Copyright 2002 by
Pearson Education, Inc. Published by Addison Wesley.

CHAPTER 10 Capital Budgeting: Introduction and Techniques

WHAT DOES CAPITAL BUDGETING MEAN?


Chapter 2 introduced the capital markets. The term capital referred to long-term securities and investments. The term retains the same meaning in this chapter. Capital budgeting is the process of deciding which long-term investments or projects a firm will acquire
using the long-term funds it has available. The term budgeting is appropriate because most
firms have more ways to spend money than they have available funds. They must allocate
these limited funds in such a way as to provide the most long-term profits. Keep in mind
that the goal of the financial manager is to increase shareholder wealth. The purpose of
this chapter is to provide techniques for selecting projects that accomplish this.

Summary of Capital Budgeting


Once a possible project has been identified, a firms management must evaluate whether
firm value will be increased if the project is accepted. There are a number of steps to
this evaluation.
1. All relevant cash flows must be identified. Surprisingly, this is where the firm will
make the greatest errors. Although it is often possible to estimate the initial cost of
the project or investment accurately, estimating the cash inflows that follow is very
difficult. For example, Robert Harshaw quit his job with Texas Instruments in 1987
to market a device he had invented to help pilots go through their safety checklist
without making errors. He thought that he was going to get rich selling his product
to the airlines. What he had failed to appreciate was that airlines are extremely reluctant to spend money on products not required by the Federal Aviation Administration. Sales were poor and losses mounted. Harshaws company did not earn a profit
until he won a contract from Cessna in 1993 to develop a digitized voice system to
alert pilots of equipment malfunctions. Because estimating cash inflows may require
estimating the success of new products, errors are almost inevitable.
2. Once all of the cash flows have been identified, they must be analyzed. We will learn
one method that does not require the use of time value of money (TVM) and four
methods that do.
The non-TVM method is the payback period. Although this method has many
faults, it continues to be widely reported and used. A projects payback is simply
the number of years until the investment is recovered.
The most widely used capital budgeting method is the net present value (NPV).
The NPV is computed by subtracting the present value of cash outflows from the
present value of cash inflows. If inflows exceed outflows on a present value basis,
the project is acceptable.
The profitability index (PI) is closely related to NPV. It converts NPV to a ratio
that is often easier to interpret than NPV.
The fourth method we will learn is the internal rate of return (IRR). The IRR is
the average compounded annual return earned by a project. If the return exceeds
the firms cost of capital, the project is accepted.

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Finally we will learn how to compute the modified internal rate of return. This
method is similar to the internal rate of return, but it is modified so that it is more
theoretically sound and in some ways easier to calculate (see Extension 10.1).
3. Finally, the results of the cash flow analysis must be interpreted. We will see that
one important advantage of the TVM-based methods is that they have a clear interpretation. This is not the case with the payback method.

Finding Investment Opportunities


Riches and wealth go to those who are able to see investment opportunities before others.
Consider Duffy Mazan and his partners at Electric Press. In 1994 they formed a company
to set up and maintain Internet Web sites. When they first began marketing their services
they had to explain to their potential customers what the Internet was. Now they receive
calls from customers who are eager to get on the Web. It takes foresight, an understanding
of the market in which you are interested, and some luck to pick growth areas such as this.
On the other hand, consider IBMs investment in OS/2 Warp. Despite huge expenditures, the operating system remains unpopular and not widely distributed. Similarly,
Steve Jobs, one of the founders of Apple Computer, has spent an estimated $130 million,
including $12 million of his own money, on Next Computer (a new computer company).
There has been little payoff from these investments to date.
Most firms are constantly seeking new investment ideas and opportunities. These
ideas may be as simple as replacing two low-output copiers with one high-speed unit.
Alternatively, an investment may change the whole face of a firm. In this chapter we
assume that management has investment ideas to evaluate. Do not lose sight of the fact
that the collection of these ideas spells the success and failure of the firm.

Steps in the Capital Budgeting Process


The capital budgeting process is so critical to the survival of a firm that it is worth discussing the full scope of the capital budgeting process, rather than simply how the evaluation tools are computed. We can identify five steps that a firm should follow.
1. Identification of opportunities: Initially, the firm must have some method in place by
which new opportunities are identified and brought to the attention of management.
For example, when First National Bank of Fairbanks offered a $100 reward to
employees who sent in ideas that were implemented, a vault teller in a small branch
suggested a cash counting machine. Management found that this branch received
large commercial deposits and that the teller was counting each bill separately. Without the reward offer, management would never have learned of the opportunity to
save substantial amounts of teller time with a small capital investment. Management
is often removed from the factory floor or direct customer contact. Employees on
the front lines must have both the incentive and the means to communicate ideas
to those who have the authority to implement them.
2. Evaluation of opportunities: Once the firm identifies an opportunity, it must be evaluated. This requires that all of the costs and benefits be tabulated. These data are

CHAPTER 10 Capital Budgeting: Introduction and Techniques


then subjected to analysis. In this chapter we focus on how to analyze data once they
have been prepared. In the next chapter we learn how to organize the cash flows
from an investment opportunity.
3. Selection: Often firms have more good projects than they can accept in any given
year. This may be because of limited funds or because of human or physical constraints facing the firm. In this chapter we look at how a firm might rank projects
to facilitate selecting among them.
4. Implementation: Once a project has been selected, it must be implemented. The
machines will be purchased, people hired, or investments made. Management must
be vigilant at this stage to ensure that the costs reflect what was initially proposed
and evaluated. For example, Twentieth-Century Fox decided to produce the movie
Titanic in 1995. They projected costs to be about $100 million and decided that the
project would be profitable. Unfortunately, by 1997 cost overruns brought the total
cost to over $200 million. Total movie revenues would have to exceed $350 million
for the project to be profitable. Although this did happen, the risk of the project was
much greater than originally anticipated.
5. Post audit: Once the project has been completed, management must compare
the costs and revenues with the original projections. This is a critical step that
is often overlooked. Holding employees responsible for errors in their projections
gives them an incentive to make more accurate future cost and revenue
projections. Employees who know that they must later explain deviations from
projections will study the results of their last estimates diligently so as to improve
in the future.
Taken together, these steps can dramatically improve a firms ability to select wealthincreasing projects, bring them to fruition, and learn from each experience. In the next
section we study methods of evaluating a project once it has been identified as a possible candidate for capital spending.

EVALUATING THE CASH FLOWS


The financial analyst first estimates the cash inflows and outflows that an investment
will generate. Then these cash flows are evaluated to determine whether the project
should be accepted. In this chapter we investigate methods for evaluating the cash flows,
and in Chapter 11 we will learn how to estimate the cash flows and to handle special situations that arise in evaluating them.
Businesses and investors commonly use the investment evaluation methods discussed earlier. Each suffers from at least one drawback. Some have many problems but
continue to be used because they are simple. We will learn all of the common techniques.
Summarized, they include the following:
Payback period
Net present value
Profitability index

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Internal rate of return
MIRR (Extension 10.1)

Payback Period Method


The payback period method is the easiest investment evaluation method to perform,
but the theoretically worst method available. The payback is simply the number of years
it takes to recover the initial investment. The timing and riskiness of the cash flows are
ignored. The reason it continues to be used is that it is easy to understand and explain
to others. Small businesses are especially likely to use the payback method if the owners or managers are not well versed in financial principles. The method is also used to
supplement more sophisticated techniques.

