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LECTURE OBJECTIVES

CAPITAL BUDGETING AND Understand the capital budgeting process in evaluating

investment proposal, including:
INVESTMENT CRITERIA
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Net present value
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Payback period
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Discounted payback period (optional – won’t test)

Internal Rate of Return
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Profitability Index

Prepared by Phan Ngoc Anh, MBA Identify the pros and cons of these different methods
Some examples used in the slides are provided by Nguyen Canh Tien, MSc

CAPITAL ASSETS AND CAPITAL STEPS TO CAPITAL BUDGETING

BUDGETING
Capital assets, what are they?
Capital budgeting: Estimate Cash Flows (inflows and outflows)
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Analysis of potential additions to fixed assets Assess the riskiness of the cash flows
Long-term decisions; involves large expenditures
Determine the appropriate cost of capital
Very important to firm’s future
Find NPV/IRR
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Accept/reject decisions

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INDEPENDENT vs MUTUALLY EXCLUSIVE NORMAL (CONVENTIONAL) vs NON-NORMAL

vs CONTINGENT PROJECTS (UNCONVENTIONAL) CASH FLOWS
Independent projects: Acceptance/rejection of one Conventional Cash Flow Project:
project would not influence the decision regarding other One change of signs
projects Most common: Cost (negative CF) followed by a
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series of positive cash inflows
Mutually exclusive projects: Only one of a number of
projects can be accepted. The acceptance of one
Unconventional Cash Flow Project:
particular project means the rejection of other projects
Two or more changes of signs
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Contingent projects: Acceptance of one projects depends Most common: Cost (negative CF), then string of
on the acceptance of other projects positive CFs, then cost to close project
Eg: nuclear power plant/strip mine
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CONVENTIONAL OR
UNCONVENTIONAL CASH FLOWS?

0 1 2 3 4 5 C UC NET PRESENT VALUE METHOD

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- + + + + +
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- + + + + - Financial Management
- - - + + +
+ + + - - -
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- + + - + -

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VALUE OF ASSET TODAY CAPITAL BUDGETING

…. is to a company what buying stock or bond

is to individuals:
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= Sum of PVs An investment decision where each want a
of future CFs return > cost
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NET PRESENT VALUE (NPV) NET PRESENT VALUE OF A PROJECT

Net present value is the difference between an

investment’s market value (in today’s dollars) and its Project’s Cash Flows
(CFt)
cost (also in today’s dollars). NPV measures the amount
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by which the value of the firm’s stock will increase if the
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project is accepted. FinancialManagement CF1 CF2 CFN

NPV = + + ··· + − Initial cost
(1 + r )1 (1 + r)2 (1 + r)N
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NCFt = after-tax cash flow in year t Project’s risk-adjusted

cost of capital
Rp = project risk = risk-adjusted discount rate for that (r)
investment
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NET PRESENT VALUE (NPV) NET PRESENT VALUE (NPV)

A project requires initial investment of $1,100 and is planned to last NPV Rule:
for 2 years. Revenues and expenses for the first year is $1,000 and
$500, respectively; for the second year $2,000 and $1,000. Assume
that all revenues and expenses are cash-basis & required return = Accept all projects with NPV > 0
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10%. Should the company accept the project?
0 1 2
Reject all projects with NPV < 0
Initial outlay Revenues $1000 Revenues $2000
For mutually exclusive projects, choose the
($1100) Expenses 500 Expenses 1000 project with the highest NPV
Cash flow 500 Cash flow $1000
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– $1100.00
1
$500 x
1.10
+454.55 1
$1000 x
1.102
+826.45

13 +$181.00 NPV 14

MUTUALLY EXCLUSIVE PROJECTS MUTUALLY EXCLUSIVE PROJECTS

(cont)
Which project is accepted?
Ex: The government is planning to extend the shipping facilities at
Haiphong port.
Option 1: Building a jetty
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Option 2: Building a port (deep enough to accommodate a larger
variety of vessels)
The environmental considerations require that only one of the
options be undertaken.

