Part 2: Section E

Investment Decisions

Topic 1.1 Introducing the Capital Budgeting Process

I. Defining Capital Investments
A. Capital investments represent the core assets and resources for the organization.
They include both tangible investments and intangible investments.
1. Tangible capital investments traditionally include investments in
buildings, equipment, land, etc.
2. On the other hand, intangible capital investments can include investments
in patents, trademarks, and goodwill.
B. One way to view capital investments is to think of the financial accounting
concept capitalized assets. Investments that are capitalized and listed as long-term
assets on the balance sheet meet the classic definition as a capital investment.
1. However, it is not a strict rule that a capital investment must meet the
financial accounting guidelines necessary to report the investment as a
long-term asset on the balance sheet.
2. For example, R&D (research and development) assets have different
reporting rules across U.S. GAAP (generally accepting accounting
principles) and IFRS (International Financial Reporting Standards). The
result is that some R&D investments are listed on the balance sheet for
IFRS but not for GAAP. Regardless of the reporting environment, R&D
typically fits the definition of a capital investment and should be handled
as a capital budgeting process.
C. The core definition of investment decisions that should be managed with capital
budgeting tools is twofold.
1. Capital investments involve significant sums of money for the
organization.
2. Capital investments have a long future horizon; that is, these investments
are made for the long term.
II. Purposes for Making Capital Investments
A. There are three reasons or purposes for making significant investments in a
business that stretch across long time horizons. Capital investments
for operational purposes typically focus on either reducing operating costs or
increasing revenue for the organization. Either or both of these improvements
should directly increase operating profits.
B. Capital investments for strategic purposes are often concentrated on strengthening
the organization's competitive position in its marketplace, which should
eventually result in protecting or improving profits. These kinds of investments
may be done to establish a barrier against possible competitors, to strengthen
relationships with suppliers or customers, or to create and improve the brand
image of the organization.
C. Capital investments for regulatory purposes are likely to not improve profits.
Examples of these kinds of capital investments include large-scale spending on
environmental protection equipment or testing, significant spending on HR
(human resource) training to meet a legal requirement, and substantial

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investments in tools or technology to ensure safety of employees or customers.

While not done to enhance profit, these investments allow the organization to
continue to operate in its industry or market, and should be analyzed in a capital
budgeting process to be as cost-efficient as possible.
III. Uncertainty and Risk in Capital Investments
A. The biggest challenge with capital investments is the uncertainty involved in
making these management decisions. Greater uncertainty means there is greater
risk in the decision. This uncertainty results primarily from the fact that capital
investment decisions are based on estimates about the future.
B. As the time frame for the capital investment increases, there is more uncertainty
in the estimates of future costs, revenues, and other crucial characteristics of the
investment. This means that as the time frame gets longer, risk in the decision is
increasing.
C. Managing risk due to uncertainty in the capital investment can be done by
increasing flexibility on certain characteristics in the investment.
1. The ability to accelerate or delay future payments involved in the capital
investment can help the organization soften the impact of other
unexpected events in its future that would otherwise create stress around
these committed capital investment payments.
2. The ability to expand or reduce the size of the investment in the future
provides the organization with opportunities to take advantage of changes
in its economic strength.
3. The ability to extend or early exit the timeline of the investment
commitment provides the organization with an ability to pull money out of
the investment should it have crucial needs in other aspects of its business.
D. In short, flexibility in the capital investment can help counter the effects of
uncertainty in the future, and this reduces risk for the organization. However,
increasing flexibility in order to reduce risk is rarely free. The organization will
need to either pay something extra or give up some potential profit in order to
have more flexibility in the investment decision.
IV. Choice and Tradeoffs in Capital Budgeting
A. Capital budgeting involves making choices among several possible capital
investments, and different investment options typically have a variety of variable
characteristics that trade off against each other in the investment choice to be
made.
B. Some investment choices may be more operationally efficient in terms of cost
savings or direct revenue improvements. Other investment choices may be more
strategically focused in terms of the impact on competitive position, a stakeholder
relationship, or the organization's brand image. And some investment choices
may provide a more effective or efficient solution to a regulatory requirement.
Overall, organizations must often evaluate investment choices across a wide array
of characteristics that trade off one against another in terms of operating
efficiency, strategic focus, and regulatory compliance. Different capital budgeting

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tools can be brought to bear to help make assessments to support the final
management decision.
V. Capital Budgeting Tools
A. There are a wide range of tools available to help with the capital investment
decision. The first set of tools are financial analysis tools, which include net
present value (NPV), internal rate of return (IRR), payback, and return on
investment (ROI) tools.
B. The second set of tools are risk analysis tools, which include scenario analysis,
sensitivity analysis, and Monte Carlo analysis.
C. The third set of tools, unlike financial analysis tools or risk analysis tools, are not
computational. Qualitative analysis tools are typically models or themes that
provide a meaningful way to consider non-quantitative characteristics of capital
investment choices. These models include quality, cultural, strategic, brand,
environmental, and ethical considerations.
D. Each of these sets of tools is individually considered in subsequent lessons in this
section of the course. The diagram below is a visual display of these toolsets.

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VI. The Capital Budgeting Process

A. The capital budgeting tools listed above tend to focus on only one of the three key
steps in a capital budgeting process or system—Step 2. However, it is important
to understand that capital budgeting is about more than choosing which capital
investment to make. The entire capital budgeting process is depicted in the
diagram below.

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1. The first step in the capital budgeting process involves effectively

assembling a set of viable investment projects or choices. Most
organizations are very much limited in what capital investments they can
afford to make. Hence, management needs to clearly identify and define
each possible capital investment project in terms of its financial, risk, and
qualitative dimensions.
2. The second step, which is typically the focus of capital investment
decision making, is the actual project or choice in which management
determines to invest significant resources. These kinds of decisions are
obviously crucial to the success of the organization's business. Hence,
careful analysis takes place in this second step.
3. The third step begins once the investment is made. This is a long-term step
in that it is a process of monitoring the investment and reviewing the
assumptions and projections that went into the decision analysis. This is
essentially an audit of the investment decision, and it is used to evaluate
the effectiveness of the first two capital budgeting steps.
B. Note in the diagram above that the capital budgeting process is depicted as a
feedback loop. As monitoring and reviewing of previous capital investment
decisions take place (Step 3 in the process), crucial feedback is provided to future
work to successfully identify and define potential projects (Step 1), and
successfully evaluate and select projects in which to invest (Step 2).

Practice Question
An e-commerce startup company is preparing to make its first significant capital investment in a
new server system. Management has identified a number of possible systems in which the
company might invest and needs to make a choice. Management obviously wants to make this

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decision carefully, and as much as possible improve the odds that the investment will be
successful. What kinds of issues should the company consider in making this investment
decision, and what does management need to understand about reducing risk in this decision?
Answer
There are three overall considerations that should explicitly be considered for this significant
capital investment in a new server system.
The first consideration involves the operational effectiveness of each proposed server system.
What are the future effects on costs and revenues for the e-commerce company related to each
system?
The second consideration involves the strategic impact of each proposed server system. How
does each system help the company protect and enlarge its competition position or its brand
image? Do these systems help the e-commerce company improve stakeholder relationships with
key suppliers or customer groups?
The third consideration involves regulatory issues, most likely involving security requirements
with sensitive supplier and customer information. What are the regulatory requirements the e-
commerce company must follow with respect to its server system, and how well does each
investment alternative meet those regulatory demands?
The e-commerce company also needs to evaluate the uncertainty involved in projecting costs,
revenues, competitive and branding impacts, regulatory performance, etc. for each potential
server system investment. To the extent there is more or less uncertainty in the analysis of each
proposed server system, there is more or less risk in that particular investment. This risk needs to
be incorporated into the selection decision.
Summary
Capital investments involve significant amounts of money and commit the organization to long-
term positions. Often, but not always, capital investments are reported as capital assets on the
balance sheet. Capital investments should be evaluated based on three key sets of issues
involving operational effectiveness, strategic impact, and regulatory compliance. Because these
are long-term investments, there can be significant uncertainty in making estimates or
projections involving these three sets of issues, and more uncertainty in a particular investment
analysis means there is more risk in the investment. However, to the extent the organization can
create flexibility in future commitments surrounding the investment, then risk can be reduced.
Tools used to assess capital investments can be grouped into financial analysis tools, risk
analysis tools, and qualitative analysis tools. Remember that the capital budgeting process is not
only about making a good capital investment selection. Before making an investment, managers
need to successfully develop a set of investment alternatives that are each clearly defined in
terms of key characteristics. And after the investment is made, managers need to commit to
ongoing monitoring of the investment decision in order to understand and improve the capital
budgeting process for future investment decisions.