Computation
The calculation of the payback is very easy if the annual cash flows are annuities (remember that annuities are equal payments received at equal intervals). The payback is found
by dividing the initial investment by the annual annuity.
If the cash flows vary from year to year, they must be accumulated until the sum
equals the initial investment. Partial years can be estimated. In Example 10.1 we use payback to evaluate an annuity.

X A M P L E

10.1

Payback Period: Annuity

In 2000 Consumer Reports listed Lindemans Bin 40 Cabernet Sauvignon as a best buy in its taste
test. If Lindemans wants to expand production to take advantage of the increased sales this report
may generate, it will have to expand its facilities. Assume that expansion of its winery will cost
$1,000,000. If this will generate after-tax cash inflows of $235,000 for 8 years, what is the payback? It will take about 4 years and 3 months for the firm to recover its initial investment.

Solution
Because the annual cash inflows are equal, simply divide them into the initial investment:
Payback = Initial investment
Annual cash inflow
$1,000,000
Payback =
= 4.25 = 4 years, 3 months
$235,000

The calculation is somewhat more complicated if the cash inflows are not equal. An
accumulation table can be constructed to compute payback in this case. We evaluate
an investment with unequal cash flows in Example 10.2.

X A M P L E

10.2

Payback Period: Unequal Cash Flows

Suppose after reviewing its cash flow estimates, Lindemans decides that the publicity provided
by the Consumer Reports article will wear off over time. As a result, cash inflows would decline
10% the first year and then 15% per year thereafter. What is the payback?

CHAPTER 10 Capital Budgeting: Introduction and Techniques


Solution
Set up a table, as presented here. The initial investment and cash inflow are given in the problem. The next column is the sum of the cash inflows. The last column is computed by subtracting the accumulated inflow column from the initial investment.
Initial
Investment

Year
0
1
2
3
4
5
6

:$1,000,000

Cash Inflow
0
$235,000.00
211,500.00
179,775.00
152,808.75
129,887.44
110,404.32

Accumulated
Inflow
0
$235,000.00
446,500.00
626,275.00
779,083.75
908,971.19
1,019,375.51

Balance
:$1,000,000.00
:765,000.00
:553,500.00
:373,725.00
:220,916.25
:91,028.81
;19,375.51

The final year can be estimated by dividing the remaining balance by the cash inflow and then
multiplying the product by 12:
$91,028.81
= 0.824 12 = 9.89 months
$110 ,404.32
It will take Lindemans about 5 years and 10 months to recover its initial investment if the cash
flow estimates are correct (5 years+9.89 months).

Self-Test Review Question*


What is the payback for an investment that requires a $10,000 initial investment
and returns $3,000 per year thereafter?

Advantages
The principal advantage of the payback method is its simplicity. It also provides information about how long funds will be tied up in a project. The shorter the payback, the
greater the projects liquidity.

Disadvantages
There are many problems with the payback method.
No clearly defined accept/reject criteria: Is a 4-year payback good or bad? We do not
have a method to determine this. Often a payback of 2 or 3 years is required, but
clearly this is arbitrary.
No risk adjustment: Risky cash flows are treated the same way as low-risk cash flows.
The required payback period could be lengthened for low-risk projects, but the exact
adjustment is still arbitrary.

265

*$10,000/$3,000=3.33. This means it will take 3.33 years to recover the initial investment. One-third of a
year is 4 months. The payback is then 3 years and 4 months.

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TABLE 10.1 Cash Inflows, $1 Million Over 3 Years
Year

Cash Inflow A

Cash Inflow B

0
1
2
3

0
$500,000
300,000
200,000

0
$200,000
300,000
500,000

Balance
$1,000,000

Ignores cash flows beyond the payback period: Any cash inflows that occur after the
payback period are excluded from the analysis. This is clearly a short-sighted way
to view investments.
Ignores time value of money: Consider Table 10.1. The payback is the same, 3 years,
but cash inflow A is clearly preferred because of the time value of money.
To properly evaluate investment projects we need a method that does not suffer from
the above problems. One such method is the net present value. One reason for learning
the payback method was to demonstrate a poor method of analysis so that you will be
able to appreciate a theoretically sophisticated method. Pay attention to how the net present value approach differs from the payback method.

Net Present Value


Study Tip
Do not simply add together
cash flows that occur at
different points in time.
This will never be correct.
Always adjust the cash
flows by computing the
value they have at a common point in time, usually
the present. You must
always adjust for the time
value of money before
combining cash flows.

The net present value (NPV) is the most popular and theoretically sound evaluation
tool available to analysts. NPV has grown in use among corporations as more students
are exposed to the method in their finance or MBA coursework. Its interpretation
requires a fundamental understanding of the time value of money. Surveys of large
national corporations find that over 70% now apply NPV to project evaluation, although
most companies continue to use other methods as well.

Theory
Most investments have some funds being spent today in the hope that greater amounts
will be received in the future. Because the cash inflows and the cash outflows occur at
different times, they cannot be compared directly. Instead, they must be translated into
a common time period. It is usually easiest to convert all of the cash flows into current
dollars because at least some expenditure is probably made at time zero. After the conversion into present values, the cash inflows are compared with the cash outflows. If
inflows exceed outflows, the project is acceptable. The difference between the cash outflows and the cash inflows is the NPV.

Computation
The formula for calculating NPV can be written several ways. Equation 10.1 uses summation notation:
n

NPV =

t =1

CFt

(1 + i)

Initial investment

(10.1)

CHAPTER 10 Capital Budgeting: Introduction and Techniques


The first term on the right-hand side of the equation computes the present value of
the cash inflows where i is the discount rate. This discount rate is equal to the firms cost
of capital when evaluating projects similar in risk to others in the firms portfolio. The
initial investment is assumed to be paid at time zero, so no discounting is required. If
the initial investment is actually paid out over a period of time, the present value of the
initial investment must be found. Each years cash outflows would have to be discounted
back to the present before subtracting from the present value of the inflows.
An alternative equation for NPV is
NPV=PV(Cash inflows)-PV(Cash outflows)

(10.2)

You can interpret a positive NPV as meaning that the current value of the income
exceeds the current value of the expenditure, so the project should be accepted. A negative NPV means the project costs more than it will bring in and so should be rejected.
The decision criteria for NPV can then be summarized as follows: Accept the project if
NPV is positive or equal to 0; reject the project if NPV is negative.

X A M P L E

10.3

Net Present Value Calculation

The owner of a Texaco gas station in Nevada is considering buying a slot machine to put in his
small convenience store. The slot machine will sell for $6,000 and is expected to bring in about
$10 per day after expenses. Slot machines in casinos have an average take of about $150 per
day after expenses, so the owner believes his cash flow estimate is conservative. If the average
cost of funds to the gas station is 15%, should the slot machine be installed? The machine is
expected to last 3 years before a newer model will be needed to attract gamblers.

