The document discusses various capital budgeting techniques used to evaluate projects and determine which to accept. It covers concepts like initial cash outlay, cash flows, payback period and its limitations. It then introduces net present value as a technique that considers the time value of money and all cash flows by discounting them to calculate the present value of future cash inflows and outflows.

1. 1
Capital-BudgetingCapital-Budgeting
TechniquesTechniques
Chapter 9Chapter 9

2. 2
Capital Budgeting Concepts
Capital Budgeting involves evaluation of (andCapital Budgeting involves evaluation of (and
decision about) projects. Which projects should bedecision about) projects. Which projects should be
accepted? Here, our goal is to accept a projectaccepted? Here, our goal is to accept a project
which maximizes the shareholder wealth. Benefitswhich maximizes the shareholder wealth. Benefits
areare worthworth more than the cost.more than the cost.
The Capital Budgeting is based on forecasting.The Capital Budgeting is based on forecasting.
Estimate future expected cash flows.Estimate future expected cash flows.
Evaluate project based on the evaluation method.Evaluate project based on the evaluation method.
Classification of ProjectsClassification of Projects
Mutually Exclusive - accept ONE project only
Independent - accept ALL profitable projects.

3. 3
Capital Budgeting Concepts
Initial Cash Outlay - amount of capital spent to getInitial Cash Outlay - amount of capital spent to get
project going.project going.
Cash FlowsCash Flows

4. 4
Capital Budgeting Concepts
Initial Cash Outlay - amount of capital spent to getInitial Cash Outlay - amount of capital spent to get
project going.project going.
If spend $10 million to build new plant then the InitialIf spend $10 million to build new plant then the Initial
Outlay (IO) = $10 millionOutlay (IO) = $10 million
Cash FlowsCash Flows
CF0 = Cash Flow time 0 = -10 millionCF0 = Cash Flow time 0 = -10 million

5. 5
Capital Budgeting Concepts
Initial Cash Outlay - amount of capital spent to getInitial Cash Outlay - amount of capital spent to get
project going.project going.
If spend $10 million to build new plant then the InitialIf spend $10 million to build new plant then the Initial
Outlay (IO) = $10 millionOutlay (IO) = $10 million
Cash FlowsCash Flows
CFn = Sales - CostsCFn = Sales - Costs
Annual Cash Inflows--after-tax CFAnnual Cash Inflows--after-tax CF
Cash inflows from the project
CF0 = Cash Flow time 0 = -10 millionCF0 = Cash Flow time 0 = -10 million
We will determine
these in Chapter 10

6. 6
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period

7. 7
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

8. 8
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
0 1 2 3 4
3,500 3,500 3,500 3,500(10,000)
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

9. 9
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
0 1 2 3 4
3,500
-6,500
3,500 3,500 3,500(10,000)
Cumulative CF
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

10. 10
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
0 1 2 3 4
3,500
-6,500
3,500
-3,000
3,500 3,500(10,000)
Cumulative CF
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

11. 11
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
0 1 2 3 4
3,500
-6,500
3,500
-3,000
3,500
+500
3,500(10,000)
Cumulative CF
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

12. 12
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
0 1 2 3 4
3,500
-6,500
3,500
-3,000
3,500
+500
3,500(10,000)
Payback 2.86 years
Cumulative CF
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

13. 13
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

14. 14
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
500 500 4,600 10,000(10,000)

15. 15
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
500
-9,500
500 4,600 10,000(10,000)
Cumulative CF

16. 16
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
500
-9,500
500
-9,000
4,600 10,000(10,000)
Cumulative CF

17. 17
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
500
-9,500
500
-9,000
4,600
-4,400
10,000(10,000)
Cumulative CF

18. 18
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
500
-9,500
500
-9,000
4,600
-4,400
10,000
+5,600
(10,000)
Cumulative CF

19. 19
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
500
-9,500
500
-9,000
4,600
-4,400
10,000
+5,600
(10,000)
Payback = 3.44 years
Cumulative CF

20. 20
Capital Budgeting Methods
Number of years needed to recover your initialNumber of years needed to recover your initial
outlay.outlay.
Payback PeriodPayback Period
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
500
-9,500
500
-9,000
4,600
-4,400
10,000
+5,600
(10,000)
Payback 3.44 years
Cumulative CF
Evaluation:Evaluation:
Company sets maximum
acceptable payback. If
Max PB = 3 years,
accept project A and
reject project C