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Topic 1.2 Cash Flows and Profits in the Capital Budgeting Process

I. Computing Cash Flows

A. It is absolutely critical to accurately forecast and compute cash flows. Otherwise,
the subsequent capital investment analysis will not be successful.
B. Computing cash flows is challenging and needs to be approached carefully with a
clear distinction on cash flows across three separate stages of the capital
investment: (1) the initial investment, (2) the ongoing operations using the
investment, and (3) the final disposal of the investment.
C. The cash flow computations in each of the three stages of the capital investment
will result in a net cash flow amount. Typically, cash is flowing both in and out of
the organization at each stage. In addition, there is often an income tax effect that
needs to be netted into the cash flow computations.
II. Cash Investment
A. The cash investment for the capital project is almost always a net outflow. Taxes
are not paid on the acquisition cost of the new asset. However, if the new asset is
replacing an old asset, there is often a tax effect on the cash received for the old
asset. 1
B. The after-tax cash received for the sale of an old asset being replaced by the new
capital asset should be netted against the initial cash cost of the new asset.
C. To compute the after-tax cash received for an old asset being replaced in the
capital investment, first determine the accounting book value of the old asset
(original purchase price minus accumulated depreciation). Then compute the tax
effect on the gain or loss on the old asset.
1. The gain or loss is determined by cash received minus the book value. If
the transaction is a gain, then the tax cost is gain × tax rate. This cost is
deducted from the cash received.
2. If the transaction is a loss, then a tax shield (tax savings) results from the
sale of the old asset. The tax shield is loss × tax rate. This amount
represents tax savings for the organization and is added to the cash
received. 2
D. Cash investment computations are demonstrated below in the Practice Question.
III. Operating Cash Flows
A. Capital investment analysis methods like NPV (net present value), IRR (internal
rate of return), and Payback are based on cash flows from operations. It is
important, therefore, to distinguish operating cash flows from operating profits.
The ROI (return on investment) method uses operating profits in its analysis.
B. When computing operating cash flows, pay attention to cash expenses and non-
cash expenses such as depreciation. Depending on which approach you take to
computing operating cash flows (an indirect approach versus a direct approach),
the computation approach to non-cash expenses is different.
1. An indirect approach to computing operating cash flows is similar to the
indirect method used in the statement of cash flows. Essentially, the

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approach is to add back all non-cash expenses (e.g., depreciation) to the

after-tax profit.

Indirect approach: After-Tax Profit+Non-Cash Expense

2. A direct approach to computing operating cash flows is a two-step method

of directly computing the after-tax amount of revenue and cash expenses,
and then in the second step adding the tax shield that results from non-
cash expenses.

Direct approach:After-Tax Cash+Tax Shield

C. Operating cash flow computations are demonstrated below in the Practice

Question.
IV. Cash from Disposal
A. Forecasting and computing cash flows resulting from future disposal of the capital
investment is similar to computing cash flows involved in the original investment.
Typically, there is a cash inflow when the investment is discontinued and the asset
is scrapped or sold. And there is often a tax effect on the cash flow that results.
B. Remember that any cash received from the disposal, unless it is exactly equal to
the book value of the investment asset at that time, will have a tax effect. If the
cash received is greater than the book value, it is a gain. The tax cost is gain × tax
rate, and this cost is deducted from the cash received.
C. If the cash received is less than the book value, then the disposal is a loss. The tax
shield (tax savings) is loss × tax rate. This amount is added to any cash received.
V. Working Capital Cash Flows
A. Capital asset investments are almost always used in some operating process for
the organization. As part of supporting that process, the organization often needs
to commit cash that is then unavailable for any other use until the end of the
capital investment life.
B. The cash committed as working capital to support the investment's operating
process is identified on the balance sheet as incremental current assets minus the
incremental current liabilities. More specifically, the organization identifies
increases in the following accounts necessary to support the capital investment,
and uses the formula below to compute working capital:

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C. The increase in working capital due to the capital investment represents cash
inflow that must be added to the initial capital investment.
D. When the capital investment is disposed of at the end of its operating life, the
decrease in working capital that results represents a cash outflow that is added to
the cash from disposal.
E. Working capital investments are not depreciated, nor do working capital cash
flows have any effect on taxes. Hence, do not include working capital when
computing tax costs or tax shield.
VI. Cash versus Profit for ROI Analysis
A. Remember that you are computing cash flows to subsequently perform capital
budgeting with analysis methods like NPV (net present value), IRR (internal rate
of return), and payback. But the ROI (return on investment) uses operating profits
in its analysis, and operating cash flow is not the same as operating profit!
B. There are many versions of the ROI method, including ROA (return on assets),
ROIC (return on invested capital), and ARR (accounting rate of return). Many of
these “return” methods you may have studied in other sections of this course. The
basic ROI formula is:

IncomeInvestment

C. “Income” in the numerator of the ROI formula above is represented by some

version of Income or Profit. Hence, you need to be sure that your computations
clearly distinguish between operating cash flows and operating profits as you use
different capital budgeting analysis methods. You can use the indirect approach
described earlier in this lesson to distinguish between cash flows and profit.

After-Tax Profit+Non-Cash Expense=After-Tax Cash

Flow
After-Tax Cash Flow−Non-Cash Expense=After-Tax
Profit

E. It is worth noting that ROI analysis can be based on the initial income and
investment, or on the average income and average investment book value over the
life of the project.

Practice Question
The Circle-M Company is planning to make a $200,000 investment into a new piece of
equipment to replace an old piece of equipment. The old equipment has $20,000 book value, and
can be sold for $15,000. The new equipment will require Circle-M to increase working capital by
$15,000 (which will be recovered at the end of this investment's life). The new equipment has a
10-year life and will generate annual revenue of $80,000 and out-of-pocket expense of $40,000.
In addition, Circle-M will recognize depreciation expense using the straight-line depreciation

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method. Despite an expectation that the new equipment can be sold for approximately $30,000 at
the end of its life, for tax purposes Circle-M can base depreciation on zero salvage value (i.e.,
can fully depreciate the asset to $0). Circle-M's average tax rate is 40%.
What is the net cash investment, the annual net operating cash flow, and the net cash on disposal
for this new capital asset?
Answer

Summary
Computing cash flows accurately is crucial to successful capital budgeting using NPV, IRR, and
Payback analysis methods. These cash flows should be computed net of tax. The net cash
investment includes not only the acquisition cost of the new asset, but the after-tax cash flow
from disposal of any old investment being replaced. It also includes any necessary increase in
working capital. Be sure to adjust the net operating cash flow to account for the tax shield from

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non-cash expenses such as depreciation. The net cash from disposal is adjusted for any tax
effects and includes as well the release of any working capital necessary to support the capital
investment. Remember that operating cash flow is not the same as operating profit. This is
important because ROI analysis is based on profit, not cash.

