FINA6000 MODULE 4 – CAPITAL BUDGETING A

MODULE 4 – CAPITAL
BUDGETING A
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Learning Outcomes
• Understand the Capital Budgeting Process
• Explain Capital Budgeting techniques
• Apply Non Discounted Cash Flow (NDCF)
Techniques
• Apply Discounted Cash Flow (DCF)Techniques
• Review Capital Budgeting in Practice
FINA6000 MODULE 4 – CAPITAL BUDGETING A

The Capital Budgeting Process

Capital budgeting is the process of planning and
managing a firm’s LONG-TERM investments: the
Size Timing Risk

of cash flows
FINA6000 MODULE 4 – CAPITAL BUDGETING A

The Capital Budgeting Process

Capital budgeting process

The process of deciding on the optimum use of the scarce
and valuable resources of a company.
A capital budget lists the projects and investments that a
company plans to undertake during future years
Objective of Capital Budgeting
• Is a particular project a good investment?
 Does it maximise shareholder value?
• If we have more than one good project, but we can
only take one of them which one should be chosen?
 Can we decide between alternatives?
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Capital Budgeting Techniques

NON-DISCOUNTED CASHFLOW (NDCF)

TECHNIQUES
• Accounting rate of return (ARR) – a measure of
profitability
• Payback period

DISCOUNTED CASH FLOW (DCF) TECHNIQUES

• Discounted Payback
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index
FINA6000 MODULE 4 – CAPITAL BUDGETING A

NDCF Techniques – measuring

Profitability of a Project

• A key objective for many organizations

• Often seen in terms of the need for smooth profits
growth
• In recent years a move away from this as an overall
business objective to shareholder value
• Research indicates if profitability and shareholder
value are in conflict the share price does not follow
profitability
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Accounting Rate of Return (ARR)

• Average profitability divided by average accounting

assets in project
• Sometimes used as a hurdle for performance
• Does not consider the timing of the project’s cash
flows
• Does not necessarily reflect what are perceived to
be the underlying economic realities of the project
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Accounting Rate of Return (ARR) - Example

Assume a company that is considering an investment
project that costs $10 000 and generates returns
(profit) in years 1 to 3 as shown in the table below.
Year 1 Year 2 Year 3 Average

Net Profit 2 000 3 000 4 000 3 000

Book Value 10 000 7 000 4 900
at beginning
Book Value 7 000 4 900 3 430
at End of
Year
Average 8 500 5 950 4 165 6 205
ARR 48.35%
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Payback Period
How long does it take the project to “pay back” its initial
investment?
Payback Period = Number of years to recover initial costs
Estimating the Payback period:
• Calculate the amount of time it takes to pay back the
initial investment, called the payback period.
• Accept the project if the payback period is less than a
pre-specified length of time—usually a few years.
• Reject the project if the payback period is greater than
that pre-specified length of time.
Minimum Acceptance Criteria: Set by management
Ranking Criteria: Set by management
 Payback Period Example
Suppose your firm is considering a project which will
generate cash flows of $83,000 per year for the next 4
years and have an initial cash outlay of $276,400. After
5 years the project can be sold for $116,000.What is
the project’s payback period?
0 1 2 3 4 5

-$276,400 $83,000 $83,000 $83,000 $83,000 $116,000

Cumulative CF: -$193,400 -$110,400 -$27,400 $55,600

Payback period = (3 x 83,000) + (27,400/83,000)

= 3.33 years
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Advantages and Disadvantages of the

Payback Period approach
Disadvantages Advantages
• Ignores the time value of money
• Easy to understand and calculate
(no discounting of CF’s!)

• Ignores cash flows after the

• Biased toward liquidity
payback period
• Often seen as an indication of
• Biased against long-term projects
risk
• Requires an arbitrary acceptance
criteria - What is the right number
of years for payback?
• A project accepted based on the
payback criteria may not have a
positive NPV
FINA6000 MODULE 4 – CAPITAL BUDGETING A

DCF Techniques - Net present value

• NPV aims to work out how much a project is worth in
today’s money by discounting expected future cash-flows
and deducting that from initial investment.

• NPV takes into account the time value of money

• To determine the Time Value of Money present value
tables and present value- annuity tables provide discount
factors.
• Discount factors take the form:

1 / (1+k)^n
• These discount factors allow us to discount future cash-
flows into today’s money or present values.
 FINA6000 MODULE 4 – CAPITAL BUDGETING A

Net Present Value (NPV) continued

• Required rate of return (k) is used to determine t factors

to calculate PV of the cash flows

• k – is the Required Rate of Return that a company

expects for each investment, for the project to be viable.
It depends on riskiness of the project.

