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Chapter 8 Capital Budgeting Process and Decision Criteria
Chapter Overview
The Opening Focus presents the story of the capital investment project by Candente Copper
Corporation. It purchased mines in Peru with the net present value of the investment being an
outstanding one billion dollars. The estimated value the mines copper, silver and gold would
produce an 18% IRR or return on their investment. Nice return for stockholders!
Opening Focus Discussion Questions
1. How does a project with a high return relate to the concept of maximizing shareholder wealth?
In other words, what is the direct relationship between returns and wealth generation?
This chapter, after introducing the basic capital budgeting problem, covers:
8-1. Introduction of Capital Budgeting
8-2. Payback Methods
Technology
1. Smart Practices Video. Dan Carter, executive vice president and chief financial officer of
Charlotte Russe, talks about decision metrics that his company uses.
3. Smart Concepts Animation provides a step-by-step explanation of the conflicts between the
NPV and IRR criteria when firms evaluate mutually exclusive projects.
4. Smart Practices Video. Beth Acton, former vice president and treasurer of Ford, notes that
6. Smart Solutions provide a step-by-step solution to Problem 8-21, which compares two
competing projects using NPV, IRR, and PI techniques.
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Lecture Guide
Firm management makes two basic decisions – the financing and the capital budgeting decisions.
This chapter provides tools that managers can use to evaluate projects that will add to shareholder
wealth.
An Introduction To Capital Budgeting
While few finance classes extensively discuss the choice of capital budgeting projects,
clearly this is of utmost importance to a firm. A firm that is unable to find and implement value-
increasing projects will not stay in business very long. Similarly, a firm that does not have good
evaluative controls in effect will have difficulty continuing its business. After a project has been
chosen and implemented, managers must continually monitor that project, ensuring that it is
meeting its stated milestones for revenue and cash flow generation. If a project is not performing
as expected, then why? Were revenues lower than expected or costs higher than expected? If a
project is exceeding expectations, then why is this happening? Is this success something that can
be repeated in another project?
The capital budgeting decision should be separate from the financing decision. Project cash
8.1a Traits of an Ideal Investment Criteria
This section brings information from prior chapters into the capital budgeting process. A
sound capital budgeting process must take time value of money – the magnitude and timing of the
cash flows into account. It also must appropriately account from relevant risk. The focus should
8.1b A Capital Budgeting Problem
This section introduces the fictitious company Global Wireless Incorporated and walks the
students through a capital budgeting investment for the firm. This is a nice problem to walk the
students through from beginning to end. Be sure to emphasize the timeline aspect of the investment
as depicted in Figure 8.1. Global Wireless .
This chapter follows Global Wireless Inc.’s fictitious capital budgeting problem. The
chapter looks at how this project would be evaluated using various capital budgeting techniques
Chapter 8 Capital Budgeting Process and Decision Criteria 203
and under what circumstances the project would be acceptable to Global Wireless. This chapter
provides the relevant cash flows, focusing on evaluation techniques, not how to generate cash
flows for capital budgeting, which is covered later in the textbook.
These slides provide students with the calculation of payback period for Global Wireless
and summarize the advantages and disadvantages of the payback method, discussed above.
• Student Interaction: Ask students under what circumstances is discounted payback
worse for a company? (When the company uses discounted payback, but doesn’t
Fig 8.1 Global Wireless Investment Proposals
8.2 Payback Methods
8.2a Payback Decision Rule
8.2b Pros and Cons of the Payback Method
This section summarizes the pros and cons of this method. Point out the advantages to
payback:
• Simple to compute and understand.
• Student Interaction: Ask students if they would rather explain payback or NPV to
a manager who has no finance background.
Show how easily payback can be misused, and lead to incorrect answers:
Consider two projects, A and B
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• Student Interaction: Ask students to take a side and tell us why we should or
should not use the Payback Method.
o Project A has a payback in 1 year, yet without doing any calculations, it is
8.2c Discounted Payback
In an effort to correct the problems associated with the payback decision method. The
8-3. Accounting Based Methods
8.3a Accounting Rate of Return (ARR)
The accounting rate of return for a project has serious limitations because it does not take
time value of money into account and it uses accounting numbers, not cash flows.