Topic 2.1 NPV and IRR Computations

I. The Time Value of Money

A. You likely understand already that time and interest rates are strongly connected.
To state it concisely, interest rates are what make money equal across time. Put
another way, using an interest rate makes one amount of money equal to a
different amount of money at a different point in time. The key to establishing
equality between two different amounts of money is identifying the right interest
rate.
B. You personally experience the equalizing power of interest rates all the time.
With the right interest rate, you are ambivalent between two different amounts of
money at two different points in time. You can think of making a loan to
experience the characteristics of an interest rate. When making a loan to another
person, you are (or should be) concerned about three issues.
1. Since you likely prefer to have your money available right now to spend,
you expect some type of compensation for delaying the use of your own
money.
2. You're probably concerned about the risk that you may not get your
money back at the end of the loan, and you want to be rewarded for taking
on that risk. Further, as the risk gets higher, you need more reward.
3. Inflation in the economy causes prices to rise, which means that when you
get your money back at the end of the loan, you can't purchase the same
goods and services. Hence, you'll need the payback amount adjusted in
order to maintain the same ability to consume goods and services.
C. These three factors, desire to consume now, risk of loss, and inflation effects,
combine to form the interest rate you demand on the loan you make to another
person. Similarly, you are (or should be!) considering these same factors on an
investment you make in a business. When the three factors (desire, risk, inflation)
are efficiently combined, you should be largely ambivalent between the money
you loan today and the money paid back to you in the future.
D. The concept of time value of money teaches us that, with the correct interest rate,
the money you loan today and the money paid back in the future is really the
same money. We call these two different amounts of money (present value and
future value) the nominal amounts. When adjusted for the correct interest rate,
these two amounts would be the same amount, and would be the “real” value in
terms of time value of money.

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E. In capital budgeting, the interest rate concept is described using a variety of

different terms, including discount rate, hurdle rate, and required rate of return.
II. Working with Your Calculator
A. The time value of money is central to capital budgeting using analysis techniques
such as NPV (net present value) and IRR (internal rate of return). Both of these
techniques base the analysis on discounting future nominal cash flows to present
value terms using the interest rate (i.e., discount rate) that correctly captures
expectations regarding desire, risk, and inflation. This approach is known as
discounted cash flow analysis.
B. Using a financial calculator or computer spreadsheet, you can do discounted cash
flow analysis involved in NPV and IRR computations. In this lesson, we will do
discounted cash flow computations using a financial calculator. The most
common financial calculators in the accounting and finance profession are various
editions of the Hewlett-Packard™ 10Bii+ and the Texas Instruments™ BA II
Plus. The calculator instructions provided in this lesson will relate to these two
types of calculators. It's important that you have access to specific guidelines for
your calculator, available on the Internet or in the instructions that accompany
your calculator.
C. Before beginning discount cash flow computations, it's critical that your
calculator has the proper settings for this lesson. There are two settings you need
to verify, and adjust if needed, on your calculator.
1. Be sure that your calculator is set to end-of-period payments (rather than
beginning-of-period payments). End-of-period payments is typically the
default setting of financial calculators. In these lessons, we assume
ordinary annuity payment streams (versus annuity-due payment streams).
Most calculators will constantly display a “BEG” on the screen if set to
beginning-of-period payments.
2. Be sure that your calculator is set to 1 period per year (rather than 12
periods per year). The default setting for most calculators is 12 periods per
year, so this is an important setting to verify and adjust if needed. In these
lessons, we treat operating cash flows as taking place annually (which is a
significant assumption). Any number of periods per year can be used in
discounted cash flow analyses (quarterly, monthly, weekly, etc.), but be
sure to adjust the discount rate to match the time period of the payment.
a. On Hewlett-Packard™ calculators, you can see the periods-per-
year setting by pressing [Gold shift] key, then [C ALL] key.
b. On Texas Instruments™ calculators, press [2nd], then [P/Y]. If the
display presents 12 or any other number than 1, you'll need to
access instructions for your calculator to change the periods per
year to 1.
D. Finally, it is highly recommended before beginning a discount cash flow analysis
on your calculator that you clear the memory of all work from previous time value
of money computations.

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1. On Hewlett-Packard™ calculators, press [Gold shift] key, then [C ALL]

key.
2. On Texas Instruments™ calculators, press [2nd] key, then [CLR TVM]
key.
III. Net Present Value (NPV)
A. Remember from the previous lesson on computing cash flows that there are three
categories of cash flows: Initial cash investment, Operating cash flows, and Cash
from final disposal. These cash flows happen at different points in time.
Remember that we can't directly compare nominal amounts of money today with
nominal amounts of money in the future. We must adjust these cash flows by an
appropriate interest (i.e., discount) rate to put all the money amounts in “real”
terms.
B. The NPV method is a straightforward approach to discounting future nominal
cash flows back to the present period in order to be able to directly compare
future flows to present costs. The figure below uses a timeline to demonstrate the
nature of how discounted cash flows work in the NPV analysis method. This
analysis assumes the following cash flows.

Net cash investment: $92,200

Net operating cash flows: $22,900 for five years

Net cash from disposal: $17,000 at end of five years

C. The discounted cash flow analysis figure above demonstrates an example of flows
for a capital investment that takes place across a five-year time period. And it
demonstrates discounting all of the future cash flows back to “Year 0,” which is
the current time period when the initial cash investment was made. The cash flow
discounting takes place using an effective discount rate to bring back each
nominal cash flow across its particular number of time periods to be comparable
with the net cash investment. For example, the operating cash flow $22,900 in

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Year 2 was discounted back two time periods to Year 0, and both the operating
cash flow of $22,900 and cash from disposal of $17,000 in Year 5 are discounted
back five time periods to Year 0. We will assume in this NPV computation
example that the effective discount rate for this analysis is 8% annual.
D. To compute the NPV, we must first discount all future cash flows to the present
value. And then we compare the present value of these future cash flows to the net
cash investment. If the present value of future cash flows is less than the net cash
investment, the capital investment NPV is less than zero (negative).
1. On Hewlett-Packard™ calculators, complete the following key strokes:

[Gold shift], [C ALL] → to clear all memory

5, [N] → to enter 5 years as the time period of the investment

8, [I/YR] → to enter 8% as the annual discount rate

22900, [PMT] → to enter $22,900 as the annual operating cash flow

17000, [FV] → to enter $17,000 as the cash from disposal

[PV] → simply pressing this key will compute the combined present value
of all future cash flows

Display: –103,003

2. On Texas Instruments™ calculators, complete the following key strokes:

[2nd], [CLR TVM] → to clear memory of all time value of money

computations

5, [N] → to enter 5 years as the time period of the investment

8, [I/Y] → to enter 8% as the annual discount rate

22900, [PMT] → to enter $22,900 as the annual operating cash flow

17000, [FV] → to enter $17,000 as the cash from disposal

[CPT], [PV] → to compute the combined present value of all future cash
flows

Display: –103,003

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E. The present value –$103,003 is negative because the calculator is indicating that a
$103,003 current investment (outflow) is equal to all the future inflows (positive
payments) that you entered in the computation, assuming an 8% discount rate.
F. Finally, computing the NPV (net present value) is done by comparing the present
value of future cash flows $103,003 to the net cash investment $92,200. The
difference is $10,803 (= 103,003 – 92,200).
1. It's important to note that this is a positive NPV because the present value
of the future inflows is more than the current net cash investment.
2. Also note that this positive NPV indicates that the internal rate of return
(IRR) for this capital investment is more than the discount rate used to
compute this discounted cash flow analysis.
IV. Internal Rate of Return (IRR)
A. As noted above, a positive NPV indicates that the IRR is higher than the discount
rate used to compute the NPV. On the other hand, a negative NPV would indicate
the IRR is less than the discount rate used. This begs the question: What is the
actual internal rate of return for the capital investment?
B. Keep your attention on the figure above, which illustrates the timing and the
discounting of future cash flows for our example. The calculator keystrokes to
compute IRR are not much different from computing NPV. In order to compute
IRR, the calculator will determine a discount rate that sets the combined value of
all future cash flows exactly equal to the net cash investment.
1. On Hewlett-Packard™ calculators, complete the following key strokes:

