1 Chapter 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) 13-2

Capital Budgeting Techniques Project evaluation methods Discounted Payback (DPB) Modified Internal Rate of Return (MIRR) Profitability Index (PI) 13-3

Choice of Decision Statistic Format Financial decisions primarily driven by –Currency –Time –Rate of return 13-4

Capital Budgeting Decisions Deciding on single project acceptance –Compute statistic –Compare with benchmark 13-5

Capital Budgeting Decisions Deciding on mutually exclusive projects –Compute statistic –Conduct “runoff” between mutually exclusive projects –Compare winning project with benchmark 13-6

Payback and Discounted Payback Payback statistic –Break-even calculation for costs of financing new project 13-7

Payback Benchmark Benchmark can vary Based on relevant external constraint 13-8

Discounted Payback Statistic Compensates for time value of money 13-9

Discounted Payback Benchmark Not recommended to compare Discounted Payback Benchmark (DPB) with Payback Benchmark (PB) DPB will be larger than regular PB 13-10

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 13-11

Net Present Value Measures value created by the project 13-12

NPV Benchmark Includes all cash flows – both inflows and outflows 13-13

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 13-14

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 13-15

NPV vs. IRR NPV and IRR are closely related 13-16

Internal Rate of Return Statistic To calculate IRR, solve the NPV formula for interest rate that makes NPV equal zero 13-17

IRR Benchmark –Calculate the IRR and compare cost of capital (investors’ required return) to see if the project is acceptable 13-18

Problems with IRR IRR will be consistent with NPV as long as project: –has normal cash flows –is independent 13-19

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 13-20

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 13-21

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 13-22

IRR, MIRR, NPV Mutually Exclusive Projects Rate-based statistics cause problems when project cash flows have differences in –scale –timing 13-23

MIRR Strengths and Weakness Strengths: 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 13-24

Profitability Index Based on NPV Use when firm has resource constraints on capital available for new project 13-25