Solution
We can simplify the calculations by using the annual projected cash inflow rather than
the daily cash inflow ($10!365=$3,650). Putting the numbers into Equation 10.1 yields
the following:
n

NPV =
NPV =

1 + ti t
t =1 (
)
CF

$3,650

(1.15)

Initial investment
$3,650

(1.15)

$3,650

(1.15)3

$6 ,000 = $2 ,333.77

Because the NPV is positive, the gas station owner should install the slot machine. The problem could also have been worked using the annuity tables to find the present value of the equal
cash inflows.1

How would you explain what an NPV of $2,333.77 means to someone who has not
taken an introductory finance course? One accurate interpretation is that the project has
returned the cost of capital (15%) plus $2,333.77. In other words, the value of the firm
will increase by $2,333.77 as a result of accepting the project.
Suppose that you had completed the analysis of an investment for a very large firm.
The initial investment is $1 billion and the NPV is $1. Assuming you are absolutely
1For

example, NPV=$3,650(PVIFA15%,3 yr)-$6,000=$2,333.68.

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positive of all of your calculations and estimates (this will probably never be true), do
you recommend that the firm make the investment? In other words, do you invest $1
billion to get an NPV of $1? The decision criterion says to accept the project if the NPV
is positive. Many students want to abandon the NPV decision criteria of accepting all
positive-NPV projects when faced with this example. You should recommend acceptance.
The reason is that the project is returning much more than $1. It is returning the required
return (the cost of capital) plus $1. In other words, the firm is getting all that it needs to
be satisfied that it is receiving a fair return, plus a $1 bonus. The point is that a positive
NPV is the amount the investor is receiving above what is required valued at time=0.

X A M P L E

10.4

Net Present Value Calculation

Not all investments are made in one lump sum. Sometimes the initiation of the project takes
several years. For example, the Trans-Alaska Pipeline took 4 years to complete, at a total cost
of $8 billion. Suppose $1 billion was spent the first year, $1 billion the second year, $2 billion
the third year, and $4 billion the last year (assume all investments are made at the beginning
of the year). If the revenues are expected to be $1 billion per year for 20 years and the discount
rate is 15%, should the pipeline have been built (assume all cash inflows occur at the end of
the year and begin at the end of year 1)?

Solution
We will first compute the present value of the cash outflows, and then we will compute the
present value of the cash inflows. Finally, we will compute NPV by subtracting the present value
of the outflows from the present value of the inflows.
Step 1: PV(outflows ) = $1 billion + $1 billion
+ $2 billion
+ $4 billion
1
2
1
(1.15)
(1.15)
(1.15)3

PV(outflows ) = $1 billion + $0.87 billion + $1.51 billion + $2.63 billion


PV(outflows ) = $6.01 billion

Step 2: PV(inflows ) = $1 billion PVIFA 20 yr, 15%

PV(inflows ) = $1 billion6.259 = $6.259 billion

Step 3: NPV = PV(inflows ) PV(outflows )


NPV = $6.259 billion $6.01 billion = $0.248 billion
Because the NPV is greater than zero, the pipeline should have been built.

Advantages
The net present value method solves the problems listed with the payback period
approach.
Uses time value of money concept: The cash flows are discounted back to the present
so that all cash flows are compared on an equal basis.
Clear decision criterion: Accept the project if the NPV is zero or greater. Reject if less
than zero.

CHAPTER 10 Capital Budgeting: Introduction and Techniques

269

Discount rate adjusts for risk: By increasing or decreasing the discount rate, the firm can
adjust for the riskiness of the cash flows. We will investigate how to do this in a later
section. The discount rate used to evaluate capital budgeting projects is the firms cost
of capital, which is the average cost of its debt and equity. The cost of capital reflects
the risk of the firm and the firms average required rate of return on its investments. In
Chapter 12 we will learn how to compute the cost of capital. For now it is best described
as the return the firm must earn on its investments to satisfy investors.

Disadvantages
The primary disadvantage to NPV is that it may be difficult for someone without a background in financial theory to understand. This problem sustains the popularity of other
methods we will study.
A second problem with NPV is that it can be difficult to use when available capital
or resources are limited. If a company must select among a group of positive-NPV projects, it may want to know which projects provide the highest return for the amount
invested. NPV does not provide this information. We will point out alternative methods
that can be helpful when the firm must rank projects.

Self-Test Review Question*


The investment required to obtain a new machine is $2,500. The cash flows are
estimated to be $500 per year for 8 years. If the firms cost of capital is 12%, should it
buy the machine? (Compute NPV)

NPV Profile
An NPV profile graphs the NPV at a variety of discount rates. The NPV profile demonstrates how sensitive the NPV is to changes in the discount rate. We will learn in Chapter 12 that it is very difficult to accurately and confidently estimate the cost of capital for
a firm. At best we can determine an approximate value. Before we recommend that a firm
accept or reject a project, we should determine whether a small error in our cost of capital estimate is important. We can do this by preparing an NPV profile. Once the profile
is prepared, we can note whether small changes in the cost of capital will result in major
changes to the NPV.
Let us prepare an NPV profile for the cash flows given in Table 10.2.
TABLE 10.2
Year

Cash Flow

0
1
2
3
4
5

:$1,000
250
250
250
250
250

Study Tip
Many students get confused about which discount rates should be used
to construct an NPV profile. Any interest rate
works. Simply pick ones
that are above and below
the crossover point. You
will not know where this
occurs until you begin
computing some NPVs.

*No; NPV=$2,483.82-$2,500=:16.18. Because the NPV is negative, do not buy the machine.

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PART III Foundations of Corporate Finance

FIGURE 10.1
NPV Profile

$300

NPV

$200
$100
$0
($100)
($200)
0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10% 11% 12%

Discount Rate

To compute the NPV profile, select a number of different discount rates and compute the NPV for each. You may use any discount rates you choose, although it is usually easiest to begin at 0% because the NPV is found simply by summing the cash flows.
Continue using increasingly larger discount rates until the NPV turns negative. The
NPVs for five interest rates using the cash flows from Table 10.2 are reported below.
Discount Rate
0%
5
7.5
10
12

NPV
$250.00
82.37
11.47
:52.30
:98.81

These numbers are graphed in Figure 10.1. We can read the point where the graph
crosses the horizontal axis. This occurs at about 8%. This is where NPV=0. To the left of
this point NPV is positive and the project is acceptable. To the right of this point NPV is
negative and the project should be rejected. If you are confident that the cost of capital (the
average cost of funds to the firm) is less than the crossover point, accept the project.

X A M P L E

10.5

Preparing an NPV Profile

You are contemplating an investment in a Putt-Putt miniature golf course. If you invest $50,000
today, you expect to receive annual cash flows of $15,000 for the next 5 years. You are not certain of your cost of capital but expect it to be around 15%. Prepare an NPV profile and discuss
whether the investment should be made.

