Capital Budgeting

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Capital Budgeting
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Instructor
Date

Capital Budgeting

Question 1
Proficient-level: Describe the Net Present Value (NPV) method for determining a capital
budgeting project's desirability. What is the acceptance benchmark when using NPV?
By computing the difference between the present value of a projects inflows and
outflows, the NPV method measures the expected increase form taking on the project. Since the
NPV is a sum of all present values of cash flows in and out for the project, any NPV equal to or
greater than zero means the project should be accepted. An NPV of less than zero means the
project should be rejected. This is the simple benchmark for acceptance. The NPV method for
determining a capital budgeting projects desirability works well for both independent projects
and for selecting from mutually exclusive projects. This is because the statistic is dollars and not
a ratio. However, this strength of the NPV method is also its weakness. Because the statistic is in
dollar format, managers may inaccurately measure this against the cost of the project,
misunderstanding that the cost of the project is already included in the statistic (Cornett,Adair, &
Nofsinger, 2016)
Distinguished-level: Identify the NPV method's strengths and weaknesses.
Strengths of NPV
Recognizes the concept of the time value of money
Gives a decision rule for either acceptance or rejection
Uses cash flows of the project and not accounting profits
It is consisted with the maximization principle
It is consisted with value addition
Weaknesses of NPV

Requires the estimation of future cash flows

It is very sensitive to discount rates

Question 2

Capital Budgeting

Proficient-level: What is the payback period statistic? What is the acceptance benchmark
when using the payback period statistic?
Assuming that the cash flows are normal and all of the outflows for a project happen at
the beginning of a projects life, the payback period statistic is the recovery period to the point
that the initial outflows or investment, are exactly offset by the inflows. One additional
assumption that must be made is that the cash inflows will come in smoothly over the period,
thus allowing the months and days to recoup of the initial outflow to be counted. The benchmark
for acceptance of a project using the payback statistic of measurement is if the maximum
allowable payback period is less than or equal to the calculated payback period. If it is greater
than the maximum allowable payback period, then the project should be rejected.
Distinguished-level: Identify what problem of the Payback Period method is corrected by
using the Discounted Payback Period method.
The payback period statistic does not allow for the time value of money. Therefore, to
compensate for this, the discount payback statistic is used. This method merely uses the present
values of the cash flows until a sum of zero is met, instead of summing the actual cash flows as
in the payback period method. Simply put, the discounted payback method determines how
quickly a project will return the cash flows of the initial investment plus interest. The benchmark
for acceptance is often set in the same arbitrary method, but includes the discounted payback vs.
just the payback. This will be slightly longer than the PB method (Cornett, Adair, & Nofsinger,
2016)
Question 3

Capital Budgeting

Proficient-level: Describe the Internal Rate of Return (IRR) method for determining a
capital budgeting project's desirability. What is the acceptance benchmark when using
IRR?
The internal rate of return (IRR) method for choosing projects is very similar to the net
present value method except it calculates for the internal rate of return instead of using a known
interest rate. A general rule of thumb to use this method is that the project has normal cash flows
and that it is being used to evaluate the project independently of other projects. The acceptance
benchmark for IRR is if the IRR is equal to or greater than the cost of capital. Or, the project
with the highest IRR would be accepted. If the IRR is less than the cost of capital, then the
project would be rejected(Cornett, Adair, & Nofsinger, 2016)
Distinguished-level: Explain how the NPV and IRR methods are similar and how they are
different.
NPV and IRR are similar in the fact that they both use the time value of money. NPV
method solves for the present value for a stream of cash flows given a discount rate. IRR on the
other hand, tells you what the rate of return is when the NPV is set to zero. Another way of
explaining the difference is, IRR tells you what rate of return you will achieve given a set of cash
flows, while NPV tells you what the set of cash flows is worth in todays dollars at a particular
discount rate. Another difference is that NPV is measured in dollars while IRR is measured in
percentage rate of return. IRR does not work well with non-normal cash flows while NPV does.
Finally, NPV works well for choosing among projects and IRR does not.
Question 4

Capital Budgeting

Proficient-level: Describe the Modified Internal Rate of Return (MIRR) method for
determining a capital budgeting project's desirability. What are MIRR's strengths and
weaknesses?
The Modified Internal Rate of Return (MIRR) calculates IRR by modifying the set of
cash flows to account for the cost of capital prior to calculating the IRR. This modification is
done by taking all the negative cash flows of a non-normal cash flow set and moving them to the
initial zero period or project start date. All of the positive cash flows are moved to the project
termination date. Once this is done, then IRR can be calculated as in the IRR method (Cornett,
Adair, & Nofsinger, 2016).
Strengths: MIRR is a better and improved method for project evaluation as it obviates all the
shortcomings of normal IRR and NPV methods. It takes into consideration the practically
possible reinvestment rate. The calculation is also not a rocket science.
Weaknesses: The disadvantage of MIRR is that it asks for two additional decisions i.e.
determination of financing rate and cost of capital. These can be estimates again and the
managers in real life may hesitate in involving these two additional estimates.
Distinguished-level: Explain the differences in the reinvestment rate assumption that
distinguishes MIRR from IRR.
This corrects the problem of IRR not being able to be used on projects with non-normal
cash flows in addition to correcting IRRs incorrect and unreasonable re-investment rate
assumptions. However, it does not solve the problem of choosing the wrong mutually exclusive
project for a set range of rates. To sum, MIRR uses the same benchmark of capital cost that IRR
does, uses the time value of money and works well with non-normal cash flows. However IRR
does not work well for choosing among MIRR also benefits over IRR because it does not assume

