Chapter 9
Capital Budgeting
Techniques
Learning Goals
1. Understand the role of capital
budgeting techniques in the capital
budgeting process.
2. Calculate, interpret, and evaluate the
payback period.
3. Calculate, interpret, and evaluate the net
present value (NPV).
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Learning Goals (cont.)
4. Calculate, interpret, and evaluate the
internal rate of return (IRR).
5. Use net present value profiles to
compare NPV and IRR techniques.
6. Discuss NPV and IRR in terms of
conflicting rankings and the theoretical
and practical strengths of each
approach.
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Capital Budgeting Techniques
Chapter Problem
Bennett Company is a medium sized metal fabricator
that is currently contemplating two projects: Project A
requires an initial investment of $42,000, project B an
initial investment of $45,000. The relevant operating
cash flows for the two projects are presented in Table
9.1 and depicted on the time lines in Figure 9.1.
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Capital Budgeting Techniques (cont.)
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Capital Budgeting Techniques (cont.)
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Payback Period
The payback method simply measures how
long (in years and/or months) it takes to recover
the initial investment.
The maximum acceptable payback period is
determined by management.
If the payback period is less than the maximum
acceptable payback period, accept the project.
If the payback period is greater than the
maximum acceptable payback period, reject
the project.
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Pros and Cons of Payback Periods
The payback method is widely used by large
firms to evaluate small projects and by small
firms to evaluate most projects.
It is simple, intuitive, and considers cash flows
rather than accounting profits.
It also gives implicit consideration to the timing
of cash flows and is widely used as a
supplement to other methods such as Net
Present Value and Internal Rate of Return.
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Pros and Cons
of Payback Periods (cont.)
One major weakness of the payback method is
that the appropriate payback period is a
subjectively determined number.
It also fails to consider the principle of wealth
maximization because it is not based on
discounted cash flows and thus provides no
indication as to whether a project adds to
firm value.
Thus, payback fails to fully consider the time
value of money.
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Pros and Cons
of Payback Periods (cont.)
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Pros and Cons
of Payback Periods (cont.)
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Net Present Value (NPV)
Net Present Value (NPV): Net Present
Value is found by subtracting the present
value of the after-tax outflows from the
present value of the after-tax inflows.
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Net Present Value (NPV) (cont.)
Net Present Value (NPV): Net Present
Value is found by subtracting the present
value of the after-tax outflows from the
present value of the after-tax inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
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Net Present Value (NPV) (cont.)
Using the Bennett Company data from Table 9.1,
assume the firm has a 10% cost of capital. Based on the
given cash flows and cost of capital (required return), the
NPV can be calculated as shown in Figure 9.2
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Net Present Value (NPV) (cont.)
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Net Present Value (NPV) (cont.)
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Net Present Value (NPV) (cont.)
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Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the
discount rate that will equate the present value
of the outflows with the present value of
the inflows.
The IRR is the projects intrinsic rate of return.
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Internal Rate of Return (IRR) (cont.)
The Internal Rate of Return (IRR) is the
discount rate that will equate the present value
of the outflows with the present value of
the inflows.
The IRR is the projects intrinsic rate of return.
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
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Internal Rate of Return (IRR) (cont.)
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Internal Rate of Return (IRR) (cont.)
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Net Present Value Profiles
NPV Profiles are graphs that depict
project NPVs for various discount rates
and provide an excellent means of making
comparisons between projects.
To prepare NPV profiles for Bennett Companys
projects A and B, the first step is to develop a number
of discount rate-NPV coordinates and then graph
them as shown in the following table and figure.
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Net Present Value Profiles (cont.)
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Net Present Value Profiles (cont.)
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Conflicting Rankings
Conflicting rankings between two or more projects
using NPV and IRR sometimes occurs because of
differences in the timing and magnitude of cash flows.
This underlying cause of conflicting rankings is the
implicit assumption concerning the reinvestment of
intermediate cash inflowscash inflows received prior
to the termination of the project.
NPV assumes intermediate cash flows are reinvested at
the cost of capital, while IRR assumes that they are
reinvested at the IRR.
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Conflicting Rankings (cont.)
A project requiring a $170,000 initial investment is
expected to provide cash inflows of $52,000, $78,000
and $100,000. The NPV of the project at 10% is
$16,867 and its IRR is 15%. Table 9.5 on the following
slide demonstrates the calculation of the projects future
value at the end of its 3-year life, assuming both a 10%
(cost of capital) and 15% (IRR) interest rate.
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Conflicting Rankings (cont.)
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Conflicting Rankings (cont.)
If the future value in each case in Table 9.5 were
viewed as the return received 3 years from today from
the $170,000 investment, then the cash flows would be
those given in Table 9.6 on the following slide.
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Conflicting Rankings (cont.)
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Conflicting Rankings (cont.)
Bennett Companys projects A and B were found to have
conflicting rankings at the firms 10% cost of capital as
depicted in Table 9.4. If we review the projects cash inflow
pattern as presented in Table 9.1 and Figure 9.1, we see
that although the projects require similar investments, they
have dissimilar cash flow patterns. Table 9.7 on the
following slide indicates that project B, which has higher
early-year cash inflows than project A, would be preferred
over project A at higher discount rates.
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Conflicting Rankings (cont.)
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Which Approach is Better?
On a purely theoretical basis, NPV is the better
approach because:
NPV assumes that intermediate cash flows are
reinvested at the cost of capital whereas IRR assumes
they are reinvested at the IRR,
Certain mathematical properties may cause a project
with non-conventional cash flows to have zero or more
than one real IRR.
Despite its theoretical superiority, however,
financial managers prefer to use the IRR
because of the preference for rates of return.
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