Solution
We will need to compute the NPV at a variety of different discount rates. We do not know which
ones until we actually begin computing a few to see how the NPV profile develops. We will
begin with the discount rate equal to zero and will compute the NPV using increasingly large
discount rates until the NPV is negative. The formula for computing NPV is
NPV=$15,000!(PVIFA5 yr,i)-$50,000

CHAPTER 10 Capital Budgeting: Introduction and Techniques


When i=0%,
NPV = $15,000(5) $50,000
NPV = $75,000 $50,000 = $25,000
When i=5%,
NPV = $15,000(4.329) $50,000
NPV = $64,935 $50,000 = $14,935
We continue computing the NPV at different discount rates until NPV is negative. The results
are reported in this table:
Discount Rate

NPV

0%
5
10
15
20

$25,000
14,935
6,862
282
(5,141)

We now graph the results to obtain our NPV profile:


$30,000.00

NPV

$20,000.00
$10,000.00
$0.00
($10,000.00)
0%

5%

10%

15%

20%

Discount Rate

From the NPV profile we see that we would accept the project as long as the cost of capital was
less than about 1514% because the NPV is positive in that range. Alternatively, we would reject
the project if the cost of capital was greater than about 1514%. In this example, since the cost
of capital is 15%, you would make the investment.

In the next section we will introduce a method that converts NPV into a ratio that
is easier for some to interpret.

Profitability Index (CostBenefit Ratio)


The profitability index (PI) uses the same inputs as the NPV, but by converting the
results to a ratio, it provides additional information. Equation 10.3 computes the PI:
PI =

PI =

(
)
PV (Cash outflows)
PV (Cash inflows)
PV Cash inflows

Initial investment

(10.3)

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The numerator is the present value of the benefits of taking the project. The denominator is the present value of the cost of taking the project. The PI is the benefit relative
to the cost, on a present value basis. An easier interpretation is that the PI is the bang for
the buck provided by the project. When NPV is zero, the PV(Cash inflows) will equal the
PV(Cash outflows) and the PI will be 1. Thus, our decision criterion is to accept the project if the PI is greater than or equal to 1.

Computation
To compute PI simply find the present value of the cash inflows and divide by the PV of
the cash outflows. If you are also computing an NPV, these values should be readily available. We can use the figures provided by Example 10.3 to illustrate the process.

X A M P L E

10.6

Profitability Index

Suppose that a $6,000 investment will yield three cash inflows of $3,650 each. With a discount
rate of 15%, what is the PI?

Solution
The PV of the cash outflow is $6,000 because the entire investment is made today. The PV of
the cash inflows is $3,650(PVIFA15%,3 yr), which is $3,650(2.2832)=$8,333.68. Put these figures into Equation 10.3:
PI =

PV (Cash inflows )

PV (Cash outflows )

$8,333.68
$6,000
PI = 1.39
PI =

The profitability index is 1.39. Because it is greater than 1, we would accept the project. Notice
that this is the same decision we reached in Example 10.3. In fact, PI and NPV will always
provide the same answer to the accept/reject question.

Advantages
The PI is useful as an aid in ranking projects from best to worst. It may be necessary to
rank projects if the firm does not have sufficient funds or capacity to accept all positiveNPV projects. Consider two positive-NPV projects, one small and one large. The large
one may have the largest NPV even though the smaller one has a greater return on the
dollars invested. The profitability index will highlight this difference by computing the
return per dollar invested, on a present value basis. The firm may be better off taking
several small high-PI projects instead of one large positive-NPV project.

Self-Test Review Question*


A machine will cost $2,500 to buy and is expected to yield profits of $500 per
year for 8 years. What is the profitability index? Assume a cost of capital of 12%.
*$500(PVIFA8,12%)=$2,483.80. PI=$2,483.80/$2,500=0.99352. Reject.

Study Tip
Because PI gives the return
per dollar invested, it is
said to give the bang per
buck.

CHAPTER 10 Capital Budgeting: Introduction and Techniques

X A M P L E

10.7

Using PI to Rank Projects

Suppose that you have collected the following data on four possible projects. Rank the projects
using PI. If your capital budget was $1,000, which project(s) would you select?
Project

Net Investment

A
B
C
D

PV (cash inflows)

$ 500
100
1,000
20

$ 550
90
1,052
25

NPV
$50
:10
52
5

Solution
Begin by computing the profitability index for each project:
Project

Net Investment

A
B
C
D

273

$500
100
1,000
20

PV (cash inflows)
$550
90
1,052
25

PI
$550$500=1.1
$90$100=.9
$1,052$1,000=1.052
$25$20=1.25

Now review the PI ratios to see which projects are acceptable. Because project B has a PI less
than 1, it is immediately rejected. Next, rank the projects in order from highest PI to lowest.
Project D has the highest PI, A is next, and C is third. This analysis suggests we should accept
projects A and D, for a total capital budget of $520. The combined NPV of these two projects
is $55, which is greater than the NPV of project C by itself.2

Disadvantages
Although there are no theoretical problems with PI, it should not replace NPV. Ultimately,
the goal of the financial manager is to maximize shareholder wealth. PI may be used as
a supplement to NPV, but not as a replacement.
In the next section we will discuss the most frequently used alternative to the net
present value: the internal rate of return.

Internal Rate of Return


The internal rate of return (IRR) is the discount rate that sets the present value of the
cash inflows equal to the present value of the cash outflows. Alternatively, IRR can be
defined as the discount rate that sets NPV equal to zero. If the IRR is greater than the
cost of capital, the project is accepted. If the IRR is less than the cost of capital, the
project is rejected.
IRR is more difficult to calculate than NPV and often requires the use of a financial
calculator or computer. However, it is far easier to interpret. For this reason it continues
to be used almost as often as NPV.
2The NPV is computed by subtracting the net investment from the PV(inflows). The NPV of A=$50,
B=:$10, C=$52, and D=$5.

Study Tip
NPV and PI will always
give the same accept/reject
decision because all of the
inputs to both models are
exactly the same. The value
of PI is to help rank projects by showing which
provide the greatest return
per dollar invested.

274

PART III Foundations of Corporate Finance

Theory
Suppose that your roommate offers you an opportunity to invest in his mail-order computer parts business. If you invest $100 today, you will receive $110 in 1 year. What is
the return on this investment? You probably answered 10% without needing paper and
pencil. The return on this investment is independent of what else is happening to market returns, so we call it an internal return.
Would you accept your roommates offer? That depends on what your required rate
of return is. If your cost of capital is 12%, you would reject the proposal.
Let us continue with this example by demonstrating how we would compute the
NPV. The figures are initially put into Equation 10.3:
NPV = $110 $100
1+ i
If we know the discount rate (i), we can compute NPV. The IRR approaches the
problem from a slightly different angle. Rather than inputting a discount rate and computing NPV, we ask how high the discount rate can be before NPV becomes negative and
the project is unacceptable. We find this breakeven discount rate by setting NPV equal
to zero and solving for i. For example,
NPV = 0 = $110 $100
1+i
$100 = $110
1+i
1 + i = $110 = 1.10
$100
i = 0.10 = 10%
The 10% interest rate is the value of the discount rate that sets the present
value of the cash inflows equal to the present value of the cash outflows. If the
10% return is acceptable, the project should be taken. In this example, because
capital cost 12%, we reject the project. Thus, the decision criterion for IRR can be
summarized as follows: Accept the project if the IRR is greater than or equal to the
cost of capital.3
Review Figure 10.1. We can read the IRR directly off the NPV profile. The IRR is
the discount rate where NPV=0. This is where the profile crosses the horizontal axis.

