CAPITAL BUDGETING

Capital Budgeting
Objectives 1. Explain the nature and importance of capital investment analysis. 2. Evaluate capital investment proposals, using the following methods: a. net present value, and internal rate of return, profitability index b. average rate of return, payback period
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Background

A good investment decision

One that raises the current market value of the firms equity, thereby creating value for the firms owners Comparing the amount of cash spent on an investment today with the cash inflows expected from it in the future

Capital budgeting involves

Discounting is the mechanism used to account for the time value of money

Converts future cash flows into todays equivalent value called present value or discounted value

Apart the timing issue, there is also the issue of the risk associated with future cash flows

Since there is always some probability that the cash flows realized in the future may not be the expected ones

Capital Budgeting
Capital budgeting is the making of long-run planning decisions for investments in projects and programs.
It is a decision-making and control tool that focuses primarily on projects or programs that span multiple years.

 It seeks to identify investments that will enhance a firms competitive advantage and increase shareholder wealth. Poor capital budgeting decisions can ultimately result in company bankruptcy

Characteristics of Capital Investment Decision

1. Substantial amount of funds are required in capital projects. 2. The elements of uncertainty because of the length of time spanned. 3. The effects of managerial errors will be difficult to reverse. 4. Plans must be made well into an uncertain future. 5. Success or failure of the company may depend upon a single or relatively few investment decisions
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Key Motives for Capital Investments

Examples
Replacing worn out or obsolete assets improving business efficiency acquiring assets for expansion into new products or markets acquiring another business complying with legal requirements

satisfying work-force demands

environmental requirements

The Capital Budgeting Process.

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Elements of Capital Budgeting

1. The net amount of the investment 2. The operating cash flows or returns from the investment 3. The minimum acceptable rate of return on the investment

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Assessing a Capital Budget

Non-Discounted Cash Flow (without time value of money)

Payback period Accounting Rate of Return Discounted payback Net present value Profitability index Internal rate of return

Discounted Cash Flow (with time value of money)

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Discounted Cash Flow Techniques

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Conditions of a Good Investment Decision

Does it adjust for the timing of the cash flows? Does it take risk into consideration? Does it maximize the firms equity value?

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Project Evaluation: Discounting Methods 1.Net Present Value (NPV)

2.Profitability Index (PI) 3. Internal Rate of Return (IRR)
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Net Present Value Method

The net present value method analyzes capital investment proposals by comparing the initial cash investment with the present value of the net cash flows.

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Net Present Value Method

Strengths:

Considers cash flows and the time value of money Cash flows assumed to be reinvested at the hurdle rate Considers all cash flows

Disadvantages/Weaknesses
Assumes that cash received can be reinvested at the rate of return May not include managerial options embedded in the project
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Net Present Value Method

ABC Company: At the beginning of 2006, equipment with an Cash Flow Present Value expected life of five years can be purchased for P200,000. At the end of five years it is anticipated that the equipment will have no residual value. A net cash flow of P70,000 is expected at the end of 2006. This net cash flow is expected to decline P10,000 each year (except 2010) until the machine is retired. The firm expects a minimum rate of return of 10%. Should the equipment be purchased?
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Net Present Value Method

First, we must determine which table to use the present value of P1 or the present value of an annuity of P1.

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Net Present Value Method

Because there are multiple years of net cash flows, shouldnt we use the present value of an annuity of P1?

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Net Present Value Method

That would be true if the net cash flows remained constant from 2006 through 2010. Note that the net cash flows are P70,000, P60,000, P50,000, P40,000, and P40,000, respectively.

So, we have to use the present value of P1 for each of the five years.
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Net Present Value Method

<200,000>

70,000

60,000

50,000

40,000

40,000

63,636 49,587 37,565 27,320 24,836

PV 202,944

70,000 x 0.90909 (n = 1; i = 10%) 60,000 x 0.82645 (n = 2; i = 10%) 50,000 x 0.75131 (n = 3; i = 10%) 40,000 x 0.68301 (n = 4; i = 10%) 40,000 x 0.620921(n = 5; i = 10%)

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Net Present Value Method

<200,000>

70,000

60,000

50,000

40,000

40,000

63,636 49,587 37,565 27,320 24,836

2,944

The equipment should be purchased because the net present value is positive.

