1. Capital Budgeting FIN 461: Financial Cases & Modeling
George W. Gallinger
Associate Professor of Finance
W. P. Carey School of Business
Arizona State University

2. Typical Capital Budgeting System
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3. Calculating Accounting Rate of Return
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4. Calculating Payback Period
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5. Calculating Discounted Payback Period
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6. Calculating NPV
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7. Calculating NPV…
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8. Use Nominal or Real WACC?
Nominal return reflects the actual dollar return; real return measures the increase in purchasing power gained by holding a certain investment
Common in capital budgeting is the use of market rates of return at the time of the analysis
Market interest rates have embedded an assumption about inflation
Use nominal cash flows to reflect the same inflation rate as that embedded in discount rate.
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9. Risk-Return Tradeoff for Projects
Projects plotting above the security market line (SML) have rates of return in excess of their required market rates
Positive NPVs
Projects plotting below the SML have rates of return less than their required market rates
Negative NPVs
Projects plotting on the SML earn their market rates
Zero NPVs.
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10. Calculating IRR
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11. Illustration for Calculating IRR
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12. IRR & Required Risk-Adjusted Rate
Appropriate rates for comparing project returns are those falling on the upward sloping market risk-return trade-off curve
Not the firm’s horizontal cost of capital line, WACC
WACC is only appropriate for evaluating projects with risk comparable to the level of risk of the firm
“Carbon copy” projects.
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13. Size Problem
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14. Cash Flow Pattern Problems
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15. Multiple IRR Solutions
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16. Undervaluation of Later Cash Flows
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17. Calculating the Profitability Index
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18. Comparison of Project Rankings
Project B is better than project A
Project B continues to earn cash flows longer
Project D is more desirable than project C
Although both projects generate the same amount of cash flows, project D does it earlier
Unanswered question:
Is Project D better than project B?
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19. Sunk Costs
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20. Salvage Value Comparisons
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21. Calculating Initial Investment
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22. Calculating Annual Operating Cash Flows
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23. Alternatively, Calculating Annual Operating Cash Flows…
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24. Calculating Terminal Cash Flows
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25. Salvage Value: Present vs. Future
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26. Another Topic: Competing Projects
Assume projects
Mutually exclusive
On-going
Different economic lives
How do you select the correct project?
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27. Example
There are times when application of the NPV rule can lead to the wrong decision
Consider a factory which must have an air cleaner
The equipment is mandated by law, so there is no “doing without”
There are two choices:
The “Cadillac cleaner” costs $4,000 today, has annual operating costs of $100 and lasts for 10 years
The “cheaper cleaner” costs $1,000 today, has annual operating costs of $500 and lasts for 5 years
Which one should we choose?
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28. Example …
At first glance, the cheap cleaner has the “better” NPV (r = 10%):
Overlooks the fact that the Cadillac cleaner lasts twice as long
When we incorporate project life, the Cadillac cleaner is actually cheaper.
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29. Example …
The Cadillac cleaner time line of cash flows:
-$4,000 –
The “cheaper cleaner” time line of cash flows over ten years:
-$1,000 – ,
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30. Investments of Unequal Lives
Replacement Chain
Repeat the projects forever, find the PV of that perpetuity
Assumption: Both projects can and will be repeated
Matching Cycle
Repeat projects until they begin and end at the same time—like we just did with the air cleaners
Compute NPV for the “repeated projects”
The Equivalent Annual Annuity (EAA) Method.
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31. Equivalent Annual Cost Method
Equivalent Annual Annuity Method
Provides the value of the level payment annuity that has the same PV as the original set of cash flows
NPV = EAA × ArT
For example, the EAA for the Cadillac air cleaner is $750.98
Annuity Table
10%, 10 years =
To find ArT, just make PMT = $1 in your financial calculator, set T and r, and solve for PV
The EAA for the cheaper air cleaner is $763.80, which confirms our earlier decision to reject it.
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32. Another Example: Calculating EAA
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33. Human Face of Capital Budgeting
NPV of a project  based on assumptions
Managers must be aware of optimistic bias in these assumptions made by supporters of the project
Companies need control measures to remove bias
Analysis done by a group independent of individual or group proposing the project
Analysts must have a sense of what is reasonable when forecasting a project’s profit margin and its growth potential
Another side of determining which projects receive funding – storytelling
Best analysts not only provide numbers to highlight a good investment, but also can explain why this investment makes sense.
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34. The End
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