Reading 32: Capital Budgeting

The Capital Budgeting Process

The steps typically involved in the capital budgeting process are as follows:

1. Generating ideas: Ideas can be generated from any part of the organization or sources outside
the company.

2. Analyzing individual proposals: This involves collecting data to forecast the cash flows of a
particular project, which are used to evaluate the feasibility of a project.

3. Planning the capital budget: Projects should fit into the company’s overall strategy, including the
timing of cash flows and availability of company resources.

4. Monitoring and postauditing: Actual performance is compared to forecasts and the reasons for
discrepancies are sought.
 The Capital Budgeting Process
Capital budgeting projects can usually be classified into the following categories:

1. Replacement projects: These projects help in maintaining the normal course of business or may
involve more efficient equipment or newer technology.

2. Expansion projects: These are projects that increase the size of the business.

3. New products and services: Venturing into new products and services brings added uncertainties,
requiring extremely detailed analysis in the decision-making process.

4. Regulatory, safety, and environmental projects: These projects are sometimes made mandatory
by a governmental agency or some external party.

5. Other projects: Some projects cannot be analyzed through capital budgeting techniques. Some
projects can be so needless or risky they are difficult to evaluate and justify using typical assessment
methods.
 The Basic Principles of Capital Budgeting
Some important capital budgeting concepts:

Sunk costs are costs that cannot be recovered once incurred.

Opportunity cost is the value of the next best alternative that is forgone in making the decision to
pursue a particular project.

An incremental cash flow is the additional cash flow realized as a result of a decision.

An externality is the effect of an investment on things other than itself.

A conventional cash flow stream consists of an initial outflow followed by a series of inflows.

For a nonconventional cash flow stream, the initial outflow is not followed exclusively by inflows,
but the direction of the flows changes from positive to negative.
 The Basic Principles of Capital Budgeting
The basic principles (assumptions) of capital budgeting are:

1. Decisions are based on actual cash flows: Only incremental cash flows are relevant to the capital budgeting process,
while sunk costs are completely ignored.

2. Timing of cash flows is crucial: Analysts try to predict when cash flows will occur, as flows received earlier are worth
more than cash flows received later in the project.

3. Cash flows are based on opportunity costs: Projects are evaluated on the incremental cash flows over and above their
next best alternative use (opportunity cost).

4. Cash flows are analyzed on an after-tax basis: The impact of taxes on cash flows is always considered before making
decisions.

5. Financing costs are ignored from calculations of operating cash flows: Financing costs are reflected in the required rate
of return from an investment project.

6. Accounting net income is not used as cash flows for capital budgeting because it is subject to noncash (e.g.,
depreciation) and financing charges (e.g., interest expense).
 Evaluation and Selection of Capital Projects
1.Independent versus mutually exclusive projects
• Independent projects are those whose cash flows are unrelated.
• Mutually exclusive projects compete directly with each other for acceptance.

2. Project sequencing
• Many projects can only be undertaken in a certain order, so investing in one project creates
the opportunity to invest in other projects in the future.

3. Unlimited funds versus capital rationing

• When the company has no constraints on the amount of capital it can raise, it will invest in
all profitable projects to maximize shareholder wealth.
• The need for capital rationing arises when the company has limited funds to invest.
 Net Present Value
Net Present Value (NPV)
For a project with one investment outflow at the beginning of the project, the net present value is
the present value of the future after-tax cash flows minus the investment outlay.

Decision Rules for NPV

1. Positive NPV projects increase shareholder wealth.

2. Projects with a negative NPV decrease shareholder wealth and should not be undertaken.
3. A project with a NPV of zero has no impact on shareholder wealth.
Net Present Value
 Practice Question
Mars Motors is considering the purchase of a new machine at a cost of $100,000. The
machine will generate $10,000 a year for 5 years followed by $25,000 a year for 3 years.

If the required rate of return is 11%, the NPV of the project is closest to:

A. –$26,785
B. $73,215
C. $125,000
 Practice Question
Mars Motors is considering the purchase of a new machine at a cost of $100,000. The
machine will generate $10,000 a year for 5 years followed by $25,000 a year for 3 years.

If the required rate of return is 11%, the NPV of the project is closest to:

A. –$26,785
B. $73,215
C. $125,000

Answer: A
 Internal Rate of Return
Internal Rate of Return (IRR)
For a project with only one outlay at inception, IRR is the discount rate that makes the sum of
present values of the future after-tax cash flows equal to the initial outlay.
Alternatively, IRR is the discount rate that equates the sum of the present values of all after-tax
cash flows for a project (inflows and outflows) to zero.

Decision Rules for IRR

A company should invest in a project if its IRR is greater than the required rate of return. When the
IRR is greater than the required return, NPV is positive.
A company should not invest in a project if its IRR is less than the required rate of return. When the
IRR is lower than the required return, NPV is negative.
Internal Rate of Return
 Payback Period
Payback Period
A project’s payback period equals the time it takes for the initial investment to be recovered through
after-tax cash flows from the project.
If two projects have the same payback period and identical cash flows, the project with cash flows earlier
in the payback period would be preferred due to its higher NPV.