[Gold shift], [C ALL] → to clear all memory

5, [N] → to enter 5 years as the time period of the investment

–92200, [PV] → to enter the negative $92,200 net cash investment as

an outflow

22900, [PMT] → to enter $22,900 as the annual operating cash flow

(inflows)

17000, [FV] → to enter $17,000 as the cash from disposal (an inflow)

[I/YR] → simply pressing this key will compute the IRR for this capital
investment

Display: 12.00

2. On Texas Instruments™ calculators, complete the following key strokes:

[2nd], [CLR TVM] → to clear memory of all time value of money

computations

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5, [N] → to enter 5 years as the time period of the investment

–92200, [PV] → to enter the negative $92,200 net cash investment as

an outflow

22900, [PMT] → to enter $22,900 as the annual operating cash flow

17000, [FV] → to enter $17,000 as the cash from disposal

[CPT], [I/Y] → to compute the IRR for this capital investment

Display: 12.00

C. The IRR for this example is 12.00% (more precisely, 11.998%). Be sure to
remember the relationship between NPV and IRR. For this capital investment
example, computing NPV with any discount rate less than 12.00% would result in
a positive NPV. And computing NPV with a discount rate set higher than 12.00%
would result in a negative NPV.
V. Going Forward
A. The example we've explored in this lesson assumes a constant operating cash
flow; that is, all operating cash flows were the same amount each year. That's not
typical of capital investments for most organizations. In the next lesson, we'll
learn how to compute NPV and IRR with uneven operating cash flows.
B. Also bear in mind that capital investment decisions are not based solely on the
financial performance of the capital investment. There are often a number of
investment choices available, and some investment choices may have lower
financial performance but have non-financial values (safety, brand, environment,
etc.) that are important to the organization. NPV and IRR performance, while
important, is certainly not the sole basis for making capital investment decisions.

Practice Question
The Circle-M Company is planning to make an investment into a new piece of equipment to
replace an old piece of equipment. Circle-M's expected rate of return is 10% and the new
equipment has a 10-year life. Below are the expected cash flows associated with this capital
investment.

 Net cash investment: $198,000

 Net operating cash flows: $32,000 for ten years
 Net cash from disposal: $33,000 at end of ten years

What is the NPV and IRR for this investment? Use a business calculator to compute these
values.
Answer

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 NPV (Net Present Value):

 On a Hewlett-Packard™ calculator (for example), complete the following key strokes:
 Gold shift], [C ALL] → to clear all memory
 10, [N] → to enter 10 years as the time period of the investment
 10, [I/YR] → to enter 10% as the annual discount rate
 32000, [PMT] → to enter $32,000 as the annual operating cash flow
 33000, [FV] → to enter $33,000 as the cash from disposal
 [PV] → simply pressing this key will compute the combined present value of all future
cash flows
 Display: –209,349 → $209,349 present value of future cash flows
 $209,349 – $198,000 = $11,349 NPV

 IRR (Internal Rate of Return):

 On a Hewlett-Packard™ calculator (for example), complete the following key strokes:
 [Gold shift], [C ALL] → to clear all memory
 10, [N] → to enter 10 years as the time period of the investment
 –198000, [PV] → to enter the negative $198,000 net cash investment as an outflow
 32000, [PMT] → to enter $32,000 as the annual operating cash flow (inflows)
 33000, [FV] → to enter $33,000 as the cash from disposal (an inflow)
 [I/YR] → press this key to compute the IRR for this capital investment
 Display: 11.23 → 11.23% IRR

Summary
Interest rates are based on three characteristics that are specific to organizations and investments:
(1) the desire to have money available now rather than in the future, (2) the inherent risk that the
investment will not pay back the initial amount, and (3) the expectation of rising prices over time
(inflation). Interest rates and discount rates are effectively the same thing for purposes of
computing NPV (net present value) and IRR (internal rate of return). Using discounted cash flow
analysis, NPV determines the present value of all future cash flows and compares that amount to
the initial net cash investment. IRR analysis is similar to NPV analysis, but instead of using a
discount rate to determine and compare the present value of future flows to the initial investment,
this method identifies this discount rate (which is the IRR) that forces the present value of future
cash flows to be equal to the initial investment. Be sure to practice NPV and IRR computations
on your own calculator.

Topic 2.2 Comparing NPV and IRR Methods with Uneven Cash Flows

I. Uneven Cash Flows and Your Calculator

A. Operating cash flows are often not at a constant level from period to period. Much
more realistically, these cash flows will be at different levels across the life of the

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capital investment, which is more challenging to analyze in your calculator or

spreadsheet (but not much more challenging).
B. The key to analyzing uneven cash flows in your calculator is to locate your cash
flow key. On a Hewlett-Packard™ business calculator, it is the CFj key. On a
Texas Instruments™ calculator, it is the CF key.
C. To use the cash flow key on your calculator, you need to enter all cash flows in
sequential order, beginning with the initial cash investment. Be sure that
cash outflows are indicated with a negative sign before you enter these flows into
the cash flow key.
D. As an example, consider a decision to invest $1,000,000 in one of two different
marketing campaigns: Plan A and Plan B. Plan A has the following set of cash
flows, including the initial net cash investment of $1,000,000.

E. Note that the net cash investment outflow takes place at time period Year 0, with
the three subsequent after-tax inflows projected in Years 1, 2, and 3. Assuming a
discount rate (also known as a cost of capital rate) of 7%, compute the NPV and
IRR as follows.
1. On various editions of the Hewlett-Packard™ 10Bii+, complete the
following key strokes:
 [Gold shift], [C ALL] → to clear all memory
 7, [I/YR] → to enter 7% as the annual discount rate
 –1000000, [CFj] → to enter –$1,000,000 as the cash outflow at
Period 0.
 420000, [CFj] → to enter $420,000 as the first cash inflow at
Period 1.
 490000, [CFj] → to enter $490,000 as the second cash inflow at
Period 2.
 630000, [CFj] → to enter $630,000 as the third cash inflow at
Period 3.
 [Gold shift], [NPV] → to compute the net present value of all four
cash flows.
 Display: 334,776.00
 To compute IRR, do not clear the memory.
 [Gold shift], [IRR/YR] → to compute the internal rate of return for
all four cash flows.
 Display: 23.24
2. On various editions of the Texas Instruments™ BA II Plus, complete the
following key strokes:

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 [2nd], [CLR TVM] → to clear memory of all time value of money

computations
 7, [I/Y] → to enter 7% as the annual discount rate
 –1000000, [CF] → to enter –$1,000,000 as the cash outflow at
Period 0.
 420000, [CF] → to enter $420,000 as the first cash inflow at
Period 1.
 490000, [CF] → to enter $490,000 as the second cash inflow at
Period 2.
 630000, [CF] → to enter $630,000 as the third cash inflow at
Period 3.
 [NPV] → to compute the net present value of all four cash flows.
 Display: 334,776.00
 To compute IRR, do not clear the memory.
 [IRR] → to compute the internal rate of return for all four cash
flows.
 Display: 23.24
F. Based on these computations, Marketing Plan A provides an NPV of $334,776
and an IRR of 23.24%. Note that with a positive NPV, the IRR is expected to be
higher than the discount rate of 7% used to compute the NPV.
G. Now practice computing NPV and IRR for Marketing Plan B, which has the
following cash flows and also assumes a 7% discount rate (cost of capital). Be
sure to clear your calculator memory before beginning this new analysis.

