Gitman Capital Budgeting

Chapter 10
Capital
Budgeting
Techniques
Copyright © 2012 Pearson Prentice Hall.

All rights reserved.
Learning Goals
LG1 Understand the key elements of the capital budgeting

process.
LG2 Calculate, interpret, and evaluate the payback period.
LG3 Calculate, interpret, and evaluate the net present value

(NPV) and economic value added (EVA)
© 2012 Pearson Prentice Hall. All rights reserved. 10-2

Learning Goals (cont.)
LG4 Calculate, interpret, and evaluate the internal rate of

return (IRR).

Overview of Capital Budgeting
• Cost of Capital is the rate of return that a firm must earn

on the projects in which it invests to maintain its market
value and attract funds.
• Time Value of Money. Money has a time value
associated with it and therefore a dollar received today is
worth more than a dollar received in the future. Money
that the firm has in its possession today is more valuable
than money in the future because the money it now has
can be invested and earn positive returns.

Overview of Capital Budgeting
• Capital budgeting is the process of evaluating and

selecting long-term investments that are consistent with
the firm’s goal of maximizing owner wealth.
• A capital expenditure is an outlay of funds by the firm
that is expected to produce benefits over a period of time
greater than 1 year.
• An operating expenditure is an outlay of funds by the
firm resulting in benefits received within 1 year.

Overview of Capital Budgeting:
Steps in the Process
The capital budgeting process consists of five steps:
1. Proposal generation. Proposals for new investment projects are made at all
levels within a business organization and are reviewed by finance
personnel.
2. Review and analysis. Financial managers perform formal review and
analysis to assess the merits of investment proposals
3. Decision making. Firms typically delegate capital expenditure decision
making on the basis of dollar limits.
4. Implementation. Following approval, expenditures are made and projects
implemented. Expenditures for a large project often occur in phases.
5. Follow-up. Results are monitored and actual costs and benefits are
compared with those that were expected. Action may be required if actual
outcomes differ from projected ones.

Basic Terminology
Independent versus Mutually Exclusive Projects
– Independent projects are projects whose cash flows are
unrelated to (or independent of) one another; the acceptance of
one does not eliminate the others from further consideration.
– Mutually exclusive projects are projects that compete with one
another, so that the acceptance of one eliminates from further
consideration all other projects that serve a similar function.

Basic Terminology (cont.)
Unlimited Funds versus Capital Rationing
– Unlimited funds is the financial situation in which a firm is able
to accept all independent projects that provide an acceptable
return.
– Capital rationing is the financial situation in which a firm has
only a fixed number of dollars available for capital expenditures,
and numerous projects compete for these dollars.

Basic Terminology (cont.)
Accept-Reject versus Ranking Approaches
– An accept–reject approach is the evaluation of
capital expenditure proposals to determine
whether they meet the firm’s minimum
acceptance criterion.
– A ranking approach is the ranking of capital
expenditure projects on the basis of some
predetermined measure, such as the rate of
return.
Cash Flows in Capital Budgeting
Conventional versus Unconventional Cash Flow Patterns

Cash flow patterns associated with capital investment
projects can be classified as conventional or
nonconventional.
 A conventional cash flow pattern consists of initial an
initial outflow followed only by a series of inflows. For
example, a firm may spend $10,000 today and as a result
expect to receive equal annual cash inflows of $2,000 (an
annuity) or mixed stream of annual cash inflows each
year for the next eight years.
Conventional versus Unconventional Cash Flow Patterns

 A unconventional cash flow pattern is one in which an initial
outflow is followed by a series of inflows and outflows. For
example, the purchase of a machine may require an initial cash
outflow of $20,000 and may generate cash inflows of $5,000 each
year for 4 years. In the fifth year after the purchase, an outflow of
$8,000 may be required to overhaul the machine, after which it
generates inflows of $5,000 each year for 5 more years.
• Difficulties often arise in evaluating projects with unconventional
patterns of cash flow.

Relevant Cash Flows

• To evaluate capital expenditure alternatives, the
firm must determine the relevant cash flows.
These are the incremental cash outflow
(investment) and resulting subsequent inflows.
The incremental cash flows represent the
additional cash flows – outflows or inflows –
expected to result from a proposed capital
expenditure.
Major Cash Flow Components

• The cash flows of any project having the
conventional pattern can include three basic
components: (1) an initial investment, (2)
operating cash flows, and (3) terminal cash flow.
All projects – whether for expansion, replacement or
renewal, or some other purpose – have the first two
components. Some, however lack the final component,
terminal cash flow.

