MFA 8033

FINANCIAL
MANAGEMENT

1
TOPIC 4

CAPITAL BUDGETING

2
TOPIC LEARNING OUTCOME

 Display the use of net present value to

make investment decision.
 Analyze a project’s budgeted cash flows
for capital budgeting process
 Display whether or not a project should
be undertaken by making an initial
assessment
3
 Topics Covered
This topic presents multiple valuation
techniques used during the capital budgeting
process.

• Net Present Value

• The Internal Rate of Return Rule
• The Profitability Index
• The Payback Rule
• More Mutually Exclusive Projects

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

 Introduction

 An investment is worth undertaking if it

creates value for its owners
 Value is created by identifying whether
the investment is worth more in the
market place than it costs us to acquire it
 s/holders want firm to invest in every
projects that is worth more than it costs

8-5
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 1. Net Present Value

Definition:
•The difference between the market value
of a project and its cost

•How much value is created from

undertaking an investment?
1. estimate the expected future cash flows.
2. estimate the required return for projects of
this risk level.
3. find the present value of the cash flows and
subtract the initial investment.

8-6
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Net Present Value

Net Present Value - Present value of cash

flows minus initial investments

Opportunity Cost of Capital - Expected rate

of return given up by investing in a project

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

 Net Present Value
Example
Q: Suppose we can invest RM50 today &
receive RM60 later today. What is our
increase in value?
A: Profit = −RM50 + RM60
= $10 RM10
Added Value
RM50 Initial Investment

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

 Net Present Value
Example
Suppose we can invest RM50 today and
receive RM60 in one year. What is our
increase in value given a 10% expected
return?

60
Profit=  50+  RM 4.55
1.10 RM4.55 Added Value
RM50 Initial Investment

This is the definition of NPV

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Net Present Value

Ct
NPV  C0 
(1  r ) t

C1 C2 Ct
NPV  C0    ... 
(1  r ) (1  r )
1 2
(1  r ) t

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

 Net Present Value
C0 = Initial cash flow (often negative)
C1 = Cash flow at time 1
C2 = Cash flow at time 2
Ct = Cash flow at time t
t = Time period of the investment
r = Opportunity cost of capital

C1 C2 Ct
NPV  C0    ... 
(1  r ) (1  r )
1 2
(1  r ) t

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

 Net Present Value
Assume you plan to invest $1,000 today and
will receive $600 each year for two years
(assume the cash is received at the end of the
year). What is the net present value if there is a
10% opportunity cost of capital?
C0 = $1,000
C1 = $600
C2 = $600
r = 0.10
$600 $600
NPV  $1,000    $41.32
(1  .10) (1  .10)
1 2
8-12
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Net Present Value
Assume you invest $1,000 today and will receive
$1,200 in two years (assume the cash is received
at the end of the 2nd year). What is the net
present value if there is a 10% opportunity cost
of capital?
C0 = ?
C1 = ?
C2 = ?
r =?
$0 $1, 200
NPV  $1, 000    $8.26
(1  .10) (1  .10)
1 2

8-13
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 NPV – Decision Rule

• If the NPV is positive, accept the

project
• A positive NPV means that the project is
expected to add value to the firm and
will therefore increase the wealth of
the owners.
• Since our goal is to increase owner
wealth, NPV is a direct measure of how
well this project will meet our goal.
8-14
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Using the NPV Rule to Choose Among
Projects
When choosing among mutually exclusive projects, calculate the
NPV of each alternative and choose the highest positive-NPV
project. Example: Consider two projects, assuming a 10%
opportunity cost of capital. Which project should be selected?
Cash Flows

Project C0 C1 C2 NPV
Project 1 - $1,000 $700 $500 $49.59
$49.59
Project 2 - $1,000 $500 $700 $33.06

Challenges to the NPV Rule

1. The Investment Timing Decision
2. The Choice between Long and Short-Lived Equipment
3. When to Replace an Old Machine
8-15
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
Example : Project Information

• You are reviewing a new project and have

estimated the following cash flows:
– Year 0: CF = -165,000
– Year 1: CF = 63,120;
– Year 2: CF = 70,800;
– Year 3: CF = 91,080;

• Your required return for assets of this risk

level is 12%.