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NPV Acceptance Criterion

Should this project be accepted?
The NPV is Positive.This means that the project will increase the shareholder wealth. [Accept as NPV > 0 ]
Note : Reject if NPV < 0

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Proposed Project Data

Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the annual 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.
Note: total cash flows = P54,000
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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 CF2 + (1+k)2 CFn - ICO +...+ n (1+k)
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NPV Solution
Basket Wonders has determined that the appropriate discount rate (k) for this project is 14%. NPV = 10,000 + 12,000 15,000 + (1.14)1 (1.14)2 (1.14)3 10,000 7,000 4 + (1.14)5 - 40,000 (1.14)
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NPV Solution
NPV = 10,000(PVIF14%,1) + 12,000(PVIF14%,2) + 15,000(PVIF14%,3) + 10,000(PVIF14%,4) + 7,000(PVIF14%,5) - 40,000 NPV = 10,000(.877) + 12,000(.769) + 15,000(.675) + 10,000(.592) + 7,000(.519) - 40,000 NPV = 8,770 + 9,228 + 10,125 + 5,920 + 3,633 = 37,676 - 40,000 = - 2,324
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NPV Acceptance Criterion

The management of Basket Wonders has determined that the required rate is 14% for projects of this type.

Should this project be accepted?

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NPV Acceptance Criterion

Should this project be accepted?
The NPV is Positive.This means that the project will increase the shareholder wealth. [Accept as NPV > 0 ]
Note : Reject if NPV < 0

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Should this project be accepted? NPV = - 2,324 No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ]

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Net Present Value Method

When capital investment funds are limited and the alternative proposals involve different amounts of investment, it is useful to prepare a ranking of the proposals using a present value index. (i.e. profitability index, internal rate of return, )

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Internal Rate of Return Method

The internal rate of return method uses the net cash flows to determine the rate of return expected from the proposal. The following approaches may be used: Trial and Error Assume a rate of return and calculate the present value. Modify the rate of return and calculate a new present value. Continue until the present value approximates the investment cost.

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Internal Rate of Return Method

Advantages: Considers cash flows and the time value of money Ability to compare projects of unequal size Disadvantages: Requires complex calculations

Assumes that cash can be reinvested at the internal rate of return

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Internal Rate of Return Method

Management is evaluating a proposal to acquire equipment costing P97,360. The equipment is expected to provide annual net cash flows of P20,000 per year for seven years. Determine the table value using the present value for an annuity of P1 table.
Amount to be invested Equal annual cash flow

97,360 20,000

= 4.868

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Internal Rate of Return Method

Find the seven year line on the table. Then, go across the 7year line until the closest amount to 4.868 is located.
Present Value of an Annuity of P1 Year 6% 1 0.943 2 1.833 2.673 3 10% 0.909 1.736 2.487 12% 15% 0.893 0.870 1.690 2.402 1.626 2.283

10%

4
5 6

3.465
4.212 4.917

3.170
3.791 4.355 4.868 4.868

3.037
3.605 4.111

2.855
3.353 3.785

5.582

4.564

4.160

Move vertically to the top of the table to determine the interest47 rate

Determine the table value using the present value for an annuity of P1 table. Amount to be invested Equal annual cash flow 97,360 20,000 = 4.868

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IRR Acceptance Criterion

The management has determined that the hurdle rate is 5% for project of this type. Should this project be accepted?
No! The firm will receive 4.868% for each dollar invested in this project at a cost of 5%. [ IRR < Hurdle Rate ]
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Learning Objective 1 Recognize the multiyear focus of capital budgeting.

Two Dimensions of Cost Analysis

1. A project dimension

2. An accounting-period dimension

The accounting system that corresponds to the project dimension is termed life-cycle costing.

Two Dimensions of Cost Analysis

Project D Project C Project B Project A 2002 2003 2004 2005 2006

Learning Objective 2 Understand the six stages of capital budgeting for a project.

Capital Budgeting Example

One of the goals of Assisted Living is to improve the diagnostic capabilities of its facility.

Management identifies a need to consider the purchase of new equipment.

The search stage yields several alternative models, but management focuses on one particular machine.

Capital Budgeting Example

The administration acquires information. Initial investment is $245,000. Investment in working capital is $5,000. Useful life is three years. Estimated residual value is zero.

Net cash savings is $125,000, $130,000, and $110,000 over its life.

Capital Budgeting Example

Working capital is expected to be recovered at the end of year 3 with an expected return of 10%.

Operating cash flows are assumed to occur at the end of the year.

In the selection stage, management must decide whether to purchase the new machine.

Learning Objective 3

Use and evaluate the two main discounted cash-flow (DCF) methods: the net present value (NPV) method and the internal rate-of-return (IRR) method.

