Topic 7a -Capital Budgeting and Valuation

Topic 7
Capital Budgeting and Valuation

T7a-pg1

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Topic 7a -Capital Budgeting and Valuation

Outline for Topic 7

• Present Value Concept (Perpetuity, Growing Perpetuity)

1. Valuation for real assets (i.e. capital budgeting methods):

① Net Present Value (NPV) & real assets valuation
② Internal Rate Of Return (IRR) (& its limitations)
③ payback period

2. Valuation of financial assets:

2.1 Bond valuation
(coupon bond valuation, zero-coupon bond valuation)
2.2 Stock valuation
• Dividend Discount Model
• Gordon Growth Model (& No growth model)
4

Learning Outcomes

• Describe the valuation of real assets and financial assets.

• Understand the main techniques used to value real assets
(capital budgeting / investment appraisal):
① Net Present Value (NPV),
② Internal Rate of Return (IRR), and
③ payback period

• Describe the methods used for the valuation of financial assets:

bonds and common stocks. 5 T7a-pg2

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Topic 7a -Capital Budgeting and Valuation

Present Value Concept

Part A: Capital Budgeting [Valuation of Real Assets]
1) Net Present Value
2) Internal Rate of Return
3) Payback

Part B: Valuation of Financial Asset

1) Bond Valuation
2) Stock Valuation
6

T7a-pg3

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Topic 7a -Capital Budgeting and Valuation

+CF =  Company  -CF Type of CF Key concept

Cash inflows cash outflows Yr uneven Even Even
[receipts] [payment] CF CF CF∞
_______ ________
T0 T1 T2 T3 T4 0 -150 100 100
______________________________________________ 1 100 100 100
-CF +CF +CF 2 220 100 100
3 350 ..
.. ..
..
Type of CF N 100 N= ∞
T0 T1 T2 T3 forever, perpetual
PV 100 220 350
PV[ uneven CF] = C1__ + C2_ +…. +Cn___
FV1 FV2 FV3 (1+1)1 (1+i)2 (1+i)n

T0 T1 T2 T3 even CF =A +A +… +A___
PV 100 100 100 PV [Annuity] (1+1)1 (1+i)2 (1+i)n
A A A
PV[ perpetuity] PV = C
[no growth , g=0]
i-0
PV[ perpetuity]
T0 T1 T2 T3 …… ∞ [with growth , g=?] PV = C_
PV 100 100 100 .…100 i-g

Introduction
• Investment in real assets is known as capital budgeting.
• Real assets are expenditures that generate cash in the future.
• In capital budgeting, the objective of firms is to maximise the value of the
cash invested by their stockholders.
• Investments in real assets have to generate returns at least equal to that
available to investors outside the firm in the financial markets.

Goal of the firm extra

Long term goal:
to maximize ____________

Short term goal:

to maximize _____________
(by investing in real assets & get positive returns)
10 T7a-pg4

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Topic 7a -Capital Budgeting and Valuation

Present Value Concept $1 (today) ≠ $1 (tomorrow)

• One dollar today is worth more than a dollar tomorrow.
• Dollar today can be invested to earn interest immediately, demonstrating the
time value of money.
• To illustrate the time value of money is the present value (also termed
discounted value).
• Represents the value today of a cash flow received in t year’s time, and is calculated by
multiplying the cash flow by a discount factor.
• Present value of many cash flows is the sum of their individual present values (principles of
value additivity).
• The PV of a cash flow stream (C1, C2, C3,, CN received at years 1, 2, 3, ., N) can be
calculated as:

where:
Ct = cash flow generated by a real asset at time t
1/ (1+r)t = discount factor, which is the value today of $1 received at time t
r = annual compounded interest rate required to accept the delayed payment,
termed discount rate. 11

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Present Value (PV) Concept

Example:
Assume a compounded interest rate of 8%.
The PV of $1,000 to be received at years 1 to 3 is:

Present value (PV) = 1,000 + 1,000 + 1,000 = $2,576

( ) ( )2 ( )3
Yr Cash flow (CF) DF PV
1 $1000 1/1.08 = 0.9259 925.90
2 $1000 1/1.082 =
3 $1000 1/1.083 ________

$2576 12 T7a-pg5

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Topic 7a -Capital Budgeting and Valuation

Perpetuity

• A perpetuity is a stream of fixed cash flows (C) received

=equivalent amount

at the end of every year from now until infinity.

• PV of a perpetuity is:
Example:
• Assume an interest rate of 8%.
• PV of a perpetuity that promises a payment of $1,000 per year
=
14
= $1,000 / 0.08 = $12,500
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Growing Perpetuity
• A growing perpetuity: a perpetual cash flow stream that grows at a
constant rate (denoted as g) over time.
• The value of a growing perpetuity can be calculated as:

Example:
• Interest rate 8%.
• PV of a growing perpetuity that promises an initial payment of $1,000 and
growth of 3%

= PV (with growth) =

= $1,000 = $20,000
(0.08 - 0.03) 15 T7a-pg6

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Topic 7a -Capital Budgeting and Valuation

Concept Check Activity:

Present Value Concept- Types of Cash Flows

________ _________ Perpetuity With ______

Year Uneven CF (Even CF) (Even CF) (uneven CF), g =10%
1 $100 $100 $100 $100
2 $120 $100 $100 $110
3 $123 $100 $100 $121
………..

N $100 ...
PV = Cn___ PV PV = C PV = C
(1+r)n r r –g

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PV = C
Activity 7.1- Present Value Concept (1+r) n
Find PV (assume i=7%)
1) $5,000 to be received in 5 years’ time.
PV = C = $ ___ = $3565
(1+r) n ( + )
2) $5,000 to be received at the end of the first 5 years, and
$2,000 at the end of years 6 to 8.
See next slide

3) $5,000 to be received from year 1 to infinity.

