The Basics of Capital Budgeting

Should we
build this
plant?
 What is capital budgeting?
• Analysis of potential additions to fixed
assets.
• Long-term decisions; involve large
expenditures.
• Very important to firm’s future.
 Steps to capital budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
 What is the difference between independent
and mutually exclusive projects?

• Independent projects – if the cash flows of one

are unaffected by the acceptance of the other.
• Mutually exclusive projects – if the cash flows
of one can be adversely impacted by the
acceptance of the other.
 What is the difference between normal and
nonnormal cash flow streams?
• Normal cash flow stream – Cost (negative CF)
followed by a series of positive cash inflows.
One change of signs.
• Nonnormal cash flow stream – Two or more
changes of signs. Most common: Cost
(negative CF), then string of positive CFs, then
cost to close project. Nuclear power plant, strip
mine, etc.
 What is the payback period?
• The number of years required to recover a
project’s cost, or “How long does it take to
get our money back?”
• Calculated by adding project’s cash inflows
to its cost until the cumulative cash flow for
the project turns positive.
 Calculating payback
0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

 Strengths and weaknesses of
payback
• Strengths
– Provides an indication of a project’s risk and
liquidity.
– Easy to calculate and understand.
• Weaknesses
– Ignores the time value of money.
– Ignores CFs occurring after the payback period.
 Discounted payback period
• Uses discounted cash flows rather than raw
CFs.
0 10% 1 2 2.7 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79

Disc PaybackL == 2 + 41.32 / 60.11 = 2.7 years

 Net Present Value (NPV)
• Sum of the PVs of all cash inflows and outflows
of a project:

n
CFt
NPV   t
t 0 ( 1  k )
 What is Project L’s NPV?
Year CFt PV of CFt
0 -100 -$100
1 10 9.09
2 60 49.59
3 80 60.11
NPVL = $18.79

NPVS = $19.98
Rationale for the NPV method
NPV = PV of inflows – Cost
= Net gain in wealth
• If projects are independent, accept if the
project NPV > 0.
• If projects are mutually exclusive, accept
projects with the highest positive NPV, those
that add the most value.
• In this example, would accept S if mutually
exclusive (NPVs > NPVL), and would accept
both if independent.
Internal Rate of Return (IRR)
• IRR is the discount rate that forces PV of inflows
equal to cost, and the NPV = 0:
n
CFt
0 t
t 0 ( 1  IRR )
 Rationale for the IRR method
• If IRR > WACC, the project’s rate of
return is greater than its costs. There is
some return left over to boost
stockholders’ returns.
 IRR Acceptance Criteria
• If IRR > k, accept project.
• If IRR < k, reject project.

• If projects are independent, accept both

projects, as both IRR > k = 10%.
• If projects are mutually exclusive, accept
S, because IRRs > IRRL.
 NPV Profiles
• A graphical representation of project NPVs at
various different costs of capital.

k NPVL NPVS
0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5
 Drawing NPV profiles

NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

10 .. S IRRS = 23.6%
L . .
0 . Discount Rate (%)
5 10 15 20 23.6
-10
 Comparing the NPV and IRR
methods
• If projects are independent, the two
methods always lead to the same
accept/reject decisions.
• If projects are mutually exclusive …
– If k > crossover point, the two methods lead
to the same decision and there is no conflict.
– If k < crossover point, the two methods lead
to different accept/reject decisions.
 Finding the crossover point
1. Find cash flow differences between the projects
for each year.
2. Enter these differences in CFLO register, then
press IRR. Crossover rate = 8.68%, rounded to
8.7%.
3. Can subtract S from L or vice versa, but better to
have first CF negative.
4. If profiles don’t cross, one project dominates the
other.
 Capital Budgeting Process
1. Capital Investment Decision
2. Evaluation
3. Minimum Cut off Rate
4. Capital Rationing
5. Desirability and Feasibility
6. Control and Monitoring
 Capital Investment Decision
On the basis of firm’s existence:
1. Replacement and Modernization decision
2. Expansion decision
3. Diversification decision
1. Core competency area
2. Non-core competency area
 Capital Investment Decision
On the basis of decision situations:
 Mutually exclusive decisions
 Accept-reject decisions
 Contingent decisions
 Project Evaluation Techniques
Any business has many projects into consideration
and selection needs evaluation, which can be done
as follows:
 Pay Back Period
 Discounted Pay Back Period
 Accounting Rate of Return
 NPV
 IRR
 PI
 Net Present Value
• The NPV method is used for evaluating
the desirability of investments or
projects.
 Internal Rate of Return
• The IRR method is same as NPV based
on discounted cash flow method.
 Average Rate of Return
The accounting rate of return is the ratio of
average after tax profit divided by the average
investment:
ARR = ∑ EBIT (1-T)/n
(I0 + In)/2
 Average Rate of Return
Period 1 2 3 4 5
∑ EBIT (1-T) 1000 2000 3000 4000 6000 = 16000/5
= 3200
(I0 + In)/2 36000 28000 20000 12000 4000 =40000/2
= 20000

ARR = 3200 x 100

20000
= 16 %
 Profitability Index
Profitability Index is the ratio of the present value
of cash inflows, at the required rate of return, to
the initial cash outflow of the investment.
PI = PV of Cash Inflows = ∑ Ct ÷ C0
Initial Cash Outlay (1+k)t
Consider as an example, the following cash flow diagram. At the start of year
1 (today) there is a cash out flow of 4,000 representing an investment in a
project. For simplicity, with no further investment, the amount of 6,000 is
returned in 3 years time at the end of year 3.
The business decides that the appropriate discount rate to use is 8%. The
discount rate (value the business places on its money) is very important in
the calculation. It will depend on a number of factors such as the risk involved
and what other opportunities the business has for the funds. At the very least
it should greater than the rate a business could earn at a bank (minimal risk),
and is usually a lot higher.
The present value of the future cash flows of this project is given by the lump
sum present value formula as follows:
PV = FV / (1 + i)n PV = 6,000 / (1 + 8%)3 PV = 4,762.99
The PI formula can now be used to calculate the profitability index.
PI = PV / I PI = 4,762.99 / 4,000 = 1.19
The project PI is 1.19 which is greater than 1, and the project should be
accepted and ranked against the PI of other projects.
Cash flow diagram
Period 1 2 3
Cash Flow ↓ 4,000 6,000 ↑
Profitability Index < 1 Example
Consider now a second project whose initial investment
at the start of year one is 100,000 and which returns a
cash flow of 140,000 in year 5.
Using the same method as above, the present value of
the future cash flows is given as follows:
PV = FV / (1 + i)n PV = 140,000 / (1 +
8%)5 PV = 95,281.65
Again, the PI formula is used to calculate the profitability
index.
PI = PV / I PI = 95,281.65 / 100,000 =
0.95
The project PI is 0.95, as this is less than 1, the project
is loss making, and should be rejected.