CAPITAL BUDGETING ANALYSIS

Capital budgeting analysis is a process used to evaluate potential projects a company may choose as investments. Key
methods used in capital budgeting include NPV, IRR, MIRR, PI, payback, and discounted payback.

In the following problem demo, you will analyze two competing and mutually exclusive projects using NPV and IRR
calculations. Your goal will be investment in a project that generates maximum wealth and value for both the firm and its
investors. Optimal investments are worth more than they cost.

Use the tabs at the bottom of the Excel window to navigate through the seven sheets of information. On each sheet in this
document, first review the content and then examine how that information applies to the two project options. After reviewing
all the information, you will review questions that will help you decide which project you will recommend.

Scenario
Elliott Enterprises is considering two investment projects. It will be your responsibility to analyze each of
the projects based on NPV, IRR, MIRR, PI, payback, and discounted payback assuming that the two
projects are mutually exclusive.

Evaluate each project assuming the following scenarios:

a) Cost of capital of 12 percent.
b) Cost of capital of 18 percent.

Expected Net Cash Flows

Year Project A Project B
0 (485) (650)
1 (400) 205
2 (225) 225
3 (75) 225
4 800 225
5 800 250
6 975 250
7 (100) -
Note: Examples of formula calculations in Excel are shown.
vestments. Key

nd IRR
e firm and its

ch sheet in this
s. After reviewing
Net Present Value (NPV) and Internal Rate of Return (IRR)
Net present value (NPV) and internal rate of return (IRR) are two of the more common methods used when analyzing capital
budgeting decisions.

NPV evaluates the benefits of a project vs. the present value costs of a project. Typically, a project will require an initial cash
outlay or start up cost followed by positive cash inflows. The NPV method discounts cash flows at the project’s cost of capital and
then sums those cash flows. The project should be accepted if the NPV is positive (i.e., the project is worth more than its cost). A
positive NPV will result in an increase in shareholder value in the firm. NPV is typically viewed as the best method for evaluation in
capital budgeting, but should not be the only decision making method used by a firm. NPV does have its limitations. NPV assumes
that management can make accurate predictions as to future cash flows. The longer the project, the harder it will be to make
accurate estimates of future cash flows. NPV assumes that the discount rate will remain constant over the life of the project. In
reality, the discount rate is affected by costs of capital, future interest rates and future use of cash flows.
Net Present Value
Net present value = sum of the present value of all cash flows.
r= 12%
Project A
Time period: 0 1 2 3 4 5 6 7
Cash flow: (485) (400) (225) (75) 800 800 975 (100)
Discounted cash flow: (485.00) (357.14) (179.37) (53.38) 508.41 453.94 493.97 (45.23)

NPV = 336.19 = sum of discounted cash flows

or use NPV function $336.19

Project B
Time period: 0 1 2 3 4 5 6 7
Cash flow: (650) 205 225 225 225 250 250 -
Discounted cash flow: (650.00) 183.04 179.37 160.15 142.99 141.86 126.66 -

NPV = 284.06 = sum of discounted cash flows

or use NPV function $284.06
 r= 18%
Project A
Time period: 0 1 2 3 4 5 6 7
Cash flow: (485) (400) (225) (75) 800 800 975 (100)
Discounted cash flow: (485.00) (338.98) (161.59) (45.65) 412.63 349.69 361.17 (31.39)

NPV = 60.87 = sum of discounted cash flows

or use NPV function $60.87

Project B
Time period: 0 1 2 3 4 5 6 7
Cash flow: (650) 205 225 225 225 250 250 -
Discounted cash flow: (650.00) 173.73 161.59 136.94 116.05 109.28 92.61 -

NPV = 140.20 = sum of discounted cash flows

or use NPV function $140.20

The IRR method calculates the discount rate at which NPV is equal to zero. Accepting a project in which the IRR is greater than the
cost of capital will increase shareholder value in the firm. Unlike NPV, IRR assumes that cash inflows will be reinvested in other
projects at IRR rather than cost of capital. When using the IRR method, you should determine if the IRR represents a realistic rate
of reinvestment.

When evaluating independent projects, NPV and IRR will always yield the same decision (accepts or reject). When considering
mutually exclusive projects, the NPV method typically proves more reliable since it assumes that cash flows can be reinvested at
the cost of capital.

IRR
Project A = 19.65% ←
Project B = 25.83%
n analyzing capital

n initial cash
ost of capital and
than its cost). A
d for evaluation in
ons. NPV assumes
ll be to make
the project. In
 is greater than the
vested in other
ts a realistic rate

n considering
be reinvested at
Modified IRR Method (MIRR) and Profitability Index (PI)

The Modified IRR method (MIRR) is based on the same methodology as IRR, but uses modified cash flows. MIRR considers time
value of money based on WACC. MIRR is considered more realistic than IRR since cost of capital is used as reinvestment rate.