PV (perpetuity) = C = $__________ = $71,428
(no growth) r
4) $5,000 to be received as a growing perpetuity (growth rate = 4%).
PV (perpetuity) = C = $__________ = $166,667
T7a-pg7
(with growth) r-g 17

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Topic 7a -Capital Budgeting and Valuation

PV = C
Activity 7.1- Present Value Concept (1+r) n
Find PV (assume i=7%)
1) $5,000 to be received in 5 years’ time.
PV = C = $5000 = $3565
(1+r) n (1+ 0.07)5
2) $5,000 to be received at the end of the first 5 years, and
$2,000 at the end of years 6 to 8.
See next slide

3) $5,000 to be received from year 1 to infinity.

PV (perpetuity) = C = $5000 = $71,428
(no growth) r 0.07
4) $5,000 to be received as a growing perpetuity (growth rate = 4%).
PV (perpetuity) = C = $5000 = $166,667
(with growth) r-g 0.07 – 0.04 18

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Activity 7.1- Present Value Concept

2) $5,000 to be received at the end of the first 5 years, and

$2,000 at the end of years 6 to 8.
Year CF DF PV

1 5000 1/(1.07)1 = 0.9346 4672.897

2 5000 1/(1.07)2 4367.194
3 5000 1/(1.07)3 4081.489
4 5000 1/(1.07)4 = 0.7629
5 = 0.7130 3564.931
6 = 0.6663 1332.684
7 = 0.6227 1245.499
8 2000 = 0.5820 1164.018
24,243.20 T7a-pg8

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Topic 7a -Capital Budgeting and Valuation

Part A: Capital Budgeting

1)Net Present Value (NPV)

2) Internal Rate of Return (IRR)
3) Payback

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T7a-Real Asset Valuation Key concept

(1)Net Present Value [NPV] ***** superior method
NPV = -Co + C1__ + C2 +….+ Cn___
(1+r)1 (1+r)2 (1+r)n
NPV = ∑C -I Yr CF DF [10%] PV
0 -150 1/(1+10%)0= 1 -150.00
(1+r)n 1 100 1/(1-10%)1=0.9090 90.90
2 100 1/(1+10%)2=0.8264 82.64
+NPV (>0)  Accept +NPV =+23.50
(=0)  accept/ reject  accept, +NPV
-NPV (<0)  Reject  maximize __________________

invest in +NPV  to maximise shareholder wealth ***

to generate more CF  increase Value of firm = __________ of firm]
(PYQ2016) (PYQ2009, 2012, 2015)
R = “_________________ rate” = opportunity cost of capital [return forgone]
= interest rate
= rate of return
= rate of equivalent investment
= cost of capital [cost of equity (Ke), cost of debt (Kd)
=
*Additivity Principle [/Property] : NPV (X+Y) = NPV (X)+ NPV (Y)
** Mutually exclusive [can choose only 1 project] T7a-pg9

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Topic 7a -Capital Budgeting and Valuation

NPV and Real Assets Valuation

• The Net Present Value (NPV) technique uses the discounting
principle to evaluate real assets.
• The NPV of a project is the sum of the present values of all the cash inflows
(C) generated in each of the t years,
less the sum of the present values of the cash investment (I).

• If the NPV is positive, the project should be accepted

as it generates cash receipts higher than cash investments.
• As its worth is more than the cost, the project makes a net contribution to
the value of the firm. Conversely,
• if the NPV is negative, the project should be rejected.
• If the NPV is zero, the firm is free to accept or reject the project.
23

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NPV and Real Assets Valuation

Opportunity Cost of Capital
• The rate of return used to discount the cash inflows has to be the
rate offered by equivalent investment alternatives in the capital market.
• This discount rate is also termed as opportunity cost of capital.
• ‘Opportunity’ represents the return forgone by investing in the project
rather than in financial assets, a market-determined opportunity cost.
• The assumption is that shareholders can reinvest their money at this market-
determined rate.
• Cost of capital indicates the costs of all the sources of both equity & debt
issues.
• Usually, managers use the same rate to discount cash flows occurring in
different years. With a flat interest rate term structure (short-term rates
being approximately the same as long-term rates), this assumption is correct.
However, when the term structure is not flat, different rates should be used
to discount cash flows in different years.
24 T7a-pg10
.
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Topic 7a -Capital Budgeting and Valuation

Present Value Concept

Investment in real assets is known as c____________ b________________.
$1 today is worth (more/ less ) than $1 tomorrow.
Time Value of Money = $ today can be invested to earn interest immediately
Opportunity cost = d_________ rate = rate of r____________ = c____ of c_______
Present Value (PV)
= discounted value
PV of a p________ PV of
(no growth) G_______Perpetuity

Net Present value

Additivity Principle:
NPV(X + Y) NPV rule enables firms to m_______ s_______ w______
= NPV( ) + NPV( ) M_______ e__________ means only one can be chosen
I_______________ = rate at which the PV of the cash inflows associated with
R_____ of R_____ a project equal the cash investment..
(IRR) IRR = rate that makes the NPV = ___
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Exam Focus
PYQ-QA7- Capital Budgeting + Stock & Bond Valuation
1. What type of cash flows have to be discounted in the NPV method?2009-5b-ZB
Explain why.(5 marks)
2. Explain what is meant by the ‘opportunity cost of capital’ in the context2009-5c-ZB
of the NPV method. (5m)
3 Explain what is meant by the opportunity cost of capital in relation to2012-5b-
the calculation of NPV. (4m) ZAB
4 Explain what is meant by the ‘opportunity cost of capital’ in the2015-5b-ZA
context of the NPV method. (4 marks)
5. Examine the factors that a firm might consider in determining the2016-5b-ZAB
discount rate to use in the NPV calculation. (4 marks)

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Topic 7a -Capital Budgeting and Valuation

5(c) Explain what is meant by the ‘opportunity cost of capital’ in the

context of the NPV method. (5 marks) 20095c

5(c) refer to p.124 of the subject guide , and to p.119 of Brealey, Myers and
Allen, Principles of corporate finance (ninth edition).
• Opportunity cost of capital – it is the rate of return used to
discount the expected cash inflows has to be the rate of return offered by
equivalent investment alternatives in the capital market.
• ‘opportunity’ derives from the fact that it represents the return forgone
by investing in the project rather than in financial assets (securities).
• the opportunity cost of capital is a market-determined opportunity cost.
The assumption is that shareholders can reinvest their money at this market-
determined rate.
• ‘cost of capital’ indicates that the costs of all the sources of capital
(both equity issues & debt issues) have to be taken into account.

