Capital Budgeting Techniques - pp13

Chapter 13
Capital Budgeting
Techniques
13.1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 13,

you should be able to:
13.2
1.
Understand the payback period (PBP) method of project evaluation and

selection, including its: (a) calculation; (b) acceptance criterion; (c)
advantages and disadvantages; and (d) focus on liquidity rather than
profitability.
2.
Understand the three major discounted cash flow (DCF) methods of

project evaluation and selection internal rate of return (IRR), net present
value (NPV), and profitability index (PI).
3.
Explain the calculation, acceptance criterion, and advantages (over the

PBP method) for each of the three major DCF methods.
4.
Define, construct, and interpret a graph called an NPV profile.
5.
Understand why ranking project proposals on the basis of IRR, NPV, and
PI methods may lead to conflicts in rankings.
6.
Describe the situations where ranking projects may be necessary and

justify when to use either IRR, NPV, or PI rankings.
7.
Understand how sensitivity analysis allows us to challenge the singlepoint input estimates used in traditional capital budgeting analysis.
8.
Explain the role and process of project monitoring, including progress

reviews and post-completion audits.
Capital Budgeting
Techniques
13.3
Project Evaluation and Selection
Potential Difficulties
Capital Rationing
Project Monitoring
Post-Completion Audit
Project Evaluation:
Alternative Methods
Payback Period (PBP)
Internal Rate of Return (IRR)
Net Present Value (NPV)
Profitability Index (PI)
13.4
Refer to the additional PowerPoint slides and the Excel

spreadsheet VW13E-13b.xlsx for computer-based
solutions.
Proposed Project Data

Julie Miller is evaluating a new project
for her firm, Basket Wonders (BW).
She has determined that the after-tax
cash flows for the project will be
$10,000; $12,000; $15,000; $10,000;
and $7,000, respectively, for each of
the Years 1 through 5. The initial
cash outlay will be $40,000.
13.5
Independent Project
For this project, assume that it is
independent of any other potential
projects that Basket Wonders may
undertake.
13.6
Independent A project whose

acceptance (or rejection) does not
prevent the acceptance of other
projects under consideration.
Payback Period (PBP)

0
40 K
1
10 K
2
12 K
3
15 K
4
10 K
5
7K
PBP is the period of time

required for the cumulative
expected cash flows from an
investment project to equal the
initial cash outflow.
13.7
Payback Solution (#1)

0
40 K (-b)
Cumulative
Inflows
13.8
10 K
10 K
12 K
22 K
3 (a)
15 K
37 K(c)
4
10 K(d)
47 K
5
7K
54 K
PBP = a + ( b c ) / d =
3 + (40 37) / 10 = 3 +
(3) / 10 = 3.3 Years
Payback Solution (#2)

0
40 K
40 K
10 K
30 K
12 K
18 K
Cumulative
Cash Flows
13.9
3
15 K
3 K
10 K
7K
7K
14 K
PBP = 3 + ( 3K ) / 10K
Years
= 3.3
Note: Take absolute value of last

negative cumulative cash flow value.
PBP Acceptance Criterion

The management of Basket Wonders
has set a maximum PBP of 3.5 years
for projects of this type.
Should this project be accepted?
Yes! The firm will receive back the
initial cash outlay in less than 3.5
years. [3.3 Years < 3.5 Year Max.]
13.10
PBP Strengths
and Weaknesses
Strengths:
Easy to use and

understand
Does not account

for TVM
Can be used as a
measure of
liquidity
Does not consider

cash flows beyond
the PBP
Cutoff period is
subjective
13.11
Weaknesses:
Easier to forecast
ST than LT flows
Internal Rate of Return (IRR)

IRR is the discount rate that equates the
present value of the future net cash
flows from an investment project with
the projects initial cash outflow.
CF1
ICO = (1 + IRR)1
13.12
CF2
(1 + IRR)
+...+
CFn
(1 + IRR)n
IRR Solution
$10,000
$12,000
$40,000 =
+
+
(1+IRR)1 (1+IRR)2
$15,000
$10,000
$7,000
+
+
(1+IRR)3 (1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the
discounted cash flows to equal $40,000.
13.13
IRR Solution (Try 10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(0.909) + $12,000(0.826) +
$15,000(0.751) + $10,000(0.683) +
$ 7,000(0.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444
[Rate is too low!!]
13.14
IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(0.870) + $12,000(0.756) +
$15,000(0.658) + $10,000(0.572) +
$ 7,000(0.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841
[Rate is too high!!]
13.15
IRR Solution (Interpolate)

