Chapter 9 capital budgetting techniques

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Chapter 9
Capital Budgeting
Techniques


Learning Goals:
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Understand the role of capital budgeting techniques in
the capital budgeting process.
Calculate, interpret and evaluate the payback period.
Calculate, interpret and evaluate net present value
(NPV).
Calculate, interpret and evaluate internal rate of return
(IRR).
Use NPV profiles to compare NPV and IRR
techniques.
Discuss NPV and IRR in terms of conflicting rankings
and the strengths/weaknesses of each approach.
Calculate, interpret and evaluate other capital
budgeting techniques.

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition


Net Present Value


Regarded as a sophisticated capital budgeting
technique, due to its explicit consideration of the
time value of money.



Calculated by:
NPV = Present Value Of - Initial Investment
Net Cash Inflows
n

NPV = ∑ (CFt × PVIFr ,t ) − CF0
t =1
[Equation 9.1a]

Where:
CF0 = Project’s initial investment
CFt = Net cash inflows for year t
r = the firm’s cost of capital
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition

Net Present Value


Decision criteria:
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Accept if NPV > $0

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Reject if NPV < $0

If the NPV is greater than $0, the firm will earn a
return greater than its cost of capital.
Using the Bennett Company data from Table 9.1,
if the firm has a cost of capital of 10%, the NPV’s
of projects A & B can be calculated as follows:

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition


Net Present Value
Project A:
NPV = Initial Investment - PVAn
= - $42,000 + ($14,000 x 3.7908)
= $11,071.20

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition

Net Present Value
Project B:
NPV = Initial Investment - PVn
= - $42,000 + ($28,000 x 0.9091 ) +
($12,000 x 0.8264 ) + ($10,000 x 0.7513 ) +
($10,000 x 0.6830) + ($10,000 x 0.6209)
= $10,923.60

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition


Internal Rate Of Return
•

Regarded as a sophisticated capital budgeting
technique for evaluating investments.

•

More difficult than NPV to calculate by hand.

•

The discount rate that equates the PV of net cash
inflows with the initial investment in the project.

•

Therefore equating the NPV of the investment
opportunity with $0.

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition


Internal Rate Of Return


Calculated by:
NPV = $0 =

CFt
∑ (1 + IRR) t − CF0
t =1
n

[Equation 9.2]
Where:
CF0 = Project’s initial investment
CFt = Net cash inflows for year t
t = Year t


Requires a trial and error approach, substituting
different discount rates until the equation
balances.
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –

9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition


Internal Rate Of Return


Decision criteria:
•

Accept if IRR > Cost Of Capital

•

Reject if IRR < Cost Of Capital

Using the Bennett Company data from Table 9.1,
if the firm has a cost of capital of 10%, the IRR of
projects A & B can be calculated as follows:
Project A:


Financial Calculator:
CF0 = -42,000, CF1 = $14,000, n = 5
IRR = 19.9%

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition


Internal Rate Of Return

Project B:
 Financial Calculator:
CF0 = -45,000, CF1 = $28,000, CF2 = $12,000,
CF3 = $10,000, n = 3
IRR = 21.7%
Based on IRR project B is most preferable as it
will provide the highest return on the investment.


Formula:
If calculating IRR manually we substitute different
interest rates into the equation using the cash
flows given until the equation balances.
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition


Ranking & Conflicting
Rankings


Ranking is necessary when:
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

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Projects are mutually exclusive
Capital rationing is necessary

Conflicting rankings arise due to
differences in cash flow:


Timing



Magnitude
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition


Which Is Better – NPV Or IRR?


On a theoretical basis NPV is preferred as:
•
•

avoids possibility of time consuming multiple
IRR’s.

•


it assumes intermediate flows are reinvested at
the firm’s cost of capital.

it directly reflects the actual project return.

On a practical basis, many financial managers prefer
IRR because:
•
•



it works with rates of return not dollars.
NPV does not measure benefits relative to the
amount invested

Most organisations use both.
Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –
9781442518193/ Gitman et al / Principles of Managerial Finance / 6th edition