1. Capital Budgeting Processes And Techniques
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Course Name / Number

2. The Capital Budgeting Decision Process
The Capital Budgeting Process involves three basic steps:
Generating long-term investment proposals
Reviewing, analyzing, and selecting from the proposals that have been generated
Implementing and monitoring the proposals that have been selected
Managers should separate investment and financing decisions

3. Capital Budgeting Decision Techniques
Payback period: most commonly used
Accounting rate of return (ARR): focuses on project’s impact on accounting profits
Net present value (NPV): best technique theoretically
Internal rate of return (IRR): widely used with strong intuitive appeal
Profitability index (PI): related to NPV

4. A Capital Budgeting Process Should:
Account for the time value of money
Account for risk
Focus on cash flow
Rank competing projects appropriately
Lead to investment decisions that maximize shareholders’ wealth

5. Entropica Investment
Entropica is a provider of magnetic resonance imaging devices
Entropica evaluating two investment proposals
Construction of completely new manufacturing plant
Refurbishing an existing plant
Construction ($ millions)
Refurbishing ($ millions)
$850
Year 5 inflow
$740
Year 4 inflow
$400
Year 3 inflow
$250
Year 2 inflow
$100
Year 1 inflow
-$1,200
Initial outlay
$48
Year 5 inflow
$47
Year 4 inflow
$41
Year 3 inflow
$30
Year 2 inflow
$22
Year 1 inflow
-$75
Initial outlay

6. Management determines maximum acceptable payback period
The payback period is the amount of time required for the firm to recover its initial investment
If the project’s payback period is less than the maximum acceptable payback period, accept the project
If the project’s payback period is greater than the maximum acceptable payback period, reject the project
Management determines maximum acceptable payback period

7. Calculating Payback Periods For Entropica Projects
Management selects a 3-year payback period
Construction project has initial outflow of -$1,200 million
But cash inflows over first 3 years only $750 million
Entropica would reject construction project based on payback
Refurbishing project has initial outflow of -$75 million
Cash inflows over first 3 years cumulate to $93 million
Project recovers initial outflow middle of year 3
Entropica would accept the project

8. Pros And Cons Of Payback Method
Advantages of payback method:
Computational simplicity
Easy to understand
Focus on cash flow
Disadvantages of payback method:
Does not account properly for time value of money
Does not account properly for risk
Cutoff period is arbitrary
Does not lead to value-maximizing decisions

9. Discounted Payback Period
Discounted payback accounts for time value
Apply discount rate to cash flows during payback period
Still ignores cash flows after payback period
Entropica uses a 16% discount rate
Reject --
Accept / reject
$67.53
$528.26
Cumulative PV
$26.27
$256.26
0.6407
PV Year 3 inflow
$22.29
$185.79
0.7432
PV Year 2 inflow
$18.97
$86.21
0.8621
PV Year 1 inflow
Refurbishing project ($million)
Construction project ($million)
PV Factors
(16%)
Item

10. Accounting Rate Of Return (ARR)
Can be computed from available accounting data
Need only profits after taxes and depreciation
Accounting ROR = Average profits after taxes  Average investment
Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows
Average profits
after taxes
Average annual operating cash inflows
Average annual
depreciation = -
ARR uses accounting numbers, not cash flows; no time value of money

11. Net Present Value
The present value of a project’s cash inflows and outflows
Discounting cash flows accounts for the time value of money
Choosing the appropriate discount rate accounts for risk
Accept projects if NPV > 0

12. Net Present Value A key input in NPV analysis is the discount rate
r represents the minimum return that the project must earn to satisfy investors
r varies with the risk of the firm and/or the risk of the project

13. Calculating NPVs For Entropica’s Projects
Assuming Entropica uses 16% discount rate, NPVs are:
Construction project: NPV = $ million
Refurbishing project: NPV = $41.43 million
Should Entropica invest in one project or both?