21. 21
•Payback Method
The payback method is not a good method as it doesThe payback method is not a good method as it does
not consider the time value of money.not consider the time value of money.
Which project should you choose?Which project should you choose?
CF0 CF1 CF2 CF3CF0 CF1 CF2 CF3
A -100,000 90,000 9,000 1,000A -100,000 90,000 9,000 1,000
B -100,000 1,000 9,000 90,000B -100,000 1,000 9,000 90,000

22. 22
•Payback Method
The Discounted payback method can correct thisThe Discounted payback method can correct this
shortcoming of the payback method.shortcoming of the payback method.
To find the discounted pay backTo find the discounted pay back
(1) Find the PV of each cash flow on the time line.(1) Find the PV of each cash flow on the time line.
(2) Find the payback using the discounted CF and(2) Find the payback using the discounted CF and
NOT the CF.NOT the CF.
Example In Table 9-2Example In Table 9-2

23. 23
•Payback Method
Also, the payback method is not a good method as itAlso, the payback method is not a good method as it
does not consider the cash flows beyond the paybackdoes not consider the cash flows beyond the payback
period.period.

24. 24
Payback Method
Also, the payback method is not a good method asAlso, the payback method is not a good method as
it does not consider the cash flows beyond theit does not consider the cash flows beyond the
payback period.payback period.
Which project should you choose?Which project should you choose?
CF0 CF1 CF2 Cf3 CF4CF0 CF1 CF2 Cf3 CF4
A -100000 90000 10000 0 0A -100000 90000 10000 0 0
B -100000 90000 9000 80000 1000000B -100000 90000 9000 80000 1000000

25. 25
Payback Method
Also, the payback method is not a good method as it doesAlso, the payback method is not a good method as it does
not consider the cash flows beyond the payback period.not consider the cash flows beyond the payback period.
Which project should you choose?Which project should you choose?
CF0 CF1 CF2 Cf3 CF4CF0 CF1 CF2 Cf3 CF4
A -100,000 90,000 10,000 0 0A -100,000 90,000 10,000 0 0
B -100,000 90,000 9,000 80,000 100,0000B -100,000 90,000 9,000 80,000 100,0000
These two shortcomings often result in an incorrect decisions.These two shortcomings often result in an incorrect decisions.

26. 26
Capital Budgeting Methods
Methods that consider time value of money and allMethods that consider time value of money and all
cash flowscash flows
Net Present Value:Net Present Value:
Present Value of all costs and benefits of a project.Present Value of all costs and benefits of a project.

27. 27
Capital Budgeting Methods
Present Value of all costs and benefits of a project.Present Value of all costs and benefits of a project.
Concept is similar to Intrinsic Value of a security butConcept is similar to Intrinsic Value of a security but
subtracts cost of the project.subtracts cost of the project.
Net Present ValueNet Present Value
NPV = PV of Inflows - Initial OutlayNPV = PV of Inflows - Initial Outlay

28. 28
Capital Budgeting Methods
Present Value of all costs and benefits of a project.Present Value of all costs and benefits of a project.
Concept is similar to Intrinsic Value of a security butConcept is similar to Intrinsic Value of a security but
subtracts of cost of project.subtracts of cost of project.
Net Present ValueNet Present Value
NPV = PV of Inflows - Initial OutlayNPV = PV of Inflows - Initial Outlay
NPV = + + +···+ – IO
CF1
(1+ k )
CF2
(1+ k )2
CF3
(1+ k )3
CFn
(1+ k )n

29. 29
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
500 500 4,600 10,000(10,000)
k=10%
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

30. 30
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
500 500 4,600 10,000(10,000)
455
k=10%
$500
(1.10)
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

31. 31
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
500 500 4,600 10,000(10,000)
455
413
k=10%
$500
(1.10) 2
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

32. 32
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
500 500 4,600 10,000(10,000)
455
413
3,456
k=10%
$4,600
(1.10) 3
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

33. 33
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
500 500 4,600 10,000(10,000)
455
6,830
413
3,456
k=10%
$10,000
(1.10) 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

