Long-run investment

decisions: capital Budgeting

Instructor: Maharouf Oyolola
 Introduction
• One of the most important decisions
managers must make concerns
investment.
• The investment decision involves how
much to invest, what capital should be
purchased, how to finance the investment
and so forth.
• We should note that when we speak of
investment by a firm, we generally do not
mean investment in stocks and bonds.
• Rather, investment is simply an addition to
the firm’s stock of resources, generally
involving the purchase of capital
equipment or land.
 Capital budgeting
• It refers to the process of planning expenditures
that give rise to revenues or returns over a
number of years.
• Capital budgeting is of crucial importance to the
firm.
• The application of new technological
breakthroughs may lead to new and more
efficient production techniques, changes in
consumer tastes may take a firm’s existing
product line obsolete
 The capital budgeting process
• In this section we discuss how the firm
projects the cash flows from an investment
project, how it calculates the net present
value of and the internal rate of return on
the project, and how the two are related.
 Project cash flows
• One of the most important and difficult
aspects of capital budgeting is the
estimation of the net cash flow from a
project.
• A typical project involves making an initial
investment and generates a series of net
cash flows over the life of the project.
 Example
• Suppose that a firm estimates that it
needs to make an initial investment of $1
million in order to introduce a new product.
• The marketing division of the firm expects
the life of the product to be five years.
 Net Present Value (NPV)
• One method of deciding whether or not a
firm should accept an investment project is
to determine the net present value of the
project.
• The net present value (NPV) of a project is
equal to the present value of the expected
stream of net cash flows from the project,
discounted at the firm’s cost of capital,
minus the initial cost of the project.
 Net Present Value (NPV)
n
Ri
NPV = ∑ −C 0
t =1 (1 + k )
t

Ri refers to the estimated net cash flow from the project in

each of the n years considered.
K is the risk-adjusted discount rate
Co is the initial cost of the project
 Estimated cash flow from project

year

1 2 3 4 5

Sales less : $1,000,000 $1,100,000 $1,210,000 $1,331,000 $1,464,100

variable costs 500,000 550,000 605,000 665,500 732,050

fixed costs 150,000 150,000 150,000 150,000 150,000

Depreciation 200,000 200,000 200,000 200,000 200,000

Profits before taxes $150,000 $200,000 $255,000 $315,500 382,050

Less: income tax 60,000 80,000 102,000 126,200 152,820

Profit after tax $90,000 120,000 153,000 189,300 229,230

plus: Depreciation 200,000 200,000 200,000 200,000 200,000

Net cash flow $290,000 $320,000 $353,000 $389,300 $429,230

Plus: salvage value of equipment 250,000

Recovery of working capital 100,000

Net cash flow in year 5 $779,230

 Example 1
$290,000 $320,000 $353,000 $389,300 $779,230
NPV = + + + + − $1,000,000
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)
1 2 3 4 5

= $1,454,852 − $1,000,000
= $454,852

This project would thus add $454,852 to the value of the firm, and the
firm should undertake it.
 Example 2
• Hershey Foods is considering an investment in a
new “Kiss” wrapping machine. The machine has
an initial cost (net investment) of $2.5 million. It
is expected to produce cost savings from
reduced labor and to generate additional
revenues because of its increased reliability and
productivity. Over its anticipated economic life of
five years, the new “Kiss” wrapping machine is
expected to generate the following stream of net
cash flows (NCF):
 Example 2
Year (t) Net cash flow (NCF)

1 $600,000
2 800,000
3 800,000
4 600,000
5 250,000
If Hershey requires a return (k) of 15 percent on a project
of this type, should it make the investment?
 present value interest factor at 15 percent Present value (4)= (2) x
year (t) cash flow (2) (3) (3)

0 ($2,500,000) 1 ($2,500,000)

1 600,000 0.86957 $521,742

2 800,000 0.75614 $604,912

3 800,000 0.65752 $526,016

4 600,000 0.57175 $343,050

5 250,000 0.49718 $124,295

($379,985)

