Capital Budgeting Techniques

Chapter 9
 Capital Budgeting Techniques

• Payback period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
Payback period
 Payback period

• Is the amount of time required for a firm to

recover its initial investment in the project
9–1 Payback period Jordan Enterprises is considering a capital expenditure
that requires an initial investment of $42,000 and returns after-tax cash
inflows of $7,000 per year for 10 years. The firm has a maximum
acceptable payback period of 8 years.

a. Determine the payback period for this project.

b. Should the company accept the project? Why or why not?
• Answer:
• (a) $42,000 / $7,000 = 6 years
•
• (b) The company should accept the project.
9–2 Payback comparisons
Nova Products has a 5-year maximum acceptable payback period.
The firm is considering the purchase of a new machine and must choose between
two alternative ones.
The first machine requires an initial investment of $14,000 and generates annual
after-tax cash inflows of $3,000 for each of the next 7 years.
The second machine requires an initial investment of $21,000 and provides an
annual cash inflow after taxes of $4,000 for 20 years.

a. Determine the payback period for each machine.

b. Comment on the acceptability of the machines, assuming that they are

independent projects.

c. Which machine should the firm accept? Why?

d. Do the machines in this problem illustrate any of the weaknesses of using

payback? Discuss.
Answer:
(a) Machine 1: $14,000  $3,000 = 4 years, 8 months
Machine 2: $21,000  $4,000 = 5 years, 3 months

(b) Only Machine 1 has a payback faster than 5 years and is acceptable.

(c) The firm will accept the first machine because the payback period of 4
years, 8 months is less than the 5-year maximum payback required by Nova
Products.

(d) Machine 2 has returns which last 20 years while Machine 1 has only seven
years of returns. Payback cannot consider this difference; it ignores all cash
inflows beyond the payback period.
9–3 choosing between two projects with acceptable payback periods
Shell Camping Gear, Inc. is considering two mutually exclusive projects.
Each requires an initial investment of $100,000. John Shell, president of the
company, has set a maximum payback period of 4 years.
The after-tax cash inflows associated with each project are as follows:

a. Determine the payback period of each project.

b. Because they are mutually exclusive, Shell must choose one. Which should the
company invest in?

c. Explain why one of the projects is a better choice than the other.
Both project A and project B have payback periods of exactly 4 years.

(b) Based on the minimum payback acceptance criteria of 4 years set by John
Shell, both projects should be accepted. However, since they are mutually
exclusive projects, John should accept project B.

(c) Project B is preferred over A because the larger cash flows are in the early
years of the project. The quicker cash inflows occur, the greater their value.
Net Present Value
(NPV)
 Net Present Value

• A sophisticated capital budgeting technique;

found by subtracting a project’s initial
investment from the present value of its cash
inflows discounted at a rate equal to the firm’s
cost of capital
9–4 NPV Calculate the net present value (NPV) for the following 20-year
projects.
Comment on the acceptability of each. Assume that the firm has an
opportunity cost of 14%.

a. Initial investment is $10,000; cash inflows are $2,000 per year.

b. Initial investment is $25,000; cash inflows are $3,000 per year.

c. Initial investment is $30,000; cash inflows are $5,000 per year.

Answer:

PVn = PMT  (PVIFA14%,20 yrs)

NPV = PVn - Initial investment

(a) PVn = $2,000  6.623 NPV = $13,246 - $10,000

PVn = $13,246 NPV = $3,246
Accept

(b) PVn = $3,000 * 6.623 NPV = $19,869- $25,000

PVn = $19,869 NPV = - $5,131
Reject

(c) PVn = $5,000 * 6.623 NPV = $33,115 - $30,000

PVn = $33,115 NPV = $3,115
Accept
9–5 NPV for varying costs of capital Dane Cosmetics is evaluating a new
fragrance-mixing machine. The machine requires an initial investment of
$24,000 and will generate after-tax cash inflows of $5,000 per year for 8 years.
For each of the costs of capital listed, (1) calculate the net present value (NPV),
(2) indicate whether to accept or reject the machine, and (3) explain your
decision.

a. The cost of capital is 10%.

b. The cost of capital is 12%.
c. The cost of capital is 14%.
Answer:
PVn = PMT (PVIFAk%,8 yrs.)
(a) 10 % (b) 12 %
PVn = $5,000(5.335) PVn = $5,000 (4.968)
PVn = $26,675 PVn =$24,840
NPV = PVn - Initial investment NPV = PVn - Initial investment
NPV = $26,675 - $24,000 NPV = $24,840 - $24,000
NPV = $2,675 NPV = $840
Accept; positive NPV Accept; positive NPV

