Chapter 10

Capital Budgeting Techniques

Outline

The capital budgeting processes and principles

Payback period method

Discounted payback period method

Average accounting rate of return

Net present value

Profitability index

Internal rate of return

The capital budgeting processes & principles

Typical steps

1.

Generating ideas

2.

Analyzing individual proposals

3.

Planning & capital budget

4.

Monitoring & post-audit

The capital budgeting processes & principles

Categories/classifications

1.

Replacement projects

2.

Expansion projects

3.

New products & services

4.

Regulatory, safety & environmental projects

The capital budgeting processes & principles

Basic assumptions

1.

Decisions are based on cash flows.

2.

Timing of cash flows is crucial.

3.

Cash flows are based on opportunity costs.

4.

Cash flows are analyzed on an after-tax basis.

5.

Financing costs are ignored.

The capital budgeting processes & principles

Some important concepts

A sunk cost is one that has already been incurred. You cannot
change a sunk cost.

An opportunity cost is what resource is worth in its next-best

use.

An incremental cash flow is the cash flow that is realized

because of a decision: the cash flow with a decision minus the
cash flow without that decision.

An externality is the effect of an investment on other things

besides the investment itself.

The capital budgeting processes & principles

Some important concepts

Independent versus mutually exclusive projects. Independent

projects are projects whose cash flows are independent of each
other. Mutually exclusive projects compete directly with each
other.

Project sequencing. Many projects are sequenced through time,

so that investing in a project creates the option to invest in
future projects.

Unlimited funds versus capital rationing. An unlimited funds

environment assumes that the company can raise the funds it
wants for all profitable projects simply by paying the required
rate of return. Capital rationing exists when the company has a
fixed amount of funds to invest.

Capital budgeting techniques

Payback Period Method

The payback period is the simplest approach in capital budgeting because it

measures how long will it take for a project to cover back its initial investment,
without taking into account time value of money.

Normally, this method is used as a rough guideline at the early stage of capital
budgeting analysis.

As an example, a project requires an initial investment of RM100,000 and is

expected to generate any of the following cash flows:

Capital budgeting techniques

The Payback Period Method
Year

Cash flow A (RM) Cash flow B (RM) Cash flow C (RM)

50,000

10,000

30,000

40,000

20,000

30,000

30,000

30,000

30,000

20,000

40,000

30,000

10,000

50,000

30,000

Capital budgeting techniques

The Payback Period Method

For cash flow A, by the end of year two, the cash flow generated is
RM90,000, just short of RM10,000 of recouping the initial investment.
Therefore, the payback period is 2 + 10,000/30,000 = 2.33 years.

For cash flow B, the payback period is 4 years, while for cash flow C, the
payback period is 3.33 years.

If a company has a minimum criteria for payback period of say, 3 years, then
cash flow A is preferred compared to cash flow B and cash flow C.

This is one of the weaknesses of payback period method, it does not

consider the timing and size of the cash flows.

It also doesnt take into account the time value of money

Capital budgeting techniques

Discounted Payback Period Method

The discounted payback period method is introduced in order to overcome

the weakness of not taking into account the time value of money.

Year
1
2
3
4
5

Cash flow A(RM)

Discounted Cash Flow (10%)
50,000
45,454.55
40,000
33,057.85
30,000
22,539.44
20,000
13,660.27
10,000
6,209.21

Therefore, the payback period is 2 + 21,487.60/30,000 = 2.72 years.

This is much longer than the 2.33 years obtained earlier without discounting.

This method still has other weaknesses such as does not take into account
the cash flow after the break-even point and also the timing and scale
problem.

Capital budgeting techniques

Average Accounting Rate of Return

AAR = Average net income/Average book value

Assume a company invests RM200,000 in a project that is depreciated

straight-line over a five-year life to a zero salvage value. Sales revenues and
cash operating expenses for each year are as shown in the following table.

Capital budgeting techniques

Average Accounting Rate of Return
(RM)

Year 1

Year 2

Year 3

Year 4

Year 5

Sales

100,000

150,000

240,000

130,000

80,000

Cash expenses

50,000

70,000

120,000

60,000

50,000

Depreciation

40,000

40,000

40,000

40,000

40,000

EBT

10,000

40,000

80,000

30,000

-10,000

Taxes (40%)

4,000

16,000

32,000

12,000

-4,000

Net income

6,000

24,000

48,000

18,000

-6,000

Capital budgeting techniques

Average Accounting Rate of Return

For the five-year period, the average net income is RM18,000.

The initial book value is RM200,000, declining by RM40,000 per
year until the final book value is RM0. The average book value
for this asset is (RM200,000 RM0)/2 = RM100,000.

The average accounting rate of return is

AAR = RM18,000/RM100,000 = 18%

Capital budgeting techniques

Net Present Value

The net present value (NPV) is by far the most popular capital
budgeting technique for several reasons.

Firstly, it takes into account the time value of money.

Secondly, all the cash flows are considered; and thirdly, it is in

dollar value instead of percentage or ratio, therefore it can be
directly tied to the shareholders maximization objective.

To calculate the NPV, we need to find the sum of the present

value of all the cash flows from the project and minus it with the
initial outlay of the project.

NPV = [CF1(1 + k)-1 + CF2(1 + k)-2 + + CF3(1 + k)-3 + ] Initial Outlay

Capital budgeting techniques

Net Present Value
Lets look at the three sets of cash flows again.
Year

Cash flow A (RM) Cash flow B (RM) Cash flow C (RM)

50,000

10,000

30,000

40,000

20,000

30,000

30,000

30,000

30,000

20,000

40,000

30,000

10,000

50,000

30,000

Capital budgeting techniques

Net Present Value

Assuming that the cost of capital (discount rate) is 10%, then the
NPVs for the projects are as follows.

