13

Weighing Net Present

Value and Other Capital
Budgeting Criteria
Finance 3rd Edition

Cornett, Adair, and Nofsinger

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

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

IRR 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 of other projects

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

NPV and IRR assumptions differ re:

reinvestment of cash flows

IRR assumes reinvestment in another project

with same earning power

NPV assumes investment are reinvested at

cost of capital
NPVs reinvestment rate assumption is

considered superior to IRRs

13-21

Modified Internal Rate of Return

Fixes IRR reinvestment rate problem
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 IRRs 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 projects

13-25