Capital Budgeting

that all cash flows will be re-invested in projects with the same rate of return. In other words,
IRR assumes the same rate of return for all cash flows as the initial project. MIRR solves for this
by converting a projects cash flow using a more consistent re-investment rate before applying
the IRR benchmark for decision.
Question 5
Proficient-level: Compute the NPV statistic for Project Y and tell [advise] whether the firm
should accept or reject the project with the cash flows shown in the chart if the appropriate
cost of capital is 12 percent.

years
0
1
2
3
4
NPV

Cash flow

Discount rate

Discounted cash

-8000
3350
4180
1520
300

12%
1
0.8929
0.7972
0.7119
0.6355

flow
-8000
2991.215
3332.296
1082.088
190.65
-403.751

Decision: the project should be rejected since its NPV is < 0

Distinguished-level: Explain how decreases in the cost of capital lead to an increase in the
number of approved projects. Show solving problem
Project Y
Time
0
1
Cash Flow
-$8,000
$3,350
(Cornett, Adair, & Nofsinger, 2016, p. 332).

2
$4,180

3
$1,520

4
$300

Decrease in the cost of capital makes the values of the discounted cash to be more thus
making the cumulative total present values of futures cash flows to be more and consequently
making the NPV to be positive

Capital Budgeting

Question 6
Proficient-level: Compute the payback period statistic for Project A and recommend
whether the firm should accept or reject the project with the cash flows shown in the chart
if the maximum allowable payback is four years.
Year
0
1
2
3
4

Cash flows
-1000
350
480
520
100

Cumulative cash flows

-1000
650
170
350
450

PBP= YEAR TO FULL RECOVER + BALANCE TO FULL RECOVERY

CASH RECEIVED FOLLOWING YEAR
=2+ 170/520
=2 + 0.326
=2 years 4 months

Distinguished-level: If the discounted payback period were computed, identify if it would

be less than, equal to, or greater than the non-discounted payback period. Show solving
problem
Project A

Capital Budgeting
Time
0
Cash Flow
-$1,000
(Cornett, Adair, & Nofsinger, 2016).

8
1
$350

2
$480

3
$520

4
$300

5
$100

If discounted payback period were computed, the payback period will be greater than the
non-discounted payback period
This is because the discounted cash flows will be less thus implying that a longer period will be
taken to recover the initial investment
Question 7
Chapter 13 in the M: Finance textbook by Cornett, Adair, and Nofsinger discusses various
criteria for calculating and analyzing the desirability of a capital budgeting project. This
task is extremely important as these projects often entail very large cash outflows and may
significantly determine the future profitability of the firm. Examine Chapter 13, with
particular emphasis on each of the six capital budgeting techniques reviewed. Assume the
role of chief financial executive of a firm that is analyzing a major project that entails a
large initial cash outflow at time point zero and has future expected cash inflows occurring
over the next 10-year period.
-If you could select only three techniques to analyze this project's desirability, which three
techniques would you select? Why?
I would choose the IRR, discounted payback period rule and NPV.IRR and NPV evaluate
projects and usually provide similar findings. Because IRR major limitation is also its greatest
strength the usage of single discount rate for evaluation of every project, it can cause problems
if two projects are evaluated, dont share a common discount rate, predictable cash flow, equal
risk and shorter time horizon. However, the discount rate usually changes over time significantly.
NPR captures these changes slightly better. MIRR is more complicated to calculate, but provides

Capital Budgeting

a healthy measure in regards to acceptability of a project. When we evaluate projects to be

funded within any given fiscal year, we use a hybrid calculation between NPV and IRR so that I
can properly justify investments to upper management. I first calculate the IRR for numerous
projects while comparing the winners IRR with the discounted payback ratio. With these
calculations (and associated pie charts to better explain these concepts) I usually convince the
Ambassador that a new car, copier or Fullbright project is worth the expense.
-When analyzing a project's desirability, which factor do you believe is more important: the
technique to analyze investment acceptability, or the use of the most accurate projections of
cash flows? Why?
Both sides of this 'equation' are quite interdependent on each other - the wrong method
with accurate projections of cash flows can yield interesting results, while the right method
chosen within understated (or overstated) cash flows can misconstrue the data. However I
believe that accurate projections of cash flows are more important as they better capture the
future payback of projects. One would assume professionals making these assumptions are
experts in their fields and would therefore be able to properly estimate these cash flows

Capital Budgeting

10
Reference

Cornett, M. M., Adair, T. A., & Nofsinger J. (2016). M: Finance (3rd ed.). New York, NY:
McGraw-Hill.