Finc 4301

Prof. M. Hassanein

Review of Capital Budgeting

Techniques
I have drawn liberally
on chapter Six of
Richard A. Brealey &
Stewart C. Mayers.
Principles of Corporate Finance
9th edition,
Macgraw-Hill- Irwin, 2008.
Professor:
Medhat Hassanein

Why NPV leads to better investment decisions

Than other criteria

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Prof. M. Hassanein

Selection criteria for investment projects

(Capital Budgeting Techniques)

Example: Fitch Industries is in the process of choosing the better of two

equal-risk, mutually exclusive capital expenditure projects- M and N. The
relevant cash flows for each project are shown in the following table.
The firms cost of capital is 14%.

Project M Project N
$28,500
$27,000

Initial Investment
Year
1
2
3
4

CF(M)
10,000
10,000
10,000
10,000

CF(N)
11,000
10,000
9,000
8,000

Calculate for each project:

a) Payback
b) Net Present Value (NPV)
c) Internal Rate of Return (IRR)
d) Discounted payback period
e) Profitability Index (PI)
f) Modified Internal Rate of Return (MIRR)
g) Select the appropriate project based on the above calculated
investment criteria.

Finc 4301

Prof. M. Hassanein

Review of Capital Budgeting Techniques

Payback Period:
Definition: is the amount of time required for the firm to recover its initial investment in a
project, as calculated from cash inflows.
Project M

Payback = 28,500 / 10,000

= 2.85 years

Project N

11,000 + 10,000 = 21,000

27,000 21,000 = 6,000
6,000 / 9,000 = 0.67
Payback = 2.67 years
Decision: select the project N since it has a shorter payback period.

Net Present Value (NPV):

Definition:
NPV = Discounted cash flows (DCF) at the weighted average cost of
Capital minus initial investment.
NPV =

CF 1 +
(1+WACC)

NPV = - I +

CF n

n=1

(1+WACC)n

CF2
(1+WACC)2

Decision Rule: For selection and ranking projects:

1. Select the project with NPV > 0
Reject the project with NPV< 0
2. Rank projects according to higher NPV
NPV for project M:
DCF = 10,000 (PVIFA) .14, 4
= 10,000 (2.914)
= $ 29,140
NPV = $29,140 - 28,500
= $ 640
NPV by the financial calculator = $637.1

+.

CFn

(1+WACC)n

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Prof. M. Hassanein

NPV for project N:

DCF = 11,000 (PVIF)1, .14

= 11,000 (.877) = $ 9,647

+ 10,000 (PVIF)2, .14 = 10,000 (.769) =

7,690

+ 9,000 (PVIF)3, .14 = 9000 (.675) =

6,075

+ 8,000 (PVIF)4, .14 = 8,000 (.592) =

4,736
$ 28,148

NPV = 28,148 27,000

= $1,148
Decision: Select project N because NPVN = $1,148 is greater than NPVM = $640

The Internal Rate of Return (IRR):

Definition:
The IRR is the rate of discount which makes NPV = 0
i.e.
N
0 = -I +
CFn
n = 1 (1+IRR) n
IRR for Project M:
0 = -28,500 + 10,000 (PVIFA)4,?
28,500 = 10,000 (PVIFA)4,?
(PVIFA)4,? = 2.850
Use PV of annuity table to search for the rate corresponding to 2.850 and 4 years.
The rate is 15% which is the IRR.
Financial calculator is 15.1%
IRR for Project N:
Search by trial and error. Try 16% to find DCF
11,000 (PVIF) .16,1 = 11,000 (.862) = $9482
+ 10,000 (PVIF) .16,2 = 10,000 (.743) = 7430
+ 9,000 (PVIF) .16,3 = 9,000 (.641) = 5769
+ 8,000 (PVIF) .16,4 = 8,000 (.552) = 4416
DCF = $27,097
NPV = 27,097 27,000
= 97
Therefore the IRR 16 %
Financial calculator is 16.2 %
Decision: Choose project N since:

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Prof. M. Hassanein

IRRN = 16%

is > IRRM = 15%

Additional Capital Budgeting Techniques

Discounted Payback:
Project M:
1- Discount project Ms cash flow at WACC
2- Find the number of years at which the accumulated discounted cash flow = initial
investment.