Time Value of Money

Compound Growth, Year 5: $1.338 Year 4: $1.262 Year 3: $1.91 Year 2: $1.124 Year 1: $1.06 Year 0: $1.00

5 periods at 6%

Discounted Cash Flow

There are two main DCF methods:

Net present value (NPV) method

Internal rate-of-return (IRR) method

Net Present Value Example

Only projects with a zero or positive net present value are acceptable.

What is the the net present value of the diagnostic machine?

Net Present Value Example

Year in the Life of the Project

1 $125,000 $130,000

$(250,000)

$115,000

Net initial investment

Annual cash inflows

Net Present Value Example

Net Cash NPV of Net Year 10% Col. Inflows Cash Inflows 1 0.909 $125,000 $113,625 2 0.826 130,000 107,380 3 0.751 115,000 86,365 Total PV of net cash inflows $307,370 Net initial investment 250,000 Net present value of project $ 57,370

Net Present Value Example

The company is considering another investment. Initial investment is $245,000. Investment in working capital is $5,000. Working capital will be recovered. Useful life is three years. Estimated residual value is $4,000. Net cash savings is $80,000 per year. Expected return is 10%.

Net Present Value Example

Net Cash NPV of Net Years 10% Col. Inflows Cash Inflows 1-3 2.487 $80,000 $198,960 3 0.751 9,000 6,759 Total PV of net cash inflows $205,719 Net initial investment 250,000 Net present value of project ($ 44,281)

Internal Rate of Return

Investment = Expected annual net cash inflow PV annuity factor

Investment Expected annual net cash inflow = PV annuity factor

Internal Rate of Return Example

Initial investment is $303,280. Useful life is five years. Net cash inflows is $80,000 per year.

What is the IRR of this project? $303,280 $80,000 = 3.791 (PV annuity factor)

10% (from the table, five-period line)

Comparison of NPV and IRR

The NPV method has the advantage that the end result of the computations is expressed in dollars and not in a percentage.

Individual projects can be added.

It can be used in situations where the required rate of return varies over the life of the project.

Comparison of NPV and IRR

The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.

Learning Objective 4 Use and evaluate the payback method.

Payback Method
Payback measures the time it will take to recoup, in the form of expected future cash flows, the initial investment in a project.

Payback Method Example

Assisted Living is considering buying Machine 1. Initial investment is $210,000. Useful life is eleven years. Estimated residual value is zero. Net cash inflows is $35,000 per year.

Payback Method Example

How long would it take to recover the investment? $210,000 $35,000 = 6 years Six years is the payback period.

Payback Method Example

Suppose that as an alternative to the $210,000 piece of equipment, there is another one (Machine 2) that also costs $210,000 but will save $42,000 per year during its five-year life.

What is the payback period? $210,000 $42,000 = 5 years Which piece of equipment is preferable?

Payback Method Example

Assisted Living is considering buying Machine 3. Initial investment is $250,000. Useful life is eleven years. Cash savings are $160,000, $180,000, and $110,000 over its life.

What is the payback period?

Payback Method Example

Year 1 brings in $160,000. Recovery of the amount invested occurs in Year 2.

Payback Method Example

Payback = 1 year

+ = =

$ 90,000 needed to complete recovery 180,000 net cash inflow in Year 2 1 year + 0.5 year 1.5 years or 1 year and 6 months

Learning Objective 5 Use and evaluate the accrual accounting rate-of-return (AARR) method.

Accrual Accounting Rate-of-Return Method

The accrual accounting rate-of-return (AARR) method divides an accounting measure of income by an accounting measure of investment.

AARR

Increase in expected average annual operating income

Initial required investment

Accrual Accounting Rate-of-Return Method Example

Initial investment is $303,280. Useful life is five years. Net cash inflows is $80,000 per year. IRR is 10%. What is the average operating income?

Accrual Accounting Rate-of-Return Method Example

Straight-line depreciation is $60,656 per year. Average operating income is $80,000 $60,656 = $19,344.

What is the AARR? AARR = ($80,000 $60,656) $303,280 = .638, or 6.4%

Learning Objective 6

Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting for performance evaluation.

Performance Evaluation
A manager who uses DCF methods to make capital budgeting decisions can face goal congruence problems if AARR is used for performance evaluation.

Suppose top management uses the AARR to judge performance if the minimum desired rate of return is 10%.

A machine with an AARR of 6.4% will be rejected.