Advantages
It is simple to calculate and explain.
It can also be used as an indicator of liquidity.

Drawbacks
It ignores the risks of the project; i.e., cash flows are not discounted.
It ignores cash flows that occur after the payback period is reached.
It is not a measure of profitability, so it cannot be used in isolation.
The payback period should be used along with the NPV or IRR to ensure decisions reflect the overall
profitability of the project being considered.
 Payback Period

The payback for this investment occurs between Years 3 and 4, where cumulative cash flows change from negative to positive.

At the end of Year 3, the project needs to recover $150 of the initial outlay, which is recovered from the $400 earned over Year 4.

The payback period equals 3 full years plus a fraction of the fourth year.

This fraction equals $150 (the amount still not recovered at the end of Year 3) divided by $400 (total amount earned during Year 4).

Therefore, the payback period equals 3.375 years.

 Discounted Payback Period
The discounted payback period equals the number of years it takes for cumulative discounted cash
flows from the project to equal the project’s initial investment outlay.

Advantage
It accounts for the time value of money and risks associated with the project’s cash flows.

Drawback
It ignores cash flows that occur after the payback period is reached. Therefore, it does not consider
the overall profitability of the project.
 Discounted Payback Period

At the end of Year 4, the project needs to recover $26.20 of the initial outlay, which is recovered from the $310.46 earned over Year 5.

The discounted payback period equals 4 full years plus a fraction of the fifth year.

This fraction equals $26.20 (the amount still not recovered at the end of Year 4) divided by $310.46 (PV of the total amount earned
during Year 5).

Therefore, the discounted payback period equals 4.08 years.

 Profitability Index
The profitability index (PI) of an investment equals the present value (PV) of a project’s future cash
flows divided by the initial investment.

The PI equals the ratio of discounted future cash flows to the initial investment.

The PI indicates the value we receive in exchange for one unit of currency invested. It is also known
as the “benefit-cost” ratio.

Decision Rules for PI

A company should invest in a project if its PI is greater than 1.
A company should not invest in a project if its PI is less than 1.
Profitability Index
 NPV Profiles
An NPV profile is a graphical illustration of a project’s NPV at different discount rates. Let’s consider two projects,
Project A and Project B. For both projects, the required rate of return equals 7%.
 Application of NPV and IRR
NPV and IRR Applied to Independent Projects

If Project A and Project B were independent projects and the cost of capital were 7%, the company would accept
both the projects, as both have positive NPVs and their IRRs exceed the cost of capital (7%).

NPV and IRR Applied to Mutually Exclusive Projects

If the projects are mutually exclusive, the company can choose only one of them. Project A has a higher IRR
(21.43% vs. 12.96%), but Project B has a higher NPV ($59,323 vs. $47,196).

The conflict in recommendations is due to the different pattern of cash flows.

Project A receives a lump sum amount of $425,000 in the first year, while Project B receives equal cash flows in
the first two years and then a lump sum amount of $466,000 in the third year.

When NPV and IRR rank two mutually exclusive projects differently, the project with the higher NPV must be
chosen. NPV is a better criterion because of its more realistic reinvestment rate assumption.
 Problems with the IRR
The Multiple IRR Problem
A project has a nonconventional cash flow pattern
when the initial outflow is not followed by inflows
only. The direction of cash flows changes from
positive to negative over the project’s life (i.e.,
there is more than one sign change in the cash
flow stream).

No IRR Problem
Sometimes cash flow streams have no IRR; i.e.,
there is no discount rate that results in a zero NPV.
 Relative Popularity of Various Techniques
• The payback method is very popular in European countries.
• Larger companies prefer the NPV and IRR methods over the payback method.
• Private corporations use the payback period more often than public companies.
• Companies headed by MBAs have a preference for discounted cash flow
techniques.
 NPV, Company Value, and Stock Price
If a company invests in a positive NPV project, the expected addition to shareholder
wealth should lead to an increase in the stock price.

Capital budgeting processes tell us two things about company management:

1. The extent to which management pursues the goal of shareholder wealth

maximization
2. Management’s effectiveness in pursuit of this goal
 Practice Question
Juke Jelly Beans is considering two mutually exclusive projects with the same level of risk. The
results of the analysis are summarized below:

Given a required rate of return of 10%, which project(s) should the firm choose?

A. Project Blue
B. Project Red
C. Project Blue or Project Red
 Practice Question
Juke Jelly Beans is considering two mutually exclusive projects with the same level of risk. The
results of the analysis are summarized below:

Given a required rate of return of 10%, which project(s) should the firm choose?

A. Project Blue
B. Project Red
C. Project Blue or Project Red

Answer: A