5

Capital Budgeting Techniques (Chapter 9)

Contents
5

Capital Budgeting Techniques (Chapter 9)......................................................1

5.1

Introduction............................................................................................... 2

5.2

NPV........................................................................................................... 3

5.2.1

Process................................................................................................ 3

5.2.2

Example.............................................................................................. 3

5.3

Payback Period.......................................................................................... 3

5.3.1

Process................................................................................................ 3

5.3.2

Example.............................................................................................. 4

5.3.3

Advantages and disadvantages..........................................................4

5.4

Discounted Payback Period.......................................................................5

5.4.1

Example.............................................................................................. 5

5.4.2

Advantages and disadvantages..........................................................6

5.5

Average Accounting Return (ARR).............................................................6

5.5.1

Process................................................................................................ 6

5.5.2

Example.............................................................................................. 6

5.5.3

Advantages and Disadvantages..........................................................7

5.6

Internal Rate of Return..............................................................................7

5.6.1

Process................................................................................................ 7

5.6.2

Example.............................................................................................. 8

5.6.3

NPV profile for the project...................................................................8

5.6.4

Advantages of IRR............................................................................... 8

5.6.5 Problems with IRR:- Non conventional Cash flow & Mutually Exclusive
Project 9
5.7

Profitability Index.................................................................................... 11

5.7.1

Example............................................................................................ 11

5.7.2

Advantages and disadvantages........................................................12

5.8

Capital Budgeting In Practice..................................................................12

5.9

Summary................................................................................................. 12

5.1 Introduction

Capital budgeting (or investment appraisal) is the planning process used

to determine whether an organization's long term investments such as
new machinery, replacement machinery, new plants, new products, and
research development projects are worth pursuing (Wikipedia)

We need to ask ourselves the following questions when evaluating capital

budgeting decision rules

Does the decision rule adjust for the time value of money?

Does the decision rule adjust for risk?

Does the decision rule provide information on whether we are

creating value for the firm?

Which method suit with our objectives?

Methods that we will cover: Net Present Value (NPV)

Payback and Discounted Payback
The average accounting return
Internal rate of return (IRR)
The profitability index (PI)

All the discussions of the methods will use the example below:

You are looking at a new project and you have estimated the following
cash flows:

Year 0:

CF = -165,000

Year 1:

CF = 63,120; NI = 13,620

Year 2:

CF = 70,800; NI = 3,300

Year 3:

CF = 91,080; NI = 29,100

Average Book Value = 72,000

Your required return for assets of this risk is 12%.

5.2 NPV

NPV is a process of identifying profitable projects by incorporating the time value

of money of the net cash flow of the project over its costs.
5.2.1 Process

The first step is to estimate the expected future cash flows.

The second step is to estimate the required return for projects of this risk
level.
The third step is to find the present value of the cash flows and subtract
the initial investment.
If the NPV is positive, accept the project
A positive NPV means that the project is expected to add value to the firm
and will therefore increase the wealth of the owners.

5.2.2 Example

Using the formulas:

Using the calculator:

NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 165,000 =

12,627.42

CF0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1;

C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.42

Do we accept or reject the project?

Accept coz NPV +

5.3 Payback Period

To know how long does it take to get the initial cost back in a nominal sense.
5.3.1 Process

Estimate the cash flows

Subtract the future cash flows from the initial cost until the initial
investment has been recovered

Decision Rule Accept if the payback period is less than some

preset limit

Formula if Cash flow is inconsistent

Payback Period= year before recovery +

unrecovered cost at start of the year

Cash flow during the year

Formula if cash flow is consistent

Payback Period =

Init ial Investment

Cash flow

5.3.2 Example

Assume we will accept the project if it pays back within two years.

Year 1: 165,000 63,120 = 101,880 still to recover

Year 2: 101,880 70,800 = 31,080 still to recover

Year 3: 31,080 91,080 = -60,000 project pays back in year 3

To be precise

Payback Period= year before recovery +

Payback perio d=2 y +

unrecovered cost at start of the year

Cash flow during the year

31,080
=2.342 years 4 months
91,080

Do we accept or reject the project?

Reject coz more than 2 years

5.3.3 Advantages and disadvantages

Advantages

Easy to understand
4

Adjusts for uncertainty of later cash flows

Biased towards liquidity

Disadvantages

Ignores the time value of money

Requires an arbitrary cutoff point

Ignores cash flows beyond the cutoff date

Biased against long-term projects, such as research and

development, and new projects

5.4 Discounted Payback Period

Similar to payback method except that the cash flow is discounted.
5.4.1 Example

Assume we will accept the project if it pays back on a discounted basis in

2 years.

