Corporate Finance

Study Session 10 & 11

Weighting: 7%
Reading 34 – Corporate Governance and ESG: An introduction (*)
Reading 35 – Capital Budgeting (***)
Reading 36 – Cost of Capital (***)
Reading 37 – Measure of Leverage (**)
Reading 38 – Working Capital Management (**)
 Capital Budgeting
Definition
The capital budgeting process is the process of identifying and
evaluating capital projects, that is, projects where the cash flow to the
firm will be received over a period longer than a year.

Four steps
1. Idea Generation
2. Analyzing project proposals
3. Create firm-wide capital budget
4. Monitor decision and post audit
Study Session 10 – Corporate Finance 1 Reading 35 – Capital Budgeting
 Types of capital budget projects
5 types of capital budget projects
1. Replacement project
A. Mandatory projects
B. Cost reduction (Require detailed analysis)
2. Expansion project (Require detailed analysis)
3. Mandatory projects by regulatory projects
4. Other projects (e.g. Research, pet projects)

Study Session 10 – Corporate Finance 2 Reading 35 – Capital Budgeting

 Special types of costs
Different types of cost
The relevant cash flows to consider as part of the capital budgeting
process are incremental cash flows, the changes in cash flows that will
occur if the project is undertaken.
1. Opportunity cost (e.g. Rent given up) (include in calculation)
2. Sunk Cost (e.g. Research cost) (exclude)
3. Externalities
A. Synergy (include in calculation)
B. Canalization (include in calculation)
4. Financing costs – considered in discount rate already (exclude)

Study Session 10 – Corporate Finance 3 Reading 35 – Capital Budgeting

 Practice Question (1)
Which of the following statement is correct?
A. Capital budgeting is the process of choosing the types of debt and
equity that will be used to finance investment projects.
B. Capital budgeting is the process of scheduling and managing the
short-term cash flows of a firm.
C. Capital budgeting is the process of analyzing projects and deciding
which ones to accept.

Study Session 10 – Corporate Finance 4 Reading 35 – Capital Budgeting

 Practice Question (2)
A company is considering building a new factory on a piece of land
that it acquired 4 years ago at a cost of $2,000,000. The company
estimated the cost of construction at $3,000,000. In this area, a land
of similar size is priced at $1,800,000. How much is the initial
investment outlay for this warehouse:

A. 6,800,000
B. 4,800,000
C. 3,800,000

Study Session 10 – Corporate Finance 5 Reading 35 – Capital Budgeting

 Methods for capital budgeting
5 Methods for capital budgeting
1. Net Present Value (NPV)
2. Internal rate of return (IRR)
3. Payback period
4. Discounted payback period
5. Profitability Index

Study Session 10 – Corporate Finance 6 Reading 35 – Capital Budgeting

 1 – Net Present Value (NPV)
1) Net Present Value (NPV)

Acceptance Criteria (For Single / Independent projects) :

NPV > 0 -> Accept
NPV < 0 -> Reject
Advantages: Directly reflect the change on the firm’s value
Disadvantages: Ignore the size of the project
Study Session 10 – Corporate Finance 7 Reading 35 – Capital Budgeting
 1 – Net Present Value (NPV)
1) Net Present Value (NPV)
Example: Initial Investment to open a restaurant is 1.5 million, cash
flow in first 3 years are $200,000, $800,000 and $1,500,000. Discount
rate is 10%
-1,500,000 200,000 800,000 1,500,000

200,000 800,000 1,500,000

𝑁𝑃𝑉 = −1,500,000 + + + = 469,947
1+10% 1+10% 2 1+10% 3

Study Session 10 – Corporate Finance 8 Reading 35 – Capital Budgeting

 2 – Internal rate of return (IRR)
2) Internal rate of return (IRR)

Acceptance Criteria (For Single / Independent projects) :

IRR > Cost of Capital -> Accept
IRR < Cost of Capital -> Reject
Advantages: Reflects the profitability
Disadvantages: No or multiple IRR problems, impractical assumptions
of reinvestment rate at IRR

Study Session 10 – Corporate Finance 9 Reading 35 – Capital Budgeting

 2 – Internal rate of return (IRR)
2) Internal rate of return (IRR)
Example

-1,500,000 200,000 800,000 1,500,000

200,000 800,000 1,500,000

𝑁𝑃𝑉 = 0 = −1,500,000 + + +
1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 2 1+𝐼𝑅𝑅 3

IRR＝22.91%
Study Session 10 – Corporate Finance 10 Reading 35 – Capital Budgeting
 2 – Internal rate of return (IRR)
2) Problems with IRR
Conventional Cashflow – cash flow pattern that the sign of cashflow
changes only once
Unconventional Cashflow – cash flow pattern that the sign of cash
flows changes more than once
No IRRs or more than 1 IRR is found (neither are the answer)
(cannot use IRR method)

