Capital Budgeting

Essentials of Corporate
Finance, 5th edition, A.A.
Finance, Stephen Ross,
Groppelli and Ehsan Nikbakht
Randolph Westerfield,
Essential
Bradford Jordan, Jorg Bley
Introduction

Financial management decisions

Working capital
Capital structure Capital budgeting
management

Decisions related to the Decisions related to The process of planning and

mix of debt and equity short-term assets and managing a firm’s long-term
maintained by a firm. short-term liabilities assets and investment.

2
What is Capital Budgeting?

▪ Capital budgeting refers to the management of a firm’s long-term assets and

investments.

▪ It refers to the methods for evaluating, comparing, and selecting projects to

achieve maximum wealth for stockholders.

▪ Maximum wealth is reflected in stock price of the firm.

▪ There are various capital budgeting techniques that managers can use to evaluate
alternative investment opportunities.
Capital Budgeting Techniques

4
Payback Period

The number of years needed to recover the initial investment cost.

Formula

Remaining uncovered cost

# of years before full recovery
Cash flow during year of coverage

Decision Criteria
If the payback period is of an acceptable length of time for a firm, the project will be selected.
When comparing alternative projects, select the project with a lower payback period.

5
Example
Kermit Inc. plans to invest in a project that has a $3,700 initial outlay. It is estimated that the
project will provide cash inflows of $1,000 in year 1, $2,000 in year 2, $1,500 in year 3, and $1,000
in year 4. If the company has a target payback period of 3 years, do you recommend that this
project be accepted?

$3,700 $1,000 $2,000 $700

Remaining uncovered cost

# of years before full recovery
Cash flow during year of coverage

$700
PBP 2 2.47 years
$1,500

Decision: Accept the project since the payback period is lower than the target
payback period of the firm.

6
Advantages and Disadvantages of the Payback Period Technique

Advantages Disadvantages
▪ Easy to use and easy to understand. ▪ Ignores the time value of money.
▪ Does not require a great deal of ▪ Ignores the cash flows after the
calculation. initial investment has been
▪ Can be of value to even the largest recovered.
multinational corporations.

7
Net Present Value (NPV)

The present value of a project’s future cash flows minus the project’s initial investment.

Formula

Present value Initial investment cost

Decision Criteria
If the net present value is positive, the project should be accepted. If the net present value is
negative, the project should be rejected. If the firm is selecting among alternative projects, the
project with a higher NPV should be accepted.

8
Example
Harris Pilton is considering a project that will provide cash flows of $6,000, $4,000,
$3,000, and $2,000, respectively, for 4 years. the discount rate is 10% and the initial
investment cost is $9,000. Do you recommend this project?
6,000 4,000 3,000 2,000
PV $12,377
1 2 3 4
(1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10)

NPV Present value Initial investment cost

NPV $12,377 $9,000 $3,377

Decision: Since NPV is positive, the project should be accepted.

9
Advantages and Disadvantages of the NPV Technique
Advantages
▪ Recognizes time value of money.
▪ By accepting only projects with
positive NPVs, the company will
increase its value which will
increase the wealth of
stockholders.
Disadvantages
▪ The method assumes that
management is able to make
detailed predictions of cash flows
for future years. Over or under
estimations of cash flows can lead
to the erroneous acceptance or
rejection of a project.
▪ Assumes that the discount rate is
the same over the life of the
project although discount rates
change over time. 10
Internal Rate of Return (IRR)
The discount rate that makes the net present value equal zero. It is therefore the
discount rate that makes present value of future cash flows equal to the initial
investment.
Formula

0 Present value Initial investment cost

Decision Criteria
If the IRR exceeds the cutoff rate, the project is accepted. Otherwise, it is rejected. When
selecting among alternative projects, the higher IRR should be selected.

11
Example
Harris Pilton is considering a project that will provide cash flows of $1,000, $4,000,
and $5,000, respectively, for 3 years. The initial investment cost is $7,650. Is the
IRR 10%, 12%, or 20% and do you recommend this project if the cut-off rate is 11%?

1,000 4,000 5,000 About

PV $7,641 $7,650
1 2 3
(1 + 0.12) (1 + 0.12) (1 + 0.12)

IRR 0 PV Initial investment cost

0 $7650 $7,650

Decision: Since IRR exceeds the cut-off rate of 11%, the project should be accepted.

12
Advantages and Disadvantages of the IRR Technique

Advantages
▪ Recognizes time value of money.
▪ It is arguably easier to look at
rates of return rather than
absolute values.
Disadvantages
▪ Can give unrealistic rates of return
which could be too good to be true.
▪ If there are negative cash flows
(cash outflows in years following
the initial investment), the IRR will
not work.

13
Discounted Payback Period
A modified version of the payback period technique that takes into account the time
value of money.
Formula

First, discount the future cash flows to the present then use the payback period
formula.

