The Capital Budgeting Decision

(Chapter 12)
 Capital Budgeting: An Overview  Estimating Incremental Cash Flows  Payback Period  Net Present Value  Internal Rate of Return  Ranking Problems  Capital Rationing  Risk Adjustment

Capital Budgeting: An Overview
 Search for investment opportunities. This process will

obviously vary among firms and industries.  Estimate all cash flows for each project.  Evaluate the cash flows. a) Payback period. b) Net Present Value. c) Internal Rate of Return. d) Modified Internal rate of Return.  Make the accept/reject decision. – Independent projects: Accept/reject decision for a project is not affected by the accept/reject decisions of other projects. – Mutually exclusive projects: Selection of one alternative precludes another alternative.  Periodically reevaluate past investment decisions.

Estimating Incremental Cash Flows
 Only changes in after-tax cash flows that would

occur if the project is accepted versus what they would be if the project is rejected are relevant.  Initial Outlay: Includes purchase price of the asset,
shipping and installation, after-tax sale of asset to be replaced if applicable, additional required investments in net working capital (e.g., increases in accounts receivable and inventory less any spontaneous increases in accounts payable and accruals), plus any other cash flows necessary to put the asset in working order.

Differential Cash Flows Over the Project’s Life:
Change in revenue - Change in operating expenses = Change in operating income before taxes - Change in taxes = Change in operating income after taxes + Change in depreciation = Differential cash flow

Note: Interest expenses are excluded when calculating differential cash flow. Instead, they are accounted for in the discount rate used to evaluate projects.  Terminal Cash Flow: Includes after-tax salvage value of the asset, recapture of nonexpense outlays that occurred at the asset’s initiation (e.g., net working capital investments), plus any other cash flows associated with project termination.

Payback Period
 The number of years required to recoup the initial outlay.

What is (n) such that:

t =1

∑ CFt = CF0


(n) = payback period (PP) CF0 = initial outlay CFt = after - tax cash flow in period (t)

Payback Period (Continued)

 Decision Rules:

– PP = payback period – MDPP = maximum desired payback period  Independent Projects: – PP ≤ MDPP - Accept – PP > MDPP - Reject  Mutually Exclusive Projects: – Select the project with the fastest payback, assuming PP ≤ MDPP.  Problems: (1) Ignores timing of the cash flows, and (2) Ignores cash flows beyond the payback period.

Net Present Value (NPV)

 The present value of all future after-tax cash flows minus

the initial outlay

CFt NPV = ∑ − CF0 t t =1 (1 + k )  CF1 CF2 CFn  = + + ... + − CF0 2 n (1 + k )   (1 + k ) (1 + k ) where : k = cost of capital (required return)


NPV (Continued)

 Decision Rules:  Independent Projects:

– NPV ≥ 0 - Accept – NPV < 0 - Reject  Mutually Exclusive Projects: – Select the project with the highest NPV, assuming NPV ≥ 0.

Internal Rate of Return (IRR)
 Rate of return on the investment. That rate of discount

which equates the present value of all future after-tax cash flows with the initial outlay. What is the IRR such that:

CFt ∑1 (1 + IRR)t = CF0 t=
 When only one interest factor is required, you can solve


for the IRR algebraically. Otherwise, trial and error is necessary.

IRR (Continued)
 If you are not using a financial calculator:

1. Guess a rate. n 2. Calculate: ∑

CFt t t =1 (1 + IRR )

3. If the calculation = CF0 you guessed right If the calculation > CF0 try a higher rate If the calculation < CF0 try a lower rate
 Note: Financial calculators do the trial and error

calculations much faster than we can!

IRR (Continued)
 Decision Rules (No Capital Rationing):

– Independent Projects: • IRR ≥ k - Accept • IRR < k - Reject – Mutually Exclusive Projects: • Select the project with the highest IRR, assuming IRR ≥ k.  Multiple IRRs: – There can be as many IRRs as there are sign reversals in the cash flow stream. When multiple IRRs exist, the normal interpretation of the IRR loses its meaning.

Ranking Problems

 When NPV = 0, IRR = k

When NPV > 0, IRR > k When NPV < 0. IRR < k  Therefore, given no capital rationing and independent projects, the NPV and IRR methods will always result in the same accept/reject decisions.  However, the methods may rank projects differently. As a result, decisions could differ if projects are mutually exclusive, or capital rationing is imposed. Ranking problems can occur when (1) initial investments differ, or (2) the timing of future cash flows differ. (See discussion on NPV profiles)

Ranking Problems (Continued)

 Ranking Conflicts: Due to reinvestment rate assumptions,

the NPV method is generally more conservative, and is considered to be the preferred method.  NPV - Assumes reinvestment of future cash flows at the cost of capital.  IRR - Assumes reinvestment of future cash flows at the project’s IRR.  In addition, the NPV method maximizes the value of the firm.

Capital Rationing
– Capital rationing exists when an artificial constraint is placed on the amount of funds that can be invested. In this case, a firm may be confronted with more “desirable” projects than it is willing to finance. A wealth maximizing firm would not engage in capital rationing.

Capital Rationing: An Example
(Firm’s Cost of Capital = 12%)
 Independent projects ranked according to their

IRRs: Project Project Size E $20,000 B 25,000 G 25,000 H 10,000 D 25,000 A 15,000 F 15,000 C 30,000

IRR 21.0% 19.0 18.0 17.5 16.5 14.0 11.0 10.0

Capital Rationing Example (Continued)

 No Capital Rationing - Only projects F and C would

be rejected. The firm’s capital budget would be $120,000.
 Capital Rationing - Suppose the capital budget is

constrained to be $80,000. Using the IRR criterion, only projects E, B, G, and H, would be accepted, even though projects D and A would also add value to the firm. Also note, however, that a theoretical optimum could be reached only be evaluating all possible combinations of projects in order to determine the portfolio of projects with the highest NPV.

Required Returns for Individual Projects That Vary in Risk Levels
 Higher hurdle rates should be used for

projects that are riskier than the existing firm, and lower hurdle rates should be used for lower risk projects.  Measuring risk and specifying the tradeoff between required return and risk, however, are indeed difficult endeavors.  Interested students should read Chapter 13 entitled Risk and Capital Budgeting.

Risk Adjusted Required Returns

Required Return
20 18 16 14 12 10 8 6 4 2 0

Risk-Return Tradeoff ka = Cost of Capital for the existing firm. Risk






Firm’s Risk Level

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