NPVA = 50,000(1.1)-1 + 40,000(1.1)-2 + 30,000(1.1)-3 + 20,000(1.1)-4 +

10,000(1.1)-5 - 100,000 = RM20,921.32

NPVB = 10,000(1.1)-1 + 20,000(1.1)-2 + 30,000(1.1)-3 + 40,000(1.1)-4 +

50,000(1.1)-5 - 100,000
= RM6,525.88

NPVC = 30,000 [(1 (1.1)-5)/0.1]- 100,000 = RM13,723.60

Capital budgeting techniques

Net Present Value

As can be seen, the cash flow A has the highest NPV,

RM20,921.32.

Normally, if the NPV is positive, the project is accepted because it

results in additional value to the company. In essence, the
shareholders wealth will increase if a company takes on a positive
NPV project.

A negative NPV project will be rejected because it will not bring in

additional value to the firm and shareholders wealth will not be
increased. Notice that the NPV is inversely related to the discount
rate, which is the cost of capital for the project. If the cost of
capital is higher than 10%, then the NPV will be smaller.

Capital budgeting techniques

Profitability Index

The profitability index (PI) is similar to the NPV, except that it shown as
a ratio, or index, instead of a dollar amount. The formula for
profitability index is as follows.

PI = [CF1(1 + k)-1 + CF2(1 + k)-2 + + CF3(1 + k)-3 + ]/Initial Outlay

The sum of present value of the cash flows is divided, instead of

deducted with the initial outlay. Using the figures in the earlier
example:

PIA = RM120,921.32/RM100,000 = 1.21

PIB = RM106,525.88/RM100,000 = 1.065
PIC = RM113,723.60/RM100,000 = 1.137

Capital budgeting techniques

Profitability Index

PI above 1.00 shows that the NPV is positive (>), therefore the project will be accepted,
and PI below 1.00 shows that the NPV is negative, therefore the project will be rejected.
The strengths of profitability index technique are similar to that of the NPV technique.
However, since PI is expressed in the form of a ratio or index, it may have a problem in
terms of projects cash flow scale. For example, lets look at the following projects:

Present Value of Cash Flows (RM)

Year Project AProject B
0 5,000 55,000
1 1,000 10,000
2 2,000 20,000
3 3,000 30,000
NPV 1,000 5,000
PI 1.20 1.10

Capital budgeting techniques

Profitability Index

In terms of NPV, project B is better, but in term of PI, project I is

better. If a company has to choose between the two projects, which
one should the company choose?

Naturally, we choose project B, because the NPV is higher, and it

can add value to the company and the shareholders by RM5,000.
However, if project A can be duplicated and run simultaneously to
generate the cash flows above, then by investing RM55,000 (the
same initial outlay for project B), we can invest in 11 project As and
obtain NPV of RM11,000.

Notice that the PI of project A will remain the same (1.20), while the
NPV is now RM11,000. Therefore, the assumptions and also
properties of each project are important before making a decision
on any capital budgeting technique.

Capital budgeting techniques

Internal Rate of Return

The internal rate of return is the rate that equates the NPV with zero
or the discount rate that will make the present value of the cash flows
equal to the initial outlay.

Also called hurdle rate, because the discount rate has to be lower
than the IRR for the project to have a positive. Therefore, if the IRR is
higher than the cost of capital, the project will be accepted and if the
IRR is lower than the cost of capital, the project will be rejected. The
general formula to find the IRR is as follows.

[CF1(1 + IRR)-1 + CF2(1 + IRR)-2 + + CF3(1 + IRR)-3 + ] = Initial

Outlay
Or alternatively,
[CF1(1 + k)-1 + CF2(1 + k)-2 + + CF3(1 + k)-3 + ] - Initial Outlay = 0

Capital budgeting techniques

Internal Rate of Return

In order to solve for the IRR above, we need to use the similar
approach in finding the YTM in the Bond Valuation chapter earlier,
which is using a combination of trial-and-error and also interpolation
technique. Using the example of cash flow B earlier,

10,000(1 + IRR)-1 + 20,000(1 + IRR)-2 + 30,000(1 + IRR)-3 + 40,000(1 +

IRR)-3 +
50,000(1 + IRR)-3 = 100,000

We know from earlier calculation that at i = 10%, the NPV is

RM20,931.32. Our objective is to find at what i will the NPV become
0; and this will be the IRR. The next step is to try another i so that the
NPV will be lower than RM100,000 and crosses over 0. Since NPV is
inversely related with interest rate, we will try a higher rate, say 12%.

Capital budgeting techniques

Internal Rate of Return

At 12%,

NPV = 10,000(1.12)-1 + 20,000(1.12)-2 + 30,000(1.12)-3 +

40,000(1.12)-4 + 50,000(1.12)-5 - 100,000 = 17

Since it is still above 0, we still have to try another rate, say 13%.

At 13%,

NPV = 10,000(1.13)-1 + 20,000(1.13)-2 + 30,000(1.13)-3 +

40,000(1.13)-4 + 50,000(1.13)-5 - 100,000 = -3,025.25

Now we can interpolate between the two rate: 12% and 13%:

Capital budgeting techniques

Internal Rate of Return
i

NPV

0.12

17

IRR

0.13

-3,025.25

(0.12 YTM)/(0.12-0.13) = (17-0)/(0-(-3,025.25))

IRR = 12.01% (which is very close to 12%)

Since the IRR (12.01%) is higher than the cost of capital (10%), the
project has a positive NPV and is thus accepted.