Chapter 10 This chapter has described six techniques used in capital budgeting analysis: NPV, IRR, MIRR, PI, payback, and discounted payback. 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 budgeting decisions are probably the most important ones that managers must make.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 because such a project increases shareholders’ value.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 independent projects, but if projects are mutually exclusivethen ranking conflicts can arise. In such cases, the NPV method should generally be relied upon.It is possible for a project to have more than one IRR if the project’s cash flows change signs more than once.Unlike the IRR, a project never has more than one modified IRR (MIRR). MIRR requires finding the terminal value of the cash inflows, compounding them at the firm’s cost of capital, and then determining the discount rate that forces the present value of the TV to equal the present value of the outflows.The profitability index (PI)is calculated by dividing the present value of cash inflows by the initial cost, so it measures relative profitability—that is, the amount of the present value per dollar of investment.The regular payback periodis defined as the number of years required to recover a project’s cost. The regular payback method has three flaws: It ignores cash flows beyond the payback period, it does not consider the time value of money, and it doesn’t give a precise acceptance rule. The payback method does, however, provide an indication of a project’s risk and liquidity, because it shows how long the invested capital will be tied up.The discounted paybackis similar to the regular payback except that it discounts cash flows atthe project’s cost of capital. It considers the time value of money, but it still ignores cash flows beyond the payback period.The chapter’s Tool KitExcelmodel and Web Extension 10Adescribe another, but seldom-used,evaluation method—the accounting rate of return.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 replacement chain (commonlife) approachor the equivalent annual annuity (EAA) approach.A project’s true value may be greater than the NPV based on its physical life if it can be terminated at the end of its economic life.

Flotation costs and increased risk associated with unusually large expansion programs can cause the marginal cost of capitalto increase as the size of the capital budget increases.Capital rationingoccurs when management places a constraint on the size of the firm’s capitalbudget during a particular period.

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