Computation
In the preceding example we saw that the calculation of the IRR was fairly straightforward when there was a single cash inflow. It becomes much more complicated when
there are multiple cash flows. There are three methods to use depending on the nature
of the cash flows and the availability of a financial calculator. They involve using financial tables, trial and error, and a calculator. We will discuss each of the methods below
and illustrate them with examples.
3When

used in this context, the cost of capital is often referred to as the hurdle rate. It is the rate the IRR must
exceed to be acceptable.

CHAPTER 10 Capital Budgeting: Introduction and Techniques


The first method involves using financial tables: If there is only one cash inflow or
if the cash inflows are equal, the financial tables may be used to find an approximation
of IRR. The steps are listed here:
1.
2.
3.
4.

Set up the problem as if you were solving for NPV.


Set NPV equal to zero.
Solve for PVIF or PVIFA.
Look up the interest rate that corresponds to the factor found in step 3 in the PVIF
or PVIFA table.

X A M P L E

10.8

Computing IRR: Factor Method

If the initial investment is $500 and the cash inflows are $200 for 3 years, what is the IRR?

Solution
NPV = 0 = $200(PVIFAIRR,3 yr) $500
$500 = $200(PVIFAIRR,3 yr)
$500/$200 = PVIFAIRR,3 yr
2.500 = PVIFAIRR,3 yr
Look in the PVIFA table for the factor equal to 2.5 with 3 periods. We find that the interest rate
falls between 9% and 10%. We could estimate the IRR to be 9.5%.

The second method involves trial and error. This method is used if the cash flows
are not equal. The problem is again set up as if you were setting NPV equal to zero. Select
an interest rate and determine whether NPV computes to zero. If not, try another. (If the
computed NPV was positive, try a higher interest rate; if it was negative, try a lower rate.)
Keep trying interest rates until NPV is equal to zero.

X A M P L E

10.9

IRR by Trial and Error

Use the cash flows from Example 10.8 and compute the IRR by trial and error.

Solution
To solve this example by trial and error we would set it up using Equation 10.3:
NPV = 0 =

$200 + $200 + $200 $500


1
( + i ) 1 (1 + i ) 2 (1 + i ) 3

If the discount rate is set equal to 9%, NPV=6.26. If the discount rate is set equal to 10%,
NPV=:2.63. The internal rate of return is between 9% and 10%.

The third method involves using a financial calculator. Many financial calculators have
built-in IRR formulas. The cash flows must be entered before the IRR can be calculated.

275

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PART III Foundations of Corporate Finance


(Refer to the owners manual to find out how to do this because each brand of calculator
is different.) Solving this example using a financial calculator yields an IRR of 9.70%.

Advantages
The primary advantage of the IRR method of investment analysis is that it is easy to interpret and explain. Investors like to speak in terms of annual interest rates when evaluating
investment options. For this reason, many firms that use NPV also compute IRR.

Disadvantages
Study Tip
Note that we also make an
assumption about reinvestment of periodic cash
flows when computing
NPV. We assume that those
cash flows are reinvested at
the firms cost of capital.

There are several serious problems with IRR that must be understood. They do not necessarily invalidate the model, but must be considered before its application.

Reinvestment Rate Assumption The IRR assumes that the cash flows are reinvested at the internal rate of return when they are received. In Example 10.8, three payments of $200 are received. The first payment is reinvested for two periods and the second
payment is reinvested for one period. IRR assumes that these payments earn 9.70% when
reinvested until the project is over. We consider this reinvestment rate assumption to be a
disadvantage because there may not be any other investments available with returns equal
to high-IRR projects, so it may not be possible to reinvest at the IRR.
The reinvestment rate assumption is a problem only when you are attempting to rank
mutually exclusive projects. If you are just attempting to reach an accept/reject decision
on a project, the reinvestment rate assumption is not relevant. On the other hand, it may
cause incorrect ranking of projects. If you depend on IRR to select among projects, you
may select the wrong one. Review Table 10.3. The initial investment is $1,000 for projects A and B, but we get conflicting rankings from NPV and IRR. NPV is higher for project A, but IRR is greater for project B. Which project do we accept? Because the NPV is
computed using the firms cost of capital, we can assume that other projects are available
at that rate. We do not know whether any more investments are available that yield 20%.
For this reason, we favor NPV when ranking projects. Note that both methods gave the
same accept/reject decision. This will always be true. A project that is found acceptable
with NPV will also be acceptable with IRR.
To better understand the ranking problem, review Figure 10.2, which graphs the
NPV profiles of projects A and B. Project A has the highest NPV for all discount rates

TABLE 10.3

Cash Flows
Year

Project A

Project B

0
1
2
3
NPV@5%
IRR

:$1,000
0
0
$1,500
$295.76
14.47%

:$1,000
$1,200
0
0
$142.86
20%

CHAPTER 10 Capital Budgeting: Introduction and Techniques

Project A
Project B

500
Project A has
greatest NPV at
a 5% discount rate.

400
300

NPV

200

Project B has
greatest NPV at
a 25% discount rate.

100
0
100
200
300
400
0%

5%

10%

15%

20%

25%

30%

Discount Rate

less than 12%. Project B is superior for all discount rates greater than 12%. The projects rank depends on the discount rate. Because the IRR method does not evaluate
the project at a particular discount rate, it cannot be used for ranking mutually exclusive projects.

There May Not Be a Solution to an IRR Problem In some instances there


is more than one solution to an IRR problem. Because computer programs and calculators cannot tell which is correct, they return an error message. This usually happens
when there are changing signs on the cash flows (most periods having positive cash flows
and some having negative cash flows). The multiple IRR problem can be shown graphically with the NPV profile.
Suppose a mining operation will spend $120 million to begin operation, will receive
$310 million the second year, and will spend $200 million to clean up. The NPV profile
is shown in Figure 10.3.
The NPV is initially negative, becomes positive, then becomes negative again.
Because it crosses the zero NPV line twice, there are two IRRs. Because cash flows often
alternate signs, this can be a serious problem.
Accurate Calculation Often Requires a Financial Calculator It becomes
very tedious to find the IRR by trial and error. You will probably not want to attempt
many IRR calculations without the help of a financial calculator or spreadsheet program.
However, with financial calculators available for less than $30, this is less of a problem
than it used to be.

277

FIGURE 10.2
IRR Ranking Problem

278

PART III Foundations of Corporate Finance

FIGURE 10.3
Multiple IRRs

NPV

0
2
4
6
8
10
0%

15%

25%

30%

33.30%

40%

Discount Rate

IRR Ignores Differences in Scale Suppose you had the choice of buying the
Kinston Indians (a small-town baseball team) or the Atlanta Braves. You can buy the
Indians for $10,000. The Atlanta Braves cost $10 million, but contractual provisions limit
you to owning only one baseball team of any kind. If both have an IRR of 25%, which
would you take if you could afford either? The IRR does not give you any help because
it converts the cash flows to percentages and ignores differences in the size or scale of
projects being considered. Clearly anyone of sound mind would go with the Braves.

