POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

CAPITAL BUDGETING
TECNIQUES

A Written Report
Presented to the Faculty of the Graduate School
Polytechnic University of the Philippines
Sta. Mesa, Manila

In Partial Fulfillment of the Requirements for the Degree

Masters in Business Administration
Major in Financial Management

By

KATHLEEN MAE C. AMADA

February 24, 2019

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CAPITAL BUDGETING TECHNIQUES

What is Capital Budgeting?
Capital budgeting is the process in which a business determines and evaluates potential
large expenses or investments. These expenditures and investments include projects such as
building a new plant or investing in a long-term venture. Often, a company assesses a
prospective project's lifetime cash inflows and outflows to determine whether the potential
returns generated meet a sufficient target benchmark, also known as "investment appraisal."
Ideally, businesses should pursue all projects and opportunities that enhance shareholder
value. However, because the amount of capital available for new projects is limited, management
needs to use capital budgeting techniques to determine which projects will yield the most return
over an applicable period. Various methods of capital budgeting can include net present value,
internal rate of return, and payback period.
When a firm is presented with a capital budgeting decision, one of its first tasks is to
determine whether or not the project will prove to be profitable. The net present value (NPV),
internal rate of return (IRR), and payback period (PB) methods are the most common
approaches to project selection. Although an ideal capital budgeting solution is such that all
three metrics will indicate the same decision, these approaches will often produce contradictory
results. Depending on management's preferences and selection criteria, more emphasis will be
put on one approach over another. Nonetheless, there are common advantages and disadvantage
associated with these widely used valuation methods.

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What is Net Present Value (NPV)?

Net present value (NPV) is the difference between the present value of cash inflows
and the present value of cash outflows over a period of time. NPV is used in capital budgeting
and investment planning to analyze the profitability of a projected investment or project.
The following formula is used to calculate NPV:

NPV is a formula used to determine the present

value of an investment by the discounted sum of all
cash flows received from the project. The formula for
the discounted sum of all cash flows can be rewritten as:
Breaking Down Net Present Value
Money in the present is worth more than the same amount in the future due to inflation
and to earnings from alternative investments that could be made during the intervening time. In
other words, a dollar earned in the future won’t be worth as much as one earned in the present.
The discount rate element of the NPV formula is a way to account for this.
For example, assume that an investor could choose a $100 payment today or in a year. A
rational investor would not be willing to postpone payment. However, what if an investor could
choose to receive $100 today or $105 in a year? If the payer was reliable, that extra 5% may be
worth the wait, but only if there wasn’t anything else the investors could do with the $100 that
would earn more than 5%.
An investor might be willing to wait a year to earn an extra 5%, but that may not be
acceptable for all investors. In this case, the 5% is the discount rate which will vary depending
on the investor. If an investor knew they could earn 8% from a relatively safe investment over
the next year, they would not be willing to postpone payment for 5%. In this case, the investor’s
discount rate is 8%.
A company may determine the discount rate using the expected return of other projects
with a similar level of risk or the cost of borrowing money needed to finance the project. For
example, a company may avoid a project that is expected to return 10% per year if it costs 12%
to finance the project or an alternative project is expected to return 14% per year.

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Example of Net Present Value

To provide an example of Net Present Value, consider company Shoes ForYou's who is
determining whether they should invest in a new project. Shoes for You's will expect to invest
$500,000 for the development of their new product. The company estimates that the first year
cash flow will be $200,000, the second year cash flow will be $300,000, and the third year cash
flow to be $200,000. The expected return of 10% is used as the discount rate.
The following table provides each year's cash flow and the present value of each cash flow.
Year Cash Flow Present Value
0 -$500,000 -$500,000
1 $200,000 $181,818.18
2 $300,000 $247,933.88
3 $200,000 $150,262.96
Net Present Value = $80,015.02
The net present value of this example can be shown in the formula:

When solving for the NPV of the formula, this new project would be estimated to be a
valuable venture.
The Bottom Line
Net present value (NPV) is the calculation used to find today’s value of a future stream
of payments. It accounts for the time value of money and can be used to compare investment
alternatives that are similar. The NPV relies on a discount rate of return that may be derived
from the cost of the capital required to make the investment, and any project or investment with
a negative NPV should be avoided. An important drawback of using an NPV analysis is that it
makes assumptions about future events that may not be reliable.

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What Is the Internal Rate of Return (IRR)?