While this method may be popular because managers are accustomed to thinking in terms of
returns, and this gives them a percent return, accounting based methods are very flawed. It is very
8.4 Net Present Value
• Student Interaction: Ask students if they would want a project/investment where someone
gives them $100 and they immediately give back $110. Students will say no, because of
the time value of money. They, like the company, want time to invest the money and earn
Chapter 8 Capital Budgeting Process and Decision Criteria 205
Point out that NPV provides correct answers to capital budgeting decisions because it
incorporates both market-determined risk and the time value of money. The rule of acceptance of
this method is also very simple and intuitive. If the NPV>0, then the company should accept the
8.4a Net Present Value Calculations
Note that this kind of calculation was made in previous chapters. The only addition to
previous chapter problems is an initial cost. In previous problems, students computed present
value – given a series of future cash flows, they applied a discount rate and calculated present
Fig. 8.2 The NPV Rule and Shareholder Wealth
Fig. 8.3a NPV of Global Wireless’s Projects at 18%
Fig. 8.3b NPV of Global Wireless’s Projects at 18%
8.4b Pros and Cons of NPV
NPV is the most theoretically correct model to use in capital budgeting. Its main drawback – that
8.4c Economic Value Added
Recently a variant of NPV has been used – Economic Value Added. Economic Value
8.5 Internal Rate of Return
Figure 8.4 NPV Profile
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8.5a Finding a Project’s IRR
Possibly the most popular of the alternative methods of capital budgeting decision-making,
IRR is intuitive and easy to use with today’s technology.
• Student Interaction: Point out to students that they have done IRR calculations in
Fig. 8.5a and 8.5b Calculating IRRs for Global Wireless Projects
Using information given in the text, this slide shows IRR for the Western Europe and Southeast
8.5b Advantages of the IRR Method
IRR has many of the same advantages as IRR. In addition, many managers are used to
thinking of their investments as a percent return. IRR provides this internal measure of
8.5c Problems with the Internal Rate of Return
Lending vs Borrowing
Timing of the cash flows can cause problems. The book gives the example of timber
cutting firms. These firms will cut and sell the timber immediately, but will have to pay to replant
Fig. 8.6 Lending vs Borrowing
Chapter 8 Capital Budgeting Process and Decision Criteria 207
Multiple IRRs
• Student Interaction: Ask students for examples of projects with non-conventional cash
Fig. 8.7 NPV Profile of a Project with Multiple IRRs
No Real Solution
• Student Interaction: Ask students for examples of projects with no IRRs. While
mathematically one can devise projects with no IRR (try Cash flow 0 = $100, Cash flow 1
8.5d IRR and NPV and Mutually Exclusive Projects
Point out that differences in answers for mutually exclusive projects result from size and
timing differences. Projects with lower initial investments that return their cash flows earlier tend
The Scale Problem
If two projects give positive returns that exceed the hurdle rate – size and scale of the
The Timing Problem
This section is a graphical representation of the conflict between mutually exclusive projects. The
instructor can point to the discount rates (below the crossover point) and which the long term
IRR.
• Student Interaction: Have students speculate about why IRR is so popular, even
though finance textbooks clearly point out its flaws. There is no definitive answer to
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Fig. 8.8 NPV Profiles Demonstrating the Timing Problem
8.6 Profitability Index
8.7 A New Investment Problem
This last section give an example using many of the capital budgeting methods introduced
Fig. 8.9 Net Present Value of Two Gas Chromatographs
Summary: Capital Budgeting
Enrichment Exercises
1. Tell students they’re in a job where they’re boss doesn’t like all those fancy finance theories.
How will you convince him (without being fired) that NPV is the best method to use in capital
Answers to Concept Review Questions
1. Other things being equal, managers would prefer (1) an easily applied capital budgeting
2. Payback is popular because it is very easy to compute and to understand and because it gives
4. Managers focus on the impact that an investment will have on reported earnings because
earnings or earnings per share are widely reported in the business press and companies (and
Chapter 8 Capital Budgeting Process and Decision Criteria 209
5. Among the factors that determine whether the annual accounting rate of return on a given
6. A project having an NPV of $1million means that $1 million in shareholder value (market
capitalization) is being added to the firm.