Performance Evaluation
The conflict between using AARR and DCF methods to evaluate performance can be reduced by evaluating managers on a project-by-project basis.

Learning Objective 7 Identify relevant cash inflows and outflows for capital budgeting decisions.

Relevant Cash Flows

Relevant cash flows are expected future cash flows that differ among the alternatives.

Relevant Cash Flows

Net initial investment components cash outflow to purchase investment working-capital cash outflow cash inflow from disposal of old asset

Relevant Cash Flow Analysis Example

G. T. is considering replacing old equipment. Old equipment: Current book value Current disposal price Terminal disposal price (5 years) Annual depreciation Working capital Income tax rate $50,000 $ 3,000 0 $10,000 $ 5,000 40%

Relevant Cash Flow Analysis Example

Current disposal price of old equipment $ 3,000 Deduct current book value of old equipment 50,000 Loss on disposal of equipment $47,000

How much are the tax savings? $47,000 0.40 = $18,800

Relevant Cash Flow Analysis Example

What is the after-tax cash flow from current disposal of old equipment?

Current disposal price Tax savings on loss Total

$ 3,000 18,800 $21,800

Relevant Cash Flow Analysis Example

New equipment: Current book value Current disposal price is irrelevant Terminal disposal price (5 years) Annual depreciation Working capital $225,000 0 $ 45,000 $ 15,000

Relevant Cash Flow Analysis Example

How much is the net investment for the new equipment?

Current cost Add increase in working capital 10,000 Deduct after-tax cash flow from current disposal of old equipment 21,800 Net investment

$225,000

$213,200

Relevant Cash Flow Analysis Example

Assume $90,000 pretax annual cash flow from operations (excluding depreciation effect).

What is the after-tax flow from operations? Cash flow from operations Deduct income tax (40%) Annual after-tax flow from operations $90,000 36,000 $54,000

Relevant Cash Flow Analysis Example

What is the difference in depreciation deduction? Annual depreciation of new equipment Deduct annual depreciation of old equipment Difference

$45,000 10,000 $35,000

Relevant Cash Flow Analysis Example

What is the annual increase in income tax savings from depreciation?

Increase in depreciation Multiply by tax rate Income tax cash savings from additional depreciation

$35,000 .40 $14,000

Relevant Cash Flow Analysis Example

What is the cash flow from operations, net of income taxes?

Annual after-tax flow from operations Income tax cash savings from additional depreciation Cash flow from operations, net of income taxes

$54,000 14,000 $68,000

Relevant Cash Flow Analysis Example

G. T. requires a 14% rate of return on its investments.

What is the net present value of the new equipment incorporating income taxes?

Relevant Cash Flow Analysis Example

Net Cash NPV of Net Years 14% Col. Inflows Cash Inflows 1-5 3.433 $68,000 $233,444 5 0.519 10,000 5,190 Total PV of net cash inflows $238,636 Investment 213,200 Net present value of new equipment $ 25,436

Postinvestment Audit
A postinvestment audit compares the actual results for a project to the costs and benefits expected at the time the project was selected.

It provides management with feedback about performance.

Strategic Considerations

Capital investment decisions that are strategic in nature require managers to consider a broad range of factors that may be difficult to estimate.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Special Cases Of Capital Budgeting

Comparing projects with unequal sizes

If

there is a limit on the total capital available for investment

Firm cannot simply select the project(s) with the highest NPV

Must first find out the combination of investments with the highest present value of future cash flows per dollar of initial cash outlay Can be done using the projects profitability index

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Special Cases Of Capital Budgeting

Firm should first rank the projects in decreasing order of their profitability indexes
Then select projects with the highest profitability index Until it has allocated the total amount of funds at its disposal

However, the profitability index rule may not be reliable

When

choosing among mutually exclusive investments When capital rationing extends beyond the first year of the project
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EXHIBIT 5: Cash Flows, Present Values, and Net Present Values for Three Investments of Unequal Size with k= 0.10.
INVESTMENT E (1) Initial cash outlay (CF0) Year-one cash flow (CF1) Year-two cash flow (CF2) (2) Present value of CF1 and CF2 at 10% Net present value = (2) (1) $1,000,000 800,000 500,000 INVESTMENT F $500,000 200,000 510,000 INVESTMENT G $500,000 100,000 700,000

$1,140,496

$603,306

$669,421

$140,496

$103,306

$169,421

Exhibit 5 describes the analysis of three investment projects of different sizes.

