Capital Budgeting

Chapter 11
Prepared By :DR. Wael Shams EL-Din
Key Concepts
❑ What is Capital Budgeting ?
❑ Why Capital Budgeting is so Important?
❑ The Capital Budgeting Decisions.
❑ Methods of Capital Budgeting
✓Payback
✓Discounted Payback
✓Net Present Value (NPV)
✓Internal rate of Return (IRR)
✓Modified Internal rate of Return (MIRR)
✓Profitability Index (PI)

2
What is Capital Budgeting ?
 Capital budgeting is the process of analyzing
Potential Projects.
 Capital budgeting can be defined as the
process of analyzing, evaluating, and
deciding whether resources should be
allocated to a project or not.
 Process of Capital budgeting ensure optimal
allocation of resources and helps management
work towards the goal of shareholder wealth
maximization.
Why Capital Budgeting is so Important?
➢Involve Massive investment of Resources.
➢Have Long-term Implications for the Firm.
➢Involve uncertainty and risk for the Firm.
Due to the above factors, capital budgeting decisions
become critical and must be evaluated very
carefully. Any firm that does not follow the capital
budgeting process will not be able to Maximize
Shareholder Wealth and management will not be
acting in the best interests of shareholders.
The Capital Budgeting Decision
Types of Decisions
◦ Expansion of Facilities
◦ Replacement
◦ Lease or Make or buy
Methods of Capital Budgeting
 Payback
 Discounted Payback
 Net Present Value (NPV)
 Internal rate of Return (IRR)
 Modified Internal rate of Return (MIRR)
 Profitability Index (PI)

Let us see how these methods Work

Payback Period Method
 The payback Period defined as the expected
number of years required to recover the
original investment, it is the formal method
used to evaluate capital budgeting project.
0 1 2 3 4
* -----------* -----------* ----------* -------------*
-1000 500 400 300 100
-1000 + 500+400 = 100
100/300 = 0.33
Payback = 2.33 Years
Payback Period Pros &Cons
Advantage
1. Easy to calculate
2. Provide an indication
of a project’s risk and liquidity

Disadvantage
 Ignore cash flow after payback period
 Doesn’t consider time value of Money
Discounted Payback
 It is a similar to the regular payback period except
that the expected cash flow is discounted by the
project’s cost of capital. Thus the discounted
payback period is defined as the number of years
required to cover the investment from discounted net
cash flows.
0 1 2 3 4
* -----------* -----------* ----------* -------------*
-1000 500 400 300 100
455 330 225 68
- 1000 + 455 + 330 = 215/225 = 0.95
Discounted Payback Period = 2.95 Years
Discounted Payback Period Pros &Cons
Advantage
 Consider Time value of Money
Disadvantage
 Ignore cash flow after payback period

Ignores cash flows

after the payback
Period.
Net Present Value (NPV)
The net present value ( NPV) Method is based
upon the discounted cash flow (DCF) Technique ,
it is based on all discounted cash flows of the
project by using cost of capital rate and then sums
those cash flows, the project should be accepted if
NPV is positive or = Zero.
Calculation of NPV
Cost of
Capital @
10% 0 1 2 3 4
* --------------------* -----------* -----------* -------------*
-1000 500 400 300 100
+455
+330
+225
+ 68
====
+ 78
If Positive NPV we will accept the Project (√)
Internal Rate of Return (IRR)
 Internal rate of Return (IRR) is defined as the
discounted rate that forces a project’s NPV to equal
zero. The project should be accepted if the IRR is
greater than cost of capital
0 1 2 3 4
* --------------------* -----------* -----------* -------------*
-1000 500 400 300 100
-1000+ 500 + 400 + 300 + 100 = Zero
(1+IRR) 1 (1+IRR) 2 (1+IRR) 3 (1+IRR) 4

