Reading 35– Capital Budgeting

Learning Outcome Statements

a. describe the capital budgeting process and distinguish among the various categories of
capital projects;
b. describe the basic principles of capital budgeting;
c. explain how the evaluation and selection of capital projects is affected by mutually
exclusive projects, project sequencing, and capital rationing;
d. calculate and interpret net present value (NPV), internal rate of return (IRR), payback
period, discounted payback period, and profitability index (PI) of a single capital project;
e. explain the NPV profile, compare the NPV and IRR methods when evaluating independent
and mutually exclusive projects, and describe the problems associated with each of the
evaluation methods;
f. contrast the NPV decision rule to the IRR decision rule and identify problems associated
with the IRR rule;
g. describe expected relations among an investment’s NPV, company value, and share price.
A - capital budgeting process and categories of capital projects.

■ Step One: Generating Ideas—Investment ideas can come from anywhere, from
the top or the bottom of the organization

■Step Two: Analyzing Individual Proposals—This step involves gathering the

information to forecast cash flows for each project and then evaluating the
project’s profitability.

■ Step Three: Planning the Capital Budget—The company must organize the
profitable proposals into a coordinated whole that fits within the company’s
overall strategies, and it also must consider the projects’ timing

■ Step Four: Monitoring and Post-auditing—In a post-audit, actual results

are compared to planned or predicted results, and any differences must be
explained
A - capital budgeting process and categories of capital projects.

Replacement projects.

Expansion projects.

New products and services.

Regulatory, safety, and environmental projects.

Other projects.
B - the basic principles of capital budgeting

❑ Decisions are based on cash flows, not accounting income : We’ll see why

The relevant cash flows to consider as part of the capital budgeting process are
incremental cash flows.

Sunk Cost : even if the project is not undertaken. Because these costs are not affected by
the accept/reject decision, they should not be included in the analysis.

Externalities : Positive and negative externalities must be considered into account,

negative externalities called cannibalization; if a hot drinks restaurants decided to offer
cold drinks, the negative effect on hot drinks sales must be taken into account.

Conventional cash flow pattern if the sign on the cash flows changes only once.
- 50000 +10000 + 15000 + 12000 + 20000 + 17000

Unconventional cash flow pattern has more than one sign change. Disposal of asset !
- 50000 +10000 + 150000 + 12000 + 20000 + 17000 – 5000
“ this kind of cash flow pattern has some troubles, we’ll see them next “
 B - the basic principles of capital budgeting

❑ Cash flows are based on opportunity costs. Opportunity costs are cash flows that a firm
will lose by undertaking the project under analysis. Project Vs. job !!

❑ The timing of cash flows is important. Capital budgeting decisions account for the time
value of money, which means that cash flows received earlier are worth more than
cash flows to be received later. “ due to discounting cash flows using a discount rate”

❑ Cash flows are analyzed on an after-tax basis. Taxes must be fully reflected in all
capital budgeting decisions. ‫ الحكومة الزم تاخد حقها‬:D :D

❑ Financing costs are ignored because it is already reflected in the discount rate
C- Mutually exclusive projects, project sequencing, and capital rationing

❑ Independent projects are projects whose cash flows are independent of each other
while mutually exclusive projects compete directly with each other and therefore only
one project can be undertaken.

❑ Project sequencing—Many projects are sequenced through time, so that investing in a

project creates the option to invest in future projects.

❑ Capital rationing exists when the company has a fixed amount of funds to invest. So
the company has to choose the most profitable project or set of projects. If the
company has access to unlimited fund it could select all profitable projects.
D- Net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and profitability index

NPV is the present value of the future after-tax cash flows minus the investment outlay.

Don’t Forget :

Cash inflows +

Cash outflow -

or

Let’s talk about

Time Value of
Money!
D- Net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and profitability index

Finance Coach Inc. is considering an investment of €120 million in a capital project that
will return after-tax cash flows of €36 million per year for the next four years plus
another €40 million in Year 5. The required rate of return is 10 percent

Whenever NPV is Positive we accept the project and the project is rejected if the Net
present value is negative.
D- Net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and profitability index

Internal rate of return ( IRR ) : is the discount rate that makes the present value of the
future after-tax cash flows equal that investment outlay.