Capital Budgeting Techniques
Bennett Company is a medium sized metal fabricator that is

currently contemplating two projects: Project A requires an
initial investment of $42,000, project B an initial investment
of $45,000. The relevant operating cash flows for the two
projects are presented in Table 10.1 and depicted on the time
lines in Figure 10.1.

Table 10.1 Capital Expenditure
Data for Bennett Company

Figure 10.1 Bennett Company’s
Projects A and B

Payback Period
The payback method is the length of time required for a

firm to recover its initial investment in a project, as
calculated from cash inflows.
Decision criteria:
– The length of the maximum acceptable payback period is
determined by management.
– If the payback period is less than the maximum acceptable
payback period, accept the project.
– If the payback period is greater than the maximum acceptable
payback period, reject the project.

Payback Period (cont.)
We can calculate the payback period for Bennett Company’s projects

A and B using the data in Table 10.1.
– For project A, which is an annuity, the payback period is 3.0 years ($42,000
initial investment ÷ $14,000 annual cash inflow).
– Because project B generates a mixed stream of cash inflows, the calculation
of its payback period is not as clear-cut.
• In year 1, the firm will recover $28,000 of its $45,000 initial investment.
• By the end of year 2, $40,000 ($28,000 from year 1 + $12,000 from year 2) will
have been recovered.
• At the end of year 3, $50,000 will have been recovered.
• Only 50% of the year-3 cash inflow of $10,000 is needed to complete the
payback of the initial $45,000.
– The payback period for project B is therefore 2.5 years (2 years + 50% of
year 3).

Payback Period: Pros and Cons
of Payback Analysis
• The payback method is widely used by large firms to evaluate small
projects and by small firms to evaluate most projects.
• Its popularity results from its computational simplicity and intuitive
appeal.
• By measuring how quickly the firm recovers its initial investment,
the payback period also gives implicit consideration to the timing of
cash flows and therefore to the time value of money.
• Because it can be viewed as a measure of risk exposure, many firms
use the payback period as a decision criterion or as a supplement to
other decision techniques.

Payback Period: Pros and Cons
of Payback Analysis (cont.)
• The major weakness of the payback period is that the appropriate
payback period is merely a subjectively determined number.
– It cannot be specified in light of the wealth maximization goal because it is
not based on discounting cash flows to determine whether they add to the
firm’s value.
• A second weakness is that this approach fails to take fully into
account the time factor in the value of money.
• A third weakness of payback is its failure to recognize cash flows
that occur after the payback period.

Focus on Practice
Limits on Payback Analysis

– While easy to compute and easy to understand, the
payback period simplicity brings with it some
drawbacks.
– Whatever the weaknesses of the payback period
method of evaluating capital projects, the simplicity of
the method does allow it to be used in conjunction with
other, more sophisticated measures.

Focus on Practice
Limits on Payback Analysis

– Question: In your view, if the payback period method is used in
conjunction with the NPV method, should it be used before or after the
NPV evaluation?
– The payback method is criticized for ignoring the time value of
money. To consider differences in timing explicitly in applying the
payback method, the discounted payback period is sometimes used. It
is found by first calculating the present value of the cash inflows at the
appropriate discount rate and then finding the payback period by using
the present value of the cash flows.
– Answer: Generally, the payback method when used in evaluating
project proposals, is intended to supplement the NPV method. Hence,
it is used after the NPV method.

Table 10.2 Relevant Cash Flows and Payback
Periods for DeYarman Enterprises’ Projects

Table 10.3 Calculation of the Payback Period for
Rashid Company’s Two Alternative Investment
Projects

Net Present Value (NPV)
Net present value (NPV) is a sophisticated capital

budgeting technique; found by subtracting a project’s initial
investment from the present value of its cash inflows
discounted at a rate equal to the firm’s cost of capital.
NPV = Present value of cash inflows – Initial investment

Present Value (PV)
How do we calculate the present value of a cash inflow

(or future value)?
Formula:
PV = FV 1 .
n
(1+r)
where: FV = future value (or cash inflow)
r = rate of return (discount rate, usually the cost of capital )
n = number of year cash inflow is expected to
be received

Present Value (NPV) (cont.)
The present value of cash inflows can also be calculated by

using the present value table:
1) Appendix B – for uneven cash inflows
2) Appendix D – for annuity
PV = FV (or cash inflow) x Present value factor

Net Present Value (NPV) (cont.)
Decision criteria:
– If the NPV is greater than $0, accept the project.
– If the NPV is less than $0, reject the project.
If the NPV is greater than $0, the firm will earn a return
greater than its cost of capital. Such action should increase
the market value of the firm, and therefore the wealth of its
owners by an amount equal to the NPV.