Discounted cash flow:

Year
1
2
3
4

DCF
10,000 (.877) = 8,770
10,000 (.769) = 7,690
10,000 (.675) = 6,750
10,000 (.592) = 5,920

ACC.DCF
8,770
16,460
23,210
29,130

28,500 23,210 = 5,290

5,290 / 5,920 = .9
Discounted payback for project M = 3.9 years
Project N:
Year

DCF

ACC.DCF

1
2
3
4

9,647
7,690
6,075
4,736

9,647
17,337
23,412
28,148

27,000 23,412 = 3,588

3,588 / 4,736 = .76
Discounted payback for project N = 3.76 years.
Decision: Select project N since it has shorter discounted payback period.

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Prof. M. Hassanein

Profitability Index (PI):

PI = NPV / Initial investment
Project

M:

PI = 640 / 28,500
= 0.0224
= 2.24 %
Project

N:

PI = 1,148 / 27,000
= 0.0425
= 4.25 %
Decision rule: The higher the PI, the better is the project.
It means that a highest PI offers the highest NPV per dollar of initial investment.
Therefore, select project N, since PIN > PIM.

Capital Rationing:
Choosing capital investments when financial resources are limited.
The selection criteria is the Profitability Index
Example:
Suppose that a firm is limited to spending $10 million on investment projects. The firm has
three projects and it needs a method of selecting the package of projects that is within its
resources, yet gives the highest net present value.
The three projects are as follows:

Project

Initial investment

A
-10
B
-5
C
-5
Calculate PI for each project

Cash Flows
C1
C2
30
5
5

($ millions)
NPV at 10%

5
20
15

21
16
12

Project

Initial Investment

PI

Rank by PI

A
B
C

$ 10
5
5

2.1
3.2
2.4

Third
First
Second

Decision: select projects B and C because total investment 5 + 5 = $10 m

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Prof. M. Hassanein

= Firm's investment budget and both have the highest NPV

Modified Internal Rate of Return (MIRR):

There are two propositions regarding the IRR criteria
Preposition one:
There is an important assumption behind the IRR selection or ranking criteria. This assumption
is that the generated cash flow from any selected or ranked project will be reinvested at the
project's IRR.
If the firm cannot reinvest the generated cash flow at the project's IRR, for example, it can only
at the WACC, therefore the project's IRR will not be the calculated IRR; it will certainly be
less than this IRR.
Example: Project N has an IRR = 16 %
Assume one of two assumptions:
1- The firm is able to reinvest the cash flow generated by this project at
16%
2- The firm is not able to reinvest the cash flow of project N at 16 %,
rather at WACC = 14 %
Find the IRR of each one of the two assumptions.
To find the IRR under the first assumption i.e.: the reinvestment rate is the calculated IRR
which is the 16 %, follow the following steps:
Step one:
Find the sum of the future value of the project's generated cash flow at the end of its economic
life (N) at the IRR.
Project N:
Year
1

Cash flow
$ 11,000

Fv of cash flow at 16 %
11,000 (FVIF) 3, .16 = 11,000 (1.561) = 17,171

10,000

10,000 (FVIF) 2, .16 = 10,000 (1.346) = 13,460

9,000

9,000 (FVIF) 1, .16 = 9,000 (1.160) = 10,440

8,000

8,000 (FVIF) 0, .16 = 8,000 (1.0)

= 8,000

Sum of future value of CFs at year 4 = $ 49,071

Step two:
Find the rate of discount which equates the sum of the discounted future cash flow obtained
from step one with the initial investment of project N.
27,000

= 49,071 (PVIF) 4,?

