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Chapter 13Chapter 13 Weighing Net Present Value and Other Capital Budgeting Criteria

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Capital Budgeting Techniques

Project evaluation methods

• Net Present Value (NPV) is preferred method

• Internal Rate of Return (IRR)

• Payback (PB)

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Capital Budgeting Techniques

Project evaluation methods

• Discounted Payback (DPB)

• Modified Internal Rate of Return (MIRR)

• Profitability Index (PI)

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Choice of Decision Statistic Format

• Financial decisions primarily driven by

– Currency

– Time

– Rate of return

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Capital Budgeting Decisions

• Deciding on single project acceptance

– Compute statistic

– Compare with benchmark

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Capital Budgeting Decisions

• Deciding on mutually exclusive projects – Compute statistic

– Conduct “runoff” between mutually exclusive projects

– Compare winning project with benchmark

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Payback and Discounted Payback

• Payback statistic– Break-even calculation for costs of financing

new project

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Payback Benchmark

• Benchmark can vary• Based on relevant external constraint

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Discounted Payback Statistic

• Compensates for time value of money

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Discounted Payback Benchmark

• Not recommended to compare Discounted Payback Benchmark (DPB) with Payback Benchmark (PB)

• DPB will be larger than regular PB

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Payback and Discounted Payback Strengths

• Strengths– Easy to calculate– Intuitive

• Weaknesses– accept/reject benchmarks are arbitrary– ignore cash flows after the payback period– PB ignores the time value of money

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Net Present Value

• Measures value created by the project

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NPV Benchmark

• Includes all cash flows – both inflows and outflows

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NPV Strengths and Weaknesses

• Strengths– Not a ratio– Works well for both independent projects and

mutually-exclusive projects

• Weaknesses– Managers can misinterpret the results

• May compare NPV to cost even though cost already incorporated into the NPV

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Internal Rate of Return and Modified Internal Rate of Return

• IRR most popular technique• IRR gives same accept/reject decision as

NPV when used with normal cash-flow projects

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NPV vs. IRR

• NPV and IRR are closely related

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Internal Rate of Return Statistic

• To calculate IRR, solve the NPV formula for interest rate that makes NPV equal zero

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IRR Benchmark

– Calculate the IRR and compare cost of capital (investors’ required return) to see if the project is acceptable

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Problems with IRR

• IRR will be consistent with NPV as long as project:– has normal cash flows– is independent

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IRR and NPV with Non-normal Cash Flows

• Recommended not to use IRR with non-normal cash flows

• Modified Internal Rate of Return is better

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Differing Reinvestment Rate Assumptions of NPV and IRR

• NPV and IRR assume cash flows are reinvested in firm

• NPV’s reinvestment rate assumption is considered superior to IRR’s

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Modified Internal Rate of Return

• “Fixes” IRR reinvestment rate problem • Modification to IRR

– Uses cost of capital to move cash flows

• MIRR not appropriate for mutually exclusive projects

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IRR, MIRR, NPV Mutually Exclusive Projects

• Rate-based statistics cause problems when project cash flows have differences in– scale

– timing

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MIRR Strengths and WeaknessStrengths:• Corrects IRR’s reinvestment rate assumption• Fixes non-normal cash flows problem

Weakness:• Does not correct IRR issues with choosing

the wrong mutually exclusive project for range of rates

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Profitability Index

• Based on NPV • Use when firm has resource constraints on

capital available for new project

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