34. 34
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
500 500 4,600 10,000(10,000)
455
$11,154
6,830
413
3,456
k=10%
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

35. 35
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
500 500 4,600 10,000(10,000)
455
6,830
413
3,456
k=10%
PV Benefits > PV Costs
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
$11,154 > $ 10,000
$11,154

36. 36
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
500 500 4,600 10,000(10,000)
455
6,830
413
3,456
k=10%
PV Benefits > PV Costs
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
$11,154 > $ 10,000
NPV > $0
$1,154 > $0
$11,154
$1,154 = NPV

37. 37
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
3,500(10,000)
k=10%
3,500 3,500 3,500
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

38. 38
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
3,500(10,000)
k=10%
3,500 3,500 3,500
NPV = + + + – 10,000
3,500
(1+ .1 )
3,500
(1+ .1)2
3,500
(1+ .1 )3
3,500
(1+ .1 )4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

39. 39
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
3,500(10,000)
k=10%
3,500 3,500 3,500
NPV = + + + – 10,000
3,500
(1+ .1 )
3,500
(1+ .1)2
3,500
(1+ .1 )3
3,500
(1+ .1 )4
PV of 3,500 Annuity for 4 years at 10%
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

40. 40
Capital Budgeting Methods
Net Present ValueNet Present Value
0 1 2 3 4
3,500(10,000)
k=10%
3,500 3,500 3,500
NPV = + + + – 10,000
3,500
(1+ .1 )
3,500
(1+ .1)2
3,500
(1+ .1 )3
3,500
(1+ .1 )4
= 3,500 x PVIFA 4,.10 - 10,000
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
= 11,095 – 10,000 = $1,095$1,095

41. 41
Capital Budgeting Methods
If projects are independent thenIf projects are independent then
accept all projects with NPVaccept all projects with NPV ≥≥ 0.0.
NPV Decision RulesNPV Decision Rules
ACCEPT A & B

42. 42
Capital Budgeting Methods
If projects are independent thenIf projects are independent then
accept all projects with NPVaccept all projects with NPV ≥≥ 0.0.
If projects are mutually exclusive,If projects are mutually exclusive,
accept projects with higher NPV.accept projects with higher NPV.
NPV Decision RulesNPV Decision Rules
ACCEPT A & B
ACCEPT B only

43. 43
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates
NPV(0%) = + + + – 10,000
3,500
(1+ 0 )
3,500
(1+ 0)2
3,500
(1+ 0 )3
3,500
(1+ 0)4
= $4,000
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

44. 44
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates
NPV(5%) = + + + – 10,0003,500
(1+ .05 )
3,500
(1+ .05)2
3,500
(1+ .05 )3
3,500
(1+ .05)4
= $2,411
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

45. 45
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates
NPV(10%) = + + + – 10,0003,500
(1+ .10 )
3,500
(1+ .10)2
3,500
(1+ .10 )3
3,500
(1+ .10)4
= $1,095
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

46. 46
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates
NPV(15%) = + + + – 10,0003,500
(1+ .15 )
3,500
(1+ .15)2
3,500
(1+ .15 )3
3,500
(1+ .15)4
= – $7.58
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

47. 47
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates
NPV(20%) = + + + – 10,0003,500
(1+ .20 )
3,500
(1+ .20)2
3,500
(1+ .20 )3
3,500
(1+ .20)4
= – $939
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

48. 48
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates
Connect the Points
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

49. 49
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
NPV(0%) = + + + – 10,000500
(1+ 0 )
500
(1+ 0)2
4,600
(1+ 0 )3
10,000
(1+ 0)4
= $5,600

50. 50
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
NPV(5%) = + + + – 10,000500
(1+.05)
500
(1+.05)2
4,600
(1+ .05)3
10,000
(1+ .05)4
= $3,130

51. 51
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
NPV(10%) = + + + – 10,000500
(1+.10)
500
(1+.10)2
4,600
(1+ .10)3
10,000
(1+ .10)4
= $1.154

52. 52
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
NPV(15%) = + + + – 10,000500
(1+.15)
500
(1+.15)2
4,600
(1+ .15)3
10,000
(1+ .15)4
= –$445

