Capital Budgeting and

Decision Criteria
Chapter 9
Learning Goals
Discuss the difficulty of finding profitable projects
in competitive markets.

Determine whether a new project should be

accepted using
1. PAYBACK PERIOD
2. NET PRESENT VALUE
3. PROFITABILITY INDEX
4. INTERNAL RATE OF RETURN
The NPV - IRR Relationship

Net present value profile

Net present value profile

- a graph showing how a project' net

present value changes as
the discount rate changes.

(IRR - the discount rate that equates

the present value of the inflows with
the present value of the outflows )
Illustration 1

Initial outlay : $105,517

Cash flow : $30,000
Duration : 5 years
 DISCOUNT RATE PROJECT’S NPV
0% $ 44, 483
15 % $ 24, 367
10 % $ 8, 207
13% $0
15% -$ 4, 952
20% -$ 15,799
25% -$ 24,839
Modified Internal Rate Of
Return

MIRR
Modified Internal Rate Of Return

the discount rate that equates the

present value of the free cash
outflows with the present value of the
project's terminal value.
What does it mean?

While the internal rate of return (IRR)

assumes the cash flows from a project
are reinvested at the IRR, the modified
IRR assumes that all cash flows are
reinvested at the firm's cost of capital.
Therefore, MIRR more accurately
reflects the profitability of a project.
Steps in calculating the MIRR

1. Determine the PV of the project's free cash

outflows.

1. Determine the terminal value of the project's

free cash inflows.

3. Determine the discount rate that equates the

PV of the terminal value and the present
value of the project's cash outflow.
Sample Problem
Galaxy Angels Company is considering
two mutually exclusive projects. The
firm, which has a 12% cost of capital,
has estimated its cash flows as shown
below.
Requirements:

a. NPV of each project

b. IRR for each project
c. NPV profiles for both projects
CHAPTER 11:

CAPITAL
BUDGETING AND
RISK ANALYSIS
1. Explain what the appropriate measure of
risk is for capital-budgeting purposes.
2. Determine the acceptability of a new
project using both the certainty
equivalent and risk-adjusted discount
rate methods of adjusting for risk.

3. Explain the use of simulation and

probability trees for imitating the
performance under evaluation.
RISK AND THE
INVESTMENT
DECISION
There are two (2) basic issues:
1. What is risk in terms of capital-budgeting decisions,
how should it be measured?
2. How should risk be incorporated into capital budgeting
analysis?
THREE MEASURES OF
RISK

1. Project standing alone risk- it is measured by

the variability of the asset’s expected returns.
2. Project’s contribution- to- firm risk- the
amount of risk that a project contributes to
the firm as a whole.
3. Systematic risk- the risk of a project
measured from the point of view of a well-
diversified shareholder.
METHODS FOR INCORPORATING
RISK INTO CAPITAL-BUDGETING

1. Certainty Equivalent- under this method, the

decision maker substitutes a set of equivalent
riskless cash flows for the expected cash flows
and then discounts these cash flows back to
the present.
2. Risk-adjusted discount rate- in this method, the
discount rate is adjusted to compensate for
risk.
 Sample problem: Cer tainty
equivalent
ZERO Corporation is studying the long-term impact of the two
projects and has gathered the following data for analysis:

A CE B CE
IO 20,000 factor
100% 12,000 factor
100%
CI
1 16,000 95% 8,000 94%
2 8,000 92% 5,000 83%
3 6,000 86% 4,000 80%
4 0 5,000 70%
5 0 4,000 60%
Discount 12% 14%
rate
Sample problem. Risk-adjusted
discount r ate
Project A Project B
IO 20,000 12,000
Cash Inflows
1 16,000 8,000
2 8,000 5,000
3 6,000 4,000
4 0 5,000
5 0 4,000
Discount rate 12% 14%
Coefficient of 5% 20%
variation
Risk-adjusted 12.6% 16.8%
discount rate