H. If you handle the calculator computations correctly, you will find that Marketing
Plan B provides an NPV of $407,379 and an IRR of 22.07%.
II. Comparing NPV and IRR Analysis Methods
A. Note in the example above for Marketing Plans A and B that the NPV and IRR
results are inconsistent. Specifically, the NPV computations indicate that Plan B
is better than Plan A ($407,379 versus $334,776, respectively). On the other hand,
the IRR computations indicate that Plan A is better than Plan B (23.25% versus
22.07%, respectively).
B. NPV and IRR analysis methods do not always provide consistent results when
comparing and choosing investments in capital budgeting. Generally, when the
two methods disagree on how to prioritize different investments, the most
consistently correct comparison method is NPV. This is because the IRR method
is based on an assumption that cash flows can be reinvested elsewhere in the
organization at the same internal rate of return. This assumption is a major

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problem in IRR analysis when the internal rate of return of the capital investment
is high (compared to the cost of capital) and cash flows vary substantially.
C. The NPV method has the following advantages compared to the IRR method:
1. NPV can adjust the discount rate for different periods of time, which
provides more control in the analysis if different years have different
expectations on risk or inflation.
2. NPV captures the total value (in money) added to the organization based
on capital investment decisions, which provides better decision incentives
to managers who may be worried about maintaining a high average IRR
performance level.
D. The NPV method also has some disadvantages compared to the IRR method,
including the following:
1. NPV results are difficult to evaluate in relative terms. That is, a positive
NPV is good, but how good is a particular dollar amount of a positive
NPV? It is clearer for most business professionals to describe the value of
an investment in terms of a rate of return on the investment.
2. NPV results do not highlight important differences in cash invested when
comparing different capital investment projects. It is hard to compare one
NPV to another unless the initial net cash investments for both projects are
the same.
E. In comparison, the IRR method has the following advantages compared to the
NPV method:
1. IRR provides results that are relatively easier than NPV to describe in
terms of “value” for the organization, i.e., using classic investment rates of
return.
2. IRR results are better for comparing performance across different capital
projects when initial net investment amounts are different across the
projects.
F. To reiterate what was mentioned above, disadvantages of the IRR methods
compared to the NPV method include the following:
1. IRR assumes that cash provided by the investment can be reinvested at the
same IRR, which creates problems in the quality of the analysis at higher
internal rates of return.
2. IRR results are also less reliable with big variations in cash flows,
especially when cash flows vary between negative and positive values.

Practice Question
Marshall Company has purchased a technology patent for $600,000 that is expected to have a
four-year life before the technology becomes obsolete. Marshall will amortize the patent cost
using a straight-line method. In the third year of the patent's use, Marshall expects an overall
cash loss due to halting business while updating and relocating the technology. Marshall's
average income tax rate is 34%, and its cost of capital is 9%. Below are the computations for the
expected after-tax cash flows on this investment. Be sure that you can reproduce these cash flow
computations yourself.

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What is the NPV and IRR for this patent investment? Use a business calculator to compute these
values.
Answer
On various editions of the Hewlett-Packard™ 10Bii+, complete the following key strokes:

 [Gold shift], [C ALL] → to clear all memory

 9, [I/YR] → to enter 9% as the annual discount rate
 –600000, [CFj] → to enter –$600,000 as the cash outflow at Period 0.
 216000, [CFj] → to enter $216,000 as the first cash inflow at Period 1.
 235800, [CFj] → to enter $235,800 as the second cash inflow at Period 2.
 –15000, [CFj] → to enter –$15,000 as the third cash inflow at Period 3.
 249000, [CFj] → to enter $249,000 as the fourth cash inflow at Period 4.
 [Gold shift], [NPV] → to compute the net present value of all four cash flows.
 [Display: −38,551.59
 To compute IRR, do not clear the memory.
 [Gold shift], [IRR/YR] → to compute the internal rate of return for all five cash flows.
 Display: 5.87

On various editions of the Texas Instruments™ BA II Plus, complete the following key

strokes:

 [2nd], [CLR TVM] → to clear memory of all time value of money computations
 9, [I/Y] → to enter 9% as the annual discount rate
 –600000, [CF] → to enter –$600,000 as the cash outflow at Period 0.
 216000, [CF] → to enter $216,000 as the first cash inflow at Period 1.
 235800, [CF] → to enter $235,800 as the second cash inflow at Period 2.
 –15000, [CF] → to enter –$15,000 as the third cash inflow at Period 3.
 249000, [CF] → to enter $249,000 as the fourth cash inflow at Period 4.
 [NPV] → to compute the net present value of all four cash flows.
 Display: −38,551.59
 To compute IRR, do not clear the memory.
 [IRR] → to compute the internal rate of return for all four cash flows.
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 Display: 5.87

Summary
Most capital budgeting projects do not involve consistently even levels of operating cash flows.
Much more typically, operating cash flows levels differ across periods of time, which
complicates the computational analysis. However, most business calculators can handle uneven
cash flows without significant difficulty, but each cash flow needs to be individually entered into
the calculator using either the CFj key (in most Hewlett-Packard™ business calculators) or the
CF key (in most Texas Instruments™ business calculators). When working with uneven cash
flows, differences can begin to appear in the usefulness of NPV analysis methods versus IRR
analysis methods. These differences are most apparent when dealing with investments with
significantly high IRR rates and with cash flows that vary significantly across the life of the
investment. Generally, when NPV and IRR results conflict with respect to recommending one
investment or another investment, the best approach is to use the NPV results.

Topic 3.1 The Payback Method

I. The Payback “Signal”

A. The Payback method is not really an analysis on the financial performance for a
capital investment. Payback is much more focused on the financial risk for a
capital investment.
B. By measuring the amount of time it takes for the original net cash investment to
be recovered (i.e., paid back), the Payback method provides important
information on the exposure and flexibility characteristics of the investment.
1. The longer it takes for the net cash investment to be recovered, the more
exposed the organization is to economic and operating events that can
negatively affect the capital project. Reducing exposure (by reducing the
Payback period) effectively reduces the risk of harmful future events
affecting the organization's investment.
2. The longer it takes for the net cash investment to be recovered, the less
flexibility the organization has to use its resources to explore and invest in
other opportunities. Increasing flexibility (by reducing the Payback
period) effectively reduces the risk of missing out on desirable future
events in which the organization may want to invest.
C. In summary, the Payback method is a signal on the financial risk of a capital
investment. In contrast, by reporting on the net present value of earnings and on
the rate of return, NPV and IRR (respectively) provide important signals on the
financial performance of a capital investment. Both types of perspectives are
important in capital budgeting decisions.
II. Payback Method—Even Cash Flows
A. The basic Payback concept is a simple formula:

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B. For example, if net cash investment is $1,500,00 and $400,00 is the annual net
operating cash flow, then Payback would be:

C. The Payback measure of 3.75 represents 3.75 periods of time before the
investment is recovered. Since these are annual cash flows, then Payback in this
example is 3.75 years. However, be sure to understand that the number of periods
the Payback represents is based on the length of time of an operating cash flow.
For example, if the $400,000 represents monthly cash flows, then the Payback
would be 3.75 months (i.e., approximately 3 months and 3 weeks).
D. The Payback solution can be represented visually on a timeline. For the example
above, the timeline solution looks like this:

E. Note the Payback method assumes that cash flows take place evenly throughout
the operating period, rather than at the end of the period. In the example above,
the 3.75 solution indicates that the investment is fully recovered by October 1 of
the third year. This can be true only if operating cash flows take place at least by
the end of each month. Remember an assumption in previous lessons using NPV
and IRR methods was that cash flow takes place at the end of each period (e.g.,
each year). Be sure to pay attention to when cash flows actually take place in the
exam problem or in your organization, and adjust your capital budgeting analysis
accordingly.
III. Payback Method—Uneven Cash Flows
A. Most operating processes do not produce even levels of net cash flows each
period of time. Realistically, most operating cash flows are uneven from period to
period, and this complicates the Payback computation approach.
B. With uneven operating cash flows, a simple single-step math solution is not
available. Instead, the cash flow in each operating time period needs to be
individually evaluated to determine if and when the net cash investment is
recovered.