Compute the PV for each cash flow and determine the payback period
using discounted cash flows

Year 1: 165,000 63,120/1.121 = 108,643

Year 2: 108,643 70,800/1.122 = 52,202

Year 3: 52,202 91,080/1.123 = -12,627 project pays back in year 3

To be precise

Payback Period= year before recovery +

Payback period=2 y+

unrecovered cost at start of the year

Cash flow during the year

52,202
=2.8052 years10 months
91,080 /(1.12)

Or you can use table.

Yr

CF

Pvif
(12%)

CF x PVIF

(2)

(3)
(3= 1 x
2)

Accumulate
d CF
(4)
(4n= 4n-1 +
3n)

0.8929
0.7972
0.7118

56,359
56,441
64,831

56,359
112,800
177,631

(1)

0
1
2
3

63120
70800
91080

Payback Period= year before recovery +

Payback period=2 y+

Remaini
ng
balance
(5)
(5n = 5n1 3n)
165000
108641
52200
(12,631)

unrecovered cost at start of the year

Cash flow during the year

165 000112,800
=2.8052 years10 months
64831

Do we accept or reject the project?

Reject coz more than 2 years.

5.4.2 Advantages and disadvantages

Advantages

Includes time value of money

Easy to understand

Does not accept negative estimated NPV investments when all

future cash flows are positive

Biased towards liquidity

Disadvantages

May reject positive NPV investments

Requires an arbitrary cutoff point

Ignores cash flows beyond the cutoff point

Biased against long-term projects, such as R&D and new products

5.5 Average Accounting Return (ARR)

Basically, there are many benchmark uses but we only focus as what being
define in the text book (page 271)

Average Net Income

Average Book Value
5.5.1 Process

Need to have cut off point

Decision Rule: Accept the project if the AAR is greater than a preset
rate.

5.5.2 Example

Assume we require an average accounting return of 25%

Average Net Income:

Average Net Income

Average Book Value

AAR =

(13,620 + 3,300 + 29,100) / 3 = 15,340

15,340 / 72,000 = .213 = 21.3%

Do we accept or reject the project?

Reject coz lower than 25%

5.5.3 Advantages and Disadvantages

Advantages

Easy to calculate

Needed information will usually be available

Disadvantages

Not a true rate of return; time value of money is ignored

Uses an arbitrary benchmark cutoff rate

Based on accounting net income and book values, not cash flows
and market values

5.6 Internal Rate of Return

Definition: IRR is the discount rate of return that makes the NPV = 0

5.6.1 Process

Decision Rule: Accept the project if the IRR is greater than the
required return

5.6.2 Example

Use trial and error or financial calculator

Let the required return is 12%

Calculator

Enter the cash flows as you did with NPV

Press IRR and then CPT
IRR = 16.13% > 12% required return

Do we accept or reject the project?

Accept since IRR is greater than the required rate of return

5.6.3 NPV profile for the project

80,000
60,000
40,000
NPV

20,000
0
-20,000

0.02 0.06
0.1
0.14 0.18 0.22
0
0.04 0.08 0.12 0.16
0.2
Discount Rate

5.6.4 Advantages of IRR

Knowing a return is intuitively appealing

It is a simple way to communicate the value of a project to someone who

doesnt know all the estimation details

If the IRR is high enough, you may not need to estimate a required return,
which is often a difficult task

5.6.5 Problems with IRR: - Non conventional Cash flow & Mutually
Exclusive Project

NPV and IRR will give similar decisions (reject or accept a project) except in two
conditions:- Non conventional Cash Flow and Mutually exclusive projects
5.6.5.1Non conventional Cash Flow

Happen when cash flow are inconsistent i.e. sometimes + and

sometimes , it will produce 2 extreme IRR which is totally inaccurate
Example
o Suppose an investment will cost $90,000 initially and will generate
the following cash flows:
o Year 1: 132,000
o Year 2: 100,000
o Year 3: -150,000
o The required return is 15%.
Should we accept or reject the project?
NPV profile

$4,000.00
$2,000.00
$0.00
($2,000.00) 0.05 0.15 0.25 0.35 0.45 0.55
NPV
0.1
0.2
0.3
0.4
0.5
($4,000.00) 0
($6,000.00)
($8,000.00)
($10,000.00)
Discount Rate

10

IRR
Summary of Decision Rules

The NPV is positive at a required return of 15%, so you should Accept

If you use the financial calculator, you would get an IRR of 10.11% which
would tell you to Reject

You need to recognize that there are non-conventional cash flows and look
at the NPV profile

5.6.5.2Mutually exclusive project

Can only select one out of many alternative projects.

However, The results base on NPV may conflicted with IRR

Example

$200.00
$150.00
NPV

$100.00
$50.00 A
$0.00
($50.00)

0.05 0.1 0.15 0.2 0.25 0.3

Discount Rate

11

Which one to choose? Project A or Project B?

