FINANCIAL MANAGEMENT

CHAPTER 6: INTRODUCTION TO CAPITAL BUDGETING

Capital Budgeting is (Montvale, N.J.: NAA, June 1, 1983)

 The process includes planning for and preparing the capital budget as well as reviewing past
investments to assess and enhance the effectiveness of the process.
 The capital budget is a key instrument in implementing organizational strategies.
 Capital budgeting involves comparing and evaluating alternative projects within a budgetary
framework.
 By evaluating potential capital projects using a portfolio of criteria, managers can be confident that all
possible costs and contributions of projects have been considered.

Firms use a variety of techniques to evaluate capital investments. Some techniques involve very simple
calculations and are intuitively easy to grasp. Financial manager prefer 1) an easily applied technique that 2)
considers cash flow, 3) recognizes the time value of money, 4) fully accounts for expected risk and return, and
5) when applied, leads to higher stock prices. Easy application accounts for the popularity of some simple
capital budgeting methods such as accounting rate of return and the payback period. More complex methods
such as net present value (NPV), internal rate of return (IRR) or the profitability index (PI) generally lead to
better decision making because they take into account issues 1-5 outlined above, factors that are neglected or
ignored by simpler methods.

Accounting Rate of Return

Some firms base their investment decision on accounting-based rate of return measures. Companies
have many different ways of defining a hurdle rate for their investment in terms of accounting rates of return.
Almost all these metrics involve two steps: 1) to identify the project’s net income each year and 2) to measure
the project’s invested capital requirements, as shown on the balance sheet, each year. Give these two figures, a
firm my calculate an accounting rate of return by dividing net income by the book value assets, either on a year-
by-year basis or by taking an average over the project’s life.
Annual Net Income
ARR =
Net Initial Investment or Average Investment

Payback Period
The payback method is the simplest of all capital budgeting decision-making tools. It enjoys widespread use,
particularly in small firms. The payback period is the time for a project’s cumulative net cash inflows to recoup
the initial investment. If a firm decides that it wants to avoid any investment that does
Payback Period = Investment / Annuity
Assume for a moment that an investment being considered by eRAGs requires an initial investment of $10,000
and is expected to generate equal annual cash flows of $4,000 in each of the next 5 years.

Net Present Value

The net present value (NPV) of a project is the sum of the present values of all its cash flows, both inflows and
outflows, discounted at a rate consistent with the project’s risk. The NPV can be defined as the present value of
future cash inflows minus the initial outlay. The NPV decision rule says that firms should invest when the sum
of the present values of future cash inflows exceeds the initial project outlay. That is, NPV > $0, when the
following occurs:
CF1 CF2 CF3 CFN
CF < + + +...+
(1 + r) 1 (1 + r) 2 (1 + r) 3 (1 + r) N

Simply stated, the NPV decision rules are:

NPV > $0 invest
NPV < $0 do not invest
Or the total present value of all cash outflows of an investment project subtracted from the total present value of
all cash inflows yields the net present value (NPV)
NPV = (Today’s value of the expected future cash flow) – (Today’s value of invested cash)

Suppose that investors require a 5% return on five-year Treasury bonds. Of course, this means that if the U.S.
Treasury issues five-year, $1,000 par value bonds paying an annual coupon of $50, the market price of these
bonds will be $1,000 equal to par value.

Internal Rate of Return

Perhaps the most popular and intuitive decision criterion is the internal rate of return (IRR) method. An
investment’s internal rate of return is analogous to a bond’s yield-to-maturity. IRR is the compound annual rate
of return on the project, give it up-front costs and subsequent cash flows. The hurdle rate represents the firm’s
minimum acceptable return for a given project, so the decision rule is to invest if the project’s IRR exceeds the
hurdle rate.
Problems with the Internal Rate of Return
1. Multiple IRRs. One difficult with the IRR method can occur when the project’s cash flow alternte
between negative and positive values, that is when the project generates an alternating series of net cash
inflows and outflows.
2. No Real Solution. When you enter the cash flow from a particular investment into a calculator or a
spreadsheet, you may receive an error message indicating that there is no solution to that problem. For
 some cash flow patterns, it is possible that there is no real discount rate that equates the project’s NPV to
zero.

Profitability Index
The profitability index is a ratio comparing the present value of a project’s net cash inflows to the
project’s net investment.
PI = Present Value of Net Cash Flows / Net Investment

The decision rule to follow when evaluating investment projects using the PI is to invest when the PI is greater
then 1.0 (i.e., when the present value of cash inflows exceeds the initial cash outflow). And to refrain from
investing when the PI is less than 1.0.

Problems:
1. The following information illustrates the calculation and use of a profitability index. eRAGs is considering
two investments: a training program for employees costing $720,000 and a series of Internet servers costing
$425,000. Corporate managers have computed the present values of the investments by discounting all future
expected cash flows at a rate of 12 percent. Present values of the expected net cash inflows are $900,000 for the
training program and $580,000 for the servers.

2. U.S Treasury issues 7 years, $ 2,500 par value bonds paying annual coupon of $55. The investors require a
6% return. Compute for the NPV. Should the firm must invest or not?Why or Why not?

3. Company C is planning to undertake a project requiring initial investment of $105 million. The project is
expected to generate $25 million per year in net cash flows for 7 years. Calculate the payback period of the
project.