The Capital Budgeting Decision

Should we
build this
plant?

Unrestricted M Naveed Alam

What is Capital Budgeting?

 Capital Budgeting:
 Represents a long-term investment decision
 Involves the planning of expenditures for a project
with a life of many years
 Usually requires a large initial cash outflow with the
expectation of future cash inflows
 Uses present value analysis
 Emphasizes cash flows rather than income

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4 Methods of Evaluating Investment
Proposals:

1. Payback Method (PB)

2. Internal Rate of Return (IRR)
3. Net Present Value (NPV)
4. Profitability Index (PI)

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Payback Method

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Payback Method

The number of years required to

recover a project’s cost, or how
long does it take to get the
business’s money back?

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Payback -Example

0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

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Example-2
0 1 1.6 2 3

CFt -100 70 100 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

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 Strengths of Payback:
1. Provides an indication of a project’s risk and
liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the payback period.

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Making decisions using Payback

 Invest in any project on which the payback is

less than some established cutoff level.

 If you must choose between two projects, take

the project with the lower cutoff period.

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Investment alternatives – Example

Cash Inflows (of $10,000 investment)

Year Investment A Investment B

1 $5,000 $1,500
2 5,000 2,000
3 2,000 2,500
4 5,000
5 5,000

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Calculate PB, NPV, IRR & PI

 Payback
 NPV @ 10% WACC
 IRR
 PI

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Calculate Payback !!

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Payback Method
 Payback Method (PB):
 computes the amount of time required to recoup the initial investment
 a cutoff period is established
 Advantages:
 easy to use
 emphasizes liquidity
 Disadvantages:
 ignores inflows after the cutoff period and fails to consider the time value
of money
 is inferior to the other 2 methods

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Calculate NPV @ 10%!

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Net Present Value:
 the present value of the cash inflows minus the
present value of the cash outflows
 the cash inflows are discounted back over the life of
the investment
 the basic discount rate is usually the firm’s cost of
capital (WACC)

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Making Decisions using NPV

 In general, if the NPV of the project is positive, we

accept the project. If the NPV is 0, we are indifferent
about the project. If the NPV of the project is negative,
we reject the project.

 In choosing between two competing projects, we

accept the project with the greater NPV.

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Calculate IRR !!!

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What’s is IRR?
0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV

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 Calculate IRR !!!

PV out flow - PV of Inflow of Low rate

IRR= High Rate -Low Rate x +Low Rate
PV of Inflow of High rate- PV of Inflow of Low rate

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Internal Rate of Return:
 represents a yield on an investment or an interest rate
 requires calculating the interest rate that equates the
cash outflow (cost) with the cash inflows
 is the interest rate where the cash outflows equal the
cash inflows (or NPV = 0)

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Accept/Reject Decision—All three
methods
A summary of the decision criteria for each method is given below.
 Payback Method (PB):
 if PB period < cutoff period, accept the project
 if PB period > cutoff period, reject the project
 Internal Rate of Return (IRR):
 if IRR > cost of capital, accept the project
 if IRR < cost of capital, reject the project
 Net Present Value (NPV):
 if NPV > 0, accept the project
 if NPV < 0, reject the project

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Capital budgeting results
Investment A Investment Selection
B

Payback method 2 years 3.8 years Quicker payout:

Investment A

Internal rate of 11.17% 14.33% Higher yield ;

return Investment B

Net present $180 $1,414 Higher net present

value value: Investment
B

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Notice that in the above
illustrations, NPV and IRR
suggested taking the same
projects—they agreed.

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But, sometimes, NPV and IRR
do NOT agree—what then?

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Generally, NPV is better
then IRR

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