0.10
0.05
$41,444
X
IRR $40,000
0.15
$36,841
X $1,444
=
13.16
$1,444
$4,603
0.05 $4,603

0.10
0.05
$41,444
X
IRR $40,000
0.15
$36,841
X $1,444
=
13.17
$1,444
$4,603
0.05 $4,603

0.10
0.05
$41,444
X
IRR $40,000
0.15
$36,841
($1,444)(0.05)
X=
$4,603
$1,444
$4,603
X = 0.0157
IRR = 0.10 + 0.0157 = 0.1157 or 11.57%

13.18
IRR Acceptance Criterion

has determined that the hurdle rate is
13% for projects of this type.
No! The firm will receive 11.57% for
each dollar invested in this project at
a cost of 13%. [ IRR < Hurdle Rate ]
13.19
IRRs on the Calculator

We will use the
cash flow registry
to solve the IRR
for this problem
quickly and
accurately!
13.20
Actual IRR Solution Using

Your Financial Calculator
Steps in the Process
13.21
Step 1:
Press CF
Step 2:
Press 2nd
Step 3: For CF0 Press
key
CLR Work keys
-40000 Enter
keys
Step 4:
Step 5:
Step 6:
Step 7:
For C01 Press

For F01 Press
For C02 Press
For F02 Press
10000
1
12000
1
Enter
Enter
Enter
Enter
keys
keys
keys
keys
Step 8: For C03 Press

Step 9: For F03 Press
15000
1
Enter
Enter
keys
keys
Actual IRR Solution Using

Steps in the Process (Part II)
Step 10:For C04 Press
Step 11:For F04 Press
13.22
10000
1
7000
1
Enter
Enter
Enter
Enter
keys
keys
keys
keys
Step 14:
Step 15:
Press
Press IRR
Step 16:
Press CPT
Result:
Internal Rate of Return = 11.47%
keys
key
key
IRR Strengths
and Weaknesses
Strengths:
Accounts for
TVM
Weaknesses:
Considers all
cash flows
Assumes all cash

flows reinvested at
the IRR
Difficulties with
project rankings and
Multiple IRRs
Less
subjectivity
13.23
Net Present Value (NPV)

NPV is the present value of an
investment projects net cash
flows minus the projects initial
cash outflow.
CF1
NPV =
(1+k)1
13.24
CF2
+
(1+k)2
CFn
ICO
+...+
(1+k)n
NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
$40,000
4 +
5
(1.13)
(1.13)
13.25
NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) $40,000
NPV = $10,000(0.885) + $12,000(0.783) +
$15,000(0.693) + $10,000(0.613) +
$ 7,000(0.543) $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 $40,000
= - $1,428
13.26
NPV Acceptance Criterion

has determined that the required
rate is 13% for projects of this type.
No! The NPV is negative. This means
that the project is reducing shareholder
wealth. [Reject as NPV < 0 ]
13.27
NPV on the Calculator

We will use the cash
flow registry to solve
the NPV for this
problem quickly and
accurately!
Hint: If you have not
cleared the cash flows
from your calculator, then
you may skip to Step 15.
13.28
Actual NPV Solution Using

Steps in the Process
13.29
Step 1:
Press CF
Step 2:
Press 2nd
Step 3: For CF0 Press
key
CLR Work keys
-40000 Enter
keys
Step 4:
Step 5:
Step 6:
Step 7:
For C01 Press

For F01 Press
For C02 Press
For F02 Press
10000
1
12000
1
Enter
Enter
Enter
Enter
keys
keys
keys
keys
Step 8: For C03 Press

Step 9: For F03 Press
15000
1
Enter
Enter
keys
keys
Actual NPV Solution Using

Steps in the Process (Part II)
10000
1
7000
1
Step 14:
Step 15:
Press
Press NPV
Step 16: For I=, Enter
13.30
Enter
Enter
Enter
Enter
keys
keys
keys
keys
keys
key
13
Enter
keys
Step 17:
Press CPT
key
Result:
Net Present Value = -$1,424.42
NPV Strengths
and Weaknesses
Strengths:
13.31
Weaknesses:
Cash flows
assumed to be
reinvested at the
hurdle rate.
May not include

managerial
options embedded
in the project. See
Accounts for TVM. Chapter 14.
Considers all
cash flows.
Net Present Value Profile

Net Present Value
$000s
15
Thre
e
10
5
Plot NPV for each

discount rate.
of th
e
se p
oint
IRR
s ar
e ea
sy n
NPV@13%
ow!
0
-4
13.32
Sum of CFs
6
9
12
Discount Rate (%)
15
Creating NPV Profiles

Using the Calculator
Hint: As long as you
do not clear the
cash flows from the
registry, simply start
at Step 15 and enter
a different discount
rate. Each resulting
NPV will provide a
point for your NPV
Profile!
13.33
Profitability Index (PI)

