Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

example

Project PV of CF (1-5)

($ in millions)

Initial outlay

($ in millions)

PI

Western Europe 325.3 250 1.3

South-eastern

Australia

75.7 50 1.5

To calculate the PI for each of Global Untethered’s
investment projects, calculate the present value of
its cash inflows from years 1–5, then divide by the
absolute value of the initial cash outflow to obtain
the following result:

Both projects have a PI greater than 1.0, so

both are worthwhile. However, if we rank projects

based on the PI, then the South-eastern Australia

project looks better.

Because the NPV, IRR and PI methods are so closely related, they share many of the same advantages

relative to payback or accounting rate of return analysis, and there is no need to reiterate those advantages

here. However, it is worth pointing out that the PI and the IRR share an important flaw. Both suffer from

the scale problem described earlier. Recall that our NPV calculations suggested that the Western Europe

project created more value for shareholders than the South-eastern Australian endeavour, whereas the

IRR and PI comparisons suggest just the opposite project ranking. The latter two analyses identify the

South-eastern Australia project as the superior investment because the differences in scale between the

two projects are ignored. For the South-eastern Australian project, the PI indicates that project cash

inflows exceed the initial cash outflow by 50% on a present-value basis. The present value of cash inflows

for the Western Europe investment exceeds the initial cash outflow by just 30%. But the Western Europe

project is much larger, and as our NPV figures reveal, it generates considerably more wealth for Global

Untethered shareholders.^9

9 The use of the profitability index in capital rationing, which occurs when the firm has more acceptable projects than it can fund from its
current budget, is discussed in Chapter 10.

finance in practice

CFO SURVEY EVIDENCE (III)

Surveys of corporate financial managers around the

world reveal both major similarities and significant

differences in the use of various capital budgeting

techniques. The graph below documents how

frequently managers in Australia, the United States,

the United Kingdom, Germany, France and Brazil

use internal rate of return, net present value,

payback period, real option analysis and accounting

rate of return. IRR and NPV are used by over 70% of

managers of Australian and US companies and by

a majority, or near-majority, of Brazilian and British

managers; but the propensity to use either of these

theoretically preferred methods of capital budgeting

decision-making is below 50% in all other countries.

The payback method is one of the most frequently

employed decision-making tools in other countries.

Beth Acton, Vice President

and Treasurer of Ford

Motor Co. (former)

‘We look at capital

investments in a very

similar fashion whether

they’re routine or large

investments.’

See the entire interview on

the CourseMate website.

COURSEMATE

SMART VIDEO

Source: Cengage Learning