14. Independent versus Mutually Exclusive Projects
Independent projects – accepting/rejecting one project has no impact on the accept/reject decision for the other project
Mutually exclusive projects – accepting one project implies rejecting another
Both Entropica projects deal with production capacity
If demand is high enough, projects may be independent
If demand warrants only one investment, projects are mutually exclusive
When ranking mutually exclusive projects, choose the project with highest NPV

15. Pros and Cons Of Using NPV As Decision Rule
NPV is the “gold standard” of investment decision rules
Key benefits of using NPV as decision rule
Focuses on cash flows, not accounting earnings
Makes appropriate adjustment for time value of money
Can properly account for risk differences between projects
Though best measure, NPV has some drawbacks
Lacks the intuitive appeal of payback
Doesn’t capture managerial flexibility (option value) well

16. Internal Rate of Return
IRR found by computer/calculator or manually by trial and error
Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project
The IRR decision rule is:
If IRR is greater than the cost of capital, accept the project
If IRR is less than the cost of capital, reject the project

17. Calculating IRRs For Entropica’s Projects
Entropica will accept all projects with at least 16% IRR:
Construction project: IRR (rC) = 19.63%
Refurbishing project: IRR (rR) = 34.54%
Which project looks better if Entropica can invest only in one?

18. Advantages of IRR Properly adjusts for time value of money
Uses cash flows rather than earnings
Accounts for all cash flows
Project IRR is a number with intuitive appeal

19. Disadvantages of IRR Three key problems encountered in using IRR:
Lending versus borrowing?
Multiple IRRs
No real solutions
IRR and NPV rankings do not always agree

20. Lending Versus Borrowing
IRR can give incorrect answers for projects with non-standard cashflows
Project 1: Invest $120 today, receive $170 in one year
Project 2: Receive $120 today, pay back $170 in one year
Project 1 amounts to lending; project 2 to borrowing
Both projects have same IRR, but #1 obviously superior
When borrowing, a low IRR is preferred on the loan.

21. Multiple IRRs
NPV ($)
NPV>0
IRR
NPV>0
Discount rate
NPV<0
NPV<0
IRR
When project cash flows have multiple sign changes, there can be multiple IRRs
With multiple IRRs, which do we compare with the cost of capital to accept/reject the project?

22. Sometimes projects do not have a real IRR solution
No Real Solution
Sometimes projects do not have a real IRR solution
Modify Entropica’s construction project to include a large negative outflow (-$1,300 million) in year 6.
There is no real number that will make NPV=0, so no real IRR.
Project is a bad idea based on NPV. At r =16%, project has NPV= -$ million, so reject!

23. Conflicts Between NPV and IRR
NPV and IRR do not always agree when ranking competing projects
The scale problem
$41.34 mn
36.53%
Refurbishing
$ mn
19.63%
Construction
NPV (16%)
IRR
Project
Refurbishing project has higher IRR, but doesn’t increase shareholders’ wealth as much as construction project

24. The Timing Problem
Long-term project
NPV
IRR = 15%
Short-term project
IRR = 17%
Discount rate
13%
15%
17%
The NPV of the long-term project is more sensitive to the discount rate than the NPV of the short-term project is
Long-term project has higher NPV if the cost of capital is less than 13%. Short-term project has higher NPV if the cost of capital is greater than 13%

25. Reconciling NPV and IRR
Timing and scale problems can cause NPV and IRR methods to rank projects differently
In these cases, calculate the IRR of the incremental project
Cash flows of large project minus cash flows of small project
Cash flows of long-term project minus cash flows of short-term project
If incremental project’s IRR exceeds the cost of capital
Accept the larger project
Accept the longer term project

26. Like IRR, PI suffers from the scale problem
Profitability Index
Calculated by dividing the PV of a project’s cash inflows by the PV of its outflows
Decision rule: Accept projects with PI > 1.0, equal to NPV > 0
Both projects’ PI > 1.0, so both acceptable if independent
1.55
$75 mn
$ mn
Refurbishing
1.12
$1.2 bn
$ mn
Construction PI
Initial Outlay
PV of CF (yrs1-5)
Project
Like IRR, PI suffers from the scale problem

27. Capital Budgeting
Generating, reviewing, analyzing, selecting, and implementing long-term investment proposals
Payback Period
Discounted payback period
Accounting rate of return
Net Present Value (NPV)
Internal rate of return (IRR)
Profitability index (PI)