(c) 14 %
PVn = $5,000 (4.639)
PVn = $23,195
NPV = PVn - Initial investment
NPV = $23,195 - $24,000
NPV = - $805
Reject; negative NPV
9–6 Net present value—Independent projects
Using a 14% cost of capital, calculate the net present value for each of the
independent projects shown in the following table, and indicate whether each is
acceptable.
Answer:
Project A
PVn = PMT (PVIFA14%,10 yrs.)
PVn = $4,000 (5.216)
PVn = $20,864
NPV = $20,864 - $26,000
NPV = - $5,136
Reject

Project B
Project D
PVn = PMT (PVIFA14%,8 yrs.)
PVn = $230,000 * 4.639
PVn = $1,066,970
NPV = PVn - Initial investment
NPV = $1,066,970 - $950,000
NPV = $116,970
Accept
9–7 NPV Simes Innovations, Inc., is negotiating to purchase exclusive rights to
manufacture and market a solar-powered toy car. The car’s inventor has offered
Simes the choice of either a one-time payment of $1,500,000 today or a series
of 5 year-end payments of $385,000.

a. If Simes has a cost of capital of 9%, which form of payment should the company
choose?

b. What yearly payment would make the two offers identical in value at a cost of
capital of 9%?

c. Would your answer to part a of this problem be different if the yearly payments
were made at the beginning of each year? Show what difference, if any, that
change in timing would make to the present value calculation.

d. The after-tax cash inflows associated with this purchase are projected to amount
to $250,000 per year for 15 years. Will this factor change the firm’s decision
about how to fund the initial investment?
Answer:
(a) PVA = $385,000 (PVIFA9%,5)
PVA = $385,000 (3.890)
PVA = $1,497,650
The immediate payment of $1,500,000 is not preferred because it has a higher
present value than does the annuity.
(b) PMT =1500000 / 3.890 =385604.11

(c) PVAdue = $385,000 (PVIFA9%,4 + 1)

PVAdue = $385,000 (3.24 + 1)
PVAdue = $385,000 (4.24)
PVAdue = $1,632,400
Changing the annuity to a beginning-of-the-period annuity due would cause Simes
Innovations to prefer the $1,500,000 one-time payment since the PV of the
annuity due is greater than the lump sum.

(d) No, the cash flows from the project will not influence the decision on how to
fund the project. The investment and financing decisions are separate.
9–8 NPV and maximum return A firm can purchase a fixed asset for a
$13,000 initial investment. The asset generates an annual after-tax cash
inflow of $4,000 for 4 years.

a. Determine the net present value (NPV) of the asset, assuming that the firm
has a 10% cost of capital. Is the project acceptable?

b. Determine the maximum required rate of return (closest whole-percentage

rate) that the firm can have and still accept the asset. Discuss this finding in
light of your response in part a.
Answer:
PVn = PMT (PVIFAk%,n)
(a) PVn = $4,000 (PVIFA10%,4)
PVn = $4,000 (3.170)
PVn = $12,680
NPV = PVn - Initial investment
NPV = $12,680 - $13,000
NPV = –$320
Reject this project due to its negative NPV.

(b) $13,000 = $4,000 (PVIFAk%,n)

$13,000  $4,000 = (PVIFAk%,4)
3.25 = PVIFA9%,4
9% is the maximum required return that the firm could have for the project to be
acceptable. Since the firm’s required return is 10% the cost of capital is
greater than the expected return and the project is rejected.
9–9 NPV—Mutually exclusive projects Hook Industries is considering the
replacement of one of its old drill presses. Three alternative replacement
presses are under consideration. The relevant cash flows associated with
each are shown in the following table. The firm’s cost of capital is 15%.

a. Calculate the net present value (NPV) of each press.

b. Using NPV, evaluate the acceptability of each press.

c. Rank the presses from best to worst using NPV.

