6/3/2025
6-0
Capital Budgeting
Some Alternative
Investment Rules
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-1
Why Use Net Present Value?
Accepting positive NPV projects benefits shareholders.
Example
Riskless project:
Initial cost: 100; unique cash flow in one year: 107; discount rate: 6 %
NPV = 0.94
If the project is forgone: bank deposit 100 106 in one year the
project benefits shareholders (absolute opportunity cost: 6)
Firm value without project: V + 100; with project: V + 107/1.06
Risky project:
About as risky as the stock market: expected return (=required return) =
10 % NPV < 0
Opportunity cost = expected return on stock market = 10 %
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-2
The Net Present Value (NPV) Rule
Net Present Value (NPV) =
Total PV of future CF’s - Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-3
Good Attributes of the NPV Rule
1. Uses cash flows
2. Uses ALL cash flows of the project
3. Discounts ALL cash flows properly
Reinvestment assumption: the NPV rule assumes
that all cash flows can be reinvested at the
discount rate.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-4
The Payback Period Rule
How long does it take the project to “pay back”
its initial investment?
Payback Period = number of years to recover
initial costs
Minimum Acceptance Criteria:
set by management
Ranking Criteria:
set by management
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-5
The Payback Period Rule (continued)
Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback criteria may
not have a positive NPV
Advantages:
Easy to understand
Biased toward liquidity
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-6
The Payback Period Rule (continued)
Year A B C
0 -100 -100 -100
1 20 50 50
2 30 30 30
3 50 20 20
4 60 60 60,000
Payback period (years) 3 3 3
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-7
The Payback Period Rule (continued)
Managerial perspective
Used by large, sophisticated companies when making
relatively small decisions
Desirable features for managerial control: shorter time to
evaluate the manager’s decision-making ability
Also used by firms with good investment opportunities but no
or little cash available
Practitioners: academic criticisms of payback overstate real-
world problems (e.g., project C)
Bigger projects: NPV becomes the order of the day
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-8
The Discounted Payback Period Rule
How long does it take the project to “pay back”
its initial investment taking the time value of
money into account?
By the time you have discounted the cash flows,
you might as well calculate the NPV.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-9
The Average Accounting Return Rule
Average Net Income
AAR
Average Book Value of Investment
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6-10
The Average Accounting Return Rule
Another attractive but fatally flawed approach.
Ranking Criteria and Minimum Acceptance Criteria set
by management
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market values
Advantages:
The accounting information is usually available
Easy to calculate
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-11
The Internal Rate of Return (IRR) Rule
IRR: the discount that sets NPV to zero
Minimum Acceptance Criteria:
Accept if the IRR exceeds the required return.
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested at the IRR.
Disadvantages:
Does not distinguish between investing and borrowing.
IRR may not exist or there may be multiple IRR
Problems with mutually exclusive investments
Advantages:
Easy to understand and communicate
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-12
The Internal Rate of Return: Example
Consider the following project:
$50 $100 $150
0 1 2 3
-$200
The internal rate of return for this project is 19.44%
$50 $100 $150
NPV 0
(1 IRR) (1 IRR) (1 IRR)3
2
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-13
The NPV Payoff Profile for This Example
If we graph NPV versus discount rate, we can see the
IRR as the x-axis intercept.
Discount Rate NPV $120.00
0% $100.00 $100.00
4% $71.04
$80.00
8% $47.32
12% $27.79 $60.00
16% $11.65 $40.00
NPV
20% ($1.74) IRR = 19.44%
$20.00
24% ($12.88)
28% ($22.17) $0.00
32% ($29.93) ($20.00)
-1% 9% 19% 29% 39%
36% ($36.43) ($40.00)
40% ($41.86)
($60.00)
Discount rate
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-14
Problems with the IRR Approach
Multiple IRRs.
Are We Borrowing or Lending?
The Scale Problem
The Timing Problem
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-15
Problems with the IRR Approach
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-16
Multiple IRRs
There are two IRRs for this project:
$200 $800
Which one
0 1 2 3 should we use?
-$200 - $800
NPV $100.00
100% = IRR2
$50.00
$0.00
-50% 0% 50% 100% 150% 200%
($50.00)
0% = IRR1 Discount rate
($100.00)
($150.00)
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-17
Summarizing rules
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-18
The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment
while the 50% return is on a $1,000 investment?