8-16
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Answer: Example

• Using the formulas:

NPV = -165,000 + 63,120/(1.12) +

70,800/(1.12)2
+ 91,080/(1.12)3
= $12,627.41

• Do we accept or reject the project?

8-17
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
Using Financial Calculator

CF 2nd CLR WORK

CF - 165,000 ENTER
↓ 63,120 ENTER ↓
↓ (FO1)
↓ 70,800 ENTER ↓
↓ (FO2)
↓ 91,080 ENTER ↓
↓ (FO3) ENTER
NPV 12 ENTER
↓ CPT
= 12,627.41
8-18
 2. PAYBACK METHOD

• The length of time it takes to

recover the initial investment back
• Computation Steps:
1. Estimate the cash flows
2. Subtract the future cash flows from the
initial cost until the initial investment has
been recovered

• Decision Rule – Accept a project if the

payback period is less than a
specified cut off period 8-19
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Payback: Example 1

The three projects below are available. The

company accepts all
projects with a 2 year or less payback period. Show
how this will impact your decision.
Cash Flows
Payback NPV
Project C0 C1 C2 C3 Period (@ 10%)
Project 1 - $1,000 $700 $500 1.6 years $49.59

Project 2 - $1,000 $500 $700 1.7 years $33.06

Project 3 - $1,000 $500 $700 $700 1.7 years $558.98

8-20
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Drawback of Payback Rule

1. Though Projects 1, 2 and 3 have

payback periods less than 2 years,
notice the differences in NPV.

2. The Payback Rule ignores the time

value of money.

8-21
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Example 2: Computing Payback for a
Project
Year 0: CF = -165,000
Year 1: CF = 63,120;
Year 2: CF = 70,800;
Year 3: CF = 91,080;
• Assume we will accept the project if it pays back
within 2 years.

Year 1: 165,000 – 63,120 = 101,880 still to

recover
Year 2: 101,880 – 70,800 = 31,080 still to recover
Year 3: 31,080 – 91,080 = - 60,000 project pays
back in 2.34 years
• Do we accept or reject the project? 8-22
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
3. Internal Rate of Return Rule

Managers increase shareholders’ wealth by

accepting all projects which offer a rate
of return that is higher than the
opportunity cost of capital.

• Definition: IRR is the return that makes

the NPV = 0
• Decision Rule: Accept the project if the
IRR is greater than the required
return. Reject if otherwise
8-23
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
3. Internal Rate of Return Rule

• This is the most important alternative to

NPV; closely related to NPV
• It is often used in practice and is
intuitively appealing
• It is based entirely on the estimated cash
flows and is independent of interest rates
found elsewhere
• Finding a single rate of return that
summarizes the merits of a project

8-24
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Internal Rate of Return
Example
You can purchase a building for
$350,000. At the end of the year you
will sell the building for $400,000.
What is the rate of return on this
investment?

400,000 − 350,000
Rate of return = = .1429 or 14.29%
350,000

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

 IRR: Example 1

Cash Flows
NPV
Project C0 C1 C2 (@ 10%) IRR
Project 1 - $1,000 $700 $500 $49.59 13.90%

Project 2 - $1,000 $500 $700 $33.06 12.32%

Project 1 Project 2
700 500 500 700
0  1, 000   0  1, 000  
(1  IRR)1 (1  IRR) 2 (1  IRR)1 (1  IRR) 2
IRR  13.90% IRR  12.32%

8-26
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Internal Rate of Return
Calculating the IRR can be a laborious task.
Fortunately, financial calculators can perform
this function easily. Note the previous
example.
HP-10B EL-733A BAII Plus
-375,000 CFj -375,000 CFi CF
25,000 CFj 25,000 CFfi 2nd {CLR Work}
25,000 CFj 25,000 CFi -375,000 ENTER
475,000 CFj 475,000 CFi 25,000 ENTER
{IRR/YR} IRR 25,000 ENTER
475,000 ENTER
All produce IRR=12.56
IRR CPT
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Example 5: Computing IRR for the
Project

• If you do not have a financial calculator, then

this becomes a trial and error process

• Calculator
– Enter the cash flows as you did with NPV
– Press IRR and then CPT
– IRR = 16.13% > 12% required return

• Do we accept or reject the project?