Because this project has a negative net present value, it does not
contribute to the goal of maximizing shareholder wealth
 Internal Rate of Return (IRR)
• Another method of determining whether a
firm should accept an investment project is
to calculate the internal rate of return on
the project.
• The IRR on a project is the discount rate
that equates the present value of the net
cash flow from the project to the initial cost
of the project.
 The internal rate of return
• The following equation is used to find the
IRR:
n
NCFt
∑1 (1 +
t=
* t
k )
=C0

IRR =k *

An investment should be accepted if the internal rate of return is

greater than or equal to the firm’s required rate of return (cost of
capital); if not, the project should be rejected.
 Example
• The internal rate of return for the
Hamilton-Beach is calculated as follows:

5
290,000
∑
t =1 (1 + r )
t
= 1,000,000
5
1 1,000,000
∑
t =1 (1 + r )
t
=
290,000
= 3.4483
 Example
• The term 5
t =1
1 
∑(1 +r ) t 


represents the present value of a $1annuity for 5 years discounted at r percent

3.5172 − 3.4483
r = 0.13 + (0.14 − 0.13)
3.5172 − 3.4331
= 0.1382

If Hamilton-Beach requires a rate of return of 12 percent on projects

of this type, then the project should return (12 percent).
 Summary of the capital
budgeting decision criteria
Criterion Project Benefits Weaknesses
acceptance
Decision Rule
Accept project if project Considers the timing of Difficult in interpreting the
Net has a positive or zero NPV;
that is, if the present value
cash flows. Provide an
objective, return-based
meaning of the NPV
computation
Present of net cash flows,
evaluated at the firm’s cost
criterion for acceptance or
rejection.

Value of capital, equals or

exceeds the net investment
required.
(NPV)
Accept project if IRR Easy to interpret the Sometimes gives decision
Internal equals or exceeds the
firm’s cost of capital.
meaning of IRR. that conflicts with NPV.
Considers the timing of
Rate of cash flows.
Provides an objective,
Multiple rates of return
problem
Return return-based criterion for
acceptance or rejection

(IRR)
 Capital rationing and the
profitability index
• In cases of capital rationing (i.e., when the
firm cannot undertake all the projects with
positive NPV), the firm should rank
projects according to their index of
profitability and choose the projects with
the highest profitability indexes rather than
those with the highest NPVs.
 The profitability index (PI)
• It is measured by:

∑[R ]
n

t /(1 +k ) t

PI = t =1
C0
 Comparison of NPV and PI rankings of
projects with unequal costs
Project A Project B Project C

Present value of net

cash flows (PVNCF) $2,600,00 $1,400,00 $1,400,00
0 0 0
Initial cost of project
(Co) 2,000,000 1,000,000 1,000,000

NPV $600,000 $400,000 $400,000

PI 1.3 1.4 1.4

 The cost of capital
• In this section, we examine how the firm
estimates the cost of raising the capital to invest.
• The firm can raise investment funds internally
(i.e., from undistributed profits) or externally (i.e.,
by borrowing and from selling stocks).
• The cost of using internal funds is the
opportunity cost or forgone return on these funds
outside the firm. The cost of external funds is the
lowest rate of return that lenders and
stockholders require to lend to or invest their
funds in the firm.
 The cost of capital
• In this section, we examine how the cost of debt
(i.e., the cost of raising capital by borrowing) and
the cost of equity capital (i.e., the cost of raising
capital by selling stocks) are determined.
• On the other hand, there are at least three
methods of estimating the cost of equity capital:
the risk-free plus premium, the divided valuation
model, and the capital asset pricing model
(CAPM).
 The cost of Debt
• The cost of debt is the return that lenders
require to lend their funds to the firm.
Since the interest payments made by the
firm on borrowed funds are deductible
from the firm’s taxable income.
• The after-tax cost of debt capital is:
Kd=r(1-t)
 The cost of equity capital: the risk-
free rate plus premium
• The cost of equity capital is the rate of
return that stockholders require to invest in
the firm.
• One method employed to estimate the cost
of equity capital (ke) is to use the risk-free
(rf) plus a risk premium (rp). That is:
ke= rf + rp
The risk-free rate is usually taken to be the six-month U.S.
Treasury bill rate.
 The cost of equity capital: The
capital asset pricing model (CAPM)