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C. For example, consider a situation similar to our Payback example above (which
also results in total future cash flows of $2,000,000). Note, though, that in this
case the cash flows are uneven as represented in the timeline below:

D. Note in the timeline above that the Payback solution is 4.17 years. The solution
approach is a year-by-year analysis. For example, the operating cash flow in Year
1 is $200,000. By the end of Year 1, the net cash investment has been paid down
to $1,300,000 (= $1,500,000 – $200,000), which is also represented in the
timeline above. Similarly, by the end of Year 2, the investment has been paid
down to $1,000,000 (= $1,300,000 – $300,000).
1. By the end of Year 4, there is only $100,000 remaining to be paid back on
the original investment. Assuming operating cash is flowing throughout
the year, then we can compare the remaining cash to be recovered at the
end of Year 4 to the total cash flow in Year 5, and estimate that the
payback takes place approximately 0.17 into Year 5 (0.17 = $100,000 ÷
$600,000), resulting in a Payback solution of 4.17 years.
2. Typically, organizations don't try to specify the payback as precisely as
4.17 years. More likely, the organization might round off the payback to a
number like 4.2, which places the payback event sometime in the month of
March in Year 5.
IV. Payback Method—Discounted Cash Flows
A. Look again at the timeline in our last Payback example and notice that by the end
of the investment's life, there remains $500,000 cash flow above and beyond the
original investment. The key question is, does this $500,000 represent the long-
term profit of the investment? Remember what you know about the time-value of
money. Spending $1,500,000 and then waiting nearly five years before seeing
positive overall cash flow does not feel like a $500,000 profit on the investment!
Due to the time value of money, the future cash flows are not directly comparable
to the original investment. These cash flows need to be discounted back to present
value before making the comparison.
B. Return back to the first Payback example with even cash flows of $400,000 each
year. Note that the excess cash after the Payback at 3.75 years is also $500,000.
Let's work with the example based on even cash flows. Using your business
calculator, you can discount back to present value each of the future cash flows
before using those discounted cash flows to compute the Payback solution. Using
the example above with uneven cash flows, and assuming a discount rate of 8%,
compute the present value of each cash flow as follows:

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1. On various editions of the Hewlett-Packard™ 10Bii+, complete the

following key strokes:
 [Gold shift], [C ALL] → to clear all memory
 8, [I/YR] → to enter 8% as the annual discount rate
 1, [N] → to enter Period 1 (Year 1) in the analysis.
 400000, [FV] → to enter $400,000 as the future cash inflow at end
of Period 1.
 [PV] → returns the present value of this future cash flow.
 Display: −370,370 → this is the present value of the $400,000
cash flow in Year 1
 Do not clear the memory!
 2, [N] → to enter Year 2 in the analysis (note that the FV is still
$400,000).
 [PV] → returns the present value of this future cash flow.
 Display: −342,936 → this is the present value of the $400,000
cash flow in Year 2
 3, [N] → to enter Year 3 in the analysis.
 [PV] → returns the present value of this future cash flow.
 Display: −317,533 → this is the present value of the $400,000
cash flow in Year 3
 4, [N] → to enter Year 4 in the analysis.
 [PV] → returns the present value of this future cash flow.
 Display: −294,012 → this is the present value of the $400,000
cash flow in Year 4
 5, [N] → to enter Year 5 in the analysis.
 [PV] → returns the present value of this future cash flow.
 Display: −272,233 → this is the present value of the $400,000
cash flow in Year 5
2. On various editions of the Texas Instruments™ BA II Plus, the
keystroke sequence is similar.
 Remember [2nd], [CLR TVM] to clear memory of all time value
of money computations.
 Remember [CPT], [PV] to compute the present value of each
future cash flow.
C. The result of discounting each of the future even cash flows is to create an uneven
cash flow analysis when performing the Payback computation. The timeline
below demonstrates the solution. Each of the nominal operating cash flows
($400,000 annual) are represented with the individual discounted cash flow
amount right below.

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D. Note at the end of Year 1 there remains $1,129,630 “real” dollars to be paid back
on the original investment (= $1,500,000 – $370,370), and this computation
continues forward year-by-year. Year 4 ends with $175,149 remaining in real
(present value) dollars to be paid back on the investment, and a $272,233 present
value cash flow in Year 5. The ratio of these two numbers ($175,149 ÷ $272,233)
is 0.64, which means that the Discounted Payback is 4.64 years. In other words,
the original investment is fully recovered in real dollars approximately sometime
in the month of August in Year 5.
E. Note that the excess real (present value) cash after the Payback at 4.64 years is
$97,084. This actually represents the net present value after the investment is paid
back. In other words, this is the NPV you would compute on your calculator
based on comparing the $1,500,000 initial investment to five years of $400,000
cash flows at an 8% discount rate. Try it on your calculator! As you can see, the
Discounted Payback method is now providing insight similar to the NPV method
regarding the financial performance of the investment.
1. In this regard, the Payback method is now shifting the focus of the
analysis from assessing the risk of returning nominal dollars to focus on
assessing the performance of the investment in terms of real dollars.
2. Sometimes the Discounted Payback method is referred to as an
“improved” method because it incorporates the time value of money. That
being said, NPV and IRR methods are more efficient and more effective in
analyzing discounted cash flows, and are the recommended approach for
assessing financial performance. Hence, in practice the Payback method is
usually based on nominal dollars and is viewed as a reasonably effective
way to assess the exposure and flexibility (i.e., risk) of the nominal cash
represented in the original investment.
V. Advantages and Disadvantages of the Payback Method
A. Remember that the Payback method, when it is based on nominal (undiscounted)
cash flows, is primarily focused on financial riskanalysis. By comparison, more
traditional discounted cash analysis methods like NPV and IRR are focused on
financial performanceanalysis.
B. The traditional (i.e., undiscounted cash flow) Payback method has the
following advantages compared to the discounted cash flow methods like NPV
and IRR:
1. Payback addresses a common, and often crucial, issue in business
investment, which is the “time to money” issue. In other words, how long

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does it take to return the original investment? This is often an important

focus in capital budgeting analysis.
2. As described in the beginning of this lesson, by knowing the “time to
money” (i.e., the time needed to recover the investment), managers are
able to consider the exposure of the investment to negative events in the
future. Managers are also able to consider the flexibility of the investment
to have money available in the future to consider other investment
opportunities.
C. The traditional Payback method has the following disadvantages compared to the
NPV and IRR methods:
1. The Payback method does not distinguish money today from money
tomorrow. In other words, it does not consider the time value of money.
We've demonstrated, however, that this concern can be addressed based on
the needs of managers.
2. More importantly, the Payback method pays no attention to “value”
created past the Payback point. In other words, once the investment hits
the Payback point, any additional cash flow is not factored into the
analysis. For example, consider our original Payback example with five
years of even operating cash flows at $400,000. The Payback was 3.75
years. What if the investment actually had six, seven, or even more years
of operating cash flows? That added value in the investment doesn't
change the Payback solution, as demonstrated below. This is a significant
limitation of this capital budgeting method.

Practice Question
Cole, Inc. is considering an $800,000 investment with a three–year life and expects the following
annual operating cash flows:

 Year 1: $325,000
 Year 2: $375,000
 Year 3: $400,000

Cole's cost of capital is 12%.

