Capabilities

1. Discuss the difficulty encountered in finding profitable projects in

competitive markets and the importance of the search.
2. Determine whether or not a new project should be accepted or
rejected using the payback period, the net present value, the
profitability index, and the internal rate of return.
3. Explain how the capital-budgeting decision process changes when a
dollar limit is placed on the dollar size of the capital budget.
4. Discuss the problems encountered in project ranking.
5. Explain the importance of ethical considerations in capital-
budgeting decisions.
6. Discuss the trends in the use of different capital-budgeting criteria.
Finding Profitable Projects
Capital-Budgeting Decision Criteria
Capital Rationing
Problems in Project RankingCapital Rationing, Mutually
Exclusive Projects, and Problems with the IRR
Ethics in Capital Budgeting
A Glance at Actual Capital-Budgeting Practices
Objective 1 FINDING PROFITABLE
PROJECTS
to evaluate profitable projects or investments in
fixed assets, a process referred to as capital
budgeting,

Axiom 5: The Curse of Competitive Markets
Why Its Hard to Find Exceptionally Profitable
Projects.

The payback period is the number of years
needed to recover the initial cash outlay.
Objective 2 CAPITAL-BUDGETING
DECISION CRITERIA
A B
Initial cash outlay $10,000 $10,000
Annual net cash inflows
Year 1 $ 6,000 $ 5,000
2 4,000 5,000
3 3,000 0
4 2,000 0
5 1,000 0


Net Present Value

The net present value (NPV) of an
investment proposal is equal to the present
value of its annual net cash flows after taxes
less the investments initial outlay.

=
+
n
t 1
t
t
k) (1
ACF

NPV = - IO
NPV
ACF
t
= the annual after-tax cash flow in
time period t .
k = the appropriate discount rate; that is,
the required rate of return or cost of capital
IO = the initial cash outlay
n = the projects expected life
Principal

NPV 0.0 : accept
NPV 0.0 : reject

NPV Illustration of Investment in New
Machinery
AFTER-TAX
CASH FLOW
Inflow year 1 15,000
2 14,000
3 13,000
4 12,000
5 11,000

Initial outlay $40,000

Calculation for NPV Illustration of Investment in New Machinery
PRESENT VALUE
AFTER-TAX FACTOR AT PRESENT
CASH FLOW 12 PERCENT VALUE
2 14,000 .797 11,158
3 13,000 .712 9,256
4 12,000 .636 7,632
5 11,000 .567 6,237
Initial outlay 40,000








Inflow year 1 15,000 .893 $13,395








Present value of cash flows $ 47,678

Net present value $ 7,678


Profitability Index (Benefit-
Cost Ratio)



The profitability index (PI), or benefit-
cost ratio, is the ratio of the present value
of the future net cash flows to the initial
outlay.

IO
k
ACF
n
t
t
t

=
+
1
) 1 (
PI =
ACF
t
= the annual after-tax cash flow in time
period t (this can take on either positive
or negative values )
k = the appropriate discount rate; that is, the
required rate of return or cost of capital
IO = the initial cash outlay
n = the projects expected life

Principale


PI 1.0 : accept
PI 1.0 : reject

PRESENT VALUE
AFTER-TAX FACTOR AT PRESENT
CASH FLOW 10 PERCENT VALUE
Inflow year 1 15,000 0.909 13,635
2 8,000 0.826 6,608
3 10,000 0.751 7,510
4 12,000 0.683 8,196
5 14,000 0.621 8,694
6 16,000 0.564 9,024










Initial outlay $50,000 1.000 $50,000

IO
k
ACF
n
t
t
t

=
+
1
) 1 (
000 , 50 $
024 , 9 $ 694 , 8 196 , 8 $ 510 , 7 $ 608 , 6 $ 635 , 13 $ + + + + +
000 , 50 $
667 , 53 $
= 1.0733
Internal Rate of Return

The internal rate of return (IRR) the
discount rate that equates the present value
of the projects future net cash flows with
the projects initial cash outlay.

