CFA Level I Corporate Finance

Capital Budgeting
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Contents
1. Introduction
2. The Capital Budgeting Process
3. Basic Principles of Capital Budgeting

4. Investment Decision Criteria

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1. Introduction
Capital budgeting is the process that companies use for decision making
on long-term projects
Capital budgeting
helps decide the future of many corporations
can be adapted for many other corporate decision such as investment in
working capital, leasing, mergers and acquisitions

Valuation principles used in capital budgeting are used in security

valuation
Corporate budgeting decisions are consistent with management goal of
maximizing share holder value
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2. The Capital Budgeting Process

The process is as follows:
1. Generating Ideas
2. Analyzing Individual Proposals
3. Planning and Capital Budgeting
4. Monitoring and Post Audit

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Project Categories
Replacement projects
Expansion projects
New products and services
Mandatory projects

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3. Basic Principles of Capital Budgeting

1. Decisions are based on cash flows
2. Timing of cash flows is crucial
3. Cash flows are based on opportunity costs
4. Cash flows are analyzed on an after-tax basis

5. Financing costs are ignored

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Key Concepts
Sunk cost (not included in investment appraisal)

Incremental cash flows

Externality (positive /negative)

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Key Concepts (Cont)

Conventional versus non-conventional cash flows

Independent versus mutually exclusive projects

Project Sequencing

Unlimited funds versus capital rationing

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4. Investment Decision Criteria

Analysts use several important criteria to evaluate capital investments.
Some known metrics are the following:

Net present value ( NPV)

Internal rate of return (IRR)
Payback and discounted payback period
Profitability index (PI)
Average accounting rate of return (AAR)

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4.1 Net Present Value

Net present value is the present value of the future after tax cash flows
minus the investment outlay

For independent projects: positive NPV accept

negative NPV reject

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Example
Cost of Capital = 10%
Expected Net After Tax Cash Flows
Year (t)

Project A

Project B

- $1,000

- $1,000

500

100

400

300

300

400

100

600

Requirement: Compute NPV for Project A and B

Answer:
NPV for A = 78.82; NPV for B = 49.18
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NPV Using Calculator

Key strokes

Display

[CF][2nd ] [CLR WORK]

CF0= 0

1000 [][ENTER]

CF0 = -1000

[] 500 [ENTER]

C01= 500

[]

F01= 1

[] 400 [ENTER]

C02= 400

[]

F02= 1

[] 300 [ENTER]

C03= 300

[]

F03= 1

[] 100 [ENTER]

C04= 100

[]

F04= 1

[NPV] 10 [ENTER]

I = 10

[] [CPT]

NPV= 78.82

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4.2 Internal Rate of Return

IRR measures the return for a given project

IRR is the discount rate that makes the present value of the future cash flows equal
to the investment outlay; we can also say that IRR is the discount rate which makes
NPV equal to 0.

IRR Decision Rule

If IRR > the required rate of return, accept the project
If IRR < the required rate of return, reject the project
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Example
Cost of Capital = 10%
Expected Net After Tax Cash Flows
Year (t)

Project A

Project B

- $1,000

- $1,000

500

100

400

300

300

400

100

600

Requirement: Compute IRR for Project A and B

Answer:
IRR of A = 14.49% ; IRR of B = 11.79%
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IRR Using Calculator

Key strokes

Display

[CF][2nd ] [CLR WORK]

CF0 = 0

1000 [][ENTER]

CF0 = -1000

[] 500 [ENTER]

C01 = 500

[]

F01 = 1

[] 400 [ENTER]

C02 = 400

[]

F02 = 1

[] 300 [ENTER]

C03 = 300

[]

F03 = 1

[] 100 [ENTER]

C04 = 100

[]

F04 = 1

[IRR] [CPT]

14.49

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4.3 Payback Period

The payback period is the number of years it takes to recover
the initial cost of the investment
Advantages:
Easy to calculate
Easy to explain
Indicator of project liquidity
Drawbacks:
Does not consider cash flows after payback period
Does not consider time value of money
Does not consider risk of a project
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4.4 Discounted Payback Period

Discounted payback method uses the present value of the estimated
cash flows; it gives the number of years to recover the initial investment
in present value terms

Drawbacks:
Does not consider any cash flow beyond payback period
Poor measure of profitability
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Example
Year
0
Project C -800

1
340

2
340

3
340

4
340

Compute the payback period and discounted payback period assuming a rate of 10%.