MIRR
r= 12%
Project A 16.28% ←
Project B 17.95%

r= 18%
Project A 18.94%
Project B 21.34%

Profitability index (PI) compares the present value of cash flows to the initial investment. Projects should be rejected if PI is
less than 1. PI compares the same values as the NPV method, but calculates a ratio rather than a dollar value.
Profitability Index (PI)
r= 12%
PV of
Future
Cash
Flows PI
Project A $821.19 1.69
Project B $934.06 1.44

r= 18%
PV of
Future
Cash
Flows PI
Project A $545.87 1.13
Project B $790.20 1.22
MIRR considers time
vestment rate.

rejected if PI is
Payback Method

Payback method ignores the time value of money, but is a widely used method due to its ease of calculation. Payback is similar
to breakeven and focuses on the time period in which the initial investment is repaid by analyzing cumulative cash flows.
Payback focuses on repayment of principal without considering interest since payback ignores time value considerations.
Payback is often used due to the method’s simplicity. Despite the fact that payback ignores the time value of money, it can be a
valuable measure to determine if capital will be repaid in a reasonable time period. It should not, however, be solely relied on in a
capital budgeting analysis since it does not provide a measure of profitability.

Payback
Project A
Time period: 0 1 2 3 4 5 6 7
Cash flow: (485) (400) (225) (75) 800 800 975 (100)
Cumulative cash flow: -485 -885 -1110 -1185 -385 415 1390 1290
% of year required for payback: 1.0000 1.0000 1.0000 1.0000 0.4813 0.0000 0.0000
Payback 4.4813

Project B
Time period: 0 1 2 3 4 5 6 7
Cash flow: (650) 205 225 225 225 250 250 -
Cumulative cash flow: -650 -445 -220 5 230 480 730 730
% of year required for payback: 1.0000 1.0000 0.9778 0.0000 0.0000 0.0000 0.0000
Payback 2.9778
 Payback is similar
cash flows.
iderations.
money, it can be a
solely relied on in a
Discounted Payback

Discounted payback uses similar methodology as the payback method, but focuses on cumulative present value rather than
cumulative cash flows. Discounted payback focuses on the time period in which the initial investment is repaid based on
cumulative present value of cash flows. Discounted payback considers repayment of both principal and interest since the time
value of money is considered when using this method.

Discounted Payback:
Project A
12%
Time period: 0 1 2 3 4 5 6 7
Cash flow: (485) (400) (225) (75) 800 800 975 (100)
Disc. cash flow: (485) (357) (179) (53) 508 454 494 (45)
Disc. cum. cash flow: (485) (842) (1,022) (1,075) (566) (113) 381 336
% of year required for payback: 1.0000 1.0000 1.0000 1.0000 1.0000 0.2278 0.0000
Discounted Payback: 5

Project B
12%
Time period: 0 1 2 3 4 5 6 7
Cash flow: (650) 205 225 225 225 250 250 -
Disc. cash flow: (650) 183 179 160 143 142 127 -
Disc. cum. cash flow: (650) (467) (288) (127) 16 157 284 284
% of year required for payback: 1.0000 1.0000 1.0000 0.8913 0.0000 0.0000 0.0000
Discounted Payback: 4
Project A
18%
Time period: 0 1 2 3 4 5 6 7
Cash flow: (485) (400) (225) (75) 800 800 975 (100)
Disc. cash flow: (485) (339) (162) (46) 413 350 361 (31)
Disc. cum. cash flow: (485) (824) (986) (1,031) (619) (269) 92 61
% of year required for payback: 1.0000 1.0000 1.0000 1.0000 1.0000 0.7445 0.0000
Discounted Payback: 6
Project B
18%
Time period: 0 1 2 3 4 5 6 7
Cash flow: (650) 205 225 225 225 250 250 -
Disc. cash flow: (650) 174 162 137 116 109 93 -
Disc. cum. cash flow: (650) (476) (315) (178) (62) 48 140 140
% of year required for payback: 1.0000 1.0000 1.0000 1.0000 0.5645 0.0000 0.0000
Discounted Payback: 5
alue rather than
based on
t since the time
Crossover Rate

Crossover rate represents cost of capital at which both projects have the same net present value. It is calculated by
finding the cash flow differential between two projects, then calculating IRR, and then NPV based on the calculated IRR.

Crossover Rate

Expected Net Cash Flows

Year Project A Project B Difference
0 (485) (650) 165
1 (400) 205 (605)
2 (225) 225 (450)
3 (75) 225 (300)
4 800 225 575
5 800 250 550
6 975 250 725
7 (100) - (100)

Crossover Rate = 14.09%

NPV at crossover rate = $229.66

 alculated by
calculated IRR.
Summary

Summary:
WACC = 12 percent WACC = 18 percent
Project A Project B Project A Project B
NPV $336.19 $284.06 $60.87 $140.20
IRR 19.65% 25.83% 19.65% 25.83%
MIRR 16.28% 17.95% 18.94% 21.34%
Profitability Index 1.69 1.44 1.13 1.22
Payback 4.4813 2.9778 4.4813 2.9778
Discounted Payback 5 4 6 5

Crossover Rate 14.09%

NPV at crossover rate $229.66

Points for Consideration

Based on the results of our analysis, which project would you ultimately recommend? Why?

How would you incorporate the results of your analysis into recommendations for
investment?

How would your recommendation(s) differ if the projects are independent (not mutually
exclusive)?

Would you ever accept a project if the NPV is less than 0? Why or why not?