53. 53
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
Connect the Points

54. 54
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
Net Present Value Profile
Graphs the Net Present Value of the project withGraphs the Net Present Value of the project with
different required ratesdifferent required rates P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

55. 55
Net Present Value Profile
Compare NPV of the two projects for differentCompare NPV of the two projects for different
required ratesrequired rates
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
Crossover point
Project A

56. 56
Net Present Value Profile
Compare NPV of the two projects for differentCompare NPV of the two projects for different
required ratesrequired rates
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
Crossover point
Project A
For any discount rate <
crossover point choose B

57. 57
Net Present Value Profile
Compare NPV of the two projects for differentCompare NPV of the two projects for different
required ratesrequired rates
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
Crossover point
For any discount rate >
crossover point choose A
Project A
For any discount rate <
crossover point choose B

58. 58
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
Measures the rate of return that will make the PV ofMeasures the rate of return that will make the PV of
future CF equal to the initial outlay.future CF equal to the initial outlay.
Definition:
The IRR is that discount rate at which
NPV = 0
IRR is like the YTM. It is the same cocept but
the term YTM is used only for bonds.

59. 59
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
Measures the rate of return that will make the PV ofMeasures the rate of return that will make the PV of
future CF equal to the initial outlay.future CF equal to the initial outlay.
The IRR is the discount rate at which NPV = 0
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
NPV = $0

60. 60
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
Measures the rate of return that will make the PV ofMeasures the rate of return that will make the PV of
future CF equal to the initial outlay.future CF equal to the initial outlay.
Or, the IRR is the discount rate at which NPV =
0
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
NPV = $0 IRRA ≈ 15%
IRRB ≈ 14%

61. 61
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
Determine the mathematical solution for IRRDetermine the mathematical solution for IRR

62. 62
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
Determine the mathematical solution for IRRDetermine the mathematical solution for IRR
0 = NPV = + +···+ – IOCF1
(1+ IRR )
CF2
(1+ IRR )2
CFn
(1+ IRR )n

63. 63
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
Determine the mathematical solution for IRRDetermine the mathematical solution for IRR
0 = NPV = + +···+ – IOCF1
(1+ IRR )
CF2
(1+ IRR )2
CFn
(1+ IRR )n
IO = + +···+CF1
(1+ IRR )
CF2
(1+ IRR )2
CFn
(1+ IRR )n
Outflow = PV of Inflows

64. 64
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
Determine the mathematical solution for IRRDetermine the mathematical solution for IRR
0 = NPV = + +···+ – IOCF1
(1+ IRR )
CF2
(1+ IRR )2
CFn
(1+ IRR )n
IO = + +···+CF1
(1+ IRR )
CF2
(1+ IRR )2
CFn
(1+ IRR )n
Outflow = PV of Inflows
Solve for Discount Rates

65. 65
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
For Project BFor Project B
Cannot solve for IRR
directly, must use Trial &
Error
10,000 = + + +500
(1+ IRR )
500
(1+ IRR )2
10,000
(1+ IRR )4
4,600
(1+ IRR )3
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
IRRB ≈ 14%

66. 66
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
For Project BFor Project B
Cannot solve for IRR
directly, must use Trial &
Error
10,000 = + + +500
(1+ IRR )
500
(1+ IRR )2
10,000
(1+ IRR )4
4,600
(1+ IRR )3
TRY 14%TRY 14%
10,000 = + + +500
(1+ .14 )
500
(1+ .14)2
10,000
(1+ .14 )4
4,600
(1+ .14 )3
?
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
IRRB ≈ 14%

67. 67
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
For Project BFor Project B
Cannot solve for IRR
directly, must use Trial &
Error
10,000 = + + +500
(1+ IRR )
500
(1+ IRR )2
10,000
(1+ IRR )4
4,600
(1+ IRR )3
TRY 14%TRY 14%
10,000 = + + +500
(1+ .14 )
500
(1+ .14)2
10,000
(1+ .14 )4
4,600
(1+ .14 )3
?
10,000 = 9,849
?
PV of Inflows too low, try lower rate
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
IRRB ≈ 14%