• k is also termed the cost of capital

FINA6000 MODULE 4 – CAPITAL BUDGETING A

Decision Rule under Net Present Value

approach
NPV rule:
• Accept a project if the NPV is greater that zero.
• Reject a project if the NPV is less than zero.
• Accepting positive NPV projects benefits shareholders: The
value of the firm rises by the value of the NPV project.
• Accepting projects with negative NPV reduces the value of
the firm
• NPV uses cash flows (i.e. not accounting figures)
• NPV uses all the cash flows resulting from the project
• NPV discounts the cash flows properly
 FINA6000 MODULE 4 – CAPITAL BUDGETING A

Inputs into Net Present Value Calculation

Net Present Value (NPV) = Total PV of future CF’s - Initial

Investment
Estimating NPV:
•Estimate initial costs
•Estimate future cash flows: how much? and when?
•Estimate terminal cash flow
•Estimate discount rate
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the project with the highest NPV
Net Present Value Example

• Example: Consider an investment project that requires an

initial outlay of $81.6 million.
• The investment is expected to generate cash flows of $28
million after the first year and for every year thereafter; and
lasting four years as shown by the timeline below.
• Should you accept this investment at a discount rate of 10%?

0 1 2 3 4
Year:

Cash Flow: ($81.60) $28 $28 $28 $28

Q1 - Does It maximise shareholder wealth?

Q2 –Can we decide between alternatives?
 FINA6000 MODULE 4 – CAPITAL BUDGETING A

Net Present Value Example continued

FV
PV =
0 1 2 (1 + r) n
3 4

Cash Flow: ($81.60) $28 $28 $28

$28

PV = - $81.60
PV = $25.45
PV = $23.14 We accept the
PV = $21.04 investment,
PV = $19.12 because its
NPV is positive!
= $7.2 m NPV
 FINA6000 MODULE 4 – CAPITAL BUDGETING A

Another Example 2 for NPV

(Bentley manufacturing Company PLC )
Project one – would enable the company to enter into a firm
contract for five years to supply the ministry of defence with 6
machines per annum to be used in armed combat. The sale
price would be $750,000 per machine, the variable cost would
be $500,000 per machine and the cash related fixed cost would
be $300,000 per annum.
Calculate the NPV. The cost of capital is 12%
The initial cost of the project is $4,000,000
(Cost of capital is the same as the required rate of return)
FINA6000 MODULE 4 – CAPITAL BUDGETING A

NPV: Solution to Bentley manufacturing company plc example

1) PROJECT ONE

CASHFLOW = 6 X (750,000 - 500,000) - 300,000 = 1,200,000

YEAR CF DF NPV

0 -4,000,000 1.00 -4,000,000

1 1,200,000 0.89
2 1,200,000 0.797
3 1,200,000 0.712
4 1,200,000 0.635
5 1,200,000 0.5674

6,000,000 3.604

1,200,000 X 3.604 = 4324,800 - 4,000,000 = 324,800

FINA6000 MODULE 4 – CAPITAL BUDGETING A

DCF Techniques - Discounted Payback

Period
How long does it take the project to “pay back” its initial
investment, taking the time value of money into account?
The period after which cumulative discounted cash flows
become zero.
Decision rule: Accept the project if it pays back on a
discounted basis within the specified time.
Issues:
• By the time you have discounted the cash flows, you
might as well calculate the NPV.
• Still the other problems of payback period exist.
Minimum Acceptance Criteria: Set by management
Ranking Criteria: Set by management
FINA6000 MODULE 4 – CAPITAL BUDGETING A

DCF Techniques - Internal Rate of Return (IRR)

The IRR is the discount rate that sets the NPV to zero.
• Decision rule: Accept if the IRR exceeds the required return.
• Minimum Acceptance Criteria: Accept if the IRR exceeds the
required return.
• Ranking Criteria: Select alternative with the highest IRR
• Reinvestment assumption: All future cash flows are assumed
to be reinvested at the IRR (NPV assumes reinvestment rate
at required rate of return).
“…the highest rate of interest an investor could afford to pay, without losing
money, if all the funds to finance the investment were borrowed, and the loan
was repaid by application of the cash proceeds from the investment as they
were earned.” (Bierman, Smidt 1993)
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Advantages and Disadvantages of IRR

Disadvantages Advantages
•Does not distinguish
•Easy to understand and
between investing and
communicate
borrowing
•IRR may not exist, or
there may be multiple
IRRs
•Problems with mutually
exclusive investments
•Percentages can distort
contribution to
shareholder wealth
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Determining Internal Rate of Return (IRR)

By setting the NPV equal to zero and solving for r, we
find the IRR:

• Take any investment opportunity where IRR exceeds

the opportunity cost of capital.
• Turn down any opportunity whose IRR is less than the
opportunity cost of capital.
C1 C2 Cn
  ...  C  0
1  r (1  r ) (1  r )
2 n 0

or: n
Ct

t 1 (1  r )
t
 C 0  0
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Internal Rate of Return (IRR) -Example

An investment requires an initial outlay of $1,100.
The investment is expected to generate cash flows as
follows:
• $500 at the end of year 1
• $1,000 at the end of year 2
What’s the investment’s IRR?
FINA6000 MODULE 4 – CAPITAL BUDGETING A

IRR Example continued

Example: An investment requires an initial outlay of
$1,100. The investment is expected to generate cash
flows as follows:
SOLUTION: Now
Now 11 2
2

Try 20.74% p.a.