=
+
n
t 1
t
t
IRR) (1
ACF

IO =
IRR
ACF
t
= the annual after-tax cash flow in
time period t (this can take on either
positive or negative values )
IO = the initial cash outlay
n = the projects expected life
IRR = the projects internal rate of return

1
) 1 (
000 , 15 $
IRR +
2
) 1 (
000 , 15 $
IRR +
3
) 1 (
000 , 15 $
IRR +
4
) 1 (
000 , 15 $
IRR +
$45,555 =
(

=
4
1
) 1 (
1
t
t
IRR
$45,555 = 15,000

$45,555 = $15,000 (PVIFA
i , 4yr
)

Dividing both sides by $15,000, this becomes

3.037 = PVIFA
i, 4yr


IRR for Uneven Cash Flows
Present Value
Net Cash Flows Factor at 15 Percent
Present Value
Inflow year 1 $1,000 .870 $ 870
Inflow year 2 2,000 .756 1,512
Inflow year 3 3,000 .658 1,974
Present value of inflows $ 4,356
Initial outlay $ 3,817
2. TRY i = 20 PERCENT:
Present Value
Net Cash Flows Factor at 20 Percent Present
Value
Inflow year 1 $1,000 .833 $ 833
Inflow year 2 2,000 .694 1,388
Inflow year 3 3,000 .579 1,737
Present value of inflows $ 3,958
Initial outlay $ 3,817
3. TRY i = 22 PERCENT:
Present Value
Net Cash Flows Factor at 22 Percent Present Value
Inflow year 1 $1,000 .820 $ 820
Inflow year 2 2,000 .672 1,344
Inflow year 3 3,000 .551 1,653
Present value of inflows $ 3,817
Initial outlay $ 3,817

Three IRR Investment

A B C
Initial outlay $10,000 $10,000 $10,000
Inflow year 1 3,362 0 1,000
Inflow year 2 3,362 0 3,000
Inflow year 3 3,362 0 6,000
Inflow year 4 3,362 13,605 7,000

15%
Present Value
Net Cash Flows Factor at 15 Percent Present Value
Inflow year 1 $1,000 .870 $ 870
Inflow year 2 3,000 .756 2,268
Inflow year 3 6,000 .658 3,948
Inflow year 4 7,000 .572 4,004
Present value of inflows $11,090
Initial outlay $ 10,000

Present Value
Net Cash Flows Factor at 19 Percent Present Value
Inflow year 1 $1,000 .840 $ 840
Inflow year 2 3,000 .706 2,118
Inflow year 3 6,000 .593 3,558
Inflow year 4 7,000 .499 3,493
Present value of inflows $10,009
Initial outlay $ 10,000

-2,000
-1,500
-1,000
-500
0
500
1,000
1,500
0 100 200 300 400 500 600
Discount rates(%)
N
e
t

p
r
e
s
e
n
t

v
a
l
u
e
(
$
)
Objective 4
PROBLEMS IN PROJECT RANKING-CAPITAL
RATIONING, MUTUALLY EXCLUSIVE PROJECTS,
AND PROBLEMS WITH THE IRR.
1 Size disparity
2 Time disparity
3 Unequal live
Capital-Rationing Example of Five Indivisible Projects
Project Initial Outlay Profitability Index Net Present Value
A $200,000 2.4 $280,000
B 200,000 2.3 260,000
C 800,000 1.7 560,000
D 300,000 1.3 90,000
E 300,000 1.2 60,000

Investment Evaluation A Primary A Secondary Total Using
Methods Used: Method Method This Method


Payback period 24% 59% 83%
Internal rate of return 88% 11% 99%
Net present value 63% 22% 85%
Profitability index 15% 18% 33%


Project Size and Decision-Making Authority
Project Size Typical Boundaries Primary Decision Site

Very small Up to $100,000 Plant
Small $100,000 to $1 million Division
Medium $1 million to $10 million Corporate
investment committee
Large Over $10 million CEO & board

KEY TERMS
Benefit-Cost Ratio (see Profitability Index)
Capital Budgeting
Capital Rationing
Equivalent Annual Annuity (EAA)
Internal Rate of Return (IRR)
Mutually Exclusive Projects
Net Present Value (NPV)
Payback period
Profitability Index (PI or Benefit-Cost Ratio)