Topic 5:

Capital Budgeting Techniques

BWFF2023 FINANCIAL MANAGEMENT II

Capital Budgeting:
The process of planning for purchases of longterm assets.
- Accept or Reject?
- Focus on Cash Flow
For

example: Suppose our firm

must decide whether to purchase a
new plastic molding machine for
$125,000. How do we decide?
Will the machine be profitable?
Will our firm earn a high rate of
return on the investment?

Decision-making Criteria in
Capital Budgeting
How do we
decide if a
capital
investment
project should
be accepted or
rejected?

Decision-making Criteria in
Capital Budgeting
The

ideal evaluation method should:

a) include all cash flows that occur

during the life of the project,
b) consider the time value of money,
and
c) incorporate the required rate of
return on the project.

Decision-making Criteria in
Capital Budgeting
Firms invest in 2 categories of projects:
1) Independent

projects do not compete with

each other. A firm may accept none, some, or
all from among a group of independent projects.

2) Mutually

exclusive projects compete against

each other. The best project from among group
of acceptable mutually exclusive projects is
selected.

Techniques in Capital
Budgeting
1)
2)
3)
4)
5)

Payback period
Discounted Payback Period
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)

1) Payback Period
The

number of years needed to recover the initial cash

outlay.
The payback period is calculated by adding the free cash
flows up until they are equal to the initial fixed investment.
How long will it take for the project to generate enough
cash to pay for itself?

Example:

Free cash flow

(500) 100 250

0

Initial outlay

50 300 300 (150) (150) (150)

3

Payback Period
Initial outlay = $500.00

Project A
Year Cash flow
1
$100
2
$250
3
$50
4
$300
5
$300
6
($150)
7
($150)
8
($150)

Annual free cash flows:

Year 1 : $100, balance left : $400
Year 2 : $250, balance left : $150
Year 3 : $50, balance left : $100

500 - 100
400 - 250
150 - 50

Year 4 : $300
We know that the payback period is 3 years ++ and the
remaining $100 can be recaptured during year 4, but how
to
find the remaining period?
To determine the remaining period:
= $ 100 (balance left in year 3)
$ 300 (cash flow in year 4)
= 0.33 year.
So the payback period for this project is 3.33 years.

Payback Period
3

+ ($100/$300) = 3 + 0.33 = 3.33 years

Is a 3.33 year payback period good?
Is it acceptable?
Firms that use this method will compare the
payback calculation to some standard set by the
firm.
If our senior management had set a cut-off of 5
years for projects like ours, what would be our
decision?
Accept the project

DECISION RULE :
ACCEPT if payback < maximum acceptable payback
period.
REJECT if payback > maximum acceptable payback
period.

Advantages of Payback Period

Uses

free cash flows measures

the true timing of benefit.
Easy to calculate and
understand.
May be used as rough screening
device.

Drawbacks of Payback Period

Firm

cutoffs are subjective.

Does not consider time value of
money.
Does not consider any required
rate of return.
Does not consider all of the
projects cash flows.

2) Discounted Payback Period

The

number of years needed to recover

initial cash outlay from the discounted
free cash flows.
Discounts the cash flows at the firms
required rate of return.
Payback period is calculated by adding
up these discounted net cash flows until
they are equal to the initial outlay.

Discounted Payback Period

(500)

250

250

250

250

250

Initial outlay = $500.00

Discounted free cash flows:
Year 1 : $219.30, balance left : $ 280.70

Year 2 : $192.37, balance left : $88.33

Year 3 : $168.74

Year Free Cash Discounted

Flow CF (14%) Balance Left
0
-500
-500.00
1

250

219.30

280.70

250

192.37

88.33

250

168.74

We know that the payback period is 2

years ++ and the remaining $88.33 can
be
recaptured during year 3, but how to
find
the remaining period?
To determine the remaining period:
= $ 88.33 (balance left in year 2)
$ 168.74 (discounted cash flow year
3)

FCF
(1 + k)n

= 0.52 year.
So the payback period for this project is
2.52 years.

Discounted Payback Period

Discounted

payback period is 2.52 years.

Is it acceptable?

ACCEPT if discounted payback < maximum acceptable

discounted payback period.
REJECT if discounted payback > maximum acceptable
discounted payback period.

Discounted Payback Period

Advantages:
Uses free cash flows
Easy to calculate and to understand
Considers time value of money
Disadvantages:
Ignores free cash flows occurring after
the payback period.
Selection of the maximum acceptable
discounted payback period is arbitrary.

Exercise:
You are considering a project with an initial outlay of $70,000 and
expected free cash flows of $20,000 at the end of each year for six years.
The required rate of return for this project is 10%.
a.What is the projects payback period?
b.What is the projects discounted payback period?