1. Both EVA and NPV provide a measure of value added, so it should not be surprising that these
methods are quite similar. EVA uses the same basic cash flows as NPV and evaluates the
9. IRR and NPV are related in that both use the time value of money and take risk into account.
10. If a single project with conventional cash flows has an IRR that exceeds the firm’s hurdle rate
11. You will recall that the “scale problem” indicates that we should use practical sense along with
IRR analysis: we should choose the investment that offers the best ABSOLUTE payoff to
maximize shareholder wealth, regardless of its percentage payoff. The “timing problem” has
12. NPV, IRR, and PI capital budgeting approaches are related because they adjust for the time
13. Both suffer from a scale problem, which the IRR and PI don’t take into consideration. When
choosing between two projects, the one that requires the larger funding but with the
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Answers to Self-Test Problems
ST8-1. Nader International is considering investing in two assets – A and B. The initial outlay,
annual cash flows, and annual depreciation for each asset is shown in the table below for
Asset A
Asset B
Year
Cash Flow
Depreciation
Cash Flow
Depreciation
0
-$200,000
-$180,000
1
$70,000
$40,000
$80,000
$36,000
3
5
100,000
a. Calculate the payback period for each asset, assess its acceptability, and indicate which
asset is best using the payback period.
b. Calculate the discounted payback for each asset, assess its acceptability, and indicate
a. Accounting rate of return
Asset A
Asset B
NPAT
NPAT
$70,000 − $40,000 = $30,000
$80,000 − $36,000 = $44,000
$80,000 − $40,000 = $40,000
$90,000 − $36,000 = $54,000
$90,000 − $40,000 = $50,000
$90,000 − $40,000 = $50,000
a. Payback
2.56 years / Not acceptable
2.33 years / Acceptable
3.17 years/Acceptable
3.62 years / Not Acceptable
Chapter 8 Capital Budgeting Process and Decision Criteria 211
c:
Asset A
Asset B
Year
CF
12% PV
Depr.
CF
12% PV
Depr.
0
-$200,000
-$180,000
1
$ 70,000
62,500
$40,000
$80,000
71,429
$36,000
2
63,776
40,000
90,000
71,747
3
4
57,196
40,000
40,000
25,420
5
d. They should take asset A because its accounting rate of return is acceptable as is its
discounted payback.
ST8-2. JK Products, Inc. is considering investing in either of two competing projects that will
allow the firm to eliminate a production bottleneck and meet the growing demand for its
products. The firm’s engineering department narrowed the alternatives down to tow –
Status Quo (SQ) and High Tech (HT). Working with the accounting and finance personnel,
the firm’s CFO developed the following estimates of the cash flows for SQ and HT over
the relevant 6-year time horizon. The firm has an 11 percent required return and views
these projects as equally risky.
Project SQ
Project HT
Year
Cash Flows
0
-$670,000
-$940,000
1
2
3
4
5
6
a. Calculate the net present value (NPV) of each project, assess its acceptability, and
indicate which project is best using NPV.
b. Calculate the internal rate of return (IRR) of each project, assess its acceptability, and
indicate which project is best using IRR.
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A:
Project SQ
Project HT
a. NPV
$87,313.87
$142,254.07*
b. IRR
16.07%*
15.17%
c. PI
1.13
1.15*
All measures indicate project acceptability:
*Indicates the preferred project using each measure.
d.
Project
Rate
SQ
HT
0%
$360,000
$710,000
$142,254.07
16.07%
At 11% HT is preferred over SQ, but because the profiles cross somewhere beyond
11% and before the functions cross the required return axis the IRR of SQ exceeds the
e. Project HT is recommended because it has the higher NPV, the better technique. In
addition its PI is higher than that of Project SQ.
Required return %
250
0
-250
HT
750
Chapter 8 Capital Budgeting Process and Decision Criteria 213
Answers to End-of-Chapter Questions
Q8–1. Can you name some industries where the payback period is unavoidably long?
A8-1. Payback period is unavoidably long in industries with long-lasting projects, for example,
the oil exploration industry, where it might take a long time to find acceptable oil fields
and make them produce. Some agricultural products take a long time – for example starting
an apple orchard would have a long payback, waiting for the trees to grow, mature and
finally produce maximum produce.
Q8–2. In statistics, you learn about Type I and Type II errors. A Type I error occurs when a
statistical test rejects a hypothesis when the hypothesis is actually true. A Type II error
occurs when a test fails to reject a hypothesis that is actually false. We can apply this type
A8-2. a. Payback could lead to Type 1 errors when it rejects a good project that has large cash
flows after the payback period cutoff.
Q8–3. Holding the cutoff period fixed, which method has a more severe bias against long-lived
projects, payback or discounted payback?