The internal rate of return (IRR) is a metric used in capital budgeting to estimate the
profitability of potential investments. The internal rate of return is a discount rate that makes the
net present value (NPV) of all cash flows from a particular project equal to zero. IRR
calculations rely on the same formula as NPV does.
The Formula for IRR Is

Where:
Ct = net cash inflow during the period t
Co = total initial investment costs
r = the discount rate, and
t = the number of time periods
How to Calculate IRR
To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount
rate (r), which is the IRR. Because of the nature of the formula, however, IRR cannot be
calculated analytically and must instead be calculated either through trial-and-error or using
software programmed to calculate IRR.
Generally speaking, the higher a project's internal rate of return, the more desirable it is to
undertake. IRR is uniform for investments of varying types and, as such, IRR can be used to
rank multiple prospective projects on a relatively even basis. Assuming the costs of investment
are equal among the various projects, the project with the highest IRR would probably be
considered the best and be undertaken first.
IRR is sometimes referred to as "economic rate of return" or "discounted cash flow rate of
return." The use of "internal" refers to the omission of external factors, such as the cost of
capital or inflation, from the calculation.
What Does IRR Tell You?
You can think of the internal rate of return as the rate of growth a project is expected to
generate. While the actual rate of return that a given project ends up generating will often differ
from its estimated IRR, a project with a substantially higher IRR value than other available
options would still provide a much better chance of strong growth.
One popular use of IRR is comparing the profitability of establishing new operations with that
of expanding existing ones. For example, an energy company may use IRR in deciding whether

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to open a new power plant or to renovate and expand a previously existing one. While both
projects are likely to add value to the company, it is likely that one will be the more logical
decision as prescribed by IRR.
IRR is also useful for corporations in evaluating stock buyback programs. Clearly, if a company
allocates a substantial amount to a stock buyback, the analysis must show that the company's
own stock is a better investment (has a higher IRR) than any other use of the funds for other
capital projects, or than any acquisition candidate at current market prices.
Key Takeaways
IRR is the rate of growth a project is expected to generate.
IRR is calculated by the condition that the discount rate is set such that the NPV = 0 for a
project.
IRR is used in capital budgeting to decide which projects or investments to undertake and which
to forgo.
Example of How to Use the Internal Rate of Return (IRR)
In theory, any project with an IRR greater than its cost of capital is a profitable one, and thus it
is in a company’s interest to undertake such projects. In planning investment projects, firms will
often establish a required rate of return (RRR) to determine the minimum acceptable return
percentage that the investment in question must earn in order to be worthwhile.
Any project with an IRR that exceeds the RRR will likely be deemed a profitable one, although
companies will not necessarily pursue a project on this basis alone. Rather, they will likely pursue
projects with the highest difference between IRR and RRR, as these likely will be the most
profitable.
IRR can also be compared against prevailing rates of return in the securities market. If a firm
can't find any projects with IRR greater than the returns that can be generated in the financial
markets, it may simply choose to invest its retained earnings into the market. Although IRR is an
appealing metric to many, it should always be used in conjunction with NPV for a clearer picture
of the value represented by a potential project a firm may undertake.
IRR in practice is calculated by trial and error since there is no analytical way to compute when
NPV will equal zero. Computers or software like Excel can do this trial and error procedure
extremely quickly. But, as an example, let's assume that you want to open a pizzeria. You
estimate all the costs and earnings for the next two years, and then calculate the net present
value for the business at various discount rates. At 6%, you get an NPV of $2000.
But, the NPV needs to be zero, so you try a higher discount rate, say 8% interest: At 8%, your
NPV calculation gives you a net loss of −$1600. Now it's negative. So you try a discount rate in
between the two, say with 7% interest: At 7%, you get an NPV of $15.
That is close enough to zero, so you can estimate that your IRR is just slightly higher than 7%.

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Limitations of the Internal Rate of Return (IRR)

While IRR is a very popular metric in estimating a project’s profitability, it can be misleading if
used alone. Depending on the initial investment costs, a project may have a low IRR but a high
NPV, meaning that while the pace at which the company sees returns on that project may be
slow, the project may also be adding a great deal of overall value to the company.
A similar issue arises when using IRR to compare projects of different lengths. For example, a
project of short duration may have a high IRR, making it appear to be an excellent investment,
but may also have a low NPV. Conversely, a longer project may have a low IRR, earning returns
slowly and steadily, but may add a large amount of value to the company over time.
Another issue with IRR is one not strictly inherent to the metric itself, but rather to a common
misuse of IRR. People may assume that, when positive cash flows are generated during the
course of a project (not at the end), the money will be reinvested at the project’s rate of return.
This can rarely be the case.
Rather, when positive cash flows are reinvested, it will be at a rate that more resembles the cost
of capital. Miscalculating using IRR in this way may lead to the belief that a project is more
profitable than it actually is. This, along with the fact that long projects with fluctuating cash
flows may have multiple distinct IRR values, has prompted the use of another metric called
modified internal rate of return (MIRR).

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What is Payback Period?