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EXHIBIT 6: Profitability Indexes for Three Investments of Unequal Size.

Figures from Exhibit 6.12

INVESTMENT E
(1) Initial cash outlay (2) Present value of future cash-flow stream
(2) (1)

INVESTMENT F
$500,000

INVESTMENT G
$500,000

$1,000,000

$1,140,496 $1,140,496 $1,000,000

$603,306 $603,306 $500,000

$669,421 $669,421 = 1.34 $500,000

(3) Profitability index =

= 1.14

= 1.21

Exhibit 6 shows the profitability index of the three investments.

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Special Cases Of Capital Budgeting

Comparing projects with unequal life spans

If

projects have unequal lives

Comparison should be made between sequences of projects such that all sequences have the same duration

In many instances, the calculations may be tedious Possible to convert each projects stream of cash flows into an equivalent stream of equal annual cash flows with the same present value as the total cash flow stream Called the constant annual-equivalent cash flow or annuity-equivalent cash flow Then, simply compare the size of the annuities

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EXHIBIT 7a: Cash Outflows and Present Values of Cost for Two Investments with Unequal Life Spans.
SEQUENCE OF TWO MACHINE AS END OF YEAR Now 1 2 3 4 CASH OUTFLOWS MACHINE 1 MACHINE 2 $80,000 4,000 4,000 $80,000 4,000 4,000 PRESENT VALUE COST OF CAPITAL = 10% $80,000 3,636 69,422 3,005 2,732 $158,795

TOTAL
$80,000 4,000 $84,000 4,000 4,000

Present Value of Costs

Exhibit 7 illustrates the case of choosing between two machines, one having an economic life half that of the other.
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EXHIBIT 7b: Cash Outflows and Present Values of Cost for Two Investments with Unequal Life Spans.
ONE MACHINE B END OF YEAR Now CASH OUTFLOWS $120,000 PRESENT VALUE COST OF CAPITAL = 10% $120,000

1
2 3 4

3,000
3,000 3,000 3,000 Present Value of Costs

2,727
2,479 2,254 2,049 $129,509

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EXHIBIT 8: Original and Annuity-Equivalent Cash Flows for Two Investments with Unequal Life Spans.
Figures from Exhibit 6.14 and Appendix 6.1

Machine A Original Cash Flow -$80,000 -4,000 -4,000 -50,096 -50,096 AnnuityEquivalent Cash Flow

Machine B Original Cash Flow -$120,000 -3,000 -3,000 -3,000 -3,000 -40,855 -40,855 -40,855 -40,855 -$129,509 AnnuityEquivalent Cash Flow

End of Year Now 1 2 3 4 Present value (10%)

-$86,942

-$86,942

-$129,509

Exhibit 8 shows how to apply the annuityequivalent cash flow approach to the choice between the two machines.
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Managerial Options Embedded In Investment Projects

The option to switch technologies

Discussed

using the designer desk lamp project of Sunlight Manufacturing Company (SMC) as an illustration

The option to abandon a project

Can

affect its net present value Demonstrated using an extended version of the designer-desk lamp project

Although the project was planned to last for five years, we assume now that SMCs management will always have the option to abandon the project at an earlier date

Depending on if the project is a success or a failure

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Dealing With Managerial Options

Above options are not the only managerial options embedded in investment projects

Option to expand Option to defer a project

Managerial options are either worthless or have a positive value

Thus, NPV of a project will always underestimate the value of an investment project The larger the number of options embedded in a project and the higher the probability that the value of the project is sensitive to changing circumstances

The greater the value of those options and the higher the value of the investment project itself

145

Dealing With Managerial Options

Valuing managerial options is a very difficult task

Managers

should at least conduct a sensitivity analysis to identify the most salient options embedded in a project, try at valuing them and then exercise sound judgment

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Capital Budgeting
ALTERNATIVES TO THE NPV RULE

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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The Payback Period

A projects payback period is the number of periods required for the sum of the projects cash flows to equal its initial cash outlay
Usually

measured in years

148

The Payback Period Rule

According to this rule, a project is acceptable if its payback period is shorter than or equal to the cutoff period
For

mutually exclusive projects, the one with the shortest payback period should be accepted

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Does the payback period rule meet the conditions of a good investment decision?

Adjustment for the timing of cash flows?

Ignores Ignores
No

the time value of money risk

Adjustment for risk? Maximization of the firms equity value?

objective reason to believe that there exists a particular cutoff period that is consistent with the maximization of the market value of the firms equity The choice of a cutoff period is always arbitrary The rule is biased against long-term projects

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Why Do Managers Use The Payback Period Rule?