What is the traditional Payback on this investment? What is the Discounted Payback on this
investment?
Answer

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Traditional Payback

 Year 1: $800,000 – $325,000 = $475,000 remaining to be recovered

 Year 2: $475,000 – $375,000 = $100,000 remaining to be recovered
 Year 3: $100,000 ÷ $400,000 = 0.25 years
 Traditional Payback = 2.25 years

Discounted Payback
For example, on a Hewlett-Packard™ business calculator, complete the following key strokes:

 [Gold shift], [C ALL] → to clear all memory

 12, [I/YR] → to enter 12% as the annual discount rate
 1, [N] → to enter Period 1 (Year 1) in the analysis.
 325000, [FV] → to enter $325,000 as the future cash inflow at end of Period 1.
 [PV] → returns the present value of Year 1 cash flow 290,179 (rounded).
 2, [N] → to enter Year 2 in the analysis
 375000, [FV] → to enter $375,000 as the future cash inflow at end of Period 2.
 [PV] → returns the present value of Year 2 cash flow 298,948 (rounded).
 3, [N] → to enter Year 3 in the analysis.
 400000, [FV] → to enter $400,000 as the future cash inflow at end of Period 3.
 [PV] → returns the present value of Year 3 cash flow 284,712 (rounded).

 Year 1: $800,000 – $290,179 = $509,821 remaining to be recovered

 Year 2: $509,821 – $298,948 = $210,873 remaining to be recovered
 Year 3: $210,873 ÷ $284,712 = 0.74 years
 Discounted Payback = 2.74 years

Summary
The Payback method provides an analysis of underlying risk in the capital investment, especially
with respect to exposure and flexibility in terms of recovering the initial net cash investment. By
dividing annual operating cash flows into the net investment, the Payback method returns a
measure of the periods of time required to recover the investment. However, a straightforward
ratio of investment to operating cash only works with even levels of operating cash flows. When
cash flows are uneven, then the cash from each operating period needs to be individually
factored against the initial investment, and periods of time summed until the Payback point is
reached. One disadvantage of the Payback method is that future cash flows are not discounted
(i.e., brought back to present value) before assessing the Payback point. This issue can be
addressed by individually discounting each future cash flow before factoring the cash flow
against the initial investment. The results of the Discounted Payback method are similar to the
NPV (net present value method), although comparatively the Discounted Payback method is
somewhat cumbersome compared to the NPV method.

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Topic 4.1 Risk Analysis and Qualitative Issues in Capital Budgeting

I. Uncertainty and Risk in Capital Budgeting

A. Risk in capital budgeting is a matter of having the analysis turn out to be wrong.
NPV, IRR, and Payback measures are based on forecasts of cash flows in a capital
investment analysis. These forecasts (i.e., predictions) are less than certain. Rarely
can any cash forecast in the capital budgeting process be measured with high
confidence and high precision.
B. In fact, when forecasting cash flows, confidence and precision move in opposite
directions. That is, as the demand for more precision in the estimate increases,
confidence in being correct diminishes. This is a common law of statistics.
C. Confidence can be measured in terms of the probability of being correct. As an
example, how confident are you that you know your own weight? That is, what do
you believe is the probability of correctly predicting your weight before stepping
onto a scale?
1. This is actually a question of precision. What is your confidence level (i.e.,
what is the probability) of correctly predicting your weight to the ounce or
gram? What is your confidence of correctly predicting your weight within
five pounds or kilograms?
2. Note that when the need for forecast precision is high, the confidence
(probability) of being correct is low. And when the need for precision is
lowered, the probability of being correct is higher.
D. Capital budgeting measures are often based on very precise cash forecasts, which
results in very precise measures of expected financial performance. Consider the
following capital investment analyses we've performed in earlier lessons on two
investment plans based on projected cash flows.

What is the probability a post-investment audit at the end of the Plan A

investment life will demonstrate that the NPV turned out to be exactly $334,776?

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For this precise NPV to result, each of the estimated cash flows in Years 1
through 3 will have to turn out to be exactly as predicted, and that is not at all
likely.

E. Forecasting cash flows is risky work, and the further out in the future the cash
flows are predicted, the less likely the cash flow will actually result with any
degree of precision. Consider both Plan A and Plan B in the analyses above.
Which plan is most dependent on cash flows further out in the future? Plan B,
which has the higher NPV, is very much dependent on a large operating cash flow
far out in Year 3. Hence, Plan B has more risk in the forecast than Plan A.
F. One way to address the difference in risk between these two investments is to
adjust the discount rate. Remember that discount rates (i.e., interest rates) are a
function of desire, risk, and inflation. The discount rate should be higher for
investments with higher risk. Since Plan B risk is higher than Plan A risk, the
discount rate to evaluate Plan B should be increased. Let's assume that a more
appropriate discount rate for Plan B is 10%. The capital investment analysis
would then indicate that Plan B's NPV is $309,542. This result dramatically
changes how the budgeted performance of Plan B compares to Plan A.
II. Scenario Analysis
A. Adjusting discount rates to better represent the inherent risk on one capital
investment versus another is one way to handle uncertainty in the capital
budgeting process. Another approach is to use scenario analysis.
B. The basic approach with scenario analysis is to include best-case and worst-case
forecasts in the capital budgeting process and then estimate the probability of
these alternative results. Subsequently, all scenarios are combined to establish the
“Expected Value” of the capital investment using the following formula:

∑(EV)

C. where EV is Expected Value = Result × Probability

D. Returning to the capital budgeting example above involving Plan A and Plan B,
we can compute the Expected Value of NPV of each capital investment.
1. For example, the crucial challenge for Plan B is the forecast of $1,050,000
in Year 3. Let's assume that the analyst team putting together the operating
cash flow forecasts on Plan B estimates that the probability of achieving
operating cash flow reasonably close to $1,050,000 in Year 3 is 50:50. In
other words, there's a 50% chance that the Year 3 operating cash flow will
be approximately $1,050,000 and there's a 50% chance that the cash flow
will be significantly above or below this amount.
2. Further analysis determines that there's a 20% probability that the Year 3
cash flow will be approximately $1,400,000 and there's a 30% probability
the cash flow will be approximately $350,000. Essentially, three scenarios

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for Plan B have been identified. Note that all probabilities in this scenario
analysis must add up to 100% (= 50% + 20% + 30%).
3. Now compute the NPV for each Plan B scenario (remember to use a 10%
discount rate), and bear in mind the probability of each NPV result.
 Scenario 1 ($1,050,000 cash flow): $309,542 → 50% probability
 Scenario 2 ($1,400,000 cash flow): $572,502 → 20% probability
 Scenario 3 ($350,000 cash flow): −$216,379 → 30% probability
4. Finally, using the Expected Value formula, we can compute an overall
expected NPV that combines the probability of each scenario.
 $309,542 × 50% = $154,771
 $572,502 × 20% = $114,500
 $216,379 × 30% = −$64,914
 Expected Value = $204,357
E. Using scenario analysis, we are able to measure and incorporate uncertainty
regarding outcomes of capital budgeting methods.
III. Sensitivity Analysis
A. Scenario analysis focuses on uncertainty in the outcomes of capital budgeting
methods. In contrast, sensitivity analysis is focused on uncertainty in
the inputs for capital budgeting methods.
B. The basic approach for sensitivity analysis is to identify the input estimate that is
most likely to cause the capital investment results to be unacceptable. Once this
weak link in the investment is identified, then management can focus attention
and resources on assessing and managing that particular issue in the investment.
C. Sensitivity analysis follows two basic steps.
1. For each input in the analysis, identify the point where the input generates
an unacceptable investment outcome.
2. Identify the probability of the unacceptable event for each input.
D. For example, let's consider a capital investment analysis of purchasing a patent for
$6,000,000 with a 10-year life and annual after-tax cash flows of $900,000. The
company's cost of capital is 7%. The investment has an NPV of $321,223 (be sure
to calculate this NPV yourself to confirm). Management wants to perform a
sensitivity analysis to identify the most likely factor (i.e., input) for the patent
investment that would result in a negative NPV.
E. There are three key factors involved in this patent investment's NPV performance:
the life of the patent, the annual operating cash flow from the patent, and the
company's cost of capital rate. Each of these factors was evaluated to identify the
point at which the factor would result in a negative NPV on the investment, and
the probability of the factor actually reaching that point was identified. The results
are as follows:

