Summary
This chapter has described six techniques (payback, discounted payback, NPV, IRR,
MIRR, and PI) that are used in capital budgeting analysis. Each approach provides a
different piece of information, so in this age of computers, managers often look at all of
them when evaluating projects. However, NPV is the best single measure, and almost
all firms now use NPV. The key concepts covered in this chapter are listed below:
Capital budgetingis the process of analyzing potential projects. Capital budget-
ing decisions are probably the most important ones managers must make.
The payback periodis defined as the number of years required to recover a proj-
ect’s cost. The regular payback method ignores cash flows beyond the payback
period, and it does not consider the time value of money. The payback does, how-
ever, provide an indication of a project’s risk and liquidity, because it shows how
long the invested capital will be “at risk.”
The discounted payback methodis similar to the regular payback method except
that it discounts cash flows at the project’s cost of capital. It considers the time
value of money, but it ignores cash flows beyond the payback period.
The net present value (NPV) methoddiscounts all 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.
The internal rate of return (IRR)is defined as the discount rate that forces a
project’s NPV to equal zero. The project should be accepted if the IRR is greater
than the cost of capital.
The NPV and IRR methods make the same accept/reject decisions for indepen-
dent projects,but if projects are mutually exclusive,then ranking conflicts can
arise. If conflicts arise, the NPV method should be used. The NPV and IRR meth-
ods are both superior to the payback, but NPV is superior to IRR.
The NPV method assumes that cash flows will be reinvested at the firm’s cost of
capital, while the IRR method assumes reinvestment at the project’s IRR. Rein-
vestment at the cost of capital is generally a better assumptionbecause it is
closer to reality.
The modified IRR (MIRR) methodcorrects some of the problems with the
regular IRR. MIRR involves finding the terminal value (TV)of the cash in-
flows, compounded at the firm’s cost of capital, and then determining the dis-
count rate that forces the present value of the TV to equal the present value of
the outflows.
The profitability index (PI) shows the dollars of present value divided by the ini-
tial cost, so it measures relative profitability.
Sophisticated managers consider all of the project evaluation measures because
each measure provides a useful piece of information.
Thepost-auditis a key element o fcapital budgeting. By comparing actual results
with predicted results and then determining why differences occurred, decision
makers can improve both their operations and their forecasts of projects’ outcomes.
Small firms tend to use the payback method rather than a discounted cash flow
method. This may be rational, because (1) the costof conducting a DCF analysis
may outweigh the benefitsfor the project being considered, (2) the firm’s cost
of capital cannot be estimated accurately,or (3) the small-business owner may
be considering nonmonetary goals.
If mutually exclusive projects have unequal lives,it may be necessary to adjust the
analysis to put the projects on an equal life basis. This can be done using the re-
placement chain (common life) approach.
286 CHAPTER 7 The Basics of Capital Budgeting: Evaluating Cash Flows
284 The Basics of Capital Budgeting: Evaluating Cash Flows