Payback period rule is used by many managers

Often in addition to other approaches Simple and easy to apply for small, repetitive investments Favors projects that pay back quickly

Redeeming qualities of this rule

Thus, contribute to the firms overall liquidity

Can be particularly important for small firms

Makes sense to apply the payback period rule to two investments that have the same NPV Because it favors short-term investments, the rule is often employed when future events are difficult to quantify

Such as for projects subject to political risk

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The Discounted Payback Period

The discounted payback period, or economic payback period

Number

of periods required for the sum of the present values of the projects expected cash flows to equal its initial cash outlay

Compared to ordinary payback periods

Discounted payback periods are longer May result in a different project ranking

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The Discounted Payback Period Rule

The discounted payback period rule says that a project is acceptable

If

discounted payback period is shorter or equal to the cutoff period

Among several projects, the one with the shortest period should be accepted

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Does the discounted payback period rule meet the conditions of a good investment decision?

Adjustment for the timing of cash flows?

The The If

rule considers the time value of money rule considers risk

Adjustment for risk? Maximization of the firms equity value?

a projects discounted payback period is shorter than the cutoff period

Projects NPV when estimated with cash flows up to the cutoff period is always positive

The rule is biased against long-term projects The discounted payback period rule cannot discriminate between the two investments
154

The Discounted Payback Period Rule Vs. The Ordinary Payback Period Rule

The discounted payback period rule is superior to the ordinary payback period rule

Considers the time value of money Considers the risk of the investments expected cash flows

However, the discounted payback period rule is more difficult to apply

Requires the same inputs as the NPV rule Used less than the ordinary payback period rule

155

The IRR Rule

A project should be accepted if its IRR is higher than its cost of capital and rejected if it is lower
If

a projects IRR is lower than its cost of capital, the project does not earn its cost of capital and should be rejected

156

Does the IRR rule meet the conditions of a good investment decision?

Adjustment for the timing of cash flows?

Considers The

the time value of money

Adjustment for risk?

rule takes risk into consideration The risk of an investment does not enter into the computation of its IRR, but the IRR rule does consider the risk of the investment because it compares the projects IRR with the minimum required rate of return--a measure of the risk of the investment

157

The IRR Rule May Be Unreliable

The IRR rule may lead to an incorrect investment decision when

Two

mutually exclusive projects are considered A projects cash flow stream changes sign more than once

158

Investments With Some Negative Future Cash Flows

Negative cash flows can occur when an investment requires the construction of several facilities that are built at different times When negative cash flows occur a project may have multiple IRRs or none at all

Firm

should ignore the IRR rule and use the NPV rule instead

159

Why Do Managers Usually Prefer The IRR Rule To The NPV Rule?

IRR calculation requires only a single input (the cash flow stream)

However, applying the IRR rule still requires a second input the cost of capital

When a projects cost of capital is uncertain, the IRR method may be the answer

Most managers find the IRR easier to understand

Managers usually have a good understanding of what an investment should "return If they agree, use the IRR If they disagree, trust the NPV rule

Advice: Compute both a projects IRR and NPV

160

The Profitability Index (PI)

The profitability index

Benefit-to-cost

ratio equal to the ratio of the present value of a projects expected cash flows to its initial cash outlay

161

The Internal Rate Of Return (IRR)

A project's internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of the project equal to zero An investments IRR summarizes its expected cash flow stream with a single rate of return that is called internal

Because it only considers the expected cash flows related to the investment

Does not depend on rates that can be earned on alternative investments

162

The Profitability Index Rule

According

to the PI rule a project should be accepted if its profitability index is greater than one and rejected if it is less than one

163

Does the PI rule meet the conditions of a good investment decision?

Adjustment for the timing of cash flows?

Takes into account the time value of money

Projects expected cash flows are discounted at their cost of capital

Adjustment for risk?

The PI rule considers risk because it uses the cost of capital as the discount rate

Maximization of the firms equity value? When a projects PI > 1 the projects NPV > 0 and viceversa

Thus, it may appear that PI is a substitute for the NPV rule Unfortunately, the PI rule may lead to a faulty decision when applied to mutually exclusive investments with different initial cash outlays

164

Use Of The Profitability Index Rule

The PI is a relative measure of an investments value

NPV

is an absolute measure

Thus, the PI rule can be a useful substitute for the NPV rule when presenting a projects benefits per dollar of investment

165