Point Resulting in Negative

Factor NPV Probability*
Life of Patent Less than 9.3 Years 10%

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Point Resulting in Negative

Factor NPV Probability*
Operating Cash Flow Less than $855,000 50%
Cost of Capital More than 8% 20%

F. The sensitivity analysis indicates that the investment factor (or input) most likely
to result in an unacceptable investment performance is the annual operating cash
flow. Hence, management will invest attention and resources to better forecast,
and subsequently better manage, the investment's operating cash flow
performance.
IV. Monte Carlo Simulations
A. Scenario analysis is focused on estimating the probability of a certain set of
possible results (e.g., original analysis scenario, best-case scenario, worst-case
scenario). However, in a complex investment with a long-term life, there are
usually too many possible results to individually evaluate each one.
B. Sensitivity analysis is about identifying the investment input factor that is most
likely (i.e., has the most risk) to lead to an unacceptable result in the financial
performance of the investment. However, as you can see in the example above for
sensitivity analysis, there were three uncertain factors in the patent investment
(life, cash flow, and cost of capital), and all three are “moving targets.” It is the
interaction of these fluctuating inputs that leads to so many possible financial
results in the investment.
C. Monte Carlo simulation uses fairly complex computer analyses to represent the
probability of each input factor for the capital investment, and then runs random
numbers into the probability distribution of each factor across a thousand or more
iterations (i.e., repetitions). The financial result of each iteration is captured and
plotted, and statistics are used to evaluate the average and variance of the total set
of results. Rather than a single number for NPV or IRR, the final outcome of a
Monte Carlo simulation is an analysis of possible results for the investment that
gives management the ability to determine the probability of being within a
certain range of the desired financial performance target—very similar to our
opening example about establishing a probability and range for your estimate of
your actual weight.
V. Real Options in Capital Budgeting
A. Remember that risk in capital budgeting is potential for the analysis to turn out to
be wrong. Real options in an investment can limit a financial loss when the
performance begins moving in the wrong direction. Without any options in an
investment, once the decision is made to go forward with the investment, the
organization is completely exposed to all events that then result in undesirable
outcomes.
B. Essentially, an investment has real options when the organization has choices
available in the investment to limit its losses. Real options can also provide

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management with the opportunity to take advantage of future positive events that
improve investment outcomes. In short, real options are inherent characteristics in
the actual capital asset that give management flexibility to take action in the
future as changing events affect the performance of the asset.
C. Examples of real options include the flexibility in an investment to subsequently
expand or reduce the size of the operation, extend the life or exit early from the
investment, and change the supply input or customer output focus of the
operation.
D. Putting a financial value on real options is challenging. Generally, the value is
captured by comparing the expected NPV of an investment with and without the
real option(s). Investments with real options usually have lower NPV. The value
of the NPV forgone to enter into an investment with real options is effectively the
value of the real option.
VI. Qualitative Analysis
A. The lessons we have studied in this section on investment decisions have largely
centered on quantitative tools used for financial analysis and risk analysis. These
are rigorous and valuable management tools, but qualitative analysis in capital
budgeting is usually how the final capital investment decision is made.
B. Qualitative analysis requires a cross-functional view of the investment, and
involves professional input from many disciplines across the organization,
including finance, marketing, operations, HR (human resources), safety,
environment, ethics, brand management, etc.
C. It's important to understand that financial analysis and risk analysis is the work
done to prepare for the decision meeting where the qualitative analysis takes
place and where the final decision is usually made. It's difficult, if not impossible,
to lay out a particular procedure that an organization should follow in order to
carefully and thoughtfully consider all qualitative issues relevant to the particular
capital budgeting process. The qualitative process is essentially the organization's
strategy for making capital investment decisions that are core to the success of its
business.
D. The best strategic choice for capital investment is not always the investment with
the highest projected financial performance and the lowest project risk exposure.
Despite the short length of this section of the lesson compared to all else we've
studied in capital budgeting, do not underestimate the importance of qualitative
analysis in capital investment decisions.

Practice Question
Stratton Associates has performed an NPV analysis on a possible $5,100,000 investment in a
fleet of delivery trucks. The size and strategic value of the investment is crucial to the success of
Stratton Associates. Management wants to incorporate an analysis of risk given the uncertainty
involved in the investment. To prepare for the risk analysis, the following data have been
gathered.
Possible NPV scenarios and the likelihood of each scenario's outcome:

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 Scenario 1: −$400,000 20% likelihood

 Scenario 2: $840,000 30% likelihood
 Scenario 3: $1,300,000 40% likelihood
 Scenario 4: $2,100,000 10% likelihood

Key input factors for this investment, and the level at which each input results in a negative
NPV, are as follows:

 Expected life of the fleet: 7 years → Less than 5 years will result in a negative NPV.
 Annual operating cash: $1,250,000 → Less than $1,000,000 will result in a negative
NPV.
 Salvage value on disposal: $900,000 → Even a zero amount will result in a positive
NPV.

Stratton's cost of capital is 11%.

What is the expected value of the NPV for this investment?
What does the management at Stratton Associates need to consider with respect to investment
sensitivity to the key input factors?
Answer:
Scenario Analysis

 Scenario 1: −$400,000 × 20% = −$80,000

 Scenario 2: $840,000 × 30% = $252,000
 Scenario 3: $1,300,000 × 40% = $520,000
 Scenario 4: $2,100,000 × 10% = $210,000
 Total Expected Valueof NPV = $902,000

Sensitivity Analysis
The management team at Stratton Associates needs to consider the likelihood (i.e., probability)
of the fleet investment lasting less than 5 years, and the probability of annual operating cash
flows being less than $1,000,000. For whichever of these input factors has the highest
probability, management should invest additional analysis and management effort to reduce the
investment's sensitivity to risk. Stratton Associates could also use Monte Carlo simulation to
assess the combined effect of the probable range of all input factors, including the salvage value,
to build a more complete view of all possible NPV performance outcomes.
Summary
Incorporating uncertainty and probability of future cash flows is fundamental to the analysis of
risk in a capital investment. One way to measure and accommodate for uncertainty is using
scenario analysis, which is to establish multiple possible outcomes or scenarios and then estimate
the probability of each outcome. The overall expected outcome on the investment is measured by
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multiplying each possible outcome by its probability and then adding up all results (this approach
is sometimes referred to as a weighted averaging method). In contrast to an outcome focus in
scenario analysis, sensitivity analysis focuses on evaluating each input factor to the investment
and determining the probability of each factor generating an unacceptable investment result. The
factor with the highest probability of leading to unacceptable results is the weak link in all the
factors and the one creating the most sensitivity in the investment's potential success. Monte
Carlo simulation is a sophisticated computer analysis method that incorporates uncertainties and
probability distributions for all inputs and uses random number inputs to map the range of
possible financial results. Real options in investments are opportunities (i.e., flexibility) to adjust
the investment as it moves forward in order to accommodate for changing conditions. Rigorous
risk analysis is important to the capital budgeting process, as is effective use of well-established
financial analysis methods such as NPV and Payback. But financial analysis and risk analysis are
often subordinate to crucial qualitative factors involved in each investment opportunity. The
qualitative issues are often the focus of the final strategic choice for the organization.

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