The payback period is the length of time required to recover the cost of an investment.
The payback period of a given investment or project is an important determinant of whether to
undertake the position or project, as longer payback periods are typically not desirable for
investment positions. The payback period ignores the time value of money (TVM), unlike other
methods of capital budgeting such as net present value (NPV), internal rate of return (IRR), and
discounted cash flow.
Breaking Down Payback Period
Much of corporate finance is about capital budgeting. One of the most important
concepts that every corporate financial analyst must learn is how to value different investments
or operational projects. The analyst must find a reliable way to determine the most profitable
project or investment to undertake. One way corporate financial analysts do this is with the
payback period.
Capital Budgeting and the Payback Period
Most capital budgeting formulas take the time value of money into consideration. The
time value of money (TVM) is the idea that money today is worth more than the same amount
in the future due to present money's earnings potential. Therefore, if you pay an investor
tomorrow, it must include an opportunity cost. The time value of money is a concept that
assigns a value to this opportunity cost.
The payback period disregards the time value of money. Simply, it is determined by
counting the number of years it takes to recover the funds invested. For example, if it takes five
years to recover the cost of the investment, the payback period is five years. Some analysts favor
the payback method for its simplicity. Others like to use it as an additional point of reference in
a capital budgeting decision framework.
Payback Period Example
Assume Company A invests $1 million in a project that is expected to save the company
$250,000 each year. The payback period for this investment is 4 years, which is found by
dividing $1 million by $250,000. Consider another project that costs $200,000, has no associated
cash savings, but will make the company an incremental $100,000 each year for the next 20 years
($2 million). Clearly, the second project can make the company twice as much money, but how
long will it take to pay the investment back? The answer is found by dividing $200,000 by
$100,000, which is 2 years. The second project will take less time to pay back and the company's
earnings potential is greater. Based solely on the payback period method, the second project is a
better investment.
The Most Simple Form of Capital Budgeting
Payback analysis is the simplest form of capital budgeting analysis and is therefore the
least accurate. However, managers still use this method because it's quick and can give managers

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a "back of the napkin" understanding of the efficacy of a project or group of projects. This
analysis calculates how long it will take to recoup the investment of a project. One can identify
the payback period by dividing the initial investment by the average yearly cash inflow.

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Evaluation Techniques of Capital Budgeting

The process of capital budgeting requires constant evaluation in order to make sure that
you are making the right decisions for your business. Here are a few of the more popular
methods of evaluation for capital budgeting.
Net Present Value
Calculating the net present value is one of the most common ways to evaluate a capital
budgeting process. In order to perform this calculation, you will take the value of the present
benefits of the project and subtract the present costs. The difference provides you with the net
present value.
Internal Rate of Return
Another popular method of evaluation is referred to as the internal rate of return. This is
a discount rate that is commonly used to determine how much of a return an investor can expect
to realize from a particular project.
Payback Period
The payback period is another method that many businesses use to determine whether
to keep pursuing a project. With this method, you are basically determining how long it will take
to pay back the initial investment that is required to undergo a project. In order to calculate this,
you would take the total cost of the project and divide it by how much cash inflow you expect to
receive each year. This will give you the total number of years or the payback period.
Example:
The Martin Company is considering the four different investment opportunities. The selected
information about each proposal is given below:
The present value of cash inflows given above have been computed using a 10% discount rate.
The company is unable to accept all available projects because the funds available for investment
are limited.
Required:
Compute the profitability index (present value index) for all the projects.
Rank the four investment projects according to preference using:
(a). net present value (NPV).
(b). profitability index (PI).
(c). internal rate of return (IRR).
Which one is the best approach for Martin Company to rank five competing projects?

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Solution:
(1). Computation of profitability index:
Formula of profitability/present value index is:
Profitability index = Present value of cash inflows/Investment required
Project 1: $1,134,540/$960,000 = 1.18
Project 2: $866,800/$720,000 = 1.20
Project 3: $672,280/$540,000 = 1.24
Project 4: $1,045,490/$900,000 = 1.16
Project 5: $759,520/$800,000 = 0.95
(2) Preference ranking of projects:
3. The best ranking approach:
The best method of ranking projects depends on the availability of good reinvestment
opportunities. Under internal rate of return (IRR) method, we assume that the funds released
from a project are reinvested in another project yielding the internal rate of return equal to the
previous project. According to IRR, the project 4 is ranked at number one with 19% IRR. It
means any funds released from project 4 must be reinvested in another project yielding an
internal rate of return of at least 19% but It might be difficult to find a project with such a high
IRR.
The profitability index (PI) shows the present value of cash inflow generated by each
dollar invested in a project. It assumes that the funds released from a project are reinvested in
another project with a return equal to the discount rate. In our problem, the discount rate is only
10%. Generally, the profitability index is considered the most dependable method of ranking
competing projects.
The net present value (NPV) method considers the net present value figure but does not
take into account the amount of investment required for the project. Therefore, this method is
not appropriate for comparing or ranking competing projects that require different amounts of
investment. For example, project 3 is ranked at number four because of its low net present
value but it is the best option if we see at the present value of net cash inflow generated by each
dollar invested in the project (as shown by the profitability index).

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