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-19
The Timing Problem
$10,000 $1,000 $1,000
Project A
0 1 2 3
-$10,000
$1,000 $1,000 $12,000
Project B
0 1 2 3
-$10,000
The preferred project in this case depends on the discount rate, not
the IRR.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-20
The Timing Problem
$5,000.00
$4,000.00
Project A
$3,000.00
Project B
$2,000.00
10.55% = crossover rate
$1,000.00
NPV
$0.00
($1,000.00) 0% 10% 20% 30% 40%
($2,000.00)
($3,000.00)
($4,000.00) 12.94% = IRRB 16.04% = IRRA
Discount rate
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-21
Calculating the Crossover Rate
Compute the IRR for either project “A-B” or
“B-A”
Year Project A Project B Project A-B Project B-A
0 ($10,000) ($10,000) $0 $0
1 $10,000 $1,000 $9,000 ($9,000)
2 $1,000 $1,000 $0 $0
3 $1,000 $12,000 ($11,000) $11,000
$3,000.00
$2,000.00
10.55% = IRR
$1,000.00
A-B
NPV
$0.00
B-A
($1,000.00) 0% 5% 10% 15% 20%
($2,000.00)
($3,000.00)
Discount rate
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-22
Mutually Exclusive vs.
Independent Project
Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring an
accounting system.
RANK all alternatives and select the best one.
Independent Projects: accepting or rejecting one project
does not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-23
The Profitability Index (PI) Rule
Total PV of Future Cash Flows
PI
Initial Investment
Minimum Acceptance Criteria:
Accept if PI > 1
Ranking Criteria:
Select alternative with highest PI
Disadvantages:
Problems with mutually exclusive investments
Advantages:
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-24
The Profitability Index (PI) Rule
Independent projects
Accept if PI > 1
Reject if PI < 1
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-25
The Profitability Index (PI) Rule
Mutually exclusive projects
PI may lead to wrong selection
This flaw can be corrected using incremental analysis
In case of capital rationing: PI may be useful
3 independent projects, limited funds: $20 million
Project 3:
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
6-26
6.8 The Practice of Capital Budgeting
Varies by industry:
Some firms use payback, others use accounting rate of
return.
The most frequently used technique for large
corporations is IRR or NPV.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-27
Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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Example of Investment Rules
Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80
NPV = $41.92 $90.80
IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-29
Example of Investment Rules
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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Relationship Between NPV and IRR
Discount rate NPV for A NPV for B
-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
6-31
NPV Profiles
$400
NPV
$300
IRR 1(A) IRR (B) IRR 2(A)
$200
$100
$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100)
($200)
Project A
Discount rates
Cross-over Rate Project B
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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6/3/2025
7-32
Incremental Cash Flows
Cash flows matter—not accounting earnings.
Incremental cash flows matter.
Cash flows with project – cash flows without project
Sunk costs don’t matter.
Sunk costs: cost already occurred, cannot be changed by
the decision to accept or reject the project.
Opportunity costs matter.
e.g., by taking a project, a firm forgoes other
opportunities for using an asset.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
7-33
Incremental Cash Flows (cont.)
Side effects
Erosion: e.g., a new product reduces the cash flows
of existing products
Synergy: e.g., a new product increases the cash flows
of existing products
Allocated costs
An expenditure may benefit a number of projects
Viewed as cash outflow only if it is an incremental
cost of the project
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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Cash Flows—Not Accounting Earnings
Consider depreciation expense.
You never write a check made out to
“depreciation”.
Much of the work in evaluating a project
lies in taking accounting numbers and
generating cash flows.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
7-35
Incremental Cash Flows
Sunk costs are not relevant
Just because “we have come this far” does not mean
that we should continue to throw good money after
bad.
Opportunity costs do matter. Just because a
project has a positive NPV that does not mean
that it should also have automatic acceptance.
Specifically if another project with a higher NPV
would have to be passed up we should not
proceed.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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Incremental Cash Flows
Side effects matter.
Erosion and cannibalism are both bad things.
If our new product causes existing customers
to demand less of current products, we need to
recognize that.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
7-37
Estimating Cash Flows
Cash Flows from Operations
Recall that:
Operating Cash Flow = EBIT – Taxes + Depreciation
Net Capital Spending
Don’t forget salvage value (after tax, of course).
Changes in Net Working Capital
Recall that when the project winds down, we enjoy a
return of net working capital.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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Interest Expense
Later chapters will deal with the impact that
the amount of debt that a firm has in its
capital structure has on firm value.
For now, it’s enough to assume that the
firm’s level of debt (hence interest expense)
is independent of the project at hand.
Capital Budgeting Associate Prof. Nguyen Viet Dzung, PhD.
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