CAPITAL BUDGETING

Capital Budgeting refers to the methods that managers use to determine which projects
should be selected and which projects should be rejected.
Imagine a manager has been presented with the following projects. The first is for a new
drink called Sugar Soda and the second is for a drink called Lime Soda. Lets call these
projects Project S and Project L.
Both drinks will cost !""" to create and market# Sugar Soda is e$pected to ha%e high
initial sales followed b& a decline as parents find out what the drink does to their children
'the& will bounce off the walls(. Lime Soda on the other hand is an ac)uired taste and
sales are e$pected to increase as consumers begin to ac)uire a taste for the product. *fter
&ear + the formula for the drinks will be obsolete and the drinks will no longer be
marketed or sold.
The cash flows for these two projects are shown below,
-hen considering two projects a manager must know whether the projects are mutually
exclusive projects or independent projects.
Mutually exclusive projects . when accepting one implies rejected the other.
/or e$ample if the compan& onl& has the capacit& to manufacture one new soda.
Independent projects . when the compan& can accept either or both projects
based onl& on the projects e$pected cash flows. /or e$ample if the firm has the
capacit& to in%est in both be%erages.
The following si$ methods are used to e%aluate projects,
!. 0et present %alue '0P1(
2. Internal 3ate of 3eturn 'I33(
4. 5odified Internal 3ate of 3eturn '5I33(
6. Profitabilit& Inde$ 'PI(
+. Pa&back Period
7. 8iscounted Pa&back
Capital Budgeting !
! Net Present "alue is also known as the discounted cash flow techni)ue. 0P1 is the
amount the shareholders wealth would increase if the firm selected the project . if this
number is positi%e then the firm should select the project.
!
9sing the following formula
we can find the 0P1 of the two projects. '*ssume a cost of capital 'r( of +:(.
( ) " !
N
t
t
t
CF
NPV
r =
=
+

( ) ( ) ( ) ( )
! 2 4 6
+"" 6"" 4"" !""
!""" !;".62
! +: ! +: ! +: ! +:
S
NPV = + + + + =
+ + + +
( ) ( ) ( ) ( )
! 2 4 6
!"" 4"" 6"" 7""
!""" 2"7.+"
! +: ! +: ! +: ! +:
L
NPV = + + + + =
+ + + +
Conclusion, Based on 0P1# and if the projects are mutuall& e$clusi%e 'i.e. onl& one
project can be selected( then the firm should go with Project L 'the Lime Soda(.
#! Internal $ate o% $eturn &I$$' the I33 is the discount rate that makes the net present
%alue of the project e)ual to <ero.
2
* projects I33 should be compared to the compan&s
cost of capital or =hurdle rate.> The (urdle rate is the rate that the project must e$ceed
to create positi%e shareholder wealth effects. '*ssume the hurdle rate 'r( is +:(.
( ) "
"
!
N
t
t
t
CF
NPV
IRR =
= =
+

( ) ( ) ( ) ( )
! 2 4 6
+"" 6"" 4"" !""
!""" "
! ! ! !
!6.+:
S
S
NPV
IRR IRR IRR IRR
IRR
= + + + + =
+ + + +
=
( ) ( ) ( ) ( )
! 2 4 6
!"" 4"" 6"" 7""
!""" "
! ! ! !
!!.;:
L
L
NPV
IRR IRR IRR IRR
IRR
= + + + + =
+ + + +
=
Conclusion, Based on I33# and if the projects are mutuall& e$clusi%e 'i.e. onl& one
project can be selected( then the firm should go with Project S 'the Sugar Soda(.
)uestion* Why do the NPV and IRR methods offer different decisions in this example
Ans+er, Because 0P1 rankings depend on the cost of capital and the timing of
the cash flows impacts their present %alues. Project S has higher short?term cash
!
@e& *ssumption, *ll cash flows are rein%ested at the compan&s cost of capital.
2
@e& *ssumption, *ll cash flows are rein%ested at the projects I33.
Capital Budgeting 2
flows while Project L has higher long?term cash flows. 0ote, Long?term cash
flows are much more sensiti%e to interest rates.
The tables below shows 0P1s for the two projects at %arious interest rates. 0otice that at
+: Project L offers a higher 0P1 while at !": Project S offers a higher 0P1.
)uestion* !t "hat rate "ould "e #e indifferent #et"een these t"o projects
Ans+er, *t the crossover rate. The crossover rate is the rate below which# the
two methods offer different accept A reject solutions. To calculate the crosso%er
rate for two projects subtract the cash flows at each time and then sol%e for the
rate at which the 0P1 e)uals <ero.
( )
( )
( )
( )
( )
( )
( )
( )
( )
( ) ( ) ( ) ( )
! 2 4 6
! 2 4 6
+"" !"" 6"" 4"" 4"" 6"" !"" 7""
!""" !""" "
! ! ! !
6"" !"" !"" +""
"
! ! ! !
B.!B:
c c c c
c c c c
c
NPV
r r r r
r r r r
r

