Posted: April 24th, 2025

Science Module 10: Critical Thinking Assignment Capital Budgeting Justification

Capital budgeting is an essential process for healthcare organizations. The challenge in quality and patient safety organizations is proving return on the capital investment without revenue impacts.Select a capital investment that you would recommend making for a patient safety concern. In a 15 slide PowerPoint Presentation address the following requirements:

Describe the capital item in detail:
Item description
Rationale for selection
Cost-benefit analysis
Complete a capital budget with projected financial benefit:
Revenue or positive financial impact
Capital equipment cost
Personnel cost
Supply cost
Review financial ratios
Return on investment
Net Present Value
Cash Payback period
Make a recommendation to lease or finance the capital item. Please support your decision with financial data.

Your presentation should meet the following structural requirements:

Be 15 slides in length, not including the title or reference slides.

Be formatted according to Saudi Electronic University and APA writing guidelines.

Provide support for your statements with citations from a minimum of six scholarly articles. These citations should be listed in the Notes section of the slide in which they appear. Two of these sources may be from the class readings, textbook, or lectures, but four must be external.

Each slide must provide detailed speaker’s notes to support the slide content. These should be a minimum of 120 words long (per slide) and must be a part of the presentation.

CHAPTER 10
Capital Structure

In chapter 9, we noted that the weights used in the cost of capital estimate represent the optimal (target) mix of debt and equity financing. These weights are established by the capital structure decision, which requires managers to analyze a number of quantitative and qualitative factors to establish the business’s optimal capital structure.

The Capital Structure Decision
Capital consists of the funds used to finance a business’s assets.
Capital structure is the financing mix on the right side of the balance sheet. It is the proportion of debt (and hence equity) used by a business.
The capital structure decision involves identifying the optimal mix of debt and equity.
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Impact of Capital Structure on
Risk and Return
Consider a new for-profit walk-in clinic that needs $200,000 in assets to begin operations.
The business is expected to produce $150,000 in revenues and $100,000 in operating costs during the first year.
The clinic has only two capital structure alternatives:
No debt financing (all equity)
$100,000 of 10% debt (50/50 mix)
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Projected Balance Sheets
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All Equity
Debt/Equity

Current assets
$100,000
$ 100,000

Fixed assets
100,000
100,000

Total assets
$200,000
$ 200,000

Bank loan (10% cost)
$ 0
$ 100,000

Total equity
200,000
100,000

Total claims
$ 200,000
$ 200,000

Projected Income Statements
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All Equity
Debt/Equity

Revenues
$ 150,000
$ 150,000

Operating costs
100,000
100,000

Operating income (EBIT)
$ 50,000
$ 50,000

Interest expense
0
10,000

Taxable income
$ 50,000
$ 40,000

Taxes (30%)
15,000
12,000

Net income
$ 35,000
$ 28,000

Based on net income, should we use debt financing?

Return on Equity (ROE)
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All Equity
Debt/Equity

Net income
$ 35,000
$ 28,000

Total equity
$200,000
$100,000

Return on equity
17.5%
28%

Based on ROE, should we use debt financing?

Conclusions
Although the use of debt financing lowers net income, it increases the return to equityholders.
Debt financing allows more of a business’s operating income to flow through to investors.
Because debt financing levers up (increases) return, its use is called financial leverage.
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Business Risk Versus Financial Risk
A business has some overall level of risk.
In a stand-alone risk sense, it can be measured by the standard deviation of ROE.
In a market risk sense, it can be measured by the stock’s beta.
This overall (total) risk can be decomposed into business risk and financial risk.
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Business risk is the uncertainty inherent in a business’s operating income (EBIT)—that is, how well can managers predict EBIT?

Business risk does not consider how the business is financed.
Business Risk
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Probability
EBIT
E(EBIT)
0
Low business risk
High business risk

Factors That Influence Business Risk
Demand (volume) variability
Sales price variability
Input cost variability
Ability to respond to changing market conditions (operating flexibility)
Liability exposure uncertainty
Operating leverage (proportion of fixed
versus variable costs)
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• Demand (volume) variability. Nursing homes have stable demand.
• Sales price variability. Cosmetic surgery has highly volatile prices.
• Input cost variability. Pharmaceutical companies have highly uncertain input costs for R&D.
• Ability to respond to changing market conditions. Some hospitals are in a better position to raise their prices when input costs rise. Other hospitals are more adept at cutting costs if the need arises.
• Liability exposure uncertainty. Hospitals that perform a large number of high-risk surgeries face more liability risk than do hospitals with a limited surgery program.
• What is operating leverage? Operating leverage measures the proportion of fixed costs in a business’s cost structure. Hospitals have a high percentage of fixed costs which by definition do not decline when demand falls off.

