Chapter 9

CAPITAL
BUDGETING
PROCESS

Alex Tajirian

Capital Budgeting Process

9-2

1. INTRODUCTION
#

Working with the left-hand-side of a balance sheet

CAPITAL BUDGETING /INVESTING in Long-term Assets

!
Definitions

"

Capital:

Fixed assets used in production

"

Budget:

Plan of in- and outflows during some period

"

Capital Budget:

"

Capital Budgeting: Process of selecting viable

investment projects.

"

Financial investment vs. economic investment

A list of planned investment (i.e.,

expenditures on fixed assets)
outlays for different projects.

In this course, investments are needed in order to:

"

Expand in existing markets.

"

Enter new markets.

"

Replace existing capital assets.

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Capital Budgeting Process

9-3

Where do these projects come from?

"

Suggested by managers of plants & divisions

"

Upper management

Upper management approves these projects

Investment and financing decisions are independent.

Some common errors:

"
Expansion without incorporating cost of financing
"
Cost cutting without looking at revenue side
"
Ignoring alternative uses of capital

TOOLS CAN BE USED IN:

!

M&As

Divestitures & spin-offs

Correct-sizing

Other

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CAPITAL BUDGETING OUTLINE

!

Develop tools & criteria of selecting projects (Ch. 8): Given

Q
Relevant CFs
Q
The required return of the project (i.e., the risk of use of
project CFs)

Determine which CFs are relevant in project analysis (Ch. 10)

Introduce possibility of forecast error in CF data used in

analysis (Chapter 11)

Assume that k (cost of financing) is known until Ch. 12

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9-5

FINANCIAL MANAGEMENT
PROCESS
Given your
Line of Business

Type of Business

List Potential
Projects
Type of
Projects

Internal
Expansion

External
(M&A)

Divestitures
& Spin Offs

Capital Budgeting

Choose Viable
Projects

Capital Structure

Choose Appropriate
Financing

Short-term financial
Management

Choose Appropriate
Working capital

Dividend Policy

Optimal
Dividend policy
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Capital Budgeting Process

9-6

CAPITAL BUDGETING &

FINANCING

INVESTMENT
DECISION

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FINANCING
DECISION

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Capital Budgeting Process

9-7

MANAGERIAL TALENT &

INVESTMENTS

Capital
Budgeting

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Managerial &
Entrepreneurial
Skills

Alex Tajirian

Capital Budgeting Process

9-8

2. TOOLS OF INVESTMENT DESIRABILITY

2.1 BASIC INTUITION
(1) Criteria
How fast you re-coup initial investment?
Benefits > Costs
Compare PV of cash inflows & PV of cash expenditure
Compare return on investment & cost of financing project
(2)

A word of Caution
A manager needs to make a decision today (t=0) given
estimated/forecasted cash flows. Obviously there is no
guarantee that the decision would always turn out as
anticipated. However, what is important is that the manager
has to make the best decision at t=0 given all the relevant
information.

2.2 INDEPENDENT vs. MUTUALLY EXCLUSIVE PROJECTS:

#

Independent:

A project that has nothing to do with other projects

under investigation.

Example:
#

Replace copy machine and build a new plant.

Mutually Exclusive: You only need one of these alternative

projects.

Example:

Buy IBM or Apple PC?

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2.3 TOOLS
3.1 Payback Period Method:
Criterion:

For two mutually exclusive projects, choose the one that

pays you back your initial cost the sooner.

Example: Calculating Payback Period

Given the following CFs, and k = 10%, we get:

Investment

Initial cost

CF1

CF2

$10,000

$14,400

10,000

$10,000

2,400

choose project B, since it pays back initial investment in one

year.

? Is this choice optimal?

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Capital Budgeting Process

9-10

3.2 Net Present Value (NPV) method:

L

Payback ignores the concept of CFs. Ignores CF after payback

and risk of CFs.

we need to look at the PV of these CFs net of any initial cost.

NPV ' PV of all Relevent CFs & Initial Investment

CF1

'

CF2

%
1

(1%k)
j
n

'

t'1

' j

(1%k)

CF t
t

(1%k)

CFt

t'0

(1%k)t

% ...%

CF n
n

(1%k)

& I0

& I0

' CF1[PVIFk,1] % CF2[PVIFk,2] % ... % CF n[PVIFk,n] & I0

where,
CFt / Net cash flow (inflow - outflow) at time t
I0
/ Initial cost or investment outlays
k
/ cost of capital (financing)
/ required return reflecting risk of use of CFs
Note: CF0 / I0
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9-11

Thus,
NPV measures the additional market value that
management expects the project to create (or destroy) if
it is undertaken.

NPV Criteria:
Since the objective of the manager is to maximize value, then for

Independent Projects :

Choose All Projects with NPV > 0.