68. 68
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
For Project BFor Project B
Cannot solve for IRR
directly, must use Trial &
Error
10,000 = + + +500
(1+ IRR )
500
(1+ IRR )2
10,000
(1+ IRR )4
4,600
(1+ IRR )3
TRY 13%TRY 13%
10,000 = + + +500
(1+ .13 )
500
(1+ .13)2
10,000
(1+ .13 )4
4,600
(1+ .13 )3
?
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
IRRB ≈ 14%

69. 69
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
For Project BFor Project B
Cannot solve for IRR
directly, must use Trial &
Error
10,000 = + + +500
(1+ IRR )
500
(1+ IRR )2
10,000
(1+ IRR )4
4,600
(1+ IRR )3
TRY 13%TRY 13%
10,000 = + + +500
(1+ .13 )
500
(1+ .13)2
10,000
(1+ .13 )4
4,600
(1+ .13 )3
?
10,000 = 10,155
?
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
IRRB ≈ 14%

70. 70
Capital Budgeting Methods
Internal Rate of ReturnInternal Rate of Return
For Project BFor Project B
Cannot solve for IRR
directly, must use Trial &
Error
10,000 = + + +500
(1+ IRR )
500
(1+ IRR )2
10,000
(1+ IRR )4
4,600
(1+ IRR )3
TRY 13%TRY 13%
10,000 = + + +500
(1+ .13 )
500
(1+ .13)2
10,000
(1+ .13 )4
4,600
(1+ .13 )3
?
10,000 = 10,155
?
13% < IRR < 14%
10%5%
0 Cost of Capital
N
P
V
6,000
3,000
20%15%
Project B
IRRB ≈ 14%

71. 71
Capital Budgeting Methods
Decision Rule for Internal Rate of ReturnDecision Rule for Internal Rate of Return
Independent Projects
Accept Projects with
IRR ≥ required rate
Mutually Exclusive Projects
Accept project with highest
IRR ≥ required rate

72. 72
Capital Budgeting Methods
Profitability IndexProfitability Index
PI = PV of Inflows
Initial Outlay
Very Similar to Net Present ValueVery Similar to Net Present Value

73. 73
Capital Budgeting Methods
Profitability IndexProfitability Index
PI = PV of Inflows
Initial Outlay
Very Similar to Net Present ValueVery Similar to Net Present Value
Instead of Subtracting the Initial Outlay from the PVInstead of Subtracting the Initial Outlay from the PV
of Inflows, the Profitability Index is the ratio of Initialof Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.Outlay to the PV of Inflows.

74. 74
Capital Budgeting Methods
Profitability IndexProfitability Index
PI = PV of Inflows
Initial Outlay
Very Similar to Net Present ValueVery Similar to Net Present Value
Instead of Subtracting the Initial Outlay from the PVInstead of Subtracting the Initial Outlay from the PV
of Inflows, the Profitability Index is the ratio of Initialof Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.Outlay to the PV of Inflows.
+ + +···+
CF1
(1+ k )
CF2
(1+ k )2
CF3
(1+ k )3
CFn
(1+ k )n
PI =
IO

75. 75
Capital Budgeting Methods
Profitability Index for Project BProfitability Index for Project B P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
+ + +500
(1+ .1 )
500
(1+ .1)2
4,600
(1+ .1 )3
10,000
(1+ .1 )4
10,000
PI =

76. 76
Capital Budgeting Methods
Profitability Index for Project BProfitability Index for Project B P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
+ + +500
(1+ .1 )
500
(1+ .1)2
4,600
(1+ .1 )3
10,000
(1+ .1 )4
10,000
PI =
PI =
11,154
10,000
= 1.1154

77. 77
Capital Budgeting Methods
Profitability Index for Project BProfitability Index for Project B P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
+ + +500
(1+ .1 )
500
(1+ .1)2
4,600
(1+ .1 )3
10,000
(1+ .1 )4
10,000
PI =
PI =
11,154
10,000
= 1.1154
Profitability Index for Project AProfitability Index for Project A
10,000
PI =
3,500 x PVIFA 4, .10

78. 78
Capital Budgeting Methods
Profitability Index for Project BProfitability Index for Project B P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
+ + +500
(1+ .1 )
500
(1+ .1)2
4,600
(1+ .1 )3
10,000
(1+ .1 )4
10,000
PI =
PI =
11,154
10,000
= 1.1154
Profitability Index for Project AProfitability Index for Project A
10,000
PI =
PI =
11,095
10,000
= 1.1095
3,500( )
1
.10(1+.10)
4
1
.10