(PVIF) 4,? = 27000 / 49,071

= 0.5Search in the present value table for the rate of discount
corresponding to the factor 0.550 at the 4 year row.
The rate is 16 %
7

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Prof. M. Hassanein

Conclusion: The calculated IRR is the IRR of the project.

Find the IRR under the second assumption i.e.: the firm does not have investment opportunities
to reinvest the generated cash flow at the IRR = 16 %, rather it can reinvest this cash flow at
the WACC, which is its opportunity cost i.e.: 14 %
Step one:
Repeat the same step one as before, but the rate at which the generated cash flow will be
compounded is the WACC = 14 %

Years

Cash flow

FV Cash flow at WACC = 14 %

$ 11,000

11,000 (1.482) .14,3 = 16,302

10,000

10,000 (1.300) .14,2 = 13,000

9,000

9,000 (1.140) .14,1 = 10,260

8,000

8,000 (1) .14,0

= 8,000

Sum of future value of CFs at year 4 = 47,562

Step Two:
Repeat the same step two as before i.e. find the rate of discount which equates the sum of the
discounted future cash flow obtained from step one with the initial investment of the project.
27,000 = 47,562 (PVIF) 4,?
(PVIF) 4,? = 27,000 / 47,562
= 0.5677
The rate is 15%
Or by financial calculator = 15.2%
You can see that the internal rate of return of project N is not 16%, it is 15%. The reason is that
the firm reinvestment rate is not 16%, it is its WACC = 14%. This is a very reasonable
assumption, and it makes the NPV method more superior to the IRR. As you know NPV
discounts cash flows at WACC.
The 15% calculated by steps one and two under assumption (2) i.e. the reinvestment rate is the
WACC is called the Modified Internal Rate of Return (MIRR).
How do you calculate the MIRR?
Step one:
Find the sum of the future value of the project's generated cash flow at the end of its economic
life (N), using the weighted Average Cost of Capital (WACC) as the compounding rate.
Step two:
Then, the MIRR is the rate of discount which equates the sum of the discounted cash flow
obtained from step one with the initial investment of the project.

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Prof. M. Hassanein

Example:
MIRR for project M.
(FVA) 4, .14 = 10000 (FVIFA) 4, .14
= 10,000(4.921)
= $49,210
28,500 = 49,210 (PVIF)4,?
By the financial calculator: MIRR= 14.63% and not IRR= 15.1%

Decision rule: Select the project with the highest Modified IRR.
Therefore select project N since MIRRN = 15 % which is greater than
MIRRM = 14.63 %
Preposition two: (The Multiple IRR Paradox)
If the expected cash flows of a project double the change of the negative sign then it is more
than likely that the solution for IRR will result in multiple of IRRs.
Example: Suppose that the cash flow of a Mining Project is as follows:

NCF ($)

0
-1,000

1
800

2
150

3
150

4
150

5
150

6
-150

Assume that WACC = 10 %

Then
NPV = $ 74.87
If we calculate IRR by using certain type of financial calculator, you will find that this cash
flow has two IRRs. One IRR = 15.2 %, and the second IRR = -50 %.
The IRR fails in this case as a method of project selection or ranking.
However, you can find the MIRR for this project as follows:
MIRR
PV = -150 (PVIF)6, .10
= -150 (.564)
= -84.6
Add to initial investment
-1000 84.6 = $ -1084.6
FV of cash flow
800 (FVIF)5,.10 = 800 (1.611) = 1,288.8
+ 150 (FVIFA)4,.10 (FVIF)1,.10

= 150 (4.641) (1.10)

= 765.8

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Prof. M. Hassanein
= $ 2,054.6

Then search for MIRR:

1084.6 = 2,054.6 (PVIF)6,?
(PVIF)6,? = 1084.6 / 2,054.6
= .5279
MIRR 11 %
Financial calculator
11.23 %

OR
FV of cash flow at 10%
2054.6
- 150.0
1904.6

PV = 1000
1000 = 1904.6 (PVIF) 6,?
MIRR= 11.34%

10