Answer:
PVn = PMT (PVIFAk%,n)
(a) & (b)

Press PV of cash inflows; NPV

A PVn = PMT (PVIFA15%,8 yrs.)
PVn = $18,000 * 4.487
PVn = $80,766
NPV = PVn - Initial investment
NPV = $80,766 - $85,000
NPV = - $4,234
Reject
9–10 Payback and NPV Neil Corporation has three projects under
consideration. The cash flows for each of them are shown in the following
table. The firm has a 16% cost of capital.

a. Calculate each project’s payback period. Which project is preferred

according to this method?

b. Calculate each project’s net present value (NPV). Which project is preferred
according to this method?

c. Comment on your findings in parts a and b, and recommend the best project.
Explain your recommendation.
Internal Rate of Return (IRR)
 Internal Rate of Return (IRR)
• It is the discount rate that equates the NPV of
an investment opportunity with $0 ( because
the present value of cash inflows equals the
initial investment)
 Internal Rate of Return (IRR)
• When IRR is used to make accept-reject
decisions, the decision criteria are as follows:
- If IRR is greater than the cost of capital, accept
the project
- - If IRR is less than the cost of capital, reject
the project
9–11 Internal rate of return For each of the projects shown in the following
table, calculate the internal rate of return (IRR). Then indicate, for each
project, the maximum cost of capital that the firm could have and still find
the IRR acceptable
Project A
Average Annuity =($20,000 + $25,000 + 30,000 + $35,000 + $40,000)  5
Average Annuity =$150,000  5
Average Annuity =$30,000

PVIFAk%,5yrs. = $90,000  $30,000 = 3.000

PVIFA19%,5 yrs. = 3.0576
PVlFA20%,5 yrs. = 2.991
However, try 17% and 18% since cash flows are greater in later years.
Project B
PVn =PMT (PVIFAk%,4 yrs.)
$490,000 = $150,000 (PVIFAk%,4 yrs.)
$490,000  $150,000 = (PVIFAk%,4 yrs.)
3.27 = PVIFAk%,4
8% IRR 9%

The firm’s maximum cost of capital for project acceptability would be 8% (8.62%).
Project C
PVn = PMT (PVIFAk%,5 yrs.)
$20,000 = $7,500 (PVIFAk%,5 yrs.)
$20,000  $7,500 = (PVIFAk%,5 yrs.)
2.67 =PVIFAk%,5 yrs.
25% IRR 26%

The firm’s maximum cost of capital for project acceptability would be 25%
(25.41%).

Project D
IRR = 21%
9–12 IRR—Mutually exclusive projects Bell Manufacturing is attempting to
choose the better of two mutually exclusive projects for expanding the firm’s
warehouse capacity. The relevant cash flows for the projects are shown in the
following table. The firm’s cost of capital is 15%.

a. Calculate the IRR to the nearest whole percent for each of the projects.

b. Assess the acceptability of each project on the basis of the IRRs found in part a.

c. Which project, on this basis, is preferred?

Answer:
(a) and (b)

Project X
IRR 16%; since IRR cost of capital, accept.

Project Y
IRR 17%; since IRR cost of capital, accept.

(c) Project Y, with the higher IRR, is preferred, although both are acceptable.
9–13 IRR, investment life, and cash inflows Oak Enterprises accepts projects
earning more than the firm’s 15% cost of capital. Oak is currently
considering a 10-year project that provides annual cash inflows of $10,000
and requires an initial investment of $61,450. (Note: All amounts are after
taxes.)

a. Determine the IRR of this project. Is it acceptable?

b. Assuming that the cash inflows continue to be $10,000 per year, how many
additional years would the flows have to continue to make the project
acceptable (that is, to make it have an IRR of 15%)?

c. With the given life, initial investment, and cost of capital, what is the
minimum annual cash inflow that the firm should accept?
Answer:
(a) PVn = PMT (PVIFAk%,n)
$61,450 = $10,000 (PVIFA k%,10 yrs.)
$61,450  $10,000 = PVIFAk%,10 yrs.
6.145 = PVIFAk%,10 yrs.
k IRR 10%

The IRR cost of capital; reject the project

(b) PVn = PMT (PVIFA%,n)

$61,450 = $10,000 (PVIFA15%,n)
$61,450  $10,000 = PVIFA15%,n
6.145 = PVIFA15%,n
18 yrs. n 19 yrs.

The project would have to run a little over 8 more years to make the project acceptable
with the 15% cost of capital.
(c) PVn = PMT (PVIFA15%,10)
$61,450 = PMT (5.019)
$61,450  5.019 = PMT
$12,243.48 = PMT
9–14 NPV and IRR
Benson Designs has prepared the following estimates for a longterm project it
is considering. The initial investment is $18,250, and the project is
expected to yield after-tax cash inflows of $4,000 per year for 7 years. The
firm has a 10% cost of capital.

a. Determine the net present value (NPV) for the project.

b. Determine the internal rate of return (IRR) for the project.

c. Would you recommend that the firm accept or reject the project? Explain
your answer.
Answer:
(a) PVn = PMT (PVIFA10%,7 yrs.)
PVn = $4,000 (4.868)
PVn = $19,472
NPV = PVn - Initial investment
NPV = $19,472 - $18,250
NPV = $1,222