Mutually Exclusive:

Choose projects with the highest

NPV.

Note:

NPV > 0 is equivalent to PV of cash inflow > PV of cash

outflow.

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9-12

Example: Calculating NPV

Given the following CFs, and k = 10%, we get:

Investment

Initial cost

CF1

CF2

$10,000

$14,400

10,000

$10,000

2,400

Solution:
NPVA '

$14,400

NPVB '

10,000

& 10,000 ' $1,901

(1%k)

(1%.1)

2,400
2

&10,000 ' $1,074

(1%.1)

choose A, since it has the highest NPV if mutually exclusive,

or both if independent as they are both with NPV >0.

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Capital Budgeting Process

9-13

Remarks on payback method:

With payback method, project B is selected. Thus, if you ignore
amount, timing, and risk of CFs, then potentially you would end up
with the wrong valuation.
Both projects would add value to shareholders. However, if you
select project "B", you would not be maximizing shareholder value,
as "A" provides more value to shareholders.
In general, if you accept a project with NPV <0, then you are
destroying shareholder value!

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Capital Budgeting Process

9-14

Example: Calculating additional Shareholder Value

Using a project's NPV = $1,901 and assuming that there are 1,000 shares
outstanding, then

Value created per share '

'
Y

NPV
# of shares outstanding
$1,901
' $1.901
1,000

If the project is adopted then the price of the stock should increase by
$1.90.

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3.3 Internal Rate of Return Method (IRR)

#

Motivation:
!
Internal in that it is a rate of return that depends on the CFs
of the project.
!

Return on investment (ROI) is a very intuitively appealing

concept; measured in % terms.
ROI '

profit
investment

Easy to determine profit if you have single CF in future. What

about if we have multi-period payoffs?

Periods

CF from project

-100

10

60

80

Profit would be calculated as:

Ending Value - Beginning Value = $80 - $100
But this calculation ignores the intermediate CFs, namely $10
and $60 in periods 1 and 2 respectively.

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9-16

Thus, when examining the return on a project, we need a

new tool that would incorporate all the cash flows of a
project.

Definition of IRR :

NPV ' 0 ' CF0 %

IRR is defined as that particular k, such that

the project breaks-even, i.e., when NPV = 0.
Thus,

CF1
(1 % IRR)

CF2
(1 % IRR)2

% ... %

CF N
(1 % IRR)N

Decision Rule:

IRR Criterion: Choose projects with IRR higher than cost of

financing.

If [the cost of financing "k"] < IRR Y NPV > 0 Y Additional

value would be created. Obviously the larger the difference between
k & IRR, the higher the NPV.
Note:

Use IRR cautiously for mutually exclusive projects!

Limitations of IRR are discussed on p. 21.
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Example: Calculating IRR (single future CF)

Given:
Period

CF($)

-100

300

Solution:

&100 %
Y

300
' 0
(1%IRR)

300
' 100
(1%IRR)

Y 100(1%IRR) ' 300

Y 100 % 100IRR ' 300
Y IRR '

300&100
200
'
' 2 ' 200%
100
100

The ROI is:

ROI '

$300 & $100

' 200%
$100

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Example: Calculating IRR (multiple future CFs)

Given:
Periods

CF from project F

-100

10

60

80

IRRF = ?

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9-19

Solution:

To calculate IRR (just like YTM) there is no simple formula to

use. Thus, we need to use either trial & error method or a
calculator. From definition of IRR,

CF0 %
!

CF1
(1% IRR)

% ... %

(1% IRR)

' 0

10
60
80
%
< 0
%
2
3
(1% .19)
(1% .19)
(1% .19)

You have guessed a number too high. Try a smaller #, say IRR =
17%, thus

& 100 %

(1% IRR)

CFN

Guess an IRR, say IRR = 19%, then substituting in above equation

yields:

& 100 %

CF2

10
60
80
%
> 0
%
2
3
(1% .17)
(1% .17)
(1% .17)

If you try IRR = 18.1%, you get correct answer.

IRRF = 18.1% (using either trial & error or calculator)

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NPV Flow Profile: Relation between NPV, IRR, and "k"

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Capital Budgeting Process

9-21

Problems With IRR for Mutually Exclusive Projects:

Problem 1:

Consider two projects such that returnA = 15%, returnB =

50%, and k = 10%. Which would you choose?

Now assume that they require the following initial investments:

IA = $1,000,000 while IB = $100

Which would you choose?

If initial investments are not equal, IRR ranking can be

misleading.

Problem 2:

Possible existence of multiple IRRs. Every time the CFs

change sign, you would get an additional IRR. (See NPV,
IRR, "k" profile)

Problem 3:

Possible conflict of ranking with NPV.