= + + + + =
+ + + +

= + + + +
+ + + +
=
This is calculated easil& b& using the cash flow register in &our financial calculator.
/or the TI B*II Plus
Enter, C/ 'C/"( C "D E 'C"!( C 6""D ENTE$ E '/"!( C !D ENTE$ E 'C"2( C !""D
ENTE$ E '/"2( C !D ENTE$ E 'C"4( C ?!""D ENTE$ E '/"4( C !D ENTE$ E 'C"6( C
?+""D ENTE$D I$$D CPT
Ans+er, ,!-,./
Capital Budgeting 4
.! Modi%ied Internal $ate o% $eturn &MI$$' 0 the modified I33 assumes that cash
flows are rein%ested at the compan&s cost of capital.
4
The cash flows are first brought
forward to their future %alues at the compan&s cost of capital. 0e$t the =terminal %alue>
is calculated b& summing all of the future %alue cash flows. /inall& the terminal %alue is
brought to the present %ale of the initial in%estment at the 5I33 rate. '*ssume a cost of
capital of +:(.
( )
( )
( )
( )
!
"
"
!
! !
!
N
N
N
t t
t N
t
N
Cash Inflo" r
Cash $utflo"
r %IRR
&erminal value
PV of costs '
%IRR
PV of terminal value

=
=
+
=
+ +
+
=

( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
( )
( )
( )
( )
6 ! 4 ! 2 ! ! !
6
6
6
!A 6
+"" ! +: 6"" ! +: 4"" ! +: !"" ! +:
!"""
!
!# 646.;!
!"""
!
!# 646.;!
! !.646;
!"""
! !.646; !."F6+
F.6+:
S
S
s
s
S
'
%IRR
'
%IRR
%IRR
%IRR
%IRR

+ + + + + + +
+
+
+ = =
+ = =
=
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
( )
( )
( )
( )
6 ! 4 ! 2 ! ! !
6
6
6
!A 6
!"" ! +: 4"" ! +: 6"" ! +: 7"" ! +:
!"""
!
!# 677.+!
!"""
!
!# 677.+!
! !.677+
!"""
! !.677+ !.!""+
!"."+:
L
L
L
L
L
'
%IRR
'
%IRR
%IRR
%IRR
%IRR

+ + + + + + +
+
+
+ = =
+ = =
=
Conclusion, Based on 5I33# and if the projects are mutuall& e$clusi%e 'i.e. onl& one
project can be selected( then the firm should go with Project L 'the Lime Soda(. Note, *t
a !": cost of capital Project S would be superior based on the 5I33 calculation.
4
I33 assumes that cash flows are in%ested at the I33 rate.
Capital Budgeting 6
1! Pro%ita2ility Index &PI' . The profitabilit& inde$ is the present %alue of the projects
cash flows di%ided b& the cost. '*ssume a +: cost of capital( PI tells us how much
profit we can earn for each dollar in%ested.
( ) "
"
!
N
t
t
t
CF
r
PV of future cash flo"s
PI
Initial cost CF
= +
= =