‹#›

Financial Risk
Financial risk is the additional risk placed on owners (or noncreditor stakeholders in NFP businesses) when debt financing is used.
The greater the proportion of debt financing, the greater the financial risk.
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Which of the following statements is most correct?
A firm’s business risk is determined solely by the financial characteristics of its industry.
A firm’s financial risk can be minimized by diversification.
A firm with low business risk is more likely to increase its use of financial leverage than a firm with high business risk, assuming all else equal.
Home health agencies typically have more operating leverage than hospitals.
An increase in operating leverage normally leads to a decrease in the standard deviation of its expected EBIT.

Capital Structure Theory
Capital structure theory attempts to define the relationship between the use of financial leverage and a business’s equity value.
The most widely accepted theory is the trade-off theory:
There are tax-related benefits to debt financing.
But there are also costs, primarily those associated with financial distress.
But first, we need to discuss MM.
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Modigliani and Miller (MM)
MM published theoretical papers that changed the way people thought about financial leverage (and dividend policy).
They won Nobel prizes in economics because of their work.
MM’s papers were published in 1958 and 1963. Miller had a separate paper in 1977. The papers differed in their assumptions about taxes.
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MM Assumptions
Firms can be grouped into homogeneous classes based on business risk.
Investors have identical expectations about firms’ future earnings.
There are no transactions costs, so securities can be bought and sold with no fees or commissions.
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All debt is riskless, and both individuals and corporations can borrow unlimited amounts of money at the risk-free rate.
All cash flows are perpetuities. This implies perpetual debt is issued, firms have zero growth, and expected EBIT is constant over time.
There are no agency or financial distress costs.
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MM Assumptions (cont.)

Proposition I:
VL = VU.

Proposition II:
R(ReL) = R(ReU) + [R(ReU) – R(Rd)](D/E).
MM Without Taxes (1958)
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MM Without Taxes Graph
Cost of Capital (%)
Proportion of Debt
R(Re)
CCC
R(Rd)

The more debt the firm adds to its capital structure, the riskier the equity becomes and thus the higher its cost.
Although the cost of debt remains constant (by assumption), the cost of equity increases with leverage at a rate that is exactly sufficient to keep the CCC constant.

What is the optimal capital structure if this theory holds?
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MM Without Taxes Conclusions

Value Versus Leverage Graph
Firm Value
VL = VU
Proportion of Debt
Under MM without taxes, the firm’s value is not affected by debt financing.
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When corporate taxes are added, the MM propositions become:

Proposition I:
VL = VU + TD.

Proposition II:
R(ReL) = R(ReU) + [R(ReU) – R(Rd)](1 – T)(D/E).
MM with Corporate Taxes (1963)
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Cost of Capital (%)
R(Re)
CCC
R(Rd)(1 – T)

MM with Corporate Taxes Graph
Proportion of Debt
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MM with Corporate Taxes Conclusions
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When corporate taxes are added,
VL ≠ VU. VL increases as debt is added to the capital structure, and the greater the debt usage, the higher the value of the firm.
The cost of equity increases with leverage at a slower rate when corporate taxes are considered because of the (1 – T) term in Proposition II.
What is the optimal capital structure if this theory holds?

VL
VU
Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.
TD
Value Versus Leverage Graph
Proportion of Debt
Firm Value
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Miller later (1977) modified the MM with corporate taxes model to incorporate individual (personal) taxes.
Miller’s Proposition I:
VL = VU + [1 – ]D.
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Te = personal tax rate on stock income.
(1 – Tc)(1 – Te)
(1 – Td)
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Assume Tc = 30%, Td = 35%, and Te = 20%.

VL = VU + [1 – ]D
= VU + (1 – 0.86)D
= VU + 0.14D.
Value rises with debt; each $100 increase in debt raises L’s value by $14.
(1 – 0.30)(1 – 0.20)
(1 – 0.35)
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How does this gain compare to the gain in the MM model with corporate taxes?
If only corporate taxes, then
VL = VU + TcD = VU + 0.30D.
Here, $100 of debt raises value by $30. But with personal taxes added, firm value increases by only $14. Thus, personal taxes lower the gain from leverage, but the net effect depends on relative tax rates.