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3.4 What tools does industry use?

Tool

% use of each
Tool

Primary method
NPV

21%

IRR

49

payback

19

AROR

Secondary method
NPV

24%

IRR

15

payback

35

AROR

19

AROR ' Accounting Rate of Return

j accounting profit after tax t /N
'

t'1

(initial outlays % salvage value)/2

where t is time, and N = # of periods

Source:

Kim, Crick, and Kim, "Do executives Practice What Academics Preach?"
Management Accounting (November 1986), pp. 49-52.

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Capital Budgeting Process

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So Why Does Industry Still use IRR Despite Problems?

<

percentage results are more intuitive than a $NPV; 50% return vs.
NPV = $500,000

<

Since IRR gives you break-even cost of financing:

The number itself is of interest to managers; you want simply
to ask at what financing cost does project break-even?

<

If a project's break-even is 100%, in a "normal" situation, you

wouldn't need to go through the trouble of estimating all the CFs, as
100% is considerably higher than a normal financing rate.

Why Do Managers Use Payback with All of its

Problems?

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3. SUMMARY
T

Payback Period

NPV

Independent Projects

Mutually exclusive

NPV =

NPV criterion is equivalent to PV of cash inflow > PV of

cash outflow

sum of discounted CFs, where the discount rate is

the cost of financing the project.

IRR
# Criterion
Two equivalent ways to look at it
Break-even or ROI > cost of financing project
# Calculation
! Trial & error
! Calculator

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4. QUESTIONS
I. True/Disagree-Explain
1.

According to the NPV criterion, you should choose all projects with NPV > 0.

2.

According to the IRR criterion, you should choose projects with IRR < cost of financing.

3.

Ignoring brokerage fees, purchasing a stock in an efficient market is a zero NPV transaction.

4.

Capital budgeting tools can be used to analyze the merits of "flextime."

5.

A NPV > 0 project might not be undertaken because of its high risk, despite the manager's
confidence in the accuracy of the CF estimates.

6.

If a company is expanding, then it is necessarily creating additional value to shareholders.

7.

If buying stocks is a NPV = 0 transaction, then no one would profit from them as an investor's
profits would be zero.

II. Problems
1) Given:
Project S

Project L

Cost

$10,000

25,000

Annual Benefits

$4,000

8,000

# of years

14%

14%

Which of these mutually exclusive projects is better based on NPV and IRR?

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9-26

ANSWERS TO QUESTIONS
I. Agree/Disagree-Explain
1.

Disagree. Only if the projects are independent. If they are mutually exclusive, then you
choose the one with the highest NPV.

2.

Disagree. If IRR < cost of financing, then the project would be losing money as it costs more
to finance than to break-even. Such a project will have NPV < 0.

3.

Agree. NPV = -market price + PV of dividends. Present value of a stock would be its Agree
worth--value. If you pay (market price) exactly its worth (PV of dividends), then NPV = 0.

4.

Agree. Analyzing flextime corresponds to analyzing its impact on a firm's CFs. However, in
practice it is difficult to obtain good estimates of the incremental CFs. Thus, if "flextime"
makes sense, then you would be undertaking a NPV > 0 project.

5.

Disagree. The risk of CFs is reflected in the cost of capital (k). Thus, the fact that you obtain
a NPV > 0, and assuming you did the correct calculation, the project should be accepted.

6.

Disagree. Only if it is re-investing revenue at a rate higher than the required rate of return.
A simple example would be a company borrowing to finance projects that are not profitable,
NPV <0. Thus, expansion does not necessarily translate into shareholder value creation.

7.

Disagree. NPV = 0 implies that an investor is being compensated by an amount

commensurate with the risk and value of the investment, i.e. there are no excess profits.

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Capital Budgeting Process

II. Problems
1)
Step 1

9-27

Are CFs of equal length? Yes

Step 2

Calculate NPV
NPVS = -10,000 + 4,000(PVIFA14%,5) = 3,732
NPVL = -25,000 + 8,000(PVIFA14%,5) = 2,465

Using IRR:

IRRS = 28.6% and IRRL = 18%

Since cost of capital for each = 14% < IRR. Y Accept S as it has a higher IRR.
Obviously, you should choose both if they were independent.

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Capital Budgeting Process

9-28
ELIMINATIONS

a. APPROACHES TO CAPITAL BUDGETING

!
!

Top Down Approach

Bottom up Approach

INTER-DEPENDENCE OF INVESTMENT &

FINANCING DECISIONS
Illustration 1:
Project 1: ATT owes you $100, and makes you an offer of $100 today or
$107 next year. Which would you choose? Assume that return
on similar risky investments is 6%.
Project 2: Suppose, in addition to the ATT opportunity, you have a "great
deal" that requires a $100 investment that is expected to payoff
$300 in a year.
Case 1:

Assume: you can borrow at a cost of 10%.