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NPV and Real Assets Valuation

Types of Relevant Cash flows
 The cash flows are the incremental cash flows,
the additional cash flows from the project.
× Sunk costs have to be excluded because they are incurred
whether or not the project is accepted.
• One implicit assumption about cash flows associated with the
investment project is that they can be estimated without error.
• However, in the real world, the cash flows associated with
investment projects represent forecasts.
=projected = expected = estimated (with errors)

28 T7a-pg12

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Topic 7a -Capital Budgeting and Valuation

CF to be included in the capital budgeting] Extra info

Relevant CF [PYQ2009] Irrelevant CF

_______________ CF [=additional CF] [incurred, with/ without the new
e.g. new fixed cost project]
New future cost Old fixed cost
Variable cost [eg labour cost] Historical cost
____________cost
Factory rental =$2k , 2 floors
1st floor Butter cake [ existing project]
2nd floor X’mas cake [new project]

$2k rental √ Incremental CF

X sunk cost √ Additional CF
X historical cost √ Additional Fixed Cost
√ Variable cost
X fixed cost

Labour $800 [existing workers]

Variable $500 [new workers]
$1300
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5(b) What type of cash flows have to be discounted in the NPV method?
Explain why.(5 marks) 20095b

5(b) refer to p.124 of the subject guide, and to p.144 of Brealey, Myers and Allen,
Principles of corporate finance (ninth edition)
 cash flows to be discounted in the NPV method are
‘incremental cash flows’, which are the additional cash flows
from the project.
× sunk costs have to be excluded from the above calculation, because
they are incurred whether or not the project is accepted.
• the implicit assumption about cash flows associated with the investment
project is that they can be estimated without error. However, in the real world,
the cash flows associated with investment projects represent forecasts, and
not real values. Therefore the cash flows have to be estimated in an
uncertain framework.

T7a-pg13

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Topic 7a -Capital Budgeting and Valuation

NPV and Real Assets Valuation

Example:
• Firm decides to purchase a new equipment.
• The relevant opportunity cost of capital is 9%; investment cost is £1,500.
The cash inflows generated by the new equipment would be £500 yearly for
four years.
• NPV of project A:

• As the NPV of equipment is positive, Year CF (9%) PV

 it should be accepted.
0 -$1500
1 $500
2 $500
3 $500
4 $500
NPV= 119.86
31

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NPV and Real Assets Valuation Year CF (9%) PV

0 -$1500
1 $500
2 $500
3 $500
4 $500
Example: NPV= 119.86
• Firm decides to purchase a new equipment.
• The relevant opportunity cost of capital is 9%; investment cost is £1,500.
The cash inflows generated by the new equipment would be £500 yearly for
4 years.
• NPV of project A:

T7a-pg14
As the NPV of equipment is positive, it should be accepted. 32

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Topic 7a -Capital Budgeting and Valuation

Activity 7.2 – Find NPV (assume int =7%)

Project B
costs $1,100 immediately & generates $600 for each of the next 5 years.
Project C
costs $1,400 immediately. It generates $500 in year 1.
It costs an extra $300 in year 2, and generates $500 in years 3, 4 and 5.

Project B Project C
Yr CF DF (7%) PV Yr CF DF (7%) PV
0 -1100 1/(1.07)0 =1 -1100 0 -1400 1/(1.07)0 = -1400
1 600 1/(1.07)1 = 0.9346 560.76 1 500 1/(1.07)1 = 0.9346 467.3
2 600 1/(1.07)2 = 524.04 2 1/(1.07)2 = 0.8734 -262.02
3 600 1/(1.07)3 = 0.8163 3 1/(1.07)3 = 0.8163 408.15
4 600 1/(1.07)4 = 0.7629 457.74 4 500 1/(1.07)4 = 0.7629 381.45
1/(1.07)5 = 0.7130 427.80 5 500 1/(1.07)5 = 0.7130 356.5
NPV = 1360.12 NPV = -48.62
Accept ?
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Activity 7.2 – Find NPV (assume int =7%)

Project B
costs $1,100 immediately & generates $600 for each of the next 5 years.
Project C
costs $1,400 immediately. It generates $500 in year 1.
It costs an extra $300 in year 2, and generates $500 in years 3, 4 and 5.

Project B Project C
Yr CF DF (7%) PV Yr CF DF (7%) PV
0 -1100 1/(1.07)0 =1 -1100 0 -1400 -1400
1 600 1/(1.07)1 = 0.9346 560.76 1 500 1/(1.07)1 = 0.9346 467.3
2 600 1/(1.07)2 = 0.8734 524.04 2 -300 1/(1.07)2 = 0.8734 -262.02
3 600 1/(1.07)3 = 0.8163 489.78 3 500 1/(1.07)3 = 0.8163 408.15
4 600 1/(1.07)4 = 0.7629 457.74 4 500 1/(1.07)4 = 0.7629 381.45
5 600 1/(1.07)5 = 0.7130 427.80 5 500 1/(1.07)5 = 0.7130 356.5
NPV = 1360.12 NPV = -48.62
Accept Reject T7a-pg15
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Topic 7a -Capital Budgeting and Valuation

Concept Check Activity:

Net Present Value (NPV)
5 (a) Consider the following projects (X and Y): ZA-2011-5a

Assuming an opportunity cost of capital of 10%, what is the NPV of the two projects?
Which project(s) would you accept? (5 marks)

Yr CF DF ( %) PV Yr CF DF ( %) PV
0 =1 0 1/(1.07)0 =1
1 1/( 1.10)1 1
2 1/( )2 2
NPV = 25.62 NPV = −164.46

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NPV and Real Assets Valuation

• The channelling of funds from lenders to borrowers makes both parties
better off by following 2 equivalent rules:

a) Net present value rule:

invest in real assets with a positive NPV.
The maximisation of the NPV
increases the market value of the stockholder’s share in the firm.
shareholder
b) Rate of return rule:
stockholders and bondholders have to invest in securities with a
return higher than the rate of return on equivalent investments in the
capital market.