($1,100) $500 $1,000

PV = -$1,100 The IRR

PV = $414 is 20.74% p.a.
PV = $686
Add: $0 NPV
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Internal Rate of Return (IRR) – Example 2

Example: Consider the following project.
$50 $100 $150

0 1 2 3
-$200

The internal rate of return for this project is 19.44%.

$50 $100 $150
NPV  0  200   
(1  IRR ) (1  IRR ) (1  IRR )
2 3
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Showing (IRR) graphically

If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.

0% $100.00
$150.00
4% $73.88
8% $51.11
$100.00
12% $31.13
16% $13.52
$50.00

NPV
20% ($2.08)
24% ($15.97)
$0.00
28% ($28.38)
32% ($39.51) -1% 9% 19% 29% 39%
($50.00)
36% ($49.54)
40% ($58.60)
44% ($66.82)
($100.00)
Discount rate
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Problems of using IRR

• Borrowing vs. lending

• Multiple IRR’s
• Mutually exclusive projects
 Only 1 of several potential projects can be chosen
 Independent projects: Accepting or rejecting one
project does not affect the decision of the other
projects.
• The scale problem
• The timing problem
Multiple IRRs - Projects with Non Conventional
Cash flows
There are two IRRs for this project. Which one should we use?

-$200 $200 $800 - $800

0 1 2 3
NPV

$100.00

$50.00

$0.00
-50% 0% 50% 100% 150% 200%
($50.00) Discount rate

($100.00)
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Mutually Exclusive Projects

Example: Consider the following investment.

Cash Flow
Year Project A Project B
0 - $350,000 - $250,000
1 $50,000 $125,000
2 $100,000 $100,000
3 $150,000 $75,000
4 $200,000 $50,000

Which project should you choose?

FINA6000 MODULE 4 – CAPITAL BUDGETING A

Mutually Exclusive Projects continued

Example: Consider the following investment.

NPV Profile

200000

150000 Based on the IRR: select ‘Project B’:

17.80% as opposed to 12.91%
100000
Based on the NPV (Higher NPV):
50000
•Select ‘Project A’ for discount rates
0 below the cross-over rate.
0 0.05 0.1 0.15 0.2 0.25
•Select ‘Project B for discount rates
-50000
above the cross-over rate.
-100000

NPV (A) NPV (B)

FINA6000 MODULE 4 – CAPITAL BUDGETING A

The Scale (Size) Problem

Example: Would you rather make 100% or 50% on your

investments?

What if the 100% return is on a $1 investment, while, the 50%

return is on a $1,000 investment?

Makes sense to accept the project with a lower IRR and yet
creates more value for you. A calculation of NPV would show
that the project with the IRR of 50% has a higher NPV.
FINA6000 MODULE 4 – CAPITAL BUDGETING A

The Timing Problem

Example: Consider the following investment. Which projects

would you choose?

Cash Flow
Year Project A Project B
0 - $10,000 - $10,000
1 $10,000 $1,000
2 $1,000 $1,000
3 $1,000 $12,000
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Timing Problem continued

The timing problem
$5,000.00 Project A
$4,000.00 Project B
$3,000.00
$2,000.00
10.55% = crossover rate
$1,000.00
NPV

$0.00
($1,000.00) 0% 10% 20% 30% 40%

($2,000.00)
($3,000.00)
($4,000.00) Crossover rate:
12.94% = IRRB 16.04% = IRRA NPV of the two
($5,000.00)
projects is equal
Discount rate
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Summary: NPV versus IRR

NPV and IRR will generally give the same decision.

Exceptions:
• Non-conventional cash flows – where cash flow signs change
more than once
• Mutually exclusive projects

An important shortcoming of IRR: because it is a return, you

cannot tell how much value in dollars has actually been created
without knowing the basis for the return.
FINA6000 MODULE 4 – CAPITAL BUDGETING A

The Profitability Index (PI)

• The present value of an investment’s future cash flows divided

by it’s initial outlay.
• Minimum Acceptance Criteria: Accept if the PI >1
• Ranking Criteria: Select alternative with the highest PI
Total PV of Future Cash Flows
PI 
Initial Investment
FINA6000 MODULE 4 – CAPITAL BUDGETING A

DCF Techniques - Profitability Index (PI)

Disadvantages Advantages

• Problems with mutually exclusive • May be useful when available

investments investment funds are limited

• Easy to understand and

communicate

• Correct decision when evaluating

independent projects

• May be useful when available

investment funds are limited.
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Capital Budgeting in Practice: What does

Industry use?

• Varies by industry - some firms use payback, others

use accounting rate of return.

• The most frequently used technique for large

corporations is either IRR or NPV.
FINA6000 MODULE 4 – CAPITAL BUDGETING A

Capital Budgeting in Practice: What does

Industry use?