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4.5 Average Accounting Rate of Return

The average accounting rate of return (AAR) can be defined as:
AAR = Average net income/ average book value

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4.6 Profitability Index

Profitability index (PI) is the present value of a projects future
cash flows divided by the initial investment
PI = PV of future cash flows/Initial investment
PI = 1+ (NPV/Initial investment)

Investment decision rule for PI is:

Invest if : PI > 1.0
Do not invest if: PI < 1.0
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4.7 NPV Profile

The NPV profile shows a projects NPV graphed as a function of various discount
rates. The NPV is graphed on the y-axis and discount rates on the x-axis respectively.
Create the NPV profile for Project X.
Year

Project X

-400

160

160

160

160

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Crossover
Draw the NPV profiles for Projects X and Y. Discuss the significance of the
cross over point.
Year

Project X

-400

160

160

160

160

Project Y

-400

800

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Example
The initial investment on a project is 200. The after-tax cash flows from this project are 80 annually for
four years. Improvements on the project equipment increase the cost by 30 and the after-tax cash flows
by 10. What is the impact on the NPV profile?
A. Vertical intercept shifts up and horizontal intercept shifts left
B. Vertical intercept shifts up and horizontal intercept shifts right
C. Vertical intercept shifts down and horizontal intercept shifts right

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4.8 Ranking Conflicts between NPV and IRR

Project A

No conflict between NPV and IRR decision rules

Conventional
Cash Flows

Project A

Project B

Conventional
Cash Flows

Conventional
Cash Flows

Project C

OR

Project D

A and B are independent

No conflict between NPV and IRR decision rules

A and B are mutually exclusive

Possible conflict between NPV and IRR decision rules
Reasons: 1) Different cash flow patterns and 2)
Different scale
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Ranking Conflict Due to Differing Cash Flow Patterns

Year
0
Project X -400

1
160

2
160

3
160

4
160

Project Y -400

800

NPV

IRR

Which project do you select according to the NPV rule using a rate of 10%?
Which project do you select according to the IRR rule?
Show the NPV profile for both projects.

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Ranking Conflict Due to Differing Project Scale

Year
0
Project C -200

1
100

2
100

3
100

4
100

Project D -800

340

340

340

340

NPV

IRR

Which project do you select according to the NPV rule using a rate of 10%?
Which project do you select according to the IRR rule?
Show the NPV profile for both projects.

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Example
For the projects shown below what discount rate would result in the same NPV? The required rate of
return is 10%.
A. A rate between 0% and 10%
B. A rate between 10% and 25%
C. A rate between 25% and 35%
Year

NPV

IRR

Project C

-200

100

100

100

100

117

35%

Project D

-800

340

340

340

340

278

25%

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4.9 The Multiple IRR Problem and No IRR Problem

Show the NPV profile for this project? Hint: use these
rates: 0%, 50%, 100%, 150%, 200%, 250%
Time

Cash Flow

-200

1,000

-1,200

Show the NPV profile for this project? Hint: use these
rates: 0%, 50%, 100%, 150%, 200%, 250%

Time

Cash Flow

100

-300

250

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Comparison between NPV and IRR

NPV
Advantages:
Direct measure of expected increase in
value of firm
Theoretically the best method

IRR
Advantages
Shows the return on each dollar invested
Allows us to compare return with the
required rate

Disadvantage:
Does not consider project size

Disadvantage:
Incorrectly assumes that money is
reinvested at IRR rate
Might conflict with NPV analysis
Possibility of multiple IRRs or no IRR for
a project

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4.10 Popularity and Usage of The Capital Budgeting Methods

See Table 13 in the curriculum; this gives an indication of the popularity
of various capital budgeting techniques in different parts of the world
NPV and IRR more likely to be used at larger firms and where
management has MBA degrees
Payback method is also quite popular, especially at private companies

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Relationship between NPV and Stock Price

NPV is a direct measure of the expected change in firm value from
undertaking a capital project
NPV is the criterion most related to stock prices
A positive NPV project should cause a proportionate increase in a
companys stock value

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Example
A company is undertaking a project with a NPV of $500 million. The company
currently has 100 million shares outstanding and each share has a price of $50.
What is the likely impact of the project on the stock price?

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Summary
Capital budgeting process
NPV calculation and NPV rule

IRR calculation and IRR rule

Issues with IRR
NPV profile
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Conclusion
Read summary
Review learning objectives

Practice problems: good but not enough

Practice questions from other sources

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