• Therefore the NPV rule

enables firms to maximise shareholder wealth. 37 T7a-pg16

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Topic 7a -Capital Budgeting and Valuation

Exam Focus
PYQ-QA7- Capital Budgeting + Stock & Bond Valuation
6 Explain why the NPV decision rule is consistent with the objective of the2010-5e-ZB
firm to maximise shareholder wealth. (3 marks)
7. Explain the relationship between the NPV decision rule and2012-5c-ZB
maximising shareholder wealth. (4 marks)
8 Explain why the NPV method leads to decisions that are2016-5f-ZB
consistent with the objective of wealth maximization. (3 marks)
9 Explain why the NPV decision rule is consistent with the objective2017-5e-
of the firm to maximise shareholder wealth. (4 marks) ZA

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5(e) Explain why the NPV decision rule is consistent with the objective of
the firm to maximise shareholder wealth. (3 marks) 20105e

(e) refer to pp.123–25 of the subject guide.

• The value of a company is made up of the value of its assets + the NPV of
current projects.
• However this will only maximise shareholder wealth
if the NPV is positive, at a cost of capital that reflects the required rate
of return demanded from shareholders.
• As the NPV rule identifies the projects generating wealth in today’s value
terms.
• Selection of those projects will generate additional wealth for the company &
shareholders.

T7a-pg17

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Topic 7a -Capital Budgeting and Valuation

NPV & Mutually Exclusive Projects

• Mutually exclusive means only one can be chosen.
• NPV possesses the additivity principle.
• A firm has only two projects (X and Y);
NPV of projects X & Y = NPV of project X + NPV of project Y
NPV(X + Y) = NPV(X) + NPV(Y)
• Because of the additivity property, when there are mutually exclusive
projects, the NPV method indicates that the project with the largest
positive NPV should be adopted.
• Reason is that the project with the largest NPV generates the
largest NPV of the firm’s aggregated cash flows.
• One example clarifies the point that the choice of project relies on the
additivity property. Assume that project X is a positive NPV project, while
project Y is a negative NPV. The joint project (X+Y) will have a lower NPV
than project X on its own. The NPV enables managers to avoid choosing
bad projects just because they are packaged with good ones.
40

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NPV (X) + NPV (Y) = NPV (X+Y)

Alpha Omega
2010-5a-ZB
0 -250,000 -370,000
1 125,000 100,000
2 140,000 140,000
3 -100,000 125,000
4 170,000 125,000

5(a) If the opportunity

Alphacost of capital is 8%, calculate the NPV for each
Omegaproject. (4 marks)
Yr CF DF(8%) PV Yr CF DF(8%) PV
0 -250 1 1 -250.000 0 -370 1 1 -370.000
1 125 1/(1.08)1 =0.9259 115.737 1 100 1/(1.08)1 =0.9259 92.590
2 140 1/(1.08)2 =0.8573 120.022 2 140 1/(1.08)2 =0.8573 120.022
3 -100 1/(1.08)3 =0.7938 -79.380 3 125 1/(1.08)3 =0.7938 99.225
4 170 1/(1.08)4 =0.7350 124.950 4 125 1/(1.08)4 =0.7350 91.875
NPV= 31.33 NPV= 33.712
T7a-pg18
Accept
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Topic 7a -Capital Budgeting and Valuation

Exam Focus
PYQ-QA7- Capital Budgeting + Stock & Bond Valuation
10 Explain the additivity property of the NPV method. (5 marks) 2009-5d-ZB
11 Explain the additivity property of the NPV method and explain why this20111a-ZA
property makes the NPV method useful for investment appraisal when
funds are limited. (7 marks)
12 Explain why the additivity property of NPV is useful when selecting2013-6e-ZA
investment projects when funds are limited. (3 marks)
13 Explain the additivity property of the NPV method. (5 marks) 2015-5c-
ZAB
14 Explain why the additivity property of NPV is useful when selecting2017-5e-ZB
investment projects where funds are limited. (4 marks)
15 Explain the additivity property of the NPV method. (6 marks) 2019-7f-ZAB

42

5(d) Explain the additivity property of the NPV method. (5 marks)

5(d) refer to p.125 of the subject guide. 20095d

• explain the meaning to the additivity property

(i.e. the NPV of projects X and Y is equal to the NPV of project X plus the
NPV of project Y) and should also provide the relevant notation:
NPV(X +Y ) = NPV(X )+ NPV(Y )
The implications of the additivity property:
① The value of the firm is simply the sum of the values of the separate projects.
② When there are mutually exclusive projects, the NPV method indicates
that the project with the largest positive NPV should be adopted. The
reason for this is that the project with the largest NPV generates the
largest NPV of the firm’s aggregated cash flows.
Additivity property holds because present values are all measured in today’s $.
• the choice of project relies on the additivity property.
• Assume that project X is a positive NPV project, while project Y is a negative NPV. The
joint project (X+Y) will have a lower NPV than project X on its own. The NPV enables T7a-pg19
managers to avoid choosing bad projects just because they are packaged with good ones
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Topic 7a -Capital Budgeting and Valuation

6(e) Explain why the additivity property of NPV is useful when selecting
investment projects when funds are limited. (3 marks) ZA2013-6e
• See the subject guide, Chapter 7, section on `NPV and mutually exclusive
projects'.
Approaching the question
• NPV possesses the additivity property.
• Assume that a firm has only two projects (X and Y); the NPV of projects X
and Y is equal to the NPV of project X plus the NPV of project Y.
• (Note that the additivity property holds because present values are all
measured in today's dollars.)
• This can be written as: NPV(X + Y) = NPV(X) + NPV(Y):
• Because of the additivity property, when there are mutually exclusive
projects, the NPV method indicates that the
project with the largest positive NPV should be adopted.
• The reason for this is that the project with the largest NPV generates the
44
largest NPV of the firm's aggregated cash-flows.
44

NPV & Limited Funds = capital rationing

• Limited funds means the amount of money available is less than
the total investment cost of all the projects.
• For safe projects, most firms have no difficulty in raising more capital, but
many impose capital budgets as part of their internal control system,
resulting in limited funds.
• Even when there are limited funds,
the NPV additivity property enables firms to choose the best project.
1) first, calculate the NPV of all the feasible combinations of possible projects
by summing the NPV of all their constituents.
2) Second, by choosing the combination with the greatest NPV.