PI is the ratio of the present value of
a projects future net cash flows to
the projects initial cash outflow.
Method #1:
CF1
PI =
(1+k)1
CF2
+
(1+k)2
+...+
CFn
(1+k)n
ICO
<< OR >>
Method #2:
13.34
PI = 1 + [ NPV / ICO ]
PI Acceptance Criterion
PI
= $38,572 / $40,000
= .9643 (Method #1, previous slide)

No! The PI is less than 1.00. This
means that the project is not profitable.
[Reject as PI < 1.00 ]
13.35
PI Strengths
and Weaknesses
Strengths:
Same as NPV
Allows
comparison of
different scale
projects
13.36
Weaknesses:
Same as NPV
Provides only
relative profitability
Potential Ranking
Problems
Evaluation Summary
Basket Wonders Independent Project
Method Project Comparison Decision
13.37
PBP
3.3
3.5
Accept
IRR
11.47%
13%
Reject
NPV
-$1,424
$0
Reject
PI
.96
1.00
Reject
Project Evaluation: Remember

Chapter 12 New Asset project?
We will start with the cash
flows of the project and also
calculate the cumulative
cash flow values.
We can use Excel functions / approaches to calculate each of
the following methods from the above cash flows.
13.38
Other Project
Relationships
Dependent A project whose
acceptance depends on the
acceptance of one or more other
projects.
Mutually Exclusive A project whose
acceptance precludes the acceptance
of one or more alternative projects.
13.39
Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may
create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
13.40
A. Scale Differences
Compare a small (S) and a
large (L) project.
END OF YEAR
13.41
NET CASH FLOWS

Project S
Project L
-$100
-$100,000
$400
$156,250
Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?
13.42
Project
IRR
100%
25%
NPV
PI
231
3.31
$29,132
1.29
Remember to refer to Excel spreadsheet

VW13E-13b.xlsx and the Scale tab.
Refer to VW13E-13b.xlsx on the Scale tab.

13.43
B. Cash Flow Pattern

Let us compare a decreasing cash-flow (D)
project and an increasing cash-flow (I) project.
END OF YEAR
0
1
2
3
13.44
NET CASH FLOWS

Project D
Project I
-$1,200
-$1,200
1,000
100
500
600
100
1,080
Cash Flow Pattern

Calculate the IRR, NPV@10%, and
PI@10%.
Which project is preferred?
Project
13.45
IRR
NPV
PI
23%
$198
1.17
17%
$198
1.17
13.46
600
Plot NPV for each

project at various
discount rates.
400
Project I
200
NPV@10%
IRR
Project D
0
-200
Net Present Value ($)
Examine NPV Profiles
10
15
20
Discount Rate (%)
25
Net Present Value ($)

-200 0 200 400
600
Fishers Rate of Intersection
13.47
At k<10%, I is best!
Fishers Rate of
Intersection
At k>10%, D is best!
10
15
20
Discount Rate ($)
25

VW13E-13b.xlsx and the Pattern tab.
B. Cash Flow Pattern
Refer to VW13E-13b.xlsx on the Pattern tab.

13.48
C. Project Life Differences

Let us compare a long life (X) project
and a short life (Y) project.
END OF YEAR
0
1
2
3
13.49
NET CASH FLOWS

Project X
Project Y
-$1,000
-$1,000
0
2,000
0
0
3,375
0
Project Life Differences

Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?
13.50
Project
IRR
NPV
PI
50%
$1,536
2.54
100%
$ 818
1.82

VW13E-13b.xlsx and the Life tab.
13.51
Another Way to
Look at Things
1.
Adjust cash flows to a common terminal

year if project Y will NOT be replaced.
Compound Project Y, Year 1 @10% for 2 years.
Year
CF
$1,000
$0
$0
Results:
IRR* = 34.26%
3
$2,420
NPV = $818
*Lower IRR from adjusted cash-flow stream. X is still Best.

13.52
Replacing Projects
with Identical Projects
2.
Use Replacement Chain Approach (Appendix B)

when project Y will be replaced.
0
$1,000
$2,000
1,000
$1,000
$1,000
Results:
IRR = 100%
$2,000
1,000
$2,000
$1,000
$2,000
NPV* = $2,238.17
*Higher NPV, but the same IRR. Y is Best.

Best
13.53

VW13E-13b.xlsx and the Life2 tab.
13.54
Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for
this capital budgeting period.
13.55
Available Projects for BW

Project
ICO
IRR
NPV
PI
A $ 500
18%
$
50 1.10
B
5,000
25 6,500 2.30
C
5,000
37 5,500 2.10
D
7,500
20 5,000 1.67
E
12,500
26
500 1.04
F
15,000
28
21,000 2.40 G
17,500
19 7,500
1.43 H
25,000
15 6,000 1.24
13.56
Choosing by IRRs for BW