Algebraically, this equation would be very difficult to solve. We normally resort to trial and
error, systematically choosing various discount rates until we find one that satisfy the
equation. “ the calculators do this easily “
The company should accept the projects with IRR greater than RRR and vice versa.
D- Net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and profitability index

The payback period is the number of years required to recover the original investment
in a project. “ the year at which cumulative cash flow equals ZERO”

The Advantages of payback period methodology are;

• easy to calculate and explain
• Could be used as a measure of liquidity; the project with less recovery period is more
liquid.

The drawbacks of the payback period are transparent. Since the cash flows are not
discounted at the project’s required rate of return, the payback period ignores the time
value of money and the risk of the project. Additionally, the payback period ignores
cash flows after the payback period is reached.
D- Net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and profitability index
D- Net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and profitability index
D- Net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and profitability index

Discounted payback period : it accounts for the time value of money and risk within the
discounted payback period, but it ignores cash flows after the discounted payback
period is reached.
The project may generate massive cash flow in the early years and massive cash outflow
in the late years. “let’s see this example”

The project discounted payback period is 2.8 years but we should reject this project
because the net present value is negative.

Challenging question : what Is the DPP of a negative NPV project ?

D- Net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and profitability index

• Average Accounting Rate of Return: calculated as the average net income for a set of
years divided by the average book value of the investment.

The advantages of the AAR are that it is easy to understand and easy to calculate.
The AAR has some important disadvantages, however. Unlike the other capital
budgeting criteria discussed here, the AAR is based on accounting numbers and
not based on cash flows. The AAR also does not account for the time value of
money.

Let’s understand this example.

D- Net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and profitability index
 D- Net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and profitability index

Profitability Index :
The profitability index (PI) is the present value of a project’s future cash flows divided
by the initial investment.

If the project PI is greater than 1 the project is accepted and it should be rejected if it is less
than 1.
* PI and NPV are the same “algebraically different equation”
E- NPV profile, IRR, NPV, and mutually exclusive projects

NPV profile : The NPV profile shows a project’s NPV graphed as a function of various
discount rates. Typically, the NPV is graphed vertically and the discount rates are graphed
horizontally.

IRR
+NPV
-NPV
E- NPV profile, IRR, NPV, and mutually exclusive projects

❑ NPV and IRR will report the same result “ accept / reject” for any single conventional
pattern.

❑ If the projects are mutually exclusive we should depend on NPV as IRR will give us a
wrong way.

❑ Challenging question : why should we choose NPV over IRR ?

E- NPV profile, IRR, NPV, and mutually exclusive projects

What is the crossover rate and how it is calculated ?

The crossover rate is the rate at which two mutually exclusive would give the same net
present value.

It is calculated by netting the two projects and then calculating the IRR.
E- NPV profile, IRR, NPV, and mutually exclusive projects

NPV profile for two mutually exclusive projects and different cash flow pattern

Crossover rate
E- NPV profile, IRR, NPV, and mutually exclusive projects

IRR problems :

If the cash flow are non-conventional “ more than one (-)” the IRR methodology won’t be
valid, as the project will produce more than one IRR or even NO IRR.

Two IRRs No IRR

E- NPV profile, IRR, NPV, and mutually exclusive projects

Capital budgeting and stock prices :

Capital budgeting can affect the stock prices up and down

The new price = (Market Cap + NPV) / # of shares

* Stock valuation is more complex process. In fact the current stock price should reflect the
expected NPV of the company projects and only appreciate or depreciate according to the
incremental changes to these expectation.
Challenging questions :

❑ Erin Chou is reviewing a profitable investment project that has a conventional cash flow
pattern. If the cash flows for the project, initial outlay, and future after-tax cash flows all
double, Chou would predict that the IRR would:

A - increase and the NPV would increase.

B - stay the same and the NPV would increase.
C - stay the same and the NPV would stay the same.

❑ Shirley Shea has evaluated an investment proposal and found that its payback period is
one year, it has a negative NPV, and it has a positive IRR. Is this combination of results
possible?

A - Yes.
B - No, because a project with a positive IRR has a positive NPV.
C - No, because a project with such a rapid payback period has a positive NPV.
Challenging questions :

❑ An investment has an outlay of 100 and after-taxash flows of 40 annually for four years. A
project enhancement increases the outlay by 15 and the annual after-tax cash flows by 5.
As a result, the vertical intercept of the NPV profile of the enhanced project shifts:

A - up and the horizontal intercept shifts left.

B - up and the horizontal intercept shifts right.
C - down and the horizontal intercept shifts left.