Chapter 11: Capital Budgeting: Decision Criteria
Overview and “vocabulary”
Methods
Payback, discounted payback
NPV
IRR, MIRR
Profitability Index
Unequal lives
Economic life
What is capital budgeting?
Analysis of potential projects.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
Steps in Capital Budgeting
Estimate cash flows (inflows & outflows).
Assess risk of cash flows.
Determine r = WACC for project.
Evaluate cash flows.
What is the difference between independent and mutually exclusive projects?
Projects are:
independent, if the cash flows of one are unaffected by the acceptance of the other.
mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.
What is the payback period?
Payback for Franchise L(Long: Most CFs in out years)
Franchise S (Short: CFs come quickly)
What’s Franchise L’s NPV?
Calculator Solution
Rationale for the NPV Method
Using NPV method, which franchise(s) should be accepted?
If Franchise S and L are mutually exclusive, accept S because NPVs > NPVL .
If S & L are independent, accept both; NPV > 0.
Internal Rate of Return: IRR
What’s Franchise L’s IRR?
Rationale for the IRR Method
Decisions on Projects S and L per IRR
If S and L are independent, accept both. IRRs > r = 10%.
If S and L are mutually exclusive, accept S because IRRS > IRRL .
Construct NPV Profiles
To Find the Crossover Rate
Two Reasons NPV Profiles Cross
Reinvestment Rate Assumptions
NPV assumes reinvest at r (opportunity cost of capital).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?
Why use MIRR versus IRR?
Normal Cash Flow Project:
Pavilion Project: NPV and IRR?
Logic of Multiple IRRs
Accept Project P?
Note that Project S could be repeated after 2 years to generate additional profits.
Can use either replacement chain or equivalent annual annuity analysis to make decision.
Franchise S with Replication:
The project is acceptable only if operated for 2 years.
A project’s engineering life does not always equal its economic life.
Choosing the Optimal Capital Budget
Finance theory says to accept all positive NPV projects.
Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:
An increasing marginal cost of capital.
Capital rationing
Increasing Marginal Cost of Capital
Externally raised capital can have large flotation costs, which increase the cost of capital.
Investors often perceive large capital budgets as being risky, which drives up the cost of capital.
If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.
Capital Rationing
Capital rationing occurs when a company chooses not to fund all positive NPV projects.
The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital.
Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.

Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects.

Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.
Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted.
Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project.
Powerpnt
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
Overview and “vocabulary”
Methods
Payback, discounted payback
NPV
IRR, MIRR
Profitability Index
Unequal lives
Economic life
What is capital budgeting?
Analysis of potential projects.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
Steps in Capital Budgeting
Estimate cash flows (inflows & outflows).
Assess risk of cash flows.
Determine r = WACC for project.
Evaluate cash flows.
What is the difference between independent and mutually exclusive projects?
Projects are:
independent, if the cash flows of one are unaffected by the acceptance of the other.
mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.
What is the payback period?
Payback for Franchise L(Long: Most CFs in out years)
Franchise S (Short: CFs come quickly)
What’s Franchise L’s NPV?
Calculator Solution
Rationale for the NPV Method
Using NPV method, which franchise(s) should be accepted?
If Franchise S and L are mutually exclusive, accept S because NPVs > NPVL .
If S & L are independent, accept both; NPV > 0.
Internal Rate of Return: IRR
What’s Franchise L’s IRR?
Rationale for the IRR Method
Decisions on Projects S and L per IRR
If S and L are independent, accept both. IRRs > r = 10%.
If S and L are mutually exclusive, accept S because IRRS > IRRL .
Construct NPV Profiles
To Find the Crossover Rate
Two Reasons NPV Profiles Cross
Reinvestment Rate Assumptions
NPV assumes reinvest at r (opportunity cost of capital).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
Managers like rates--prefer IRR to NPV comparisons. Can we give them a better IRR?
Why use MIRR versus IRR?
Normal Cash Flow Project:
Pavilion Project: NPV and IRR?
Logic of Multiple IRRs
Accept Project P?
Note that Project S could be repeated after 2 years to generate additional profits.
Can use either replacement chain or equivalent annual annuity analysis to make decision.
Franchise S with Replication:
The project is acceptable only if operated for 2 years.
A project’s engineering life does not always equal its economic life.
Choosing the Optimal Capital Budget
Finance theory says to accept all positive NPV projects.
Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:
An increasing marginal cost of capital.
Capital rationing
Increasing Marginal Cost of Capital
Externally raised capital can have large flotation costs, which increase the cost of capital.
Investors often perceive large capital budgets as being risky, which drives up the cost of capital.
If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.
Capital Rationing
Capital rationing occurs when a company chooses not to fund all positive NPV projects.
The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital.
Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.

Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects.

Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.
Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted.
Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project.
Powerpnt
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
Overview and “vocabulary”
Methods
Payback, discounted payback
NPV
IRR, MIRR
Profitability Index
Unequal lives
Economic life
What is capital budgeting?
Analysis of potential projects.
Long-te

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