Exercise:
You are considering a project with an initial outlay of $70,000 and
expected free cash flows of $20,000 at the end of each year for six years.
The required rate of return for this project is 10%.
a.What is the projects payback period?
b.What is the projects discounted payback period?
Solution:
Payback period
Year
Year
Year
Year
Year

0
1
2
3
4

Cash Flow
(70,000)
20,000
20,000
20,000
20,000

Balance left
-70,000
-50,000
-30,000
-10,000

Payback period = 3 + (10,000/20,000) = 3.5 years

(balance left in year 3)

(cash flow in year 4)

Exercise:
You are considering a project with an initial outlay of $70,000 and
expected free cash flows of $20,000 at the end of each year for six years.
The required rate of return for this project is 10%.
a.What is the projects payback period?
b.What is the projects discounted payback period?
Solution:

FCF
(1 + k)n

Discounted Payback period

Year
0
1
2
3
4
5

Free Cash Flow

(70,000)
20,000
20,000
20,000
20,000
20,000

Discounted Cash Flow

(70,000)
18,181.82
16,528.93
15,026.30
13,660.27
12,418.43

Balance left
-70,000
-51,818.18
-35,289.25
-20,262.95
-6,602.68

Payback period = 4 + (6,602.68/12,418.43) = 4.53 years

(balance left in year 4)

(discounted cash flow in year 5)

Exercise:
You are considering 3 independent projects; project A, project B and
project C. The required rate of return is 10% on each. Given the following
free cash flow information, calculate the payback period and discounted
payback period for each .
YEAR

PROJECT A

PROJECT B

PROJECT C

- $ 10, 000

- $5, 000

- $ 1,000

600

5,000

1,000

300

3,000

1,000

200

3,000

2,000

100

3,000

2,000

500

3,000

2,000

If you required a three-year payback for both the traditional and

discounted payback period methods before an investment can be
accepted, which project would be accepted under each method?

Other Methods
3) Net Present Value (NPV)
4) Profitability Index (PI)
5) Internal Rate of Return (IRR)
Consider each of these decision-making
criteria:
All net cash flows.
The time value of money.
The required rate of return.

3) Net Present Value (NPV)

NPV

= the total of all PV of the annual

net cash flows the initial outlay

Net Present Value (NPV)

Decision rule :
ACCEPT if NPV is positive { NPV > 0.0 }
REJECT if NPV is negative { NPV < 0.0 }

NPV Example
Suppose we are considering a capital investment
that costs $250,000 and provides annual net cash
flows of $100,000 for five years. The firms
required rate of return is 15%.
(250,000)
0

100,000
1

100,000
2

100,000
3

100,000
4

100,000
5

NPV Example
Suppose we are considering a capital investment
that costs $250,000 and provides annual net cash
flows of $100,000 for five years. The firms
required rate of return is 15%.
(250,000)

100,000

100,000

100,000

100,000
4

(n=1)
(n=2)
(n=3)
(n=4)
(n=5)

100,000
5

Steps to calculate NPV

Find the PV for every cash flows
discounted @ the investors
required rate of return
2. Sum up the PV of all the cash flow
involved
3. Minus the initial outlay from the
total of PV of all cash flows
1.

Solution:
Year
1
2
3
4
5

Cash flow
$100,000
$100,000
$100,000
$100,000
$100,000

PVIFk,n
(0.870)
(0.756)
(0.658)
(0.572)
(0.497)

PV of cash flows
=$87,000
=$75,600
=$65,800
=$57,200
=$49,700
PV =$335,300
minus IO = (250,000)
NPV = $85,300

Since the NPV is positive ( > 0.0 ) , so we

should accept this project.

Solution:
NPV = 100,000
+
(1.15)1

100,000
+
(1.15)2

100,000
+
(1.15)3

100,000
+
(1.15)4

100,000
- 250,000

(1.15)5

= 335215.50 250,000 = 85,215.50

Since the NPV is positive ( > 0.0 ) , so we

should accept this project.