NPV Versus IRR


Which method should you use to evaluate a project? It depends on who your audience
is, whether you are ranking projects or just trying to determine which are acceptable,
and whether the project has alternating signs on the cash flows.
If you are a small business owner doing calculations for your own business, you do
not have to worry about the sophistication of your audience. However, most of the time
you will be presenting your analysis to other investors. How successful would you be in
convincing your art major roommate to invest in your new mail-order pizza business if
you spoke only of net present values, cost of capital, risk-adjusted discount rates, and
the like? Once you were convinced your numbers were correct by using NPV, a simplified presentation using IRR and payback may be more successful.
The choice of analysis methodology also depends on whether you are attempting to
select among many good projects or just determining the acceptability of a single project. Remember that IRR cannot be used to rank projects.
Finally, if your project has cash flow sign changes, you may not be able to compute
an IRR. This will force you to focus on NPV. Never rely wholly on the payback method
because it leaves so much out of the analysis.
Some analysts have attempted to save the IRR method by developing an alternative
calculation that reinvests funds at the cost of capital. This method, known as the modified internal rate of return, is often used in real estate analysis.

CHAPTER 10 Capital Budgeting: Introduction and Techniques

EXTENSION 10.1
Modified Internal Rate of Return (MIRR)
Because of the problems listed above for the internal rate of return, analysts have developed an alternative evaluation technique that is similar to IRR, but attempts to improve on
it. The cash outflows are discounted back to the present at the cost of capital and the cash
inflows are compounded at the cost of capital to the end of the projects life. The future
value of the cash inflows is called the terminal value. The modified internal rate of return
(MIRR) is the interest rate that sets the PV of outflows equal to the terminal value.
The calculation of MIRR, though it takes several steps, is not difficult.
1. Find the present value of all cash outflows at the firms cost of capital. Often the only
cash outflow is the initial investment. If any subsequent cash outflows are required,
such as a future modification, compute the present value of these outflows as well.
2. Find the future value of all cash inflows at the firms cost of capital. All positive cash
flows are compounded to the point in time at which the last cash inflow is received.
3. Compute the yield that sets the present value of the inflows equal to the present
value of the outflows. This yield is the modified internal rate of return.
An example will help explain this method.

X A M P L E

10.10

Modified Internal Rate of Return

Compute the MIRR for the following cash flow stream. Assume a cost of capital of 10%. The
initial investment is $500. The cash inflows are $300 per year for 2 years, followed by a $200
expenditure and then one more $300 inflow.

Solution
Prepare a time line to better visualize the process:
0
1
2
$500

$300

$300

$200

$300

1. The investment is $500+200(PVIF 3 yr, 10%)=$650.26.


2. There are three positive cash inflows that must be compounded to the end of the fourth
period. The first $300 cash flow is compounded for three periods. The second $300 cash
flow is compounded for two periods, and the last $300 earns no interest. The sum of the
future value of the cash flows is the terminal value:
Terminal value=$300(1.103)+$300(1.102)+$300
Terminal value=$399.30+$363.00+$300
Terminal value=$1,062.30
3. In this step we compute the interest rate that will set the investment of $650.26 equal to the
terminal value of $1,062.30. This is most easily done using a financial calculator.

279

280

PART III Foundations of Corporate Finance


Calculator solution:
PV=:650.26,

FV=$1,062.30,

Factor table solution:

N=4,

PMT=0,

compute I=13.05%

PV = FV(PVIFn,i)

650.26 = 1,062.30(PVIFn,i)
PVIFn,i =

650.26 = 0.6121
1,062.30

Now go to the PVIF table and find the factor closest to 0.6121 in the row corresponding to four
periods. We find that the factor falls close to 13%, so we estimate the MIRR as about 13%.

The MIRR solves the reinvestment rate assumption problem because all cash flows
are compounded at the cost of capital. It also solves the problem of changing cash flow
signs resulting in multiple IRRs. It still suffers from scale problems. Remember that one
problem with IRR is that it does not distinguish between large and small projects effectively. MIRR suffers from this same limitation. As a result, it cannot be used to rank projects. Hence, it can only be used to make the accept/reject decision, which is accurately
done by IRR. Again we reach the same conclusion: Because NPV is easy to calculate and
provides a correct wealth-maximizing decision, it is the preferred method.

Self-Test Review Question*


The initial investment for a project is $706.80. It will generate cash inflows
for each of the next 3 years of $300. What is the MIRR, assuming a cost of capital
of 10%?
*Terminal value is $300(1.12)+$300(1.1)+$300=$993. The initial investment is $706.80. The MIRR is
found using a financial calculator with N=3, PV=:$706.80, FV=$993, and PMT=0; we compute
I=12%. Alternatively, the PVIF=$706.80/$993=0.7118, which corresponds to 12% at 3 periods.

Careers in Finance
Large corporations employ financial analysts
whose primary responsibility is to evaluate capital spending projects of interest to the firm. A
financial analyst collects information from
throughout the firm to prepare cash flow estimates. These
estimates are then analyzed to determine whether the firm
should pursue the projects. The financial analyst is often
also employed in reviewing projects as they are implemented and post completion.

Financial Analyst
Financial analysts salaries range from
$23,000$27,000 for new hires by small firms
to $50,000 or $60,000 for seasoned analysts
employed by larger firms. Many financial analysts use the skills they learn analyzing individual projects
to advance into into positions of chief financial officer,
where salaries can reach several hundred thousand dollars per year.

CHAPTER 10 Capital Budgeting: Introduction and Techniques

281

CHAPTER SUMMARY
Capital budgeting is the process of evaluating the cash flows
from investment opportunities and deciding which investments should be accepted or rejected by the firm. The capital
budgeting process requires two distinct steps. First, the cash
flows from the project must be accurately estimated. Second,
the cash flows must be evaluated to determine whether they
provide a return sufficient to cover the firms cost of capital.
This chapter introduced five methods to evaluate potential
investment opportunities. In Chapter 11 we will investigate
how cash flows are estimated.
The payback period method simply computes the number of years required to recapture the initial cash outflows.
This method is used primarily because of its simplicity. It can
also provide an indication of the projects liquidity because it
tells the analyst how long the firms funds will be tied up in
the project. However, it fails to adjust for risk or for the time
value of money. Additionally, any cash flows that occur after
the payback period are ignored.
The net present value (NPV) method is the preferred way
of evaluating cash flows. It adjusts for risk and for the time
value of money by evaluating all cash flows in the present. It
is theoretically accurate and is easy to compute. Accepting all
positive-NPV projects will lead to maximizing the value of the
firm. It can also be used to rank projects if the firm is unable
to accept all positive-NPV opportunities.
The profitability index (PI) is the ratio of the present value
of the cash inflows to the present value of the cash outflows

(initial investment). If the PI is greater than 1, the project


should be accepted. Although the PI always gives the same
accept/reject decision as NPV, it has the advantage of providing
an indication of the return per dollar invested (the bang for the
buck). This can be useful in attempting to rank projects.
The internal rate of return (IRR) is popular because it
provides a percentage return on the project that is easy to
interpret and to explain to others. It suffers from several problems, however. First, there is a fundamental theoretical problem in that the cash flows are assumed to be reinvested at the
IRR instead of at the cost of capital. Second, when there are
alternating signs in the cash flows, no single solution may be
available. Third, the IRR is difficult to compute. It usually
requires a financial calculator. Finally, it cannot be used to
rank projects because it does not adjust for differences in scale.
The IRR and the NPV always provide the same
accept/reject decision. This means that as long as IRR is not
being used to rank the merits of projects, it can be used to
evaluate potential investment opportunities.
The modified IRR (MIRR) attempts to solve some of the
problems of the IRR. All cash flows are assumed to be reinvested at the cost of capital. The MIRR is the rate that sets the
present value of the initial investment equal to the future
value of the periodic cash flows.
In Chapter 11 we will learn to estimate cash flows and
some refinements to capital budgeting techniques that are
often required.