A8-3. Discounted payback has a more severe bias – discounted cash flows will be smaller,
making it even harder for a project to pass the payback hurdle.
Q8–5. “Cash flow projections more than a few years out are not worth the paper they’re written
on. Therefore, using payback analysis, which ignores long-term cash flows, is more
reasonable than making wild guesses as one has to do in the NPV approach.” Respond to
this comment.
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A8-5. NPV automatically adjusts for project time by using an exponentially smaller discount rate
applied to later cash flows. It gives these cash flows less importance in the final answer.
Q8–6. “Smart analysts can massage the numbers in NPV analysis to make any project’s NPV look
A8-6. Any method can be manipulated. It would be hard to argue that accounting numbers can’t
Q8–7. In what way is the NPV consistent with the principle of shareholder wealth maximization?
What happens to the value of a firm if a positive-NPV project is accepted? If a negative–
NPV project is accepted?
A8-7. The NPV approach is consistent with shareholder maximization because it suggests that
firms should only accept projects which earn returns above the opportunity costs of the
Q8–8. A particular firm’s shareholders demand a 15% return on their investment, given the firm’s
risk. However, this firm has historically generated returns in excess of shareholder
expectations, with an average return on its portfolio of investments of 25%.
a. Looking back, what kind of stock-price performance would you expect to see for this
firm?
A8-8. a. A firm that consistently earns returns higher than its opportunity cost of capital is
adding value to the firm, and its stock price should increase.
Q8-9. What are the potential faults in using the IRR as a capital budgeting technique? Given these
faults, why is this technique so popular among corporate managers?
A8-9. The IRR suffers from several problems. The IRR is not well suited to ranking projects with
very different scales or projects with very different cash flow timing patterns. The IRR
Q8-10. Why is the NPV considered to be theoretically superior to all other capital budgeting
techniques? Reconcile this result with the prevalence of the use of IRR in practice. How
Chapter 8 Capital Budgeting Process and Decision Criteria 215
would you respond to your CFO if she instructed you to use the IRR technique to make
capital budgeting decisions on projects with cash flow streams that alternate between
inflows and outflows?
Q8-11. Outline the differences between NPV, IRR, and PI. What are the advantages and
disadvantages of each technique? Do they agree with regard to simple accept or reject
decisions?
A8-11. The NPV is calculated by discounting all of a project’s cash flows to the present. The IRR
is calculated by finding the discount rate which equates the NPV to zero. The profitability
Q8-12. Under what circumstances will the NPV, IRR, and PI techniques provide different capital
budgeting decisions? What are the underlying causes of the differences often found in the
ranking of mutually exclusive projects using NPV and IRR?
A8-12. IRR, NPV, and PI can lead to different decisions when they are used to rank projects or to
Solutions to End-of-Chapter Problems
Payback Methods
P8-1. Suppose that a 30-year U.S. Treasury bond offers a 4% coupon rate, paid semiannually.
The market price of the bond is $1,000, equal to its par value.
a. What is the payback period for this bond?
b. With such a long payback period, is the bond a bad investment?
c. What is the discounted payback period for the bond assuming its 4% coupon rate is the
required return? What general principle does this example illustrate regarding a
project’s life, its discounted payback period, and its NPV?
A8-1. a. Payback on this bond is 25 years. You pay $1,000. You receive $40 a year for 25
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P8-2. The cash flows associated with three different projects are as follows:
Cash Flows
Alpha
($ in millions)
Beta
($ in millions)
Gamma
($ in millions)
Initial Outflow
– 1.5
– 0.4
– 7.5
Year 1
0.3
0.1
2.0
Year 2
0.5
0.2
3.0
Year 3
0.5
0.2
2.0
Year 4
0.4
0.1
1.5
Year 5
0.3
– 0.2
5.5
a. Calculate the payback period of each investment.
b. Which investments does the firm accept if the cutoff payback period is three years?
Four years?
e. One of these almost certainly should be rejected, but might be accepted if the firm uses
payback analysis. Which one?
f. One of these projects almost certainly should be accepted (unless the firm’s
opportunity cost of capital is very high), but might be rejected if the firm uses payback
analysis. Which one?
A8-2. a. Payback of Alpha = 3.5 years, payback of Beta = 2.5 years, payback of Gamma = 3.3
years
e. Project Beta should be rejected. You must pay out a total of .6 million and take in .6