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

Net Present Value (NPV):
NPV and the Profitability Index (PI)
For a project that has an initial cash outflow followed by
cash inflows, the profitability index (PI) is simply equal to
the present value of cash inflows divided by the initial cash
outflow:
Decision Criterion:
When companies evaluate investment opportunities using the PI, the
decision rule they follow is to invest in the project when the index is
greater than 1.0.

Net Present Value (NPV): NPV and
the Profitability Index (cont.)
We can refer back to Figure 10.2, which shows the present
value of cash inflows for projects A and B, to calculate the
PI for each of Bennett’s investment options:
PIA = $53,071 ÷ $42,000 = 1.26
PIB = $55,924 ÷ $45,000 = 1.24
The profitability index can be helpful in comparing
returns from different-size investments by placing them on
a common measuring standard.
Now, try to determine the PI of the projects in Figure 10.3 (Rashid Company). Take
note that the projects have the same amount of investment requirement.

Net Present Value (NPV): NPV
and Economic Value Added
• Economic Value Added (or EVA), a registered trademark
of the consulting firm, Stern Stewart & Co., is another
close cousin of the NPV method.
• The EVA method begins the same way that NPV does—
by calculating a project’s net cash flows.
• However, the EVA approach subtracts from those cash
flows a charge that is designed to capture the return that
the firm’s investors demand on the project.
• EVA determines whether a project earns a pure
economic profit–a profit above and beyond the normal
competitive rate of return in a line of business.
Net Present Value (NPV): NPV
and Economic Value Added
Suppose a certain project costs $1,000,000 up front, but
after that it will generate net cash inflows each year (in
perpetuity) of $120,000. If the firm’s cost of capital is 10%,
then the project’s NPV and EVA are:
NPV = –$1,000,000 + ($120,000 ÷ 0.10) = $200,000
EVA = $120,000 – $100,000 = $20,000

Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is a sophisticated

capital budgeting technique; the discount rate that equates
the NPV of an investment opportunity with $0 (because the
present value of cash inflows equals the initial investment);
it is the rate of return that the firm will earn if it invests in
the project and receives the given cash inflows.

Internal Rate of Return (IRR)
Decision criteria:
– If the IRR is greater than the cost of capital, accept the project.
– If the IRR is less than the cost of capital, reject the project.
These criteria guarantee that the firm will earn at least its
required return. Such an outcome should increase the market
value of the firm and, therefore, the wealth of its owners.

Internal Rate of Return (IRR):
Calculating the IRR
The internal rate of return (IRR) calls for determining the
yield on an investment, that is, calculating the interest rate
that equates the cash outflows (cost) of an investment with
the subsequent cash inflows.
For example, a $1,000 investment returning an annuity of
$244 per year for five years provides an internal rate of
return of 7%, as indicated by the following calculations.

Calculating the IRR (cont’d.)
1. First divide the investment (present value) by the annuity.
Cost of investment/Annuity=$1,000/$244 = 4.1 (PVIFA)
2. Then proceed to Appendix D (present value of annuity).
The factor of 4.1 for five years indicates a yield of 7
percent.
Whenever an annuity is being evaluated, annuity interest

factors (PVIFA) can be used to find the final IRR solution.

