CAPITAL BUDGETING

QUESTION (A)
What is capital
budgeting?
• Analysis of potential projects.
• Long-term decisions; involve
large expenditures.
• Very important to firm’s future.
• Evaluate & select long term
investment, align with the goal of
the firm, maximize s/holder
wealth.
 QUESTION (B)
What is the difference
between independent
and mutually exclusive
projects?
Projects are:
Independent, if the cash flows of
one are unaffected by the
acceptance of the other.
Mutually exclusive, if the cash
flows of one can be adversely
impacted by the acceptance of the
other.
 QUESTION C (1)
What is the payback
period? Find the paybacks
for Franchises L and S.
The payback period is the expected number of years required to
recover a project's cost. We calculate the payback by developing
the cumulative cash flows

Franchise L
0 1 2 3
| | | | Payback L: 2 + ($30/$80) = 2.4 years
-100 10 60 80
-90 -30 50
Franchise S
0 1 2 3
| | | |
Payback S: 1 + ($30/$50) = 1.6 years
-100 70 50 20
-30 20 40
 QUESTION C (2)
What is the rational for the payback
method? According to the payback
criterion, which franchises should be
accepted if the firm’s maximum
acceptable payback is 2 years, and if
franchises L and S are independent? If
they are mutually exclusive?
• Payback represents a type of "breakeven"
analysis: the payback period tells us when the
project will break even in a cash flow sense.
• With a required payback of 2 years, franchise S
is acceptable, but franchise L is not.
• Whether the two projects are independent or
mutually exclusive makes no difference in this
case.
 QUESTION C (3)
What is the difference
between the regular and
discounted payback
periods?
 Payback period Discounted payback period
• A capital budgeting procedure • the payback period only measure
used to determine the profitability how long it take for the initial cash
of a project. outflow to be paid back, ignoring
• Provides the overall value of a the time value of money
project, a discounted payback
period gives the number of years it
takes to break even from
undertaking the initial expenditure.
 QUESTION C (3)
What is the main disadvantage of
discounted payback? Is the
payback method of any real
usefulness in capital budgeting
decisions?
• Time value of money is not considered when you

calculate payback period.

• lack of consideration of cash flows beyond the
payback period.
• discounted payback period does not really give the
financial manager or business owner a solid decision
criterion upon which to make an investment decision.
• However, payback is not generally used as the
primary decision tool. Rather, it is used as a rough
measure of a project's liquidity and riskiness.
 QUESTION D(1)
Define the term net present
value (NPV). What is each
franchise’s NPV?
NPV compares the value of a dollar today to the value of that same
dollar in the future. If the NPV of a prospective project is positive, it
should be accepted and vice versa.

Franchise L’s NPV is = $18.79 Franchise S’s NPV is = $19.99

0 1 2 3 0 1 2 3
| | | | | | | |
(100.00) 10 60 80 (100.00) 70 50 20
9.09 63.64
49.59 41.32
60.11 15.03
18.79 = NPV L 19.99 = NPV S
 QUESTION D (2)
What is the rationale behind the NPV
method? According to NPV, which
franchise or franchises should be
accepted if they are independent?
Mutually exclusive?
• If the NPV of any project is zero then it means that the return from

the project is equal to the outflow of the project. There is no chance

of making a profit from the project.
• A positive NPV indicates that project earns more than its cash
outflow and is profitable. In the case of negative NPV, the implication
is vice-versa.

• If franchises L and S are independent, then both should be

accepted, because they both add to shareholders' wealth, hence to
the stock price.
• If the franchises are mutually exclusive, then franchise S should be
chosen over L, because S adds more to the value of the firm.
 QUESTION D(3)
Would the NPVs change if the cost of
capital changed?

The NPV of a project is dependent

on the cost of capital used. Thus, if
the cost of capital changed, the
NPV of each project would change.
NPV declines as r increases, and
NPV rises as r falls.
 QUESTION E(1) (2)
Define the term Internal Rate of
Return (IRR). What is each
franchise's IRR?
How is the IRR on a project related
to the YTM on a bond?
Internal Rate of Return (IRR) is the discount rate that
will equate the present value of the outflows with the
present value of the inflows.

By using Financial Calculator, we get IRRL = 18.1%

and IRRS = 23.6%.

e. (2) How is the IRR on a project related to the YTM

on a bond?

IRR to a capital project is like YTM to a bond. IRR is the

expected rate of return on the project, just as YTM is
the promised rate of return on a bond.
 QUESTION E(3)
What is the logic behind the
IRR method? According to
IRR, which franchises should
be accepted if they are
independent? Mutually
exclusive?
IRR measures a project's profitability in the rate of return sense.

If IRR = k : cash flows are just sufficient to provide investors with their
required rates of return.

If IRR > k : economic profit, which accrues to the firm's shareholders.

If IRR < k : economic loss, or a project that will not earn enough to
cover its cost of capital.

If S and L are independent, accept both. IRRs > r = 10%.

If S and L are mutually exclusive, accept S because IRRS nor IRRL .