• The NPV method is the optimal technique for the valuation of real
assets because it enables the management to maximise the expected
wealth of shareholders. In practice, however, several other techniques are
used, such as the Internal Rate of Return (IRR) and the payback period.
45 T7a-pg20

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Topic 7a -Capital Budgeting and Valuation

NPV
(Mutually Exclusive)

46

Mutually exclusive [choose 1 only] Extra info

mutually exclusive  both +NPV  choose higher NPV
mutually exclusive  both –NPV  reject both
No  both +NPV  choose both
No  both –NPV  reject both
Mutually Exclusive
 conflicting decision for NPV & IRR [i.e NPV & IRR give different results
[bec NPV is based on absolute returns; IRR is based on % returns.]
 follow NPV decision
[because NPV consistent with maximize shareholder wealth, which
is the objective of firm]

Period Project A Project B

0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74 T7a-pg21

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Topic 7a -Capital Budgeting and Valuation

5(d) Based on your calculations in part (a) and (c) explain which
project you would accept and why. (5 marks) 2015-5d-ZB

Reading for this question

See subject guide, Chapter 7, pp.144–46.
Approaching the question
The two methods give different results as sometimes happens when
comparing projects that are mutually exclusive.
This is because the two methods are based on different criteria –
NPV is based on absolute returns and
IRR is based on % returns.
When there is a conflict of ranking using NPV and IRR w
e normally go with NPV
as this is consistent with maximising the value of the firm.

48

Concept Check Activity: Mutually Exclusive, +NPV Projects

5. A firm is considering investing in the following two mutually exclusive projects:
Alpha Omega 2010-5a-ZB Homework
0 -250,000 -370,000
1 125,000 100,000
2 140,000 140,000
3 -100,000 125,000
4 170,000 125,000

5(a) If the opportunity

Alphacost of capital is 8%, calculate the NPV for each
Omegaproject. (4 marks)
Yr CF DF(8%) PV Yr CF DF(8%) PV
0 0
1 1
2 2
3 3
4 4
NPV= 31.33 NPV= 33.712
T7a-pg22
? ?
49
Topic 7a -Capital Budgeting and Valuation

Concept Check Activity: Mutually Exclusive, + NPV Projects

5. A firm is considering investing in the following two mutually exclusive projects:
Alpha Omega
2010-5a-ZB
0 -250,000 -370,000
1 125,000 100,000
2 140,000 140,000
3 -100,000 125,000
4 170,000 125,000

5(a) If the opportunity

Alphacost of capital is 8%, calculate the NPV for each
Omegaproject. (4 marks)
Yr CF DF(8%) PV Yr CF DF(8%) PV
0 -250 1 1 -250.000 0 -370 1 1 -370.000
1 125 1/(1.08)1 =0.9259 115.737 1 100 1/(1.08)1 =0.9259 92.590
2 140 1/(1.08)2 =0.8573 120.022 2 140 1/(1.08)2 =0.8573 120.022
3 -100 1/(1.08)3 =0.7938 -79.380 3 125 1/(1.08)3 =0.7938 99.225
4 170 1/(1.08)4 =0.7350 124.950 4 125 1/(1.08)4 =0.7350 91.875
NPV= 31.33 NPV= 33.712
Accept
50

Concept Check Activity : Mutually Exclusive, -NPV Projects

5. (a) Consider the two following mutually exclusive projects (A and B):
Cash Flows 2009-5a
Project C0 C1 C2
A -1500 900 250
B -1500 0 1500

Assuming an opportunity cost of capital of 10%,

what is the NPV of the two projects? Which project would you accept? (5 marks)
Project A Project B
Yr CF DF(10%) PV Yr CF DF(10%) PV
0 0
1 1
2 2
NPV = -475.28 NPV = -261
? ? T7a-pg23

51
Topic 7a -Capital Budgeting and Valuation

Concept Check Activity: Mutually Exclusive, -NPV Projects

5. (a) Consider the two following mutually exclusive projects (A and B):
Cash Flows
2009-5a
Project C0 C1 C2 Homework
A -1500 900 250
B -1500 0 1500

Assuming an opportunity cost of capital of 10%,

what is the NPV of the two projects? Which project would you accept? (5 marks)
Project A Project B
Yr CF DF(10%) PV Yr CF DF(10%) PV
0 -1500 1 1 -1500 0 -1500 1 1 -1500
1 900 1/(1.1)1 =0.909 818.1 1 0 1/(1.1)1 =0.909 0
2 250 1/(1.1)2 =0.826 206.61 2 1500 1/(1.1)2 =0.826 1239
NPV = -475.28 NPV = -261
reject reject
52

Concept Check Acitivty: Not Mutually Exclusive 2018-Q5-ZA

5. A firm is considering two investment projects, Yana and Zeta. These projects are
NOT mutually exclusive. Assume the firm is not capital constrained.
The initial costs and cash flows for these projects are:
Year Yana Zeta
0 -50,000 -45,000
1 19,000 10,000
2 17,000 20,000
3 25,000 25,000
(a) Using a discount rate of 10% calculate the net present value for each project. What decision would
you make based on your calculations? (4 marks)
(b) How would your decision change if the discount rate used for calculating the net present value is
12%? (4 marks)
(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 10%. What decision would
you make based on your calculations? (6 marks)
(d) Calculate the payback period for each project. The company looks to select investment
projects paying back in 2 years. What decision would you make based on your calculations? (2m
(e) Discuss the advantages and disadvantages of the payback rule of investment appraisal. (4m
(f) Discuss the limitations of the internal rate of return method of investment appraisal. (5m)
T7a-pg24

53
Topic 7a -Capital Budgeting and Valuation

Concept Check Acitivty: Not Mutually Exclusive 2018-Q5a-ZA

5. A firm is considering two investment projects, Yana and Zeta. These projects are
NOT mutually exclusive. Assume the firm is not capital constrained. The initial costs and cash flows for
these projects are:
Year Yana Zeta
0 -50,000 -45,000
1 19,000 10,000
2 17,000 20,000
3 25,000 25,000
5(a) Using a discount rate of 10% calculate the net present value for each project. What decision would
you make based on your calculations? (4 marks)
Solution
(a) Yana Zeta
-50000.00 -45000.00
17272.72 9090.90
14049.58 16528.92
18782.87 18782.87
NPV = 105.18 NPV= -$597.29
Decision= Accept/ Reject Yana Accept / Reject Zeta.