Year 0 1 2 3
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Jetty (1 million) 0.5 mi 0.7 mi 0.8 mi

Port (3 million) 1.3 mi 1.3 mi 1.3 mi

Assuming a required rate of return of 8% for both projects, which one

15 of these mutually exclusive projects would you recommend? 16

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PROBLEMS WITH NPV PROBLEMS WITH NPV

COMPARING PROJECTS WITH DIFFERENT LIVES
Company faces capital rationing ( have limited fund When comparing two mutually-exclusive projects
and cannot invest in all positive NPV projects) with different lives, it is necessary to make
comparisons over the same time period.
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How to choose mutually exclusive projects with
different life time? So, we compare the ANNUAL EQUIVALENT (AE) , or
the annual annuity with the same NPV
Superior heating Medium heating
system system The equivalent annual annuity (AE) approach calculates the
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vs constant annual cash flow generated by a project over its
15 years duration 7 years duration lifespan if it was an annuity. The present value of the constant
$20,000 $9,000 annual cash flows is exactly equal to the project's net present
value (NPV).
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PROBLEMS WITH NPV PROBLEMS WITH NPV

COMPARING PROJECTS WITH DIFFERENT LIVES COMPARING PROJECTS WITH DIFFERENT LIVES
Machine A costs $3,000 and then $1,000 per annum Step 1. Calculate the NPV for each project
for the next four years
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Machine B costs $6,000 and then $1,200 for the next
eight years.
The required rate of return for both projects is 10
per cent. If either of the machines wears out, the Step 2. Convert the NPVs for each project into an Annual
company would have to replace with a new one. Equivalent annuity
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Which is the better project the company should choose? Note:

Assume that the two projects bring the same benefits (profits)
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to the company.

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PROBLEMS WITH NPV PROBLEMS WITH NPV

COMPARING PROJECTS WITH DIFFERENT LIVES COMPARING PROJECTS WITH DIFFERENT LIVES
CLASS EXERCISE

P&G must decide which of the two machines it should use to

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produce its new line of products – new generation of
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shampoo called Maxxhairr
Machine A costs $100,000, has a useful life of 4 years, and
generates after-tax cash flows of $40,000 per year

Machine B costs $65,000, has a useful life of 3 years, and

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generates after-tax cash flows of $35,000 per year

Assume that the discount rate is 10% per year. Which

machine P&G should buy ?
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A DECISION TREE FOR EVALUATION OF

COMPETING PROJECTS – ON A CONTINUING CYCLE
Select all projects
Are projects
independent ?
Yes with NPV >0
PAYBACK METHOD
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Mutually exclusive
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No

Do projects have Financial Management

equal lives ?
No Yes
Select project with
highest NPV annual Select projects with
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equivalent the highest +NPV

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PAYBACK PERIOD PAYBACK ILLUSTRATION

The payback period is the amount of time required for
the firm to recover its initial investment Initial investment = –$1,000

Year Cash flow

1 $200
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– If the project’s payback period is less than the 2 400
maximum acceptable payback period, accept the 3 600
project
Accumulated
– If the project’s payback period is greater than the Year Cash flow
maximum acceptable payback period, reject the
1 $200
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project
2 600
3 1200
Management determines maximum acceptable
payback period (cut-off point) 25 Payback period = 22/3 years
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PAYBACK ILLUSTRATION PAYBACK – PROS AND CONS

Advantages of payback method:
Example:
Extremely simple
Helps prevent cash flow problems
Project CF0 CF1 CF2 CF3 Payback NPV (at 10%)
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Since cash is recovered as quickly as possible
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Useful when technology changes rapidly
A -2,000 +1,000 +1,000 +10,000 2 $7,249 Cost of machinery is recovered before new model comes out
B -2,000 +1,000 +1,000 0 2 -264
C -2,000 0 +2,000 0 2 -347 Disadvantages of payback method:
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Ignores the time value of money

What do you think about these 3 projects ?
Ignores cash flows after the payback period
Arbitrary acceptance criteria
A project is accepted based on the payback criteria may
not have a positive NPV 28
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DISCOUNTED PAYBACK (optional)

How long does it take the project to “pay back” its initial
investment taking the time value of money into account?
DISCOUNTED PAYBACK METHOD
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Accumulated
Initial investment = —$1,000 Year discounted cash flows
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R = 10%
PV of 1 $182
Year Cash flow Cash flows 2 513
1 $200 $182 3 1,039
4 1,244
2 400 331
Discounted payback period is just under three
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3 700 526
years
4 300 205

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ORDINARY AND DISCOUNTED PAYBACK DISCOUNTED PAYBACK PROS AND

(optional) CONS
Initial investment = –$300 Advantages Disadvantages
R = 12.5%
Cash Flow Accumulated Cash Flows - Includes time value of -May reject positive NPV
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Year Undiscounted Discounted Undiscounted Discounted money investments
1 $ 100 $ 89 $ 100 $89 - Easy to understand -Arbitrary determination of
2 100 79 200 168 - Does not accept acceptable payback period
3 100 70 300 238
4
negative estimated NPV -Ignores cash flows beyond the cut-
100 62 400 300
5 100 55 500 355 investments off date
-Biased towards liquidity -Biased against long-term and new
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- Used by large companies products

•Ordinary payback? when they are making
•Discounted payback? relatively minor decisions
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INTERNAL RATE OF RETURN