Action: Take both projects (independent)

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Capital Budgeting Process

9-29

choose $107 as

PVATT '

$107
' 100.94 > $100 Y
(1 % .06)

NPVATT ' & 100 % 100.94 ' $.94

PVATT '

1.06

NPVgreat deal ' & 100 %

300

' $172.7

Thus, if you borrow, in effect you would be undertaking both

projects.

Total NPVindependent

Case 2:

= NPVATT + NPVgreat deal

= 0.94 + 172.7 = 173.64

You cannot borrow, or cost of borrowing is 400% and

assume that a project with same risk as "great deal" has
a return of 12%.
Action:

Mutually exclusive projects

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NPV"great deal" ' & 100 %

300
(1 % 4)

' & 100 % 60 ' & 40 < PVIRS

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Obviously, in this case you are better off taking $100 from ATT. Thus,
NPV ' & 100 %

300
' & 100 % 267.8 ' 167.8 < NPVindependent
1% .12

Choose project with highest NPV Y choose "great deal".

Notes:
!
!

You discount at 12%, since it is the return you have to forego

if you invest in a project with same risk as ATT.
NPVindependent > NPVmutually exclusive

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b. RELATIONSHIP BETWEEN P, DIVIDENDS, g, & NPV

p0 = PV (CF of existing business) + NPV ( dividend growth due to
investment of future earnings)
EPS1
k

% NPVGO

..................................................
Let RR' Retention Ratio Y D1 ' (1& RR)(EPS1)

Y return on retained earnings ' (RR)(EPS1)(ROE)

EPS1

where ROE '

book equity per share

Y NPV1 ' & I0 % PV of increases CFs

' & (RR)(EPS1) %

(RR)(EPS1)(ROE)
k

' (RR)(EPS1) & 1 %

ROE
. .
k

.......(( ( )

Y NPV1, NPV2,.... are growing at a rate (RR)(ROE) ' g

Y NPVGO '

NPV1
k & g

p0 '

EPS1
k

NPV1
k & g

Substitute NPVGO in (*), we get

Conclusions: NPVGO depends on

a.
EPS1: current earnings size
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'

D1
k & g

Capital Budgeting Process

b.
c.
d.

9-33

RR
Relative magnitudes of ROE and k; see equation (**) above.
Growth, (RR)(ROE), does not necessarily imply NPV _.

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c. WHERE DO NPV> 0 PROJECTS COME FROM?

#

In long-run NPV = 0 ] excess economic profit = 0

Sources of NPV > 0 (Sources of competitive advantage)

!
Barriers to entry
!
product differentiation
!
economies of scale
!
better distribution channels
!
luck
INVESTMENT UNDER UNCERTAINTY

Classical micro-economic theory

Observations:
#
Firms use cost of capital "hurdle rate" in NPV > 3 times cost of
capital ] firms invest only if price is substantially > LRAC
(Summers '87)
#

Firms stay in business even after p < AVC

First quarter of '85 $ started `. By end of '87, $ was at '78 level.

But, import volume did not ` until 2 years later. (Krugman &
Baldwin '87)
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U.S. firms abandon project earlier than Japanese (TV, VCR, semiconductors)

Explanation:
Agree NPV = NPV + flexibility option
Sources of option value:
#
sunk costs in abandonment decision
!
Severance pay for workers (-)
!
scarp value (+) (Myers & Majd '85)
"
capital used is industry specific (eg. steel mills) Y Who
is going to buy machinery when entire industry is
suffering?!
"
lemon problem
"
stop and re-start needs additional costs (McDonald &
Siegel '85)
#

Uncertainty: product price, operating costs, interest rates

Y value in option to wait (Pindyck '91, Ross & Ingersoll '92)
!
parameters:
"
if uncertainly is high Y value of waiting _
"
if k is low Y future outcomes valued more Y value of
option to wait and resolve future uncertainty _.
"
What happens if there are other firms in industry? Y
"balance" between waiting and implementing
(Fudenburg & Tirole '83, Stiglitz '89)
"
if k ` does not Y Investment _ as cost of waiting `
"
Why did U.S. abandon color TVs, VCRs and semiconductors?
The value of waiting to invest is governed by
downside risk. But Japanese government supports
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firms during downside through cartelization to

avoid destructive competition. (Bernake '83)
!
#

Sequential investing , as in drug industry

Remarks
!
If 400% (in above illustration) is the cost of borrowing, maybe
that is the Agree cost of financing.
!
If a project sounds "too good to be Agree," it probably is "too
good to be Agree."
!
Role of market in information processing vs. personal
borrowing market.

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