Study Session 10 – Corporate Finance 11 Reading 35 – Capital Budgeting

 3 – Payback Period
3) Payback Period
The payback period (PBP) is the number of years it takes to recover the initial
cost of an investment.
PBP = A +B/C;
A = last year with negative cumulative cash flow,
B = absolute value of the gap between 0 and last year with negative cash
flow
C = Full year cash flow
No Acceptance Criteria
Advantages: Simple to use, reflects liquidity
Disadvantages: Not a measure of value or profitability, no decision rule, no
consideration of time value and risk, ignore cashflow after payback period

Study Session 10 – Corporate Finance 12 Reading 35 – Capital Budgeting

 3 – Payback Period
Example

-1,500,000 200,000 800,000 1,500,000

Year 0 Year 1 Year 2 Year 3

Cash flow -1,500,000 200,000 800,000 1,500,000
Cumulative Cash flow -1,500,000 -1,300,000 -500,000 1,000,000

500,000
PBP = 2 + = 2.333 𝑦𝑒𝑎𝑟𝑠
1,500,000
Study Session 10 – Corporate Finance 13 Reading 35 – Capital Budgeting
 4 – Discounted Payback period
4) Discounted Payback period
Discount Payback period use the present values of the project’s estimated cash
flows
Discounted PBP = A +B/C;
A = last year with negative cumulative discounted cash flow,
B = absolute value of the gap between 0 and last year with negative discounted
cash flow
C = Full year discounted cash flow

Acceptance Criteria (For Single / Independent projects) :

Advantages: reflects liquidity
Disadvantages: Not a measure of value or profitability, no decision rule, ignore
cashflow after payback period
Study Session 10 – Corporate Finance 14 Reading 35 – Capital Budgeting
 4 – Discounted Payback period
Example

-1,500,000 -200,000 800,000 1,500,000

Year 0 Year 1 Year 2 Year 3

Cash flow -1,500,000 -200,000 800,000 1,500,000
Discounted cash flow -1,500,000 181,818 661,157 1,126,972
Cumulative Cash flow -1,500,000 -1,318,182 -657,025 469,947
657,025
Discounted PBP = 2 + = 2.44 𝑦𝑒𝑎𝑟𝑠
1,500,000
Study Session 10 – Corporate Finance 15 Reading 35 – Capital Budgeting
 5 – Profitability Index (PI)
5) Profitability Index
The profitability index (PI) is the present value of a project’s future cash flows
divided by the initial cash outlay. How much value will $1 becomes?

Acceptance Criteria (For Single / Independent projects) :

P.I. > 1 -> Accept
P.I. < 1 -> Reject
Advantages: Measure profitability, directly shows the amount of value
created per unit
Disadvantages: Absolute NPV is ignored
Study Session 10 – Corporate Finance 16 Reading 35 – Capital Budgeting
 5 – Profitability Index (PI)
Example

-1,500,000 -200,000 800,000 1,500,000

469,947
𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 = 1 + = 1.313
1,500,000
200,000 800,000 1,500,000
Profitability Index = ( 1+𝐼𝑅𝑅
+
1+𝐼𝑅𝑅 2
+ 1+𝐼𝑅𝑅 3
) / 1,500,000 = 1.313

Study Session 10 – Corporate Finance 17 Reading 35 – Capital Budgeting

 Independent & Mutually exclusive projects
Independent Project
Independent projects are projects that are unrelated to each other and allow for
each project to be evaluated based on its own profitability.
Assumption: The firm has unlimited fund
Result: NPV, IRR, PI give same result, i.e. NPV > 0, IRR > Cost of Capital, PI >1

Mutually exclusive
Only one or more but not all projects in a set of possible projects can be accepted
and that the projects compete with each other due to
i) Capital Rationing
ii) Project Sequence
Result: NPV, IRR, PI give contradictory result. NPV is the key factor
Study Session 10 – Corporate Finance 18 Reading 35 – Capital Budgeting
 Practice Question (3)
Which of the following statements about NPV and IRR is least
accurate?

A. For independent projects if the IRR is less than the cost of capital
not accept the project.
B. The NPV method assumes that all cash flows are reinvested at the
cost of capital.
C. For mutually exclusive projects you should use the IRR to rank and
select projects.

Study Session 10 – Corporate Finance 19 Reading 35 – Capital Budgeting

 Practice Question (4)
A project has the following annual cash flows. With a discount rate of
8%, the discounted payback period (in years) is closest to:

Year 0 Year 1 Year 2 Year 3 Year 4

–$75,000 $21,600 $23,328 $37,791 $40,815

A. 2.8
B. 3.0
C. 3.2

Study Session 10 – Corporate Finance 20 Reading 35 – Capital Budgeting

 Practice Question (5)
A project has the following annual cash flows: Which discount
rate most likely provides a positive net present value?

Year 0 Year 1 Year 2 Year 3

$606,061 $2,151,515 $2,542,424 $1,000,000

A. 15%
B. 18%
C. 21%

Study Session 10 – Corporate Finance 21 Reading 35 – Capital Budgeting