Internal rate of return (IRR) is the discount rate that
results in a zero NPV for the project
INTERNAL RATE OF RETURN CF1 CF2 CF3 CFT
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NPV = 0 = CF0 + + + + .... +
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2 3
(1 + IRR) (1 + IRR) (1 + IRR) (1 + IRR)T
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• IRR found by computer/calculator or manually by trial

and error
The IRR decision rule is:
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– If IRR is greater than the cost of capital, accept the
project
– If IRR is less than the cost of capital, reject the project 34

INTERNAL RATE OF RETURN - INTERNAL RATE OF RETURN -

ILLUSTRATION ILLUSTRATION
Trial and Error
Initial investment = –$200
Discount rates NPV
Year Cash flow
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1 $ 50 0% $100
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2 100
3 150 5% 68
Find the IRR such that NPV = 0 10% 41
50 100 150
0 = –200 + + + 15% 18
(1+IRR) 1 (1+IRR) 2 (1+IRR) 3
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20% –2
50 100 150
200 = + +
(1+IRR) 1 (1+IRR) 2 (1+IRR) 3 IRR is just under 20%—about 19.44%

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THE NPV PAYOFF PROFILE FOR THIS

PROBLEMS WITH IRR
EXAMPLE
Three key problems encountered in using IRR:
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Borrowing or lending ?
Multiple IRRs
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Mutually exclusive projects

IRR and NPV rankings do not always agree

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PROBLEMS WITH IRR PROBLEMS WITH IRR

BORROWING OR LENDING? MULTIPLE RATES OF RETURNS
Project will have multiple rates of returns in case of
unconventional cash flows (there is more than one negative
NPV at 10%
Project 0 1 IRR discount rate cash flows)
Year Cash flows
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A -1,000 1,500 50% 363.64 0 –$252

1 1431
B 1,000 -1,500 50% -363.64
2 –3035
3 2850
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Both projects have an IRR = 50%, but only project A is 4 –1000

acceptable !

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PROBLEMS WITH IRR PROBLEMS WITH IRR

MULTIPLE RATES OF RETURNS MULTIPLE RATES OF RETURNS
What’s the IRR? Find the rate at which When the cash flows
the computed NPV = 0: change sign more than
once, there is more NPV > 0
at 25.00%: NPV = 0 than one IRR.
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at 33.33%: NPV = 0 When you solve for IRR
you are solving for the
at 42.86%: NPV = 0
root of an equation and
at 66.67%: NPV = 0 when you cross the x
axis more than once,
there will be more than
Two questions: one return that solves
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NPV <0
1. What’s going on here? the equation.

2. How many IRRs can there be? If you have more than
one IRR, you cannot use
any of them to make
41 your decision.

PROBLEMS WITH IRR PROBLEMS WITH IRR

MUTUALLY EXCLUSIVE PROJECTS MUTUALLY EXCLUSIVE PROJECTS
The timing problem The scale problem

Year 0 1 IRR NPV

0 1 2 IRR NPV
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Small
project
-1 +1.5 50% 0.43
-5,000 8,000 0 60% 2,273
Large
-5,000 0 9,800 40% 3,099 project
-100 +110 10% 4.76
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IRR does not take into account project scale (size)

Despite having a higher IRR, Project A is less valuable
In the above example, we would recommend the “small project”
than project B !
based on IRR, but recommend the “large project” based on NPV
43 44 – assume 5% required rate of return

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NPV vs. IRR RULES

Usually, NPV and IRR are consistent with each other. If

IRR says accept the project, then NPV will also say
accept the project. PROFITABILITY INDEX METHOD
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However, IRR can be in conflict with NPV if
Investing or Financing decisions
Projects are mutually exclusive
Projects differ in scale of investment
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Cash flows pattern of projects are different
Projects have unconventional cash flows

If IRR and NPV conflict, use NPV approach

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PROFITABILITY INDEX PROFITABILITY INDEX

Why in the first place exists this variation of Net Profitability Index expresses a project’s benefits
Present Value ? relative to its initial cost
Capital rationing: Limit set on the amount of funds
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available for investment. Sometimes the amount of
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CF1 CF2 CFT
capital that an organisation can invest in long-term + 2
+ ... +
projects is limited. PV of cash flows (1 + r ) (1 + r ) (1 + r ) T
PI = =
Initial investment CF0

Solution: Management will obviously wish to select

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those projects that will give the greatest return per Acceptance criteria: Accept a project with a PI > 1.0
dollar invested (highest profitability index).

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Management PROFITABILITY INDEX PROFITABILITY INDEX

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This is a good project
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because the present
value of the inflows
exceeds the outlay.

Each dollar invested

generates $1.1645 in
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value

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