8-28
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Using Calculator
CF 2nd CLR WORK
CF - 165,000 ENTER
Year 0: -165,000
↓ 63,120 ENTER Year 1: 63,120;
↓ 1 ENTER Year 2: 70,800;
↓ 70,800 ENTER Year 3: 91,080;
↓ 1 ENTER
↓ 91,080 ENTER
↓ 1 ENTER
IRR CPT
= 16.13 %

8-29
 NPV vs. IRR
 NPV and IRR will generally give us the same decision
 Conditions:
1. The project’s CFs must be conventional (1st CF is
negative & all the rest is positive)

2. Projects must be independent

• The decision to accept / reject a project does
not affect the decision to accept / reject any
other projects.

8-30 9-30
 Internal Rate of Return
Example
You have two proposals to choose
between. The initial proposal has a
cash flow that is different than the
revised proposal. Using IRR, which do
you prefer?
Project C0 C1 C2 C3 IRR NPV@7%
Initial Proposal -350 400 14.29% $ 23,832

Revised Proposal -375 25 25 475 12.56% $ 57,942

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

 4. Profitability Index
• Measures the NPV of a project per dollar of investment
• A profitability index of 1.1 implies that for every $1 of
investment, we create an additional $0.10 in value
• This measure can be very useful in situations in which we have
limited capital
NPV
Profitability Index 
Initial Investment
Cash Flows
NPV (@ Profitability
Project C0 C1 C2 10%) Index
Project 1 - $1,000 $700 $500 $49.59 .0496
Project 2 - $1,000 $500 $700 $33.06 .0331

8-32
 Capital Rationing

Limit set on the amount of funds available

for investment.

Soft Rationing – Limits on funds imposed by

management.

Hard Rationing – Limits on funds imposed by

the lack of available funds in the capital
market.

8-33
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Project Interactions
• When you need to choose between
mutually exclusive projects, the decision
rule is simple:
– Calculate the NPV of each project
– From those options that have a
positive NPV, choose the one
whose NPV is highest

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

 Mutually Exclusive Projects
Example
Select one of the two following projects,
based on highest NPV

System C0 C1 C2 C3 NPV
Faster -800 350 350 350 +118.5

Slower -700 300 300 300 +87.3

Assume a 7% discount rate

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

 Investment Timing
• Sometimes you have the ability to defer an
investment and select a time that is more
ideal at which to make the investment
decision
– A common example involves a
tree farm
– You may defer the harvesting of
trees
• By doing so, you defer the receipt of the cash
flow, yet increase the cash flow

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

 Capital Budgeting Techniques
Criterion Definition Investment Rule Comments
Accept project if NPV
The “gold standard” of investment criteria. Only criterion
is positive. For
Present value of cash necessarily consistent with maximizing the value of the firm.
Net present mutually exclusive
inflows minus present Provides appropriate rule for choosing among mutually exclusive
value (NPV) projects, choose the
value of cash outflows investments. Only pitfall involves capital rationing, when one
one with the highest
cannot accept all positive NPV projects.
(positive) NPV.
If used properly, results in same accept-reject decision as NPV in
Accept project if IRR is the absence of project interactions. However, beware of the
The discount rate at
Internal rate of greater than following pitfalls: IRR cannot rank mutually exclusive projects—
which project NPR
return (IRR) opportunity cost of the project with higher IRR may have lower NPV. The simple IRR
equals zero
capital. rule cannot be used in cases of multiple IRRs or an upward-
sloping NPV profile.
Accept project if
profitability index is
Results in same accept-reject decision as NPV in the absence of
Ratio of net present greater than 0. In case
Profitability project interactions. Useful for ranking projects in case of capital
value to initial of capital rationing,
index rationing, but misleading in the presence of interactions. Cannot
investment accept projects with
rank mutually exclusive projects.
highest profitability
index.

Time until the sum of Accept project if A quick and dirty rule of thumb, with several critical pitfalls.
Payback project cash flows payback period is less Ignores cash flows beyond the acceptable payback period.
period equals the initial than some specified Ignores discounting. Tends to improperly reject long-lived
investment number of years. projects.
THANKS