Impact of Personal Taxes
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Corporate tax laws favor debt over equity financing because interest expense is tax deductible while dividends are not.
However, personal tax laws favor equity over debt because stocks provide tax deferral, a lower capital gains tax rate, and a lower dividend tax rate.

Impact of Personal Taxes (Cont.)
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This increases the attractiveness of stock investments (lowers the cost of equity) and hence decreases the spread between debt and equity costs.
Thus, some of the advantage of debt financing is lost, and debt financing is less valuable to businesses.
What is the optimal capital structure if the Miller theory holds?

What does capital structure theory
prescribe for corporate managers?
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MM, No Taxes: Capital structure is irrelevant—no impact on firm value.
MM, Corporate Taxes: Value increases, so firms should use (almost) 100% debt financing.
Miller, Personal Taxes: Value increases, but less than under MM, so again firms should use (almost) 100% debt financing.

Do firms follow the recommendations
of capital structure theory?
Firms don’t follow MM/Miller to 100% debt. Debt ratios average about 40%.
However, debt ratios did increase after MM. At the time, many thought debt ratios were too low, and MM led to changes in financial policies.
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Financial Distress Costs
As firms use more and more debt financing, they face a higher probability of future financial distress, which brings with it lower sales, higher costs, lower earnings, and the greater potential of incurring bankruptcy costs. These effects, called financial distress costs, lower the values of stocks and bonds.
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Agency Costs
As more and more debt is used, managerial actions become more restricted due to restrictive covenants and oversight by creditors. Furthermore, debtholders tend to increase monitoring activity as more debt is used, which raises the cost of debt. Such costs, called agency costs, also lower the values of stocks and bonds.

How do financial distress and agency costs change the MM and Miller models?
MM/Miller ignored these costs; hence their models show firm value increasing continuously with leverage.
Because financial distress and agency costs increase with leverage, such costs reduce the value of debt financing.
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The major contribution of the Miller model is that it demonstrates that:
Personal taxes increase the value of corporate debt.
Personal taxes decrease the value of corporate debt.
Financial distress and agency costs reduce the value of corporate debt.
Equity costs increase with financial leverage.
Debt costs increase with financial leverage.

The trade-off theory includes financial distress and agency costs.

X represents either Tc in the MM model or the more complex Miller term.
Now, optimal financial leverage involves a trade-off between the tax benefits of debt and financial distress and agency costs.
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VL = VU + XD – – .
PV of expected
fin. distress costs
PV of agency
costs

%
D/A
R(Re)
CCC
R(Rd)(1 – T)

What is the optimal capital structure?

Trade-Off Theory
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Trade-Off Theory Implications
Both too little or too much debt is bad.
There is an optimal, or target, capital structure for every business that balances the costs and benefits of debt financing.
Unfortunately, capital structure theory cannot be used in practice to find a business’s optimal structure.
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Trade-Off Theory Implications (cont.)
Firms should borrow more if they:
Have low business risk
Employ tangible assets (buildings and equipment)
Expect to pay taxes at a high rate
Firms should borrow less if they:
Have high business risk
Employ intangible assets (intellectual capital and goodwill)
Expect to pay taxes at a low rate
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‹#›

Asymmetric Information Theory
MM assumed that investors and managers have the same information.
But managers often have better information. Thus, they would:
Sell stock if stock is overvalued
Sell bonds if stock is undervalued
Investors understand this, so they view new stock sales as a negative signal.

What are the implications for managers?
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‹#›

Asymmetric Information Theory (cont.)
In general, mature firms follow a “pecking order” when financing:
First, use internal funds.
Next, draw on marketable securities.
Then, issue new debt.
Finally, and only as a last resort, issue new common stock.
This behavior is consistent with the asymmetric information theory.
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‹#›

Summary of Capital Structure Theory
Both too little or too much debt is bad.
There is an optimal (target) capital structure for every investor-owned business that balances the costs and benefits of debt financing.
Specific financing conditions are influenced by asymmetric information.
Unfortunately, capital structure theory cannot be used in practice to find a business’s optimal structure.
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Not-For-Profit Businesses
The same general concepts of capital structure apply to not-for-profit businesses:
Benefit to debt financing—cost of debt is lower because it is tax exempt
Cost to debt financing—increased risk of financial distress
However, not-for-profit firms do not have the same financial flexibility as do investor-owned businesses.
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Factors That Influence Capital
Structure Decisions in Practice
Long-run viability
Managerial conservatism
Lender and rating agency attitudes
Reserve borrowing capacity
Industry averages