(b) PVn = PMT (PVIFAk%,n)

$18,250 = $4,000 (PVIFAk%,7yrs.)
$18,250  $4,000 = (PVIFAk%,7 yrs.)
4.563 = PVIFAk%,7 yrs.
IRR = 12%

(c) The project should be accepted since the NPV 0 and the IRR the cost of
capital.
9–15 NPV, with rankings
Botany Bay, Inc., a maker of casual clothing, is considering four projects. Because
of past financial difficulties, the company has a high cost of capital at 15%.
Which of these projects would be acceptable under those cost circumstances?

a. Calculate the NPV of each project, using a cost of capital of 15%.

b. Rank acceptable projects by NPV.

Answer:
(a) NPVA = $20,000(PVIFA15%,3) - $50,000
NPVA = $20,000(2.283) - $50,000
NPVA = $45,660 - $50,000 = - $4,340
Reject

NPVB = $35,000(PVIF15%,1) + $50,000(PVIFA15%,2) (PVIF15%,1) - $100,000

NPVB = $35,000(0.870) + $50,000(1.626)(0.870) - $100,000
NPVB = $30,450 + $70,731- $100,000 = $1,181
Accept

NPVC = $20,000(PVIF15%,1) + $40,000(PVIF15%,2) + $60,000(PVIF15%,3) - $80,000

NPVC = $20,000(0.870) + $40,000(0.756) + $60,000(0.658) - $80,000
NPVC = $17,400 + $30,240 + 39,480 - $80,000 = $7,120
Accept
NPVD = $100,000(PVIF15%,1) + $80,000(PVIF15%,2) + $60,000(PVIF15%,3)- $180,000
NPVD = $100,000(0.870) + $80,000(0.756) + $60,000(0.658) - $180,000
NPVD = $87,000 + $60,480 + 39,480 - $180,000 = $6,960
Accept
9–16 All techniques, conflicting rankings Nicholson Roofing
Materials, Inc., is considering two mutually exclusive projects, each
with an initial investment of $150,000. The company’s board of
directors has set a 4-year payback requirement and has set its cost of
capital at 9%.

a. Calculate the payback period for each project.

c. Calculate the NPV of each project at 9%.

(c)NPVA = $45,000(PVIFA9%,6) - $150,000
NPVA = $45,000(4.486) - $150,000
NPVA = $201,870 - $150,000 = $51,870

NPVB = $75,000(PVIF9%,1) + $60,000(PVIF9%,2) + $30,000(PVIFA9%,4)(PVIF9%,2)

- $150,000
NPVB = $75,000(0.917) + $60,000(0.842) + $30,000(3.24)(0.842) - $150,000
NPVB = $68,775 + $50,520 + $81,842 - $150,000 = $51,137
9–17 Payback, NPV, and IRR Rieger International is attempting to evaluate
the feasibility of investing $95,000 in a piece of equipment that has a 5-
year life. The firm has estimated the cash inflows associated with the
proposal as shown in the following table. The firm has a 12% cost of
capital.
(c)
IRR 15%

(d) NPV $9,085; since NPV 0; accept

IRR 15%; since IRR 12% cost of capital; accept
The project should be implemented since it meets the decision criteria for both
NPV and IRR.
9–18 NPV, IRR, and NPV profiles Thomas Company is considering two
mutually exclusive projects. The firm, which has a 12% cost of capital, has
estimated its cash flows as shown in the following table.

a. Calculate the NPV of each project, and assess its acceptability.

b. Calculate the IRR for each project, and assess its acceptability.
 problem 9-14 page 342

• project x
• average annuity = (100+120+150+190+250) / 5 =162
• PVIFA = 500/162 = 3.0864
• there is 3.058 on table A-4 at 5 years & 19% there is 3.127 at 5 years & 18%
• approximately IRR between 17% & 16% because the bigger cash flows at end of the life of the
project
• IRR for project X bigger than cost of capital (15%) accept X
• project Y
• average annuity = (140+120+95+70+50) /5 = 95
• PVIFA = 325 /95 =3.421
• There is 3.433 on table A-4 at 5 years &14% and there is 3.352 at 15%
• approximately IRR between 16% & 17% because the bigger cash flows at the beginning years of the
project
• IRR for project bigger than cost of capital (15%) accept Y
• Y is preferred because the bigger cash flows at the beginning years of the project
• if you try (like slide 42 of ch 9 power point )you find IRR for project x = 16 , project y =17
approximately
•