54

Concept Check Acitivty: Not Mutually Exclusive 2018-Q5b-ZA

5. A firm is considering two investment projects, Yana and Zeta. These projects are
NOT mutually exclusive. Assume the firm is not capital constrained. The initial costs and cash
flows for these projects are:
Year Yana Zeta
0 -50,000 -45,000
1 19,000 10,000
2 17,000 20,000
3 25,000 25,000
(b) How would your decision change if the discount rate used for calculating
the net present value is 12%? (4 marks)
Solution
5(b) Yana Zeta
-50000.00 -45000.00
16964.29 8928.57
13552.30 15943.88
17794.51 17794.51
NPV =-1688.91 NPV =-2333.04
T7a-pg25
Decision=
56
Topic 7a -Capital Budgeting and Valuation

extra
Concept Check Activity: Mutually Exclusive Projects
The required return for both projects is 10%.
Which project should you accept and why?

Period Project A Project B

0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74
For conflicting recommendation, follow _____________
decision, because

if Results of NPV ≠ Results of IRR  Follow NPV recommendation (see 20105c)

58

ZA2013-Q6
Concept Check Activity: NPV
6. Chamberlain PLC is considering two investment projects: Homework
Project: A B_____
Project Life 6 years 5 years
$000 $000
Initial investment in plant and equipment 220,000 150,000
Net cash flows:
Year 1 25,000
Year 2 28,500
Year 3 33,000
Year 4 44,500
Year 5 67,500
Year 6 155,500
Net Present Value (10%) | $15,512
Internal Rate of Return (approx.) 17.9%
6(a) Determine the net present value of project A using Chamberlain's
required rate of return on projects of 10% (show all workings). (4 marks) 59 T7a-pg26

59
Topic 7a -Capital Budgeting and Valuation

ZA2013-Q6
Concept Check Activity: NPV
6(a) Determine the net present value of project A using Chamberlain's required
rate of return on projects of 10% (show all workings). (4 marks) Homework

60

60

Part A: Capital Budgeting

1) Net Present Value

2)Internal Rate of Return

3) Payback

61 T7a-pg27

61
Topic 7a -Capital Budgeting and Valuation

(B) Internal Rate of Return [IRR), % Key concept

NPV = -C0 + Cn ______ = 0 IRR is the [discount] rate when NPV =0
(1+ IRR)n
Hurdle rate: =min req rate of return
= risk free int rate
IRR > hurdle rate  Accept
<  Reject Solve IRR trial & error
Interpolation method
Step (1) : set any 2 rates r% [says, 10%] R% [says, 25%]
Step (2): find NPV (r%) – NPR (R%) [note: must 1
+NPV, 1 –NPV]
Yr CF try r% try R%
Step (3) ) Use interpolation formula 0
IRR = r% + NPV______ (R%-r%) 1
NPV + NPV 2
NPV(r%) -NPV(R%)

*** Problems [/drawbacks/ limitations/ disadvantages] of IRR

X Additivity property does not apply to IRR -+++ conventional CF
X more than 1 solution [ multiple IRRs] - + + - + non-conventional CF  IRRs
X No solution [-NPV, +NPV at every discount rate]

X IRR recommendation ≠ NPV recommendation [for mutually exclusive project]

 follow NPV recommendation  +NPV proj  maximize shareholder wealth

62

Key concept
IRR- Linear Interpolation method
Steps to solve IRR
1) Set any 2 rates (R%, r%)
2) Find NPV(R%), NPV (r%) (must +NPV, -NPV)
3) Use interpolation formula
IRR = r% + NPV______ (R%-r%)
NPV + NPV

Yr CF Try r% PV Try R% PV
DF(10%) DF
(20%)
0 -50
1 100
2 100
+NPV (r%) -NPV (R%)

T7a-pg28

63
Topic 7a -Capital Budgeting and Valuation

Internal Rate Of Return (IRR)

• The internal rate of return (IRR) is the rate at which the
present values of the cash inflows associated with a project
equal the cash investment. [discount rate when

• The IRR is the rate that makes the NPV equal to zero.
• Mathematically, the IRR solves this equation:

• The calculation of the IRR involves an iterative process, which can

be viewed as a trial & error procedure.

64

64

Internal Rate Of Return (IRR)

• The choice of projects is made by comparing the IRR
to a required rate of return termed hurdle rate (R*).
• If the IRR is higher than the hurdle rate, the project has to be accepted.
• The hurdle rate is usually represented by the risk-free interest rate where
cash flows are riskless.
• The decision process can be represented by Fig 7.1, where the
NPV is on the vertical axis, and the discount rate on the horizontal axis.
• If the hurdle rate is the opportunity cost of capital used in the NPV
calculation, then the 2 methodologies (IRR & NPV) would give the
same result, and thus the same investment recommendation.
NPV NPV diagram Figure 7.1, the IRR is higher than the hurdle rate (R*), and thus the
project represented by this curve should be accepted.