Alternative Solution:
Since the amount of annual cash flow is
equal for each period (an annuity), total PV
can be determined as follows:
n=5

k = 15%

PMT = 100,000

PV of cash flows = 100,000 (PVIFA15%,5)

= 100,000 (3.352)
= $335,200
NPV = total PV IO
= 335,200 250,000
= $85,200
NPV > 0.0 , so ACCEPT

Exercise:
Find the NPV of project A if the expected free
cash flows are as follows. The firm required
rate of return is 10%.
Year
0
1
2
3
4

Free cash flows

(110,000)
20,000
30,000
40,000
50,000

Exercise:
Find the NPV of project A if the expected free
cash flows are as follows. The firm required
rate of return is 10%.
Year
0
1
2
3
4

Free cash flows

(110,000)
20,000
30,000
40,000
50,000

NPV = 20000+ 30000+ 40000

50000 - 110,000
+
(1.10)1 (1.10)2 (1.10)3 (1.10)4
= 107178.47 110,000 = - 2821.53 (REJECT)

4) Profitability Index (PI)

Also

known as profit and cost ratio, i.e

benefit/costs

PI = Present value of future free cash flow

Initial outlay

Decision rule :
ACCEPT if PI is greater than or equal to one { PI >
1.0}
REJECT if PI is less than one { PI < 1.0 }

Profitability Index
Advantages:
Uses free cash flows
Recognizes the time value of money
Consistent with the firms goal of
shareholder wealth maximization.
Disadvantages:
Requires detailed long-term forecasts
of a projects free cash flows.

Example:
Emerald Corp. is considering an
investment with a cost of $250,000
and future benefits of $100,000
every year.
If the companys
required rate of return is 15%, based
on the profitability index (PI), should
the Emerald accept the project?

Year
1
2
3
4
5

Cash flow PVIFk,n PV of cash flow

$100,000 (0.870) =$87,000
$100,000 (0.756) =$75,600
$100,000 (0.658) =$65,800
$100,000 (0.572) =$57,200
$100,000 (0.497) =$49,700
PV=$335,300

PI = $335,300/250,000
= 1.3412 (Accept)

5) Internal Rate of Return (IRR)

The

discount rate that equates the

present value of the projects future free
cash flows with the projects initial outlay.
The return on the firms invested capital.
IRR is simply the rate of return that the
firm earns on its capital budgeting
projects.

Decision rule :
ACCEPT if IRR > required rate of return
REJECT if IRR < required rate of return

Internal Rate of Return (IRR)

n

IRR:

FCFt
= IO
t
(1 + IRR)

t=1

IRR

is the rate of return that makes the

PV of the cash flows equal to the initial
outlay.
This looks very similar to our Yield to
Maturity formula for bonds. In fact, YTM
is the IRR of a bond.

Internal Rate of Return

Advantages:
Uses free cash flows
Recognizes the time value of money
Consistent with the firms goal of
shareholder wealth maximization.
Disadvantages:
Possibility of multiple IRRs
Assumes cash flows over the life of the
project are reinvested at the IRR.
Requires detailed long-term forecasts of a
projects free cash flows.

Calculating IRR

Looking again at our problem:

The IRR is the discount rate that makes
the PV of the projected cash flows
equal to the initial outlay. req. rtn 15%

(250,000) 100,000 100,000 100,000 100,000 100,000

0

Calculating IRR
Method: trial and error/Interpolation
Choose any discount rate [(randomly) TIPs used req. rate as a base].
2. Compare ACF in step 1 with IO. If ACF = IO, we successfully find the IRR.
If not, try again (step 3).
3. If ACF > IO , you should increased the discount rate.
BUT, if ACF < IO, you should reduced the discount rate. Continue until
you find the exact IRR (approximately).
4.After we have decide IRR is between the TWO discount rate that we
choose, then use the interpolation method.
1.

Discount Rate PV = ACF/(1+IRR)n

28%

RM253,000

IRR

RM250,000

29%
______
1%

___________
3,000

PVA =CF/(1+IRR)n
RM253,000

RM248,300
__________
4,700

IRR = 28% + [{3,000/4,700} ( 29 -28)]

28% + (0.6382)(1)
28.64%

EXAMPLE:

Example:
Syarikat ABC is considering one project with an
initial investment of RM49,900. This project is
expected to produce ACF RM15,146 for the next
5 years. If the cost of capital (discount rate) is
13%, what is Syarikat ABC IRR?

IRR is a good decision-making tool

as long as cash flows are
conventional.
Problem: If there are multiple sign
changes in the cash flow stream, we
could get multiple IRRs.

(500)

200

100

(200)

400

300

Summary Problem
Enter the cash flows only once.
Find the IRR.
Using a discount rate of 15%, find NPV.
Add back IO and divide by IO to get PI.

(900)

300

400

400

500

600

Noraziah Che Arshad

45

Summary Problem
IRR = 34.37%.
Using a discount rate of 15%,
NPV = $510.52.
PI = 1.57.

(900)

300

400

400

500

600

Modified Internal Rate of Return

(MIRR)
IRR assumes that all cash flows are
reinvested at the IRR.
MIRR provides a rate of return measure
that assumes cash flows are reinvested
at the required rate of return.