Cross over rate = 11.8%

IRR A (19.43%) < IRR B (22.7%)

Based on IRR should select B is it correct?

Nope depend on the required rate of return.
Before cross over rate NPV A > NPV B, Beyond Cross over rate NPV B > NPV A.
We should decide our investment based on required rate of return, if our required
return is less than 11.8% the answer should be project A and if more than 11.8%
should choose project B. In a nutshell we may reject project A by mistake due to
IRR based decisions.
Therefore crossover rate is vital in determine which project should we accept.
Below and beyond crossover rate will give different results regarding which
project should we accept.
To calculate crossover rate (April 2008 Q 3)
Yea Projec Projec Differe
r
tx
tY
nt
95000 12500 82500
0
0
0
0
33000
27500
1
0 55000
0
40000
35000
2
0 50000
0
45000
40000
3
0 50000
0

IRR

10.95
%

Use your financial calculator to find IRR (crossover rate). = 10.95%

Which project should we choose?
Two methods: - Graph or Calculation
Method 1:- Graph
First, calculate IRR for each project

12

Yea
r
0
1
2
3
IRR

Projec Projec
tx
tY
95000 12500
0
0
33000
0 55000
40000
0 50000
45000
0 50000
11.06 11.79
%
%

X
Y

Below Cross over rate = project X, Beyond cross over rate, project Y
Method 2:- Calculation
Recalculate NPV based on two different rates, below and beyond crossover rate.
Crossover rate = 10.95%
Let, I = 9 % and 12 %
I= 9%

I=12%

Yea
r
Project x
Project Y
Project x
Project Y
0
-950000
-125000
-950000
-125000
1
330000
55000
330000
55000
2
400000
50000
400000
50000
3
450000
50000
450000
50000
NP
RM36,906. RM6,151. (RM16,178.
(RM444.
V
86
89
48)
15)
Before cross over rate= project x, beyond crossover rate=project Y

5.6.5.3Conflicts between NPV and IRR

13

Based on the discussion in previous sections we can say that:

NPV directly measures the increase in value to the firm

Whenever there is a conflict between NPV and another decision rule, you
should always use NPV

IRR is unreliable in the following situations

Non-conventional cash flows

Mutually exclusive projects

5.7 Profitability Index

An index that attempts to identify the relationship between the costs and benefits of a proposed project through the
use of a ratio calculation (investopedia)
An index that attempts to identify the relationship between the costs and benefits of a proposed project through the
use of a ratio calculated as:

Net Present Value

=

1+
Initial Investment Required

Read more: http://www.investopedia.com/terms/p/profitability.asp#ixzz1qrfqQnpD

If we have more than 1, then the project can be accepted. PI >1 also indicate that NPV is positive.

5.7.1 Example
Extract from accountingexplained.com
Company C is undertaking a project at a cost of $50 million which is expected to generate future net cash flows with a
present value of $65 million. Calculate the profitability index.

Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Net Future Cash Flows Initial Investment Required
Net Present Value = $65M-$50M = $15M.

The information about NPV and initial investment can be used to calculate profitability index as follows:

14

Profitability Index = 1 + (Net Present Value / Initial Investment Required)

Profitability Index = 1 + $15M/$65 = 1.3

5.7.2 Advantages and disadvantages

Advantages

Closely related to NPV, generally leading to identical decisions

Easy to understand and communicate

May be useful when available investment funds are limited

Disadvantages

May lead to incorrect decisions in comparisons of mutually exclusive

investments
Example (page 284):Project A: - cost = $5 PVCF = $10
$150
PI A = 2 NPV A = $5

Project B: - cost=$100 PVCF=

PI B= 1.5 NPV B = $50

If based on PI, than accept A which is wrong as NPV is superior than

PI.

5.8 Capital Budgeting In Practice

We should consider several investment criteria when making decisions

NPV and IRR are the most commonly used primary investment criteria

Payback is a commonly used secondary investment criteria

5.9 Summary

Net present value

Difference between market value and cost
Take the project if the NPV is positive
Has no serious problems
Preferred decision criterion

Internal rate of return

Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required
return
Same decision as NPV with conventional cash flows
15

IRR is unreliable with non-conventional cash flows or

mutually exclusive projects

Profitability

Payback period
Length of time until initial investment is recovered
Take the project if it pays back in some specified period
Doesnt account for time value of money and there is an
arbitrary cutoff period

Discounted payback period

Length of time until initial investment is recovered on a
discounted basis
Take the project if it pays back in some specified period
There is an arbitrary cutoff period

Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital
rationing

Average Accounting Return

Measure of accounting profit relative to book value

Similar to return on assets measure

Take the investment if the AAR exceeds some specified return

level

Serious problems and should not be used

16