KEY WORDS
capital budgeting 261
cost of capital 269
internal rate of return
(IRR) 273

modified internal rate of


return (MIRR) 279
net present value
(NPV) 266

NPV profile 269


payback period 264
profitability index (PI) 271

DISCUSSION QUESTIONS
1. Why is capital an appropriate word to use to describe the
process of evaluating possible investment projects?
2. What steps should a firm take to maximize its chance
of successfully identifying and implementing investment projects?
3. What is the purpose of the post audit?
4. What are the advantages and disadvantages of the
payback method, NPV, IRR, PI, and MIRR?
5. What is the decision criterion for NPV, PI, IRR, and
MIRR?

6. What is the purpose of the NPV profile? Where is the


IRR on the profile? Which region of the profile shows
acceptable projects?
7. Why would you choose to use the PI over the NPV?
(What does the PI tell you that the NPV does not?)
8. What is the reinvestment assumption for the NPV and
for the IRR? Which is more theoretically sound?
9. When is the IRR as good a method to use as the NPV?
When should IRR not be used?
10. What problems with the IRR are fixed by the MIRR?
(Extension 10.1)

282

PART III Foundations of Corporate Finance

PROBLEMS
1. Consider the cash flows for the following two
investments:
Year
0
1
2
3
4

Investment 1
:$150
20
50
70
120

Investment 2
:$150
30
40
100
110

a. What are the payback periods on these two


investments?
b. What are the NPV and PI for each project if the
required rate of return is 8%?
c. If these two investments were mutually exclusive, which would you choose?
2. Consider the following cash flows:
Year
0
1
2
3
4

Project 1

Project 2

:$200
0
50
100
150

:$300
100
100
100
100

a. Calculate the NPV and PI for each project.


There is a 10% required return.
b. Calculate the IRR for project 2.
3. Using the data from problem 2,
a. Use the cash flows from project 2 to prepare an
NPV profile.
b. On the graph prepared in step a, identify the
range of discount rates at which the project is
acceptable.
c. On the graph prepared in step a, identify the
range of discount rates at which the project is
not acceptable.
d. On the graph prepared in step a, locate the IRR.
4. Compute the NPV, PI, and IRR for the following projects.
Which projects should be accepted?
a. The project requires an initial investment of
$1,200 and provides five annual cash inflows of
$350. Assume a cost of capital of 13%.
b. The project requires an initial investment of
$12,000 and provides five annual cash inflows
of $3,500. Assume a cost of capital of 13%.
c. The project requires an initial investment of
$12,000 and provides 10 annual cash inflows of
$1,750. Assume a cost of capital of 13%.

5.

6.

7.

8.

d. The project requires an initial investment


of $12,000 and provides 10 annual cash
inflows of $1,750. Assume a cost of capital
of 8%.
e. The project requires an initial investment
of $12,000 and provides 10 annual cash
inflows of $1,750. Assume a cost of capital
of 6%.
Project L has a cost of $40,000, and its expected net cash
inflows are $9,000 per year for 8 years.
a. What is the projects payback period?
b. The cost of capital is 12%. What are the projects NPV and PI?
c. What is the projects IRR?
A factory costs $550,000. You forecast that it will produce cash inflows of $100,000 in year 1, $200,000 in
year 2, and $300,000 in year 3. The cost of capital is
12%. What is the NPV of the factory?
You are presented a proposal for a project. Project Iron
costs $5,000 and will bring in $25,000 in the first year.
The next year you will have to pay out $20,000. With a
10% cost of capital, calculate the NPV for the project. Do
you accept the project?
Rollins Supplies Company is considering an expansion
project. The cash flows are shown in the following table.
The cost of capital is 20%.
Year

Cash Flow

0
1
2
3
4
5

:$2,500
1,500
1,700
1,000
1,000
1,000

a. Calculate the NPV and PI for the expansion


project.
b. What is the IRR of the project?
9. You are considering building a shopping mall. The initial investment for the mall is $1 million. The cash flows
are $500,000 for year 1, $400,000 for year 2, $300,000
for year 3, and $100,000 for year 4.
a. What are the NPV and PI of the project if the
cost of capital is 10%?
b. Compute the IRR for the project.
c. Construct an NPV profile for the project.
10. Consider the following two projects. All cash flows
shown are on an after-tax basis.

CHAPTER 10 Capital Budgeting: Introduction and Techniques


Year

Project A

Project B

0
1
2
3

:$75,000
30,000
18,000
50,000

:$55,000
22,000
13,200
37,000

a. If the discount rate is 16%, what are the PI and


NPV of project A?
b. If the discount rate is 16%, what are the PI and
NPV of project B?
c. Find the IRR of project A.
d. Find the IRR of project B.
e. Which project would you prefer?
f. If the cost of capital for project A is 13% and
the cost of capital for project B is still 16%,
which project would you prefer?
11. A firm has a project with a cost of $65,000 that is
expected to produce benefits of $14,000 per year for 10
years. Calculate the projects payback period, NPV, PI,
and IRR. Assume a cost of capital of 14%.
12. Eastern Building is considering two mutually exclusive
projects. With a 12% cost of capital, evaluate the given
net cash flows to determine which project, if any, should
be accepted, and why. Comment on any differences in
NPV, MIRR (Extension 10.1), and IRR (if any exist). The
IRR is 17.28% for Rivergate and 17.12% for Treywood.
The initial cost of Rivergate is $445,000, whereas the cost
of Treywood is $1,400,000.
Years
1
2
3
4
5

283

13. The Renn project cost $55,000 and its expected net cash
inflows are $12,000 per year for 8 years.
a. What is the projects payback period?
b. The cost of capital is 12%. What is the projects
NPV?
c. What is the projects IRR?
d. Calculate the projects MIRR assuming a 12%
cost of capital. (Extension 10.1)
14. Lacey Industries Co. has been evaluating a project with
a cost of $700,000. Estimated net cash flows of $180,000
are expected for a 7-year period. The cost of capital is
14%. Find the NPV and IRR.
15. The Fitness Center is considering including two pieces
of equipment, a treadmill and a step machine, in
this years capital budget. The projects are independent.
The cash outlay for the treadmill is $1,700 and for
the step machine it is $2,200. The firms cost of capital
is 14%. After-tax cash flows, including depreciation,
are as shown in the following table. Calculate the NPV,
the IRR, and the MIRR (Extension 10.1) for each
project, and indicate the correct accept/reject decision
for each.
Years

Treadmill

Step Machine

1
2
3
4
5

$510
510
510
510
510

$750
750
750
750
750

Rivergate
Treywood
Net Cash Flows Net Cash Flows
$160,000
160,000
160,000
95,000
95,000

$275,000
275,000
600,000
600,000
600,000

SELF-TEST PROBLEMS
1. XYZ Company wants to know the payback period for
a project with an initial investment of $4 million and
annual cash flows of $800,000. What is it?
2. Suppose the annual cash flows listed for problem 1
start at $800,000 and then decrease by 15% each year.
What is the payback period?