 QUESTION E(4)
Would the franchises'
IRR change if the cost of
capital changed?
IRR are independent of the cost of capital.

Therefore, neither IRRS nor IRRL would

change if k changed.

However, the acceptability of the franchises

could change; L would be rejected if k was
above 18.1%, and S would also be rejected if
k was above 23.6%.
 QUESTION F(1)
Draw NPV profiles for
franchises L and S. At what
discount rate do the profiles
cross?
 Cost of Capital % NPV L % NPV S %
0 50 40
5 33 29
10 19 20
15 7 12
20 (4) 5

The crossover point is 8.7 percent. To calculate the crossover rate,

by using Financial Calculator:

Cash Flow Differences = Cash Flow L – Cash Flow S;

CF0 = -100 – (-100) = 0

CF1 = 10 – 70 = -60
CF2 = 60 – 50 = 10
CF3 = 80 – 20 = 60
 QUESTION F(2)
Look at your NPV profile graph without
referring to the actual NPVs and IRRs.
Which franchise or franchises should
be accepted if they are independent?
Mutually exclusive? Explain. Are your
answers correct at any cost of capital
less than 23.6 percent?
NPV and IRR always lead to the same accept/reject
decision for independent projects;

k < IRR and NPV > 0 : Accept

k > IRR and NPV < 0 : Reject

However, for mutually exclusive projects;

K < 8.7 : NPVL > NPVS , IRRS > IRRL ; Conflict

K > 8.7 : NPVs > NPVL , IRRS > IRRL ; No Conflict

 QUESTION G(1)
What is the underlying
cause of ranking conflicts
between NPV and IRR?
• A conflict exists if the cost of capital
is less than the crossover rate.
• Two basic condition:
 When project size (or scale)
differences exist
 When timing differences
exist
 QUESTION G(2)
What is the
“reinvestment rate
assumption,” and how
does it affect the NPV
versus IRR conflict?
The underlying cause of ranking conflicts is the
reinvestment rate assumption
• Assumed that a project will cost some
money up front, and then produce cash flow
returns over a period of time
• Assumed that these cash flows will be
reinvested by the firm
• NPV assumes that the cash flows will be
reinvested at the firm's cost of capital (WACC)
• IRR assumes that cash flows are reinvested
at the IRR rate.
 QUESTION G (3)
Which method is the
best? Why?
• The best assumption :
The project’s cash flows can be
reinvested at the cost of capital
• NPV method is more reliable
• More realistic in real world
 QUESTION H(1)
Define the term modified
IRR (MIRR). Find the MIRRs
for Franchise L and S

The discount rate that causes a

project’s cost (or cash outflows) to
equal the present value of the
project’s terminal value.
Franchise L WACC = 10%

0 1 2 3
(100) 70 50 20
55
84.7
TV = 159.7
MIRRL = 16.50%
Franchise S WACC = 10%

0 1 2 3
(100) 10 60 80
66
12.1
TV = 158.1
MIRRS = 16.89%
 QUESTION H(2)
What are the MIRR’s
advantages and
disadvantages vis-a-
vis the regular IRR?
• MIRR assumes that cash flows from all the
firm’s projects are reinvested at the cost of
capital.
• MIRR is a better indicator of a project’s
true profitability.
• MIRR solves the multiple IRR problems, as a
set of cash flows can have but one MIRR.
What are the MIRR’s advantages and
disadvantages vis-a-vis the NPV?

• MIRR does not always lead to the same

decision as NPV when mutually exclusive
projects are being considered
• NPV remains the single best decision rule
• NPV also does provides the best indication of
how much each project will add to the value
of the firm.
QUESTION I
As a separate project (project P), you are considering sponsoring a pavilion at the
upcoming world's fair. The pavilion would cost $800,000, and it is expected to
result in $5 million of incremental cash inflows during its 1 year of operation.
However, it would then take another year, and $5 million of costs, to demolish the
site and return it to its original condition. Thus, project P's expected net cash flows
look like this (in millions of dollars):

Year Net Cash Flows

0 ($0.8)
1 5.0
2 (5.0)
The project is estimated to be of average risk, so its cost of capital is 10 percent.

(1) What are normal and non-normal cash flows?

• Normal cash flows begin with a negative or a series of negative cash flows, switch
to positive cash flows and then remain positive and vice versa.
•They have only one change in sign.
•Non-normal cash flows have more than one sign change. For example, they may
start with negative cash flows, switch to positive, and then switch back to negative.
 (2) What is project P’s NPV? What is its IRR? It’s MIRR?

Here is the time line for the cash flows, and the NPV;
0 10% 1 2
| | |
-800,000 -5,000,000 5,000,000

NPV = -$386,776.86.

We can find the NPV by entering the cash flows into the cash flow register, entering i=
10, and then pressing the NPV button. However, calculating the IRR presents a
problem. With the cash flows in the register, press the IRR button will give the
message "error-soln." This means that project P has multiple IRRs. As you are asked to
guess, if you guess 10%, the calculator will produce IRR = 25%. If you guess a high
number, such as 200%, it will produce the second IRR, 400%. The MIRR of project P =
5.6%, and is found by computing the discount rate that equates the terminal value
($5.5 million) to the present value of cost ($4.93 million).
i. (3) Does project P have normal or non-normal
cash flows? Should this project be accepted?

