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
0 - $1,000 - $1,000
1 500 100
2 400 300
3 300 400
4 100 600
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
0 - $1,000 - $1,000
1 500 100
2 400 300
3 300 400
4 100 600
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 1 2 3 4
Project C -800 340 340 340 340
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 project’s 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 project’s 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 0 1 2 3 4
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 0 1 2 3 4
Project X -400 160 160 160 160
Project Y -400 0 0 0 800
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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
A and B are independent
Conventional Conventional No conflict between NPV and IRR decision rules
Cash Flows Cash Flows
A and B are mutually exclusive
Project C OR Project D 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 1 2 3 4 NPV IRR
Project X -400 160 160 160 160
Project Y -400 0 0 0 800
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 1 2 3 4 NPV IRR
Project C -200 100 100 100 100
Project D -800 340 340 340 340
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 0 1 2 3 4 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 0 1 2
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 0 1 2
Cash Flow 100 -300 250
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Comparison between NPV and IRR
NPV IRR
• Advantages: • Advantages
Direct measure of expected increase in Shows the return on each dollar invested
value of firm Allows us to compare return with the
Theoretically the best method required rate
• Disadvantage: • Disadvantage:
Does not consider project size 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
company’s 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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