If an uneven cash inflow is involved, we are not so lucky. We need to
use a trial and error method. The first question is, Where do we start?
What interest rate should we pick for our first trial?
Assuming we are evaluating the two investments of Razzore Company
below: Cash Inflows
(of $10,000 investment) .
Year Investment A Investment B
1 $5,000 $1,500
2 5,000 2,000
3 2,000 2,500
4 5,000
5 5,000

Because neither proposal represents a precise annuity
stream, we must use a trial and error approach to determine
the IRR. We begin with Investment A.
1. To find a beginning value to start our first trial, average
the inflows as if we were really getting an annuity.
$5,000 + 5,000 + 2,000 = $12,000/3 = $4,000
2. Then divide the investment by the “assumed” annuity
value in step 1.
Investment/Annuity = $10,000/$4,000 = 2.5 (PVIFA)

Investment A.
3. Proceed to Appendix D to arrive at a first approximation
of the IRR, using:
PVIFA = 2.5
n(period) = 3
What did you find? The factor falls between 9 and 10 percent.
This is only a first approximation – our actual answer will be
closer to 10% or higher because our method of averaging cash
flows theoretically moved receipts from the first two years into
the last year. This averaging understates the actual IRR.
Investment A.
The same method would overstate the IRR for Investment B
because it would move cash from the last two years into the first
three years. Since we know the cash flows in the early years are
worth more and increase our return, we can usually gauge
whether our first approximation is overstated or understated.
4. We now enter into a trial and error process to arrive at an

answer. Because the cash flows are uneven than an annuity, we
need to use Appendix B. We will begin with 10% and then try
12%.

Investment A.
Year 10%
1 $5,000 x 0,909 = $ 4,545
2 5,000 x 0.826 = 4,130
3 2,000 x 0.751 = 1,502
$10,177
At 10%, the present value of the inflows exceeds $10,000 –

we therefore use a higher discount rate. We will try 12%
then.

Investment A.
Year 12%
1 $5,000 x 0,893 = $ 4,465
2 5,000 x 0.797 = 3,985
3 2,000 x 0.712 = 1,424
$ 9,874
The answer must fall between 10% and 12%, indicating an

approximate answer of 11 percent. If we want to be more
accurate, the results can be interpolated.

Investment A.
Because the internal rate of return is determined when the
present value of the inflows (PVI) equals the present value
of the outflows (PVO), we need to find a discount rate that
equates the PVI to the cost of $10,000 (PVO). The difference
in the present values between 10% and 12% is $303.
$10,177 …PVI @ 10% $10,177…PVI @ 10%
- 9,874…PVI @ 12% -10,000…(cost)
$ 303 $ 177

Investment A.
The solution at 10% is $177 away from $10,000, the
solution. Actually the solution is a 2 percentage point
difference between the 2 rates used to evaluate the cash
inflows, we need to multiply the fraction by 2% and then
add our answer to 10% for the final answer of:
10% + ($177 / $303) (2%) = 11.17% IRR

Investment A.
The solution at 10% is $177 away from $10,000, the
solution. Actually the solution is a 2 percentage point
difference between the 2 rates used to evaluate the cash
inflows, we need to multiply the fraction by 2% and then
add our answer to 10% for the final answer of:
10% + ($177 / $303) (2%) = 11.17% IRR

• Now that we have determined the exact IRR of
investment A (11.17%), try to calculate the IRR of
investment B.
• Investment B’s IRR is _________.

REINVESTMENT ASSUMPTION
 A prime characteristic of the IRR is the reinvestment assumption

that all inflows can be reinvested at the yield from a given
investment.
 For example, in the case of Razzore Company’s investment A
yielding 11.17%, the assumption is made that the dollar amounts
coming in each year can be reinvested at that rate.
 For investment B. with a 14.33% IRR, the new funds are assumed
to be reinvested at this rate.
 For investments with very high IRR, it may be unrealistic to assume
that reinvestment can occur at an equally high rate.

REINVESTMENT ASSUMPTION
 The net present value method makes the more conservative

assumption that each inflow can be reinvested at the cost of capital
or discount rate.
 The reinvestment assumption under the present value method
allows for a certain consistency. Inflows from each project are
assumed to have the same (though conservative) investment
opportunity.
 Although this may not be an accurate picture for all firms, net
present value is generally the preferred method.

Matter of Fact
Which Methods Do Companies Actually Use?

– A recent survey asked Chief Financial Officers (CFOs) what
methods they used to evaluate capital investment projects.
– The most popular approaches by far were IRR and NPV, used
by 76% and 75% (respectively) of the CFOs responding to the
survey.
– These techniques enjoy wider use in larger firms, with the
payback approach being more common in smaller firms.