• Project P has non-normal cash flows because it

has more than one change of signs in the cash
flows. Besides it has two IRRs at 25% and at
400%, multiple IRRs is only possible in non-
normal cash flow pattern.

• Since project P's NPV is negative, the project

should be rejected, even though both IRRs (25%
and 400%) are greater than the project's 10 % of
capital. The MIRR of 5.6% also supports the
decision that the project should be rejected.
QUESTION (J)
In an unrelated analysis, you have the opportunity to choose between the
following two mutually exclusive projects:
Expected Net Cash Flows

Year Project S Project L

0 ($100,000) ($100,000)
1 60,000 33,500
2 60,000 33,500
3 -- 33,500
4 -- 33,500

The projects provide a necessary service, so whichever one is selected is

expected to be repeated into the foreseeable future. Both projects have a
10 percent cost of capital.
(1) What is each project's initial NPV without replication?

The NPVs, found with a financial calculator, are calculated as follows:

Input the following: CF0 = -100000, CF1 = 60000, N = 2, AND I = 10 to

solve for NPVs= $4,132.23 ≈ $4,132.

Input the following: CF0 = -100000, CF1 = 33500, N = 4, AND I = 10 to

solve for NPVL = $6,190.49 ≈ $6,190.

However, if we make our decision based on the raw NPVs, we would

be biasing the decision against the shorter project. Since the projects
are expected to be replicated, if we initially choose project S, it would
Be repeated after 2 years. However, the raw NPVs do not reflect the
replication cash flows.
(2) Now apply the replacement chain approach to determine the
projects’ extended NPVs. Which project should be chosen?
The simple replacement chain approach assumes that the projects will be replicated
out to a common life. Since project S has a 2-year life and L has a 4-year life, the
shortest common life is 4 years.

Project L's common life NPV is its raw NPVL = $6,190 (since actual duration = 4 years)

However, project S would be replicated in year 2, and if we assume that the replicated
project's cash flows are identical to the first set of cash flows, then the replicated NPV
is also $4,132, but it "comes in" in year 2. We can put project S's cash flow situation
on
a time line:0 10% 1 2 3 4
| | | | |
4132 4132
3,415
7,547
7547
(3) Now assume that the cost to replicate project S in 2 years will increase
to $105,000 because of inflationary pressures. How should the
analysis be handled now, and which project should be chosen?

If the cost of project S is expected to increase, the replication project is not

identical to the original so in this situation, we would put the cash flows on a time
line as follows:
0 r = 10% 1 2 3 4
| | | | |
100,000 60,000 60,000 60,000 60,000
-105,000
- 45,000

Common Life NPVS = $3,415

With this change, the common life NPV of project S is less than that for project
L, and hence project L should be chosen.
QUESTION K
You are also considering another project which has a physical life of 3 years; that is, the
machinery will be totally worn out after 3 years. However, if the project were terminated prior
to the end of 3 years, the machinery would have a positive salvage value. Here are the
project’s estimated cash flows:

Year Initial Investment End-Of-Year Cash Operating Net Salvage

Flows Value
0 ($5,000) $5,000
1 2,100 3,100
2 2,000 2,000
3 1,750 0

Using the 10 percent cost of capital, what is the project’s NPV if it is operated for the full 3
years? Would the NPV change if the company planned to terminate the project at the end of
year 2, at the end of year 1? And what is the project’s optimal (economic) life?
 Solution:

(i) No Project Termination

3 Years Project Timeline.

0 1 2 3
10%

CF ($5000) ($2100) ($2000) ($1750)

Salvage ($0)
Value
($1750)

Therefore, Net Present Value for no project termination is (NPV) = -$123.22/ -$123.
 (i) With Termination After 2 Years

2 Years Project Timeline.

0 1 2
10%

CF ($5000) ($2100) ($2000)

Salvage ($2000)
Value
($4000)

Therefore, Net Present Value with project termination after 2 years is (NPV) = $214.88/
$215.
 (i) With Termination After 1Years

1 Year Project Timeline.

0 1
10%

CF ($5000) ($2100)

Salvage ($3100)
Value ($4000)

Therefore, Net Present Value with project termination after 2 years is (NPV) = $-272.73/
-$273.
CONCLUSION:
Based on all NPV value from three different options
can be conclude that the optimal economic life is the
project should be terminate after years 2 where the
NPV value is positive ($215). Moreover, it also
indicated that a project engineering life does not
always equal to its economic life.
QUESTION L

After examining all the potential

projects, you discover that there
are many more projects this year
with positive NPVs than in a normal
year. What two problems might this
extra-large capital budget cause?
 Increasing in
Cost of Capital
• cause company to
reject projects that
they might
otherwise accept

Capital
Rationing
 THANK YOU
Q & A SESSION