Introduction to Finance

LO 17.2
The capital budgeting process is composed of fi ve stages: 
identifi cation, development, selection, implementation, and follow-up. 
LO 17.3 
Since the capital budgeting process involves the analysis of 
cash fl ows over time, it is best to examine projects using a selection 
technique that considers the time value of money. The net present 
value, internal rate of return, modifi ed internal rate of return, and 
profi tability index are four such methods. A fi fth method, the 
payback period, measures how quickly a project will pay for itself 
but ignores time value concerns. Of these selection methods, the 
net present value is the best since it measures the dollar amount 
by which a project will change shareholder wealth. It is equal to 
the present value of a project’s cash fl ows minus its initial outlay 
or cost.
LO 17.4 
The internal rate of return is the discount rate such that 
the present value of the cash fl ows equals the initial cost of a capital 
budgeting project. A project is acceptable if its IRR exceeds the fi rm’s 
cost of capital. The IRR measures the return earned on the funds that 
remained invested in a project over time. A drawback of the IRR 
measure is there may be more than one IRR if the project’s cash fl ows 
alternate between positive and negative over the project’s life.
LO 17.5 
The modifi ed internal rate of return (MIRR) tries to address 
the “multiple answer” issue of the IRR. There is only one MIRR for 
a given set of cash fl ow estimates. It is computed by fi rst fi nding 
the present value of all cash outfl ows of a project, using the cost of 
capital as the discount rate. Second, compute the terminal value—
the sum of the future values—of a project’s cash fl ows, compounding 
the cash fl ows at the fi rm’s cost of capital. Third, fi nd the discount 
rate that equates the present value of the outfl ows and the terminal 
value. This discount rate is the MIRR. The project is acceptable if 
the MIRR exceeds the fi rm’s cost of capital.