1. Application: How could capital budgeting be applied in your organization or to your personal finances?
2. Not-for Profit Entities: Are the capital budgeting criteria discussed in the chapter applicable to not-for-profit corporations or the government?How so?

from the text

9.7

The Practice of Capital Budgeting

Given that NPV seems to be telling us directly what we want to know, you might be wondering why there are so many other procedures and why alternative procedures are commonly used. Recall that we are trying to make an investment decision and that we are frequently operating under considerable uncertainty about the future. We can onlyestimatethe NPV of an investment in this case. The resulting estimate can be very "soft," meaning that the true NPV might be quite different.

Because the true NPV is unknown, the astute financial manager seeks clues to help in assessing whether the estimated NPV is reliable. For this reason, firms would typically use multiple criteria for evaluating a proposal. For example, suppose we have an investment with a positive estimated NPV. Based on our experience with other projects, this one appears to have a short payback and a very high AAR. In this case, the different indicators seem to agree that it's "all systems go." Put another way, the payback and the AAR are consistent with the conclusion that the NPV is positive.

On the other hand, suppose we had a positive estimated NPV, a long payback, and a low AAR. This could still be a good investment, but it looks like we need to be much more careful in making the decision because we are getting conflicting signals. If the estimated

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NPV is based on projections in which we have little confidence, then further analysis is probably in order. We will consider how to evaluate NPV estimates in more detail in the next two chapters.

Large firms often have huge capital budgets. For example, for 2017, ExxonMobil announced that it expected to have about $22 billion in capital outlays during the year, down from its record $42.5 billion in 2013. About the same time, competitor Chevron announced that it would decrease its capital budgeting for 2017 to $19.8 billion, down from $26.6 billion in 2016. Other companies with large capital spending budgets included Walmart, which projected capital spending of about $11 billion for 2017, and Apple, which projected capital spending of about $16 billion for 2017.

According to information released by the Census Bureau in 2017, capital investment for the economy as a whole was $1.401 trillion in 2013, $1.507 trillion in 2014, and $1.545 trillion in 2015. The total for the three years therefore exceeded $4.4 trillion! Given the sums at stake, it is not too surprising that careful analysis of capital expenditures is something at which successful businesses seek to become adept.

There have been a number of surveys conducted asking firms what types of investment criteria they actually use.Table 9.6summarizes the results of several of these. Panel A of the table is a historical comparison looking at the primary capital budgeting techniques used by large firms through time. In 1959, only 19 percent of the firms surveyed used either IRR or NPV, and 68 percent used either payback periods or accounting returns. It is clear that by the 1980s, IRR and NPV had become the dominant criteria.

TABLE 9.6Capital Budgeting Techniques in PracticeA. Historical Comparison of the Primary Use of Various Capital Budgeting Techniques

1959

1964

1970

1975

1977

1979

1981

Payback period

34%

24%

12%

15%

9%

10%

5%

Average accounting return (AAR)

34

30

26

10

25

14

11

Internal rate of return (IRR)

19

38

57

37

54

60

65

Net present value (NPV)

26

10

14

17

IRR or NPV

19

38

57

63

64

74

82

B. Percentage of CFOs Who Always or Almost Always Used a Given Technique in 1999

Average Score [Scale is 4 (always) to 0 (never)]

Capital Budgeting Technique

Percentage AlwaysorAlmost AlwaysUsing

Overall

Large Firms

Small Firms

Internal rate of return

76%

3.09

3.41

2.87

Net present value

75

3.08

3.42

2.83

Payback period

57

2.53

2.25

2.72

Discounted payback period

29

1.56

1.55

1.58

Accounting rate of return

20

1.34

1.25

1.41

Profitability index

12

.83

.75

.88

Sources: Graham, J. R., and Harvey, C. R., "The Theory and Practice of Corporate Finance: Evidence from the Field," Journal of Financial Economics, May-June 2001, 187-243; Moore, J. S, and Reichert, A. K., "An Analysis of the Financial Management Techniques Currently Employed by Large U.S. Corporations," Journal of Business Finance and Accounting, Winter 1983, 623-45; and Stanley, M. T., and Block, S. R., "A Survey of Multinational Capital Budgeting," The Financial Review, March 1984, 36-51.

Panel B ofTable 9.6summarizes the results of a 1999 survey of chief financial officers (CFOs) at both large and small firms in the United States. A total of 392 CFOs responded. What is shown is the percentage of CFOs who always or almost always used

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the various capital budgeting techniques we describe in this chapter. Not surprisingly, IRR and NPV were the two most widely used techniques, particularly at larger firms. However, over half of the respondents always, or almost always, used the payback criterion as well. In fact, among smaller firms, payback was used just about as much as NPV and IRR. Less commonly used were discounted payback, accounting rates of return, and the profitability index. For future reference, the various criteria we have discussed are summarized inTable 9.7.

TABLE 9.7Summary of Investment CriteriaI. Discounted Cash Flow Criteria

1. Net present value (NPV): The NPV of an investment is the difference between its market value and its cost. The NPV rule is to take a project if its NPV is positive. NPV is frequently estimated by calculating the present value of the future cash flows (to estimate market value) and then subtracting the cost. NPV has no serious flaws; it is the preferred decision criterion.
2. Internal rate of return (IRR): The IRR is the discount rate that makes the estimated NPV of an investment equal to zero; it is sometimes called thediscounted cash flow (DCF) return. The IRR rule is to take a project when its IRR exceeds the required return. IRR is closely related to NPV, and it leads to exactly the same decisions as NPV for conventional, independent projects. When project cash flows are not conventional, there may be no IRR or there may be more than one. More seriously, the IRR cannot be used to rank mutually exclusive projects; the project with the highest IRR is not necessarily the preferred investment.
3. Modified internal rate of return (MIRR): The MIRR is a modification to the IRR. A project's cash flows are modified by (1) discounting the negative cash flows back to the present; (2) compounding cash flows to the end of the project's life; or (3) combining (1) and (2). An IRR is then computed on the modified cash flows. MIRRs are guaranteed to avoid the multiple rate of return problem, but it is unclear how to interpret them; and they are not truly "internal" because they depend on externally supplied discounting or compounding rates.
4. Profitability index (PI): The PI, also called thebenefit-cost ratio,is the ratio of present value to cost. The PI rule is to take an investment if the index exceeds 1. The PI measures the present value of an investment per dollar invested. It is quite similar to NPV; but, like IRR, it cannot be used to rank mutually exclusive projects. However, it is sometimes used to rank projects when a firm has more positive NPV investments than it can currently finance.

II. Payback Criteria

1. Payback period: The payback period is the length of time until the sum of an investment's cash flows equals its cost. The payback period rule is to take a project if its payback is less than some cutoff. The payback period is a flawed criterion, primarily because it ignores risk, the time value of money, and cash flows beyond the cutoff point.
2. Discounted payback period: The discounted payback period is the length of time until the sum of an investment's discounted cash flows equals its cost. The discounted payback period rule is to take an investment if the discounted payback is less than some cutoff. The discounted payback rule is flawed, primarily because it ignores cash flows after the cutoff.

III. Accounting Criterion

1. Average accounting return (AAR): The AAR is a measure of accounting profit relative to book value. It isnotrelated to the IRR, but it is similar to the accounting return on assets (ROA) measure inChapter 3. The AAR rule is to take an investment if its AAR exceeds a benchmark AAR. The AAR is seriously flawed for a variety of reasons, and it has little to recommend it.