( ) ( ) ( ) ( )
! 2 4 6
+"" 6"" 4"" !""
! +: ! +: ! +: ! +:
!"""
!!;".62
!.!;
!"""
S
PI
+ + +
+ + + +
=
= =
( ) ( ) ( ) ( )
! 2 4 6
!"" 4"" 6"" 7""
! +: ! +: ! +: ! +:
!"""
!2"7.+"
!.2!
!"""
L
PI
+ + +
+ + + +
=
= =
Conclusion, Based on PI# and if the projects are mutuall& e$clusi%e 'i.e. onl& one project
can be selected( then the firm should go with Project L 'the Lime Soda(. *ccording to
the Profitabilit& Inde$ calculation at a +: cost of capital Project L will &ield !.2! for
e%er& dollar in%ested in the project. Note, *t a !": cost of capital Project S would be
superior based on the PI calculation.
3! Pay2ac4 Period 0 The pa&back period is the e$pected number of &ears re)uired to
reco%er the original in%estment.
The pa&back period method has three main flaws, !( dollars recei%ed in different &ears
are all gi%en the same weight 2( cash flows be&ond the pa&back &ear are not considered
4( pa&back period anal&sis does not pro%ide an indication of how much shareholder
wealth should increase 'like 0P1( and 6( pa&back period anal&sis does not indicate how
much the project will &ield o%er the cost of capital 'like I33(.
Pay#ac( Num#er of years prior to full recovery
)nrecovered cost at start of year
Cash flo" durin* full recovery year
=
+
!""
2 2.44
4""
S
Pay#ac( years = + =
Capital Budgeting +
2""
4 4.44
7""
L
Pay#ac( years = + =
Project 5 Cas( 6lo+s
Gear " C ?!"""
Gear ! C +""
Gear 2 C 6""
Gear 4 C 4""
Gear 6 C !""
Cu7ulative C6s
?!"""
?+""
?!""
2""
4""
Project L Cas( 6lo+s
Gear " C ?!"""
Gear ! C !""
Gear 2 C 4""
Gear 4 C 6""
Gear 6 C 7""
Cu7ulative C6s
?!"""
?F""
?7""
?2""
6""
Conclusion, Based on the pa&back method# and if the projects are mutuall& e$clusi%e
then the firm should go with Project S 'the Sugar Soda(.
-! Discounted Pay2ac4 . This method is similar to the pa&back period method e$cept
the cash flows are discounted b& the projects cost of capital. The discounted pa&back
period is the number of &ears re)uired to reco%er the in%estment from the discounted net
cash flows. '*ssume a cost of capital of +:(
H
H
+iscounted Pay#ac( Num#er of years prior to full recovery,
)nrecovered cost at start of year,
Cash flo" durin* full recovery year
considers discounted cash flo"s
=
+
Project 5 Cas( 6lo+s
Gear " C ?!"""
Gear ! C +""
Gear 2 C 6""
Gear 4 C 4""
Gear 6 C !""
Discounted C6s
?!"""A'!."+(
"
C ?!""".""
+""A'!."+(
!
C 6B7.!F
6""A'!."+(
2
C 472.;!
4""A'!."+(
4
C 2+F.!+
!""A'!."+(
6
C ;2.2B
Cu7ulative C6s
?!""".""
?+24.;!
?!7!.""
F;.!+
!;".62
!7!.""
2 2.72
2+F.!+
S
Pay#ac( years = + =
Project L Cas( 6lo+s
Gear " C ?!"""
Gear ! C !""
Gear 2 C 4""
Gear 4 C 6""
Gear 6 C 7""
Discounted C6s
?!"""A'!."+(
"
C ?!""".""
!""A'!."+(
!
C F+.;4
4""A'!."+(
2
C 2B2.!!
6""A'!."+(
4
C 46+.+6
7""A'!."+(
6
C 6F4.72
Cu7ulative C6s
?!""".""
?F"6.B7
?742.7+
?2;B.!2
2"7.+"
2;B
4 4.+;
6F4
L
Pay#ac( years = + =
Conclusion, Based on the discounted pa&back method# and if the projects are mutuall&
e$clusi%e then the firm should go with Project S 'the Sugar Soda(.
Capital Budgeting 7