Remaining uncovered cost

# of years before full recovery
Cash flow during year of coverage

Decision Criteria
If the discounted payback period is of an acceptable length of time for a firm, the project will be
selected. When comparing alternative projects, select the project with a lower discounted payback
period.
14
 Example
Pizza Gnomes is considering a project that will provide cash flows of $250,000,
$400,000, $300,000, and $450,000, respectively, for 4 years. The initial investment
cost is $800,000. Assume a 12% discount rate. Should the project be accepted if the
firm has a target discounted payback period of 2 years?
250,000 400,000 300,000 450,000
PV $1,041,850
1 2 3 4
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)

$223,250 $318,800 $213,600 $286,200

$800,000 $223,250 $318,800 $213,600 $44,350

$44,350
PBP 3 3.15 years
$286,200

Decision: Reject the project since the discounted payback period is higher than the
target payback period of the firm.
15
Advantages and Disadvantages of the Discounted Payback Period Technique
Advantages
▪ Recognizes time value of money.
▪ Easy to understand and use.
Disadvantages
▪ The cash flows beyond the payback
period are ignored.
▪ The discounted payback period
could be longer than the desired
payback period which means the
project should be rejected even
though NPV or IRR could favor the
project.
▪ The accuracy of the estimates of
cash flows and the discount rate
could result in erroneous decisions. 16
Modified Internal Rate of Return (MIRR)
A modified version of the IRR technique which addresses some of the problems that
can arise when using the standard IRR technique. For projects with alternative positive
and negative cash flows, the standard IRR technique does not work.

Formula
There are different methods for applying the MIRR technique. One method is called the
Discounting approach in which any negative cash flows (other than the initial cost) are
discounted to the present and added to the initial cost.

0 Present value Initial investment cost

Decision Criteria
If the MIRR exceeds the cutoff rate, the project is accepted. Otherwise, it is rejected. When
selecting among alternative projects, the higher MIRR should be selected.
17
Example (Discounting Approach)
Harris Pilton is considering a project that will provide cash flows of $91,500,
$95,700, -$11,200, and $118,400, respectively, for 4 years. The initial investment
cost is $215,900. Is the MIRR 14.12%, 17.57%, or 9.49% and do you recommend this
project if the firm requires a return of 14%?
11,200
3 7,559.68 215,900 $223,459.68
(1 + 0.14)

91,500 95,700 118,400 About

PV $223,469
1 2 4 $223,459.68
(1 + 0.1412) (1 + 0.1412) (1 + 0.1412)

IRR 0 PV Initial investment cost

0 $223,459.68 $223,459.68

Decision: Since MIRR exceeds the cut-off rate of 14%, the project should be
accepted. 18
Advantages and Disadvantages of the MIRR Technique
Advantages
▪ Addresses some of the problems
associated with the standard IRR
technique.
▪ Takes into account the time value
of money.
Disadvantages
▪ There are different methods for
calculating MIRR and there is no
clear reason to say one of the
three methods is better than the
other.
▪ It is a rate of return on a modified
set of cash flows, the project’s
actual cash flows.
19
Certainty Equivalent Approach
The idea behind this technique is to separate the timing of cash flows from their
riskiness. Cash flows are converted into riskless (certain) cash flows, which are then
discounted at a risk-free rate.
Formula

First, determine the percentages of the expected cash flows that are certain. Calculate the certain
cash flows by multiplying the expected cash flows by the certainty equivalent factors. Compute the
present value of the project using the risk-free rate. Determine the net present value of the project.

Decision Criteria
If the net present value is positive, accept the project. The project should be rejected if the net
present value is negative. Higher net present values are desirable when comparing alternative
projects.

20
Example
Pizza Gnomes is considering a project that will provide cash flows of $7,000, $6,000,
$5,000, $4,000, and $3,000, respectively, for 5 years. The initial investment cost is
$11,000. Assume a 10% risk-free rate. The certainty equivalent factors are 95%, 80%,
70%, 60%, and 40%, respectively. Should the project be accepted?

$7,000 95% $6,650

$6,000 80% $4,800
$5,000 70% $3,500
$4,000 60% $2,400
$3,000 40% $1,200
6,650 4,800 3,500 2,400 1,200
PV $15,022.55
1 2 3 4 5
(1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10)

NPV $15,022.55 $11,000 $4,022.55

Decision: Accept the project since the NPV is positive.

21
Advantages and Disadvantages of the Certainty Equivalent Approach

Advantages
▪ Simple and easy to use.
▪ Takes into account the riskiness of
the cash flows.
Disadvantages
▪ There is no practical way to
estimate certainty equivalents.
▪ Certainty equivalents should reflect
shareholders’ risk preference
rather than those of management.
▪ The accuracy of the estimates of
cash flows could result in erroneous
decisions.

22
Adjusting for Inflation

23
Adjusting for Inflation
▪ Inflation is a general price increase in the economy.

▪ When inflation increases, the real value of expected cash flows decreases.

▪ If the analyst does not adjust for risk of inflation, the NPV or IRR may be
artificially high.

▪ In other words, you might accept a project with an unadjusted NPV or IRR while
an adjusted NPV or IRR could be unacceptable.

▪ One way to adjust for inflation is by subtracting the inflation rate from the
24
discount rate.
Example
A project provides the following cash flows: $1,000, $2,000, and $3,000. The
discount rate is 13% and the annual rate of inflation is 6%. The initial investment cost
is $4,000. what is the NPV for the project after adjusting for inflation?

13% 6% 7%

1,000 2,000 3,000

PV $5,130
1 2 3
(1 + 0.07) (1 + 0.07) (1 + 0.07)

NPV $5,130 $4,000 $1,130

Decision: Accept the project since the NPV is positive.

25
End of Lecture!
Any questions?
You can find me at:
Tarek.Elkalla@gmail.com

26