Control of investor-owned corporations
Asset structure
Growth rate
Profitability
Taxes

Implications of the
Capital Structure Decision
The estimated optimal capital structure becomes the business’s target capital structure.
It is an important factor in financial decision making because:
It defines the weights that are used in the corporate cost of capital estimate.
It plays a role in future financing decisions.
Note that the target weights are market (as opposed to book) value weights for FP businesses.
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Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?
Its sales become less stable over time.
Management believes that the firm’s stock has become overvalued.
The corporate tax rate increases.
The costs that would be incurred in the event of bankruptcy increase.
Its degree of operating leverage increases.

The use of debt financing increases the rate of return to owners, but it also increases their risk.
Debt financing provides benefits because of the tax deductibility of interest. However, beyond some point, financial distress and agency costs offset the tax advantage of debt.
Capital structure theory does not provide answers to the optimal capital structure question. Thus, many factors must be considered when actually choosing a firm’s target capital structure, and the final decision will be based on both analysis and judgment.
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Three Key Learning Points

CHAPTER 10 EXTENSION
This chapter extension focuses on the debt maturity decision.

The Debt Maturity Decision
Once the capital structure decision is made, another decision is necessary. Given the optimal amount of debt financing, what is the optimal maturity mix of that debt?
This decision is based on the business’s mix of permanent and temporary assets.
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Alternative Debt Maturity Policies
Maturity Matching: Matches the maturity of the assets with the maturity of the financing.
Aggressive: Uses short-term (temporary) capital to finance some permanent assets.
Conservative: Uses long-term (permanent) capital to finance some temporary assets.
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‹#›

Years
$

Perm C.A.
Fixed Assets
Temp. C.A.
What are “permanent” assets?
S-T
Loans
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Maturity Matching Financing Policy
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‹#›

Years
$

Perm C.A.
Fixed Assets
Temp. C.A.
The lower the dashed line, the more aggressive.
S-T
Loans
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Aggressive Financing Policy
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‹#›

Conservative Financing Policy
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Fixed Assets
Years
$

Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Marketable Securities
Zero S-T
debt

‹#›

Conclusion Regarding Debt Maturities
The choice of debt maturities is a classic risk/return trade-off.
The aggressive policy promises the highest return but carries the greatest risk.
The conservative policy has the least risk but also the lowest expected return.
The moderate (maturity matching) policy falls between the two extremes.
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‹#›

CHAPTER 11
Capital Budgeting
In recent chapters, we focused on capital acquisition, cost of capital, and capital structure—in other words, decisions that provide a business with its capital (funds). Now, we turn our attention to the capital allocation decision, or how those funds can be deployed (used) in the most economically efficient manner.

Capital Budgeting Basics
Capital budgeting is the analysis of potential additions to a business’s fixed assets.
Such decisions:
Typically are long-term in nature
Often involve large expenditures
Usually define strategic direction
Thus, capital budgeting decisions are very important to businesses.
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Project Classifications
Proposed projects are classified according to purpose and size (cost). For example,
Mandatory replacement
Expansion of existing services
Less than $1 million
$1 million or more
Expansion into new services
Less than $1 million
$1 million or more

Role of Project Financial Analysis
For investor-owned businesses, financial analysis identifies those projects that are expected to contribute to shareholder wealth.
For not-for-profit businesses, financial analysis identifies a project’s expected effect on the business’s financial condition.

Overview of Capital Budgeting Financial Analysis
1. Estimate the project’s cash flows:
Capital outlay
Operating flows
Terminal flow
2. Assess the project’s riskiness.
3. Estimate the project cost of capital.
4. Measure the financial impact.
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‹#›

Key Concepts in Cash Flow Estimation
Identifying the relevant cash flows
Inc. CF = CF(w/ project) – CF(w/o project)
Cash flow versus accounting income
Cash flow timing
Project life
Sunk costs
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Key Concepts (cont.)
Opportunity costs
Effect on the business’s other projects
Shipping and installation costs
Changes in net working capital
Inflation effects
Cash flow estimation bias
Strategic value
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Cash Flow Estimation Example
Assume Midtown Clinic, a not-for-profit provider, is evaluating a new piece of diagnostic equipment.
Cost:
$200,000 purchase price
$40,000 shipping and installation
Expected life = 4 years
Salvage value = $25,000
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Cash Flow Estimation Example (cont.)
Volume = 5,000 scans/year
Net revenue = $80 per scan
Supplies costs = $40 per scan
Labor costs = $100,000
Neutral inflation rate = 5%
Corporate cost of capital = 10%