3. A firm is evaluating a project with an initial cost of $3.35


million and annual cash flows of $1.15 million for 4
years. If the cost of capital for the firm is 14%, what is
the NPV? Should the firm accept or reject the project?
4. Suppose the cost of capital for the firm in problem 3
increases to 15%. What is the NPV? Should the firm
accept or reject the project?

284

PART III Foundations of Corporate Finance

5. Evergreen Inc. is evaluating a project with an initial


cost of $6 million. Cash flows would start at $1 million and increase by $750,000 annually for the next
3 years. If the cost of the capital for the firm is 12%,
what is the NPV? Should the firm accept or reject
the project?
6. A project has projected cash outflows of $2 million in
the current time period. Additional cash outflows of
$1 million, $1 million, and $2 million are projected
during the next 3 years of operation. Cash inflows of
$1.3 million are expected in years 4 through 13
(10 cash inflows). Should the project be accepted if
the company has a cost of capital of 14%? (What is
the NPV?)
7. Would the accept/reject decision change for the project described in problem 6 if the costs of capital fell
to 12%?
8. Suppose that a $10,000 investment will yield three
annual cash flows of $4,000 each. With a discount
rate of 12%, what is the PI? What is the accept/
reject decision?
9. Rank the following projects by PI:
Project
A
B
C
D
E

Net
Investment
$ 400
700
150
1,000
250

PV (cash
inflows)
$480
735
225
950
275

NPV
$80
35
75
(50)
25

10. If the initial investment for a project is $500 and the


cash inflows are $300 for 3 years, what is the IRR?

11. If the initial investment for a project is $500 and the


cash inflows are $300 for year 1, $250 for year 2, and
$150 for year 3, what is the IRR?
12. If the initial investment for a project is $1,500
and the cash inflows are $300 for 4 years, what is
the IRR?
13. Suppose Project A has an NPV of $350 with an IRR of
12% and Project B has an NPV of $300 with an IRR of
20%. If these projects are mutually exclusive, which
project should you accept? Why?
14. Compute the MIRR for a project with a $10,000
investment and cash flows of $3,000 for 4 years.
Assume of the cost of capital is 12%.
15. Compute the IRR and MIRR for a project with a $5,000
investment and cash flows of $1,500 for 4 years.
Assume the cost of capital is 13%.
16. Compute the MIRR for a project with a $6,000 investment and cash flows of $1,000 in year 1, $2,000 in year
2, $3,000 in year 3, and $4,000 in year 4. Assume the
cost of capital is 10%.
17. Compute the MIRR after reversing the cash flows in
problem 16. (Cash flows of $4,000 in year 1, $3,000 in
year 2, etc.) Assume the investment and cost of capital
do not change.
18. Compute the IRR for problem 16.
19. Compute the IRR for problem 17.
20. What is the NPV of a project with initial investments
of $3 million at the beginning of years 1 and 2, and
cash inflows of $1.5 million at the beginning of years
2 through 6? Assume the cost of capital is 10%. Should
the project be accepted? (Hint: At the beginning of year
2, the net cash flow is :1.5 million.)

WEB EXPLORATION
1. The concepts behind NPV and IRR apply equally to
investing in capital projects or in securities. Go to
www.financenter.com/calculate/all_calculate.fcs and
choose the calculator titled What Selling Price Provides
My Desired Return? This site allows you to input a variety of variables and to look at the rate of return the
investment provides. It also allows you to view graphs of
the answers. Relate the results you find using this calculator to IRR and NPV.

2. There are many instructional sites on the Web that are


sponsored by educational institutions. One particularly
good one sponsored by the University of South Carolina
is available at hadm.sph.sc.edu/courses/econ/invest/
invest.html. Review this site and investigate any of the
links that you feel may improve your understanding of
the concepts behind NPV and IRR. The calculators
attached can be very helpful.

CHAPTER 10 Capital Budgeting: Introduction and Techniques

285

MINI CASE

ou have recently gone to work for a development/construction firm. This company does contract and bid
construction work as well as real estate development. You
work on the development side helping to select projects that
will be profitable. The development company is organized
as a separate entity from the construction firm. This requires
that both firms be independently profitable.
The company founder, Jerry Hammer, is primarily
responsible for identifying development opportunities. Once
an opportunity is identified, Hammer turns it over to his staff
for analysis. Jerry began as a carpenter and has built the firm
into a multimillion dollar enterprise mostly based on good
intuition and street smarts. He has no college education.
Last week Jerry called the staff of the development firm
together to discuss his latest idea. He would like to build a
new strip mall on a corner of property near the university.
He visualizes a group of tenets that would service the needs
of college students. He directed you to let him know if the
project was feasible.
Your first step was to collect cost and revenue estimates. The proposed mall is a duplicate of one built last year
for $3,750,000 with minor cosmetic changes. The mall will
have 30,000 square feet, all of which can be leased. You contact the owner of the property and find it can be purchased
for $500,000.
The revenues are more difficult to estimate. You decide
the most practical approach is to assume the mall will lease
for $2.75 per square foot per month. The mall will take about
10 months to build and you think the mall will be 10%
leased by the end of the first year. You will get 10% of the

possible revenues for 2 months. Thus, the first year revenues


will be computed as $16,500 (30,000!$2.75!.1!2).
You project to get about 60% of the possible revenues during the second year (i.e., 30,000!$2.75!12!.6). This
will rise to 90% by the end of the third year. During the
fourth year you project the mall to be fully leased. It is the
intent of the company to sell the property once it is fully
leased. You think it reasonable to project a sale by the end of
the fifth year for $150 per square foot.
You decide a 15% discount accurately reflects the firms
cost of capital.
a. Project the annual cash flows. Remember that the lease
revenues will be received until the property is sold.
Assume the initial cash flow occurs at the beginning of
the first year and that all other cash flows occur at the
end of the year. Ignore taxes and depreciation.
b. Put the cash flows onto a time line.
c. Compute the payback period. Is this any help in making an accept/reject decision?
d. Compute the NPV.
e. Prepare an NPV profile. Identify the IRR on the graph.
Identify on the graph the discount rates that make the
project acceptable and those that make it unacceptable.
f. Compute the IRR.
g. Compute the PI.
h. Compute the MIRR. (Extension 10.1)
i. Do all of the methods (except payback) give the same
accept/reject result? Is this surprising?
j. Discuss how you would present your results to Jerry
Hammer.

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