CHAPTER 12 CAPITAL BUDGETING

Purpose of Capital Budgeting

-Used for analyzing, evaluating and creating investment projects.
-Firms growth and ability to remain competitive depends on the quality
of investments it chooses and hence vital to firms survival.
Categories of projects:
-Conventional project: Invest money up front and generate CFs in the
future.
-Unconventional project: can be any activity that adds value to firm.
Can be something that reduces costs.
-Level of approval required is determined by complexity and size of
project.
-Categories of projects:
1. Replacement needed to continue profitable operations.
2. Replacement to reduce costs. Eg. replacing obsolete
equipment with new
one; replacing manual labor with
automation.
3. Expansion of existing products or markets. Must do growth
analysis.
4. Expansion into new products or markets: detailed analysis
required of risks and returns. Must be approved by top
management. For example, Krafts expansion in Pennsylvania for
new products and in Brazil for new market.
5. Contraction decisions: should operations be shut down
because of reduced capacity? Reduce fixed costs? For example,
GM shutting down Opel and Chevrolet in Russia.
6. Safety and/or environmental projects: compliance with
environmental orders, labor agreements, etc. For example,
Starbucks.
7. Other: office buildings, parking lots, transportation, etc.
8. Mergers & Acquisitions
Techniques for analyzing projects:
1.
2.
3.
4.
5.
6.

NPV
IRR
MIRR
PI
Payback
Discounted Payback

Discuss Independent versus Mutually exclusive projects

Net Present Value (NPV):
1. Show equation on PPT
2. Fig 12-1; Compute NPV for S and L on Fin Cal
a. NPVS = $804.38; NPVL = $1048.02
b. Show computation on Excel
c. If S and L independent, accept both. If mutually exclusive,
accept L since it adds more value.
Decision Rule: If NPV > 0 discounted value of CFs > Cost accept
project since it adds value.
Internal Rate of Return (IRR):
1. See NPV profile on PPT.
2. It is the discount rate that forces the PV of cash inflow to
equal the cash outflow i.e. NPV = 0.
3. The IRR is comparable to a bonds YTM i.e. you would earn the
YTM only if you were able to reinvest the cash inflows (interest
payments) at the YTM.
4. Show IRR computation on Excel and Fin Cal.
IRRS = 14.69%; IRRL = 13.79%
5. Why is the IRR important? Because it is a projects rate of
return and the difference from the cost (r) either adds (or
destroys) value for SH.
Decision Rule:
Independent projects: accept both as long as IRR > Cost of Capital
Mutually exclusive projects: accept the project with highest IRR
If Projects S and L independent No conflict between NPV and IRR
If Projects S and L mutually exclusive Conflict between NPV and IRR
Generally, in case of conflict, go with NPV criterion since it adds
value in terms of dollars.

Re-investment Rate Assumptions:

-

NPV assumes cash flows are reinvested at the projects cost of

capital
IRR assumes cash flows are reinvested at the projects IRR
Which is more practical? NPV. Why?
o If firm operates in a competitive industry, its returns on
investments will be close to its cost of capital.
o If firm were to earn much higher returns, competitors will
enter market and drive prices and hence returns down.
o If firm uses internal funds, opportunity cost of such funds
will equal cost of capital.

Modified Internal Rate of Return (MIRR):

1.
2.
3.
4.

Fig 12-4 - what is the problem?

Normal versus nonnormal CFs
Fig. 12-4: IRR calculation on Excel (use with and without guess)
Fig/ 12-6 MIRR of Project S on Fin Cal:
a. Compute the NPV of CFs (dont include initial investment)
= $10,804.38
b. Next, FV(PV=NPV, N=4, I/YR=10%) = $15,818.7
c. Next, I/YR(FV = 15,818.7, PV=-10,000, N=4) = MIRR =
12.15%

Crossover Rates
1. Fig 12-5.
2. Crossover rate and its computation on excel.
3. If WACC left of cross-over rate: conflict; else no conflict: See
Figure
4. For normal, independent projects, there is no conflict
between NPV and IRR.
5. For mutually exclusive projects, if the profiles intersect and if the
r is less than the crossover rate, then conflict arises.
6. There are primarily two reasons why NPV profiles cross:
a. Timing differences: Most of one projects CFs come in early
while the other projects CFs come in later. This is the case
in our example. IRR favors projects that have larger
CFs coming in earlier.

b. Project size/scale differences: If amount invested in one

project is much larger than the other. NPV always favors
larger projects.

Profitability Index
PI = PV of future CF/Initial Cost
Project is acceptable as long as PI > 1 NPV > 0
Payback Period
1.
2.
3.

4.

The number of years required to recover a projects cost or

how long does it take for a project to pay for itself.
Show examples on PPT.
Flaws of regular payback method:
a. Time value of money is not considered.
b. CFs beyond payback period not considered.
c. Does not specify how much value is added for investors.
d. The choice of payback period depends entirely on
managerial judgment and may be arbitrary.
Useful for:
a. Measuring liquidity particularly for small firms that are cash
challenged.
b. Riskiness since distant CFs riskier than earlier CFs.

Discounted Payback Period

Takes into account time value of money.
Show example on PPT.
Conclusion
While quantitative methods provide valuable information, these should
be used in conjunction with sound managerial judgment.

Show Table 12-1: Survey of methods used in practice. Trends over the
years.
Capital Rationing
Why do companies forego value-adding projects?
Reasons and solutions on PPT.