(CF0)
+
Terminal
CF
NCF0
NCF1
NCF2
NCF3
NCF4

Operating cash flows (000s)
1
2
3
4
Revenues
$400
$420
$441
$463
Supplies costs
200
210
221
232
Net op. CF
$100
$105
$110
$116
How were these values developed?
Why haven’t we included depreciation?
Labor costs
100
105
110
116
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Self-Test
Which of the following factors would not have an impact on the cash flow estimates?
The new equipment would require $5,000 in shipping costs.
$25,000 was spent last year to improve the space that will house the equipment.
The space for the equipment could be rented out for $1,000 per month.
The new equipment would reduce the volume of an existing service line.
The new equipment would increase accounts receivable by $20,000.
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If this were a replacement rather than a new (expansion) project, would the analysis change?
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The relevant operating cash flows would be the difference between the cash flows on the new and old project.
Also, selling the old equipment would produce an immediate cash inflow, but the salvage value at the end of its original life is foregone.

Breakeven Analysis
There are many different approaches to breakeven in project analysis:
Time breakeven
Input variable breakeven
Volume (4,142 versus 5,000 expected)
Net revenue ($73.13 versus $80 expected)
We will focus on time breakeven, which is measured by payback (or payback period).
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Payback Illustration
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0
$100
1
$105
2
$110
3
$141
4
($240)
Cumulative CFs:
$ 75
($240)
($ 35)
($140)
$216
Payback = 2 + 35 / 110 = 2.3 years.

Advantages of Payback:
1. Easy to calculate and understand
Provides an indication of a project’s risk and liquidity
Disadvantages of Payback:
1. Ignores time value
2. Ignores all cash flows that occur after the payback period
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Profitability (ROI) Analysis
Return on investment (ROI) analysis focuses on a project’s financial return.
As with any investment, returns can be measured either in dollar terms or in rate of return (percentage) terms.
Net present value (NPV) measures a project’s time value adjusted dollar return.
Internal rate of return (IRR) measures a project’s rate of (percentage) return.
Modified IRR (MIRR) also measures percentage return.
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Net Present Value (NPV)
NPV measures return on investment (ROI) in dollar terms.
NPV is merely the sum of the present values of the project’s net cash flows.
The discount rate used is called the project cost of capital (PCC). If we assume that the illustrative project has average risk, its project cost of capital is the corporate cost of capital, 10%.
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Net Present Value (NPV) Calculation
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0
$100
1
$105
2
$110
3
$141
4
($240.00)
10%
90.91
86.78
82.64
96.30
$116.63
Thus, the project’s NPV is about $117,000.

Spreadsheet Solution

Interpretation of the NPV
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NPV is the excess dollar contribution of the project to the equity value of the business.
A positive NPV signifies that the project will enhance the financial condition of the business.
The greater the NPV, the more attractive the project financially.

Internal Rate of Return (IRR)
IRR measures ROI in percentage (rate of return) terms.
It is the discount rate that forces the PV of the inflows to equal the cost of the project. In other words, it is the discount rate that forces the project’s NPV to equal $0.
IRR is the project’s expected rate of return.
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IRR Calculation (cont.)
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0
$100
1
$105
2
$110
3
$141
4
($240.00)
77.11
62.46
50.48
49.95
$ 0.00
= NPV
29.6%
Thus, the project’s IRR is 29.6%.

Spreadsheet Solution

Interpretation of the IRR
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If a project’s IRR is greater than its cost of capital, then there is an “excess” return that contributes to the equity value of the business.
In our example, IRR = 29.6 and the project cost of capital is 10%, so the project is expected to enhance Midtown Clinic’s financial condition.

Self-Test
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Which of the following statements is most correct?
a. If NPV > $0, IRR PCC, NPV < $0.
c. If NPV = $0, IRR = PCC.
d. If IRR $0.
e. If NPV PCC.

Modified Internal Rate of Return (MIRR)
Both NPV and IRR require a reinvestment rate assumption.
NPV assumes it is the cost of capital.
IRR assumes it is the IRR rate.
Of the two, reinvestment at the cost of capital is the better assumption.
MIRR is a rate of return measure that forces reinvestment at the cost of capital.
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