Reinforcement Activity: QUIZ
The Danforth Tire Company is considering the purchase of a new machine

that would increase the speed of manufacturing and save money. The net
cost of this machine is $66,000. The annual cash flows have the following
projections:
Year Cash Flow
1 $21,000
2 29,000
3 36,000
4 16,000
5 8,000
a. If the cost of capital is 10%, what is the net present value?
b. What is the internal rate of return?
c. Should the project be accepted? Why?

Gitman Capital Budgeting

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Chapter 10

Copyright © 2012 Pearson Prentice Hall.

LG1 Understand the key elements of the capital budgeting

LG2 Calculate, interpret, and evaluate the payback period.

LG3 Calculate, interpret, and evaluate the net present value

© 2012 Pearson Prentice Hall. All rights reserved. 10-2

LG4 Calculate, interpret, and evaluate the internal rate of

© 2012 Pearson Prentice Hall. All rights reserved. 10-3

• Cost of Capital is the rate of return that a firm must earn

© 2012 Pearson Prentice Hall. All rights reserved. 10-4

• Capital budgeting is the process of evaluating and

© 2012 Pearson Prentice Hall. All rights reserved. 10-5

© 2012 Pearson Prentice Hall. All rights reserved. 10-6

© 2012 Pearson Prentice Hall. All rights reserved. 10-7

© 2012 Pearson Prentice Hall. All rights reserved. 10-8

Conventional versus Unconventional Cash Flow Patterns

Conventional versus Unconventional Cash Flow Patterns

© 2012 Pearson Prentice Hall. All rights reserved. 10-11

Relevant Cash Flows

Major Cash Flow Components

© 2012 Pearson Prentice Hall. All rights reserved. 10-13

Bennett Company is a medium sized metal fabricator that is

© 2012 Pearson Prentice Hall. All rights reserved. 10-14

© 2012 Pearson Prentice Hall. All rights reserved. 10-15

© 2012 Pearson Prentice Hall. All rights reserved. 10-16

The payback method is the length of time required for a

© 2012 Pearson Prentice Hall. All rights reserved. 10-17

We can calculate the payback period for Bennett Company’s projects

© 2012 Pearson Prentice Hall. All rights reserved. 10-18

© 2012 Pearson Prentice Hall. All rights reserved. 10-19

© 2012 Pearson Prentice Hall. All rights reserved. 10-20

Limits on Payback Analysis

© 2012 Pearson Prentice Hall. All rights reserved. 10-21

Limits on Payback Analysis

© 2012 Pearson Prentice Hall. All rights reserved. 10-22

© 2012 Pearson Prentice Hall. All rights reserved. 10-23

© 2012 Pearson Prentice Hall. All rights reserved. 10-24

Net present value (NPV) is a sophisticated capital

© 2012 Pearson Prentice Hall. All rights reserved. 10-25

How do we calculate the present value of a cash inflow

© 2012 Pearson Prentice Hall. All rights reserved. 10-26

The present value of cash inflows can also be calculated by

PV = FV (or cash inflow) x Present value factor

© 2012 Pearson Prentice Hall. All rights reserved. 10-27

© 2012 Pearson Prentice Hall. All rights reserved. 10-28

© 2012 Pearson Prentice Hall. All rights reserved. 10-29

© 2012 Pearson Prentice Hall. All rights reserved. 10-30

© 2012 Pearson Prentice Hall. All rights reserved. 10-31

© 2012 Pearson Prentice Hall. All rights reserved. 10-33

The Internal Rate of Return (IRR) is a sophisticated

© 2012 Pearson Prentice Hall. All rights reserved. 10-34

© 2012 Pearson Prentice Hall. All rights reserved. 10-35

© 2012 Pearson Prentice Hall. All rights reserved. 10-36

Whenever an annuity is being evaluated, annuity interest

© 2012 Pearson Prentice Hall. All rights reserved. 10-37

© 2012 Pearson Prentice Hall. All rights reserved. 10-38

© 2012 Pearson Prentice Hall. All rights reserved. 10-39

4. We now enter into a trial and error process to arrive at an

© 2012 Pearson Prentice Hall. All rights reserved. 10-41

At 10%, the present value of the inflows exceeds $10,000 –

© 2012 Pearson Prentice Hall. All rights reserved. 10-42

The answer must fall between 10% and 12%, indicating an

© 2012 Pearson Prentice Hall. All rights reserved. 10-43

© 2012 Pearson Prentice Hall. All rights reserved. 10-44