 If IRR > WACC we will accept the project because the

project’s rate of return is greater than its cost.
 If IRR < WACC we will Reject the project because the
project’s rate of return is less than its
Modified Internal Rate of Return (MIRR)
 Modified Internal rate of Return (MIRR) correct some of
the problem with regular IRR since MIRR involves finding
the terminal value (TV) of the cash inflows, compounded at
the firm’s cost of capital and then determining the discount
rate that forces the Present value of the TV to equal the PV
of the out flows.
0 1 2 3 4
* --------------------* -----------* -----------* -------------*
-1000 500 400 300 100
 330 +
484
665.50
======
TV 1579.50
Calculation of MIRR
PV = FV (TV)
(1+MIRR) 4

1000 = 1579.50
(1+MIRR) 4
MIRR = 12.10%
If MIRR > WACC ,we Accept the project
If MIRR < WACC ,we Reject the project
Since 12.10%> 10% (√) Accept.
Profitability Index (PI )
0 1 2 3 4
Cost of * --------------------* -----------* -----------* -------------*
Capital @ -1000 500 400 300 100
10%
+455
+330
+225
+ 68
====
Profitability index shows the
+ 1078
dollars of present value divided
PI = 1078 = $ 1.08 by the initial cost, so it measure
1000
relative profitability.
So the project is expected to produce $1.08 for each $ 1 of
investment, if we compare 2 projects we will select the project
with higher (PI) and must be greater than (1).
Which Approach is Better?
On a purely theoretical basis, NPV is considered the better
approach because:-
◦ NPV measures how much wealth a project creates (or
destroys if the NPV is negative for shareholders.
◦ Also NPV consider reinvestment of cash flow at cost of
capital which is more conservative.
◦ Despite the fact most of the financial managers prefer to
use the IRR approach in addition to NPV method because
of the preference for rates of return.
Independent Project vs. Mutually
Exclusive Projects
❑ Independent Project: if the cash flows of one project is unaffected
by the acceptance of the other. IRR > WACC
 Mutually exclusive projects: if the cash flows of one can be adversely
impacted by the acceptance of the other. IRRL > IRRS

 The NPV and IRR make the same accept/reject decisions for
independent projects, but if projects are mutually exclusive, then
conflicts can arise. If conflicts arise NPV Method should be used
because reinvestment at cost is more realistic as well as conservative, so
NPV Method will be the best one, therefore NPV should be used to
select between Mutually Exclusive projects.
NPV & IRR (Conflict/ No Conflict)
❑ NPV & IRR (No Conflict)
IRR > WACC while NPV ≥ Zero Accept the project
IRR < WACC while NPV < Zero Reject the project
❑ NPV & IRR (Conflict)

Method Project (S ( Project (L)

IRR 14 13
NPV 300 350

We will select the one with highest NPV

NPV assumes reinvest cash flow at cost of capital rate
IRR assume reinvest cash flow at IRR
Comparing 2 Projects with unequal Life
Project (c) with 6 years cash flow
Project (F) with 3 years cash flow

Project (c) @ cost of capital 11.50%

0 1 2 3 4 5 6
* ---------------* -----------------* ----------------* ----------------*-----------------*--------------*
-40000 8000 14000 13000 12000 11000 10000

Project (F) @ cost of capital 11.50%

0 1 2 3
* ---------------* -----------------* ----------------*
- 20000 7000 13000 12000
 NPV of Project C

Project (c) @ cost of capital 11.50%

0 1 2 3 4 5 6

* ---------------* -----------------* ----------------* ----------------*-----------------*--------------*

-40000 8000 14000 13000 12000 11000 10000
7175
11261
9378
7764
6383
5204
======
NPV + 7165
NPV of Project F
Project (F) @ cost of capital 11.50%

0 1 2 3 4 5 6

* ---------------* -----------------* ----------------* ----------------*-----------------*--------------*

-20000 7000 13000 (8000) 7000 13000 12000
6278
10456
(5770)
4529
7543
6245
======
NPV + 9281

Here we will assume that cost and annual cash flow will not change, if the project
is repeated again in 3 years and cost of capital remain at 11.50% , Therefore we
will select the project with Highest NPV, so Project (F) is accepted (√)
Assignment 1
❑(ST-1)
❑(11-1) - (11-2)-(11-3)- (11-4)- (11-5)
❑(11-6) - (11-7)-(11-8)- (11-9)-(11-10)
❑(11-11)-(11-12)

From Page 404 till 407

Thank You