79. 79
Capital Budgeting Methods
Profitability Index Decision RulesProfitability Index Decision Rules
Independent ProjectsIndependent Projects
Accept Project if PI ≥ 1
Mutually Exclusive ProjectsMutually Exclusive Projects
Accept Highest PI ≥ 1 Project

80. 80
Comparison of Methods
Project A Project B Choose
Payback < 3 years < 4 years A
NPV $1,095 $1,154 B
IRR 14.96% 13.50% A
PI 1.1095 1.1154 B

81. 81
Comparison of Methods
Time Value of MoneyTime Value of Money
Payback - Does not adjust for timing differences
(ignore Discounted Payback)
NPV, IRR and PI take into account the time value
of money

82. 82
Comparison of Methods
Time Value of MoneyTime Value of Money
Payback - Does not adjust for timing differences
NPV, IRR and PI take into account the time value
of money
Relevant Cash Flows?Relevant Cash Flows?
NPV, IRR and PI use all Cash Flows
Payback method ignores Cash Flows that occur
after the Payback Period.

83. 83
Comparison of Methods
Time Value of MoneyTime Value of Money
Payback - Does not adjust for timing differences
NPV, IRR and PI take into account the time value
of money
Relevant Cash Flows?Relevant Cash Flows?
NPV, IRR and PI use all Cash Flows
Payback method ignores Cash Flows that occur
after the Payback Period.
0 1 2
5,000 5,000(10,000)
Project 1

84. 84
Comparison of Methods
Time Value of MoneyTime Value of Money
Payback - Does not adjust for timing differences
NPV, IRR and PI take into account the time value
of money
Relevant Cash Flows?Relevant Cash Flows?
NPV, IRR and PI use all Cash Flows
Payback method ignores Cash Flows that occur
after the Payback Period.
0 1 2
5,000 5,000(10,000)
Project 1
0 1 2 3
5,000 5,000(10,000)
Project 2
10,000
Both Projects have
Identical Payback

85. 85
Comparison of Methods
NPV & PI indicated accept Project B while IRR indicated thatNPV & PI indicated accept Project B while IRR indicated that
Project A should be accepted. Why?Project A should be accepted. Why?
Sometimes there is a conflict between the decisions based onSometimes there is a conflict between the decisions based on
NPV and IRR methods.NPV and IRR methods.
The conflict arises if there is difference in the timing of CFs orThe conflict arises if there is difference in the timing of CFs or
sizes of the projects (or both).sizes of the projects (or both).
The cause of the conflict is the underlying reinvestment rateThe cause of the conflict is the underlying reinvestment rate
assumption.assumption.
Reinvestment Rate AssumptionsReinvestment Rate Assumptions
NPV assumes cash flows are reinvested at the required
rate, k.
IRR assumes cash flows are reinvested at IRR.
Reinvestment Rate of k more realistic as most projects earnReinvestment Rate of k more realistic as most projects earn
approximately k (due to competition)approximately k (due to competition)
NPVNPV is the Better Method for project evaluationis the Better Method for project evaluation

86. 86
IRR
Because of its unreasonable reinvestment rate assumption, IRRBecause of its unreasonable reinvestment rate assumption, IRR
method can result in bad decisions.method can result in bad decisions.
Another problem with IRR is that if the sign of the cash flowAnother problem with IRR is that if the sign of the cash flow
changes more than once, there is a possibility of multiple IRR.changes more than once, there is a possibility of multiple IRR.
See p 340.See p 340.
The problem of unreasonable assumption can be addressed byThe problem of unreasonable assumption can be addressed by
using Modified IRRusing Modified IRR

87. 87
MIRR
To find MIRRTo find MIRR
1.Find the FV of all intermediate CFs using the cost of1.Find the FV of all intermediate CFs using the cost of
capital (the hurdle rate) as the interest rate.capital (the hurdle rate) as the interest rate.
2.Add all FV.2.Add all FV.
3. Find that discount rate which makes the PV of the3. Find that discount rate which makes the PV of the
FV equal to the PV of outflows.FV equal to the PV of outflows.
Drop MIRR computations.Drop MIRR computations.

88. 88