Project
C
F
E
B
ICO
IRR
NPV
PI
$ 5,000
15,000
12,500
5,000
37%
28
26
25
$ 5,500
21,000
500
6,500
2.10
2.40
1.04
2.30
Projects C, F, and E have the

three largest IRRs.
The resulting increase in shareholder wealth
is $27,000 with a $32,500 outlay.
13.57
Choosing by NPVs for BW

Project
F
G
B
ICO
$15,000
17,500
5,000
IRR
NPV
PI
28%
19
25
$21,000
7,500
6,500
2.40
1.43
2.30
Projects F and G have the

two largest NPVs.
The resulting increase in shareholder wealth
is $28,500 with a $32,500 outlay.
13.58
Choosing by PIs for BW

Project
F
B
C
D
G
ICO
IRR
NPV
PI
$15,000
5,000
5,000
7,500
17,500
28%
25
37
20
19
$21,000
6,500
5,500
5,000
7,500
2.40
2.30
2.10
1.67
1.43
Projects F, B, C, and D have the four largest PIs.

The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
13.59
Summary of Comparison
Method Projects Accepted
PI
F, B, C, and D
Value Added
$38,000
NPV
F and G
$28,500
IRR
C, F, and E
$27,000
PI generates the greatest increase in

shareholder wealth when a limited capital
budget exists for a single period.
13.60
Single-Point Estimate
and Sensitivity Analysis
Sensitivity Analysis:
Analysis A type of what-if
uncertainty analysis in which variables or
assumptions are changed from a base case in
order to determine their impact on a projects
measured results (such as NPV or IRR).
13.61
Allows us to change from single-point (i.e.,

revenue, installation cost, salvage, etc.) estimates
to a what if analysis
Utilize a base-case to compare the impact of
individual variable changes
E.g., Change forecasted sales units to see
impact on the projects NPV
Post-Completion Audit
Post-completion Audit
A formal comparison of the actual costs and
benefits of a project with original estimates.
Identify any project weaknesses
Develop a possible set of corrective actions
Provide appropriate feedback
Result: Making better future decisions!

13.62
Multiple IRR Problem*

Let us assume the following cash flow
pattern for a project for Years 0 to 4:
$100 +$100 +$900 $1,000
How many potential IRRs could this
project have?
Two!! There are as many potential
IRRs as there are sign changes.
* Refer to Appendix A
13.63
NPV Profile Multiple IRRs

Net Present Value
($000s)
75
50
25
0
100
13.64
Multiple IRRs at
k = 12.95% and 191.15%
40
80
120
160
Discount Rate (%)
200
NPV Profile Multiple IRRs

Hint: Your calculator
will only find ONE
IRR even if there
are multiple IRRs. It
will give you the
lowest IRR. In this
case, 12.95%.
13.65

Capital Budgeting Techniques - pp13

Încărcat de

Informații document

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Capital Budgeting Techniques - pp13

Încărcat de

Drepturi de autor:

Formate disponibile

Chapter 13

After Studying Chapter 13,

Understand the payback period (PBP) method of project evaluation and

Understand the three major discounted cash flow (DCF) methods of

Explain the calculation, acceptance criterion, and advantages (over the

Define, construct, and interpret a graph called an NPV profile.

Describe the situations where ranking projects may be necessary and

Explain the role and process of project monitoring, including progress

Project Evaluation and Selection

Payback Period (PBP)

Internal Rate of Return (IRR)

Net Present Value (NPV)

Profitability Index (PI)

Refer to the additional PowerPoint slides and the Excel

Proposed Project Data

Independent A project whose

Payback Period (PBP)

PBP is the period of time

Payback Solution (#1)

Payback Solution (#2)

Note: Take absolute value of last

PBP Acceptance Criterion

Easy to use and

Does not account

Does not consider

Internal Rate of Return (IRR)

IRR Solution (Try 10%)

IRR Solution (Try 15%)

IRR Solution (Interpolate)

IRR Solution (Interpolate)

IRR Solution (Interpolate)

IRR = 0.10 + 0.0157 = 0.1157 or 11.57%

IRR Acceptance Criterion

IRRs on the Calculator

Actual IRR Solution Using

For C01 Press

Step 8: For C03 Press

Actual IRR Solution Using

Internal Rate of Return = 11.47%

Assumes all cash

Net Present Value (NPV)

NPV Acceptance Criterion

NPV on the Calculator

Actual NPV Solution Using

For C01 Press

Step 8: For C03 Press

Actual NPV Solution Using

Step 16: For I=, Enter

Net Present Value = -$1,424.42

May not include

Net Present Value Profile

Plot NPV for each

Creating NPV Profiles

Profitability Index (PI)

Should this project be accepted?

Method Project Comparison Decision

Project Evaluation: Remember

NET CASH FLOWS

Remember to refer to Excel spreadsheet

Refer to VW13E-13b.xlsx on the Scale tab.

B. Cash Flow Pattern

NET CASH FLOWS

Cash Flow Pattern