Discount rate
65 T7a-pg29
Source: M. Buckle (2011) Principle of Banking and Finance, ch7

65
Topic 7a -Capital Budgeting and Valuation

Extra Notes

+NPV

-NPV

66

IRR- Linear Interpolation method Extra Notes

Steps to solve IRR

1) Set any 2 rates (R%, r%)
2) Find NPV(R%), NPV (r%) (must +NPV, -NPV)
3) Use interpolation formula
IRR = r% + NPV______ (R%-r%)
NPV + NPV

Yr CF Try r% PV Try R% PV
DF(10%) DF
(20%)
0 -50
1 100
2 100
+NPV (r%) -NPV (R%)

T7a-pg30

67
Topic 7a -Capital Budgeting and Valuation

Internal Rate Of Return (IRR)

Example:
• The purchase of additional machinery costs $9,500 today.
• Positive cash flows equal to $4,000, $5,000 & $4,000
will be generated respectively in years 1, 2 and 3.
• This cash flow structure can be summarised as follows:
• Assume a risk-free rate of 7%. The IRR is the rate in the equation:
Cash flows ($)
Project C0 C1 C2 C3
-9,500 +4,000 +5,000 +4,000

IRR IRR IRR

68

68

Yr CF Try DF PV Yr CF Try DF PV
(r= (R=
0 -9500 1 1 -9500.000 0 -9500 1 1 -9500.000
1 4000 1/(1.1)1 =0.9091 3636.400 1 4000 1/(1.2)1 =0.8333 3333.200
2 5000 1/(1.1)2 =0.8264 4132.000 2 5000 1/(1.2)2 =0.6944 3472.000
3 4000 1/(1.1)3 =0.7513 3005.259 3 4000 1/(1.2)3 =0.5787 2314.800
NPV +1273.66 NPV -380
Interpolation method (To double check answer)

IRR = r% + NPV______ (R%-r%) = % + ____________ ( % - %) = 17.7%

NPV + NPV
NPV NPV diagram

IRR

10% 17.5% 20%

NPV =-380 T7a-pg31
NPV = +1273.66
69
Topic 7a -Capital Budgeting and Valuation

Yr CF Try DF PV Yr CF Try DF PV
(r=10%) (R=20%)
0 -9500 1 1 -9500.000 0 -9500 1 1 -9500.000

1 4000 1/(1.1)1 =0.9091 3636.400 1 4000 1/(1.2)1 =0.8333 3333.200

2 5000 1/(1.1)2 =0.8264 4132.000 2 5000 1/(1.2)2 =0.6944 3472.000

3 4000 1/(1.1)3 =0.7513 3005.259 3 4000 1/(1.2)3 =0.5787 2314.800

NPV +1273.66 NPV -380

Interpolation method (To double check answer)

IRR = r% + NPV______ (R%-r%) = 10% + 1273.66 (20% - 10%) = 17.7%

NPV + NPV 1273.66 + 380
NPV NPV diagram

IRR

10% 17.5% 20%

NPV = +1273.66 NPV =-380

70

Internal Rate Of Return (IRR)

• Let us arbitrarily try a 10% discount rate. The NPV is positive (+ $1,273).
• As the NPV is positive, the IRR must be greater than 10%.

• Let us try a 20% discount rate.

• The NPV becomes negative (–$380).
• Therefore the NPV must be lower than 20%.
• Plot these two combinations on a graph like Figure 7.1, and
choose the IRR that gives the desired NPV of zero.
• This occurs when the IRR is 17.5%.
• The IRR is higher than the hurdle rate (equal to the risk-free rate, 7%), and
thus the project is accepted.

71 T7a-pg32

71
Topic 7a -Capital Budgeting and Valuation

72
Internal Rate Of Return (IRR)
• Instead of plotting the two points for NPV and discount rate on a graph and reading
off the IRR from the graph we can use a linear interpolation method to
estimate a value for the IRR.
• Here we assume the relationship between NPV and discount rate between the two
points is linear. In fact, as we can see from Figure 7.1 the relationship is non-linear.
• By applying linear interpolation we will always find an approximate value for the
IRR. Therefore, it is important that the two discount rates that we interpolate between
are reasonably close together.
• The closer they are together, the more realistic our assumption of a linear
relationship between NPV and discount rate becomes and the more accurate is our
estimate of IRR.
• Of course, the two points we interpolate between must involve a positive NPV and
negative NPV so that the line between the points captures the IRR (where NPV = 0).
• The formula for finding the IRR using linear interpolation is:

72

Activity 7.3- Internal Rate Of Return (IRR)

Activity 7.3- Internal Rate of Retrun
Consider project ABC that costs $1,300 immediately.
It generates $500 in year 1. It costs an extra $500 in year 2, and
generates $1,600 in year 3. Assume a risk-free rate of 7%.
Calculate the IRR of project ABC, and
a) State whether it should be accepted or rejected.
b) Would your decision remain the same if you use the NPV as a decision rule?

73 T7a-pg33

73
Topic 7a -Capital Budgeting and Valuation

Activity 7.3- Internal Rate Of Return (IRR)

Homework
Yr CF Try DF PV Yr CF Try DF PV
( %) (10%)
0 -1300 0 -1300

1 500 1 500

2 -500 2 -500

3 1600 3 1600

NPV 36.68 NPV -56.57

NPV diagram

7% 10%
8.1%

Interpolation method (To double check answer)

IRR = r% + NPV (R%-r%) = = 8.18% (> hurdle rate of 7% =>

74
NPV + NPV
74

Activity 7.3- Internal Rate Of Return (IRR)

Yr CF Try DF PV Yr CF Try DF PV
(7%) (10%)
0 -1300 1 1 -1300 0 -1300 1 1 -1300
1 500 1/(1.07)1 = 0.9346 467.300 1 500 1/(1.1)1 =0.9091 454.550
2 -500 1/(1.07)2 = 0.8734 -436.700 2 -500 1/(1.1)2 =0.8264 -413.200
3 1600 1/(1.07)3 = 0.8163 1306.080 3 1600 1/(1.1)3 =0.7513 1202.080
NPV 36.68 NPV -56.57

NPV diagram

7% 10%
8.1%

Interpolation method (To double check answer)

IRR = r% + NPV (R%-r%) = 7% + 36.68 (10% -7%) = 8.18% (> hurdle rate of 7% => accept)
75 T7a-pg34
NPV + NPV 36.68+ 56.57
75
Topic 7a -Capital Budgeting and Valuation

Concept Check Activity:

NPV, IRR, Payback (2017-Q5-ZB)
5. A firm is considering investing in the following two mutually exclusive projects:
Year Yeti Zylo Homework
0 -260000 -350000
1 120000 100000
2 140000 130000
3 -100000 125000
4 170000 125000
(a) If the opportunity cost of capital is 9%, calculate the net present value (NPV) for each
projects. (4 marks)
(b) Calculate the net present value for each project for discount rates of 12% and 14%. Draw a
diagram of NPV against discount rates of 9%, 12% and 14% and identify the approximate
internal rate of return (IRR) for each project (you may give your answer as a range e.g. 5%
to 5.5%). (7 marks)
(c) Based on your results for (a) and (b) which investment project(s) should the company invest
in? Explain your decision. (4 marks)
(d) Critically assess the usefulness of the internal rate of return criterion for investment
appraisal. (6 marks)
(e) Explain why the additivity property of NPV is useful when selecting investment projects
where funds are limited. (4 marks)

76

5(a) If the opportunity cost of capital is 9%, calculate the net present value
(NPV) for each project. (4 marks) 2017-5a-ZB

T7a-pg35

77
Topic 7a -Capital Budgeting and Valuation

5(b) Calculate the net present value for each project for discount rates of
12% and 14%. Draw a diagram of NPV against discount rates of 9%, 12%
and 14% and identify the approximate internal rate of return (IRR) for each
project (you may give your answer as a range e.g. 5% to 5.5%).(7 marks)
• 2017-5b-ZB

78

Limitations Of Internal Rate Of Return (IRR)

• In the IRR method, it assumes that shareholders can reinvest their money at
the project’s own internal rate, which is the same IRR.
• In contrast, the NPV assumes that shareholders can reinvest their money at
the opportunity cost of capital determined by the market.
ZA-20115d 2016-5e-ZB
• Under the IRR, this assumption about the reinvestment rate implies that
different rates can exist for projects with the same risk!
20105c
• Under perfect capital markets, it is the NPV and not the IRR method that
makes the correct assumption about the reinvestment rate.
x In the evaluation of mutually exclusive projects,
the IRR can lead to choices that do not maximise shareholders’ wealth.
79 T7a-pg36

79
Topic 7a -Capital Budgeting and Valuation

Exam Focus
PYQ-QA7- Capital Budgeting + Stock & Bond Valuation
18 Discuss the reinvestment assumptions of the NPV & IRR methods 2011-5d-ZA
19 Compare the reinvestment assumptions of the NPV&IRR methods. 5m 2016-5e-ZB

80

5(d) Discuss the reinvestment assumptions of the NPV and IRR methods. (7
marks)

• See pp.144–46 of the subject guide. ZA-2011-5d

• For NPV the reinvestment assumption is that funds are reinvested at the
market determined cost of capital.
• For IRR, the assumption is that funds can be reinvested at the IRR. The
latter is unrealistic as it is possible for two projects with the same risk to
have different IRRs and hence reinvestment rates.
• This should not be possible in equilibrium – reference to the CAPM is useful
here.

IRR { reinvest cash ows at the projects computed IRR. 2016-5e-ZB

NPV { reinvest cash ows at the discount rate (= market rate).
NPV more realistic as cash flows being invested at a market rate.
The IRR may be unrealistic.

Reinvestment rate implicit in the IRR method is not compatible with well-functioning
capital markets. T7a-pg37
2017-5d-ZB
81
Topic 7a -Capital Budgeting and Valuation

Limitations Of Internal Rate Of Return (IRR)

But when Figure 7.2: IRR and mutually exclusive projects.
IRRs of both projects A & B exceed the hurdle rate (R*).
low discount rate
Moreover, the IRR of project B is greater
NPV(A) > NPV (B)
than the IRR of project A, project B is preferred.
A is preferred However,
when the discount rate is low, A has the higher NPV;
< < when the discount rate is high, B has the higher NPV.
Source: M. Buckle (2011) Principle of Banking and Finance, ch7 See next slide for bigger diagram

• In Figure 7.2, if the hurdle rate is the opportunity cost of capital,

then NPV of project A is higher than NPV of project B. Project A is preferred.
• This implies that the additivity property does not apply to the IRR.
• The project with the largest IRR (B) is not the project with the largest NPV,
and thus it is not the best choice in a set of mutually exclusive projects
because it does not maximise shareholder wealth.
• Base on IRR rule, many managers would choose project B. 82

82

Limitations Of Internal Rate Of Return (IRR)

But when
low discount rate Figure 7.2: IRR and mutually exclusive projects.
IRRs of both projects A & B exceed the hurdle rate (R*).
NPV(A) > NPV (B)
Moreover, the IRR of project B is greater
A is preferred than the IRR of project A, and
thus project B should be preferred.
However,
when the discount rate is low, A has the higher
NPV; when the discount rate is high, B has the higher
NPV.

Source: M. Buckle (2011) Principle of Banking and Finance, ch7

T7a-pg38

83
Topic 7a -Capital Budgeting and Valuation

Internal Rate Of Return (IRR)

• The preference for the IRR method could be justified under the assumption of
a shortage of funds because the cash flows of the shorter-lived project could
finance another later project. Non-conventional casF (- + + - + + +)
• IRR method can give either more than one solution or no solution.
• One example of a project with 2 IRR is a coal-mining investment, with the
following cash flow structure: negative initial cash flows (creation of the mine),
series of positive cash flows, and final negative cash flow for the land
reclamation.
Figure 7.3: Multiple IRR
Two IRR that make NPV equal to zero.
The IRR does not give an answer to
the question of which would maximise the
shareholder wealth.

Source: M. Buckle (2011) Principle of Banking and Finance, ch7

84

84

Internal Rate Of Return (IRR)

• It is possible to have no IRR, as shown in Figure 7.4.
• Project D has a positive NPV at every discount rate,
and thus is a very good project. However there is no IRR.
• In a case where the signs of the cash flows of project D were reversed (as in
project E), the project would have no IRR and always have a negative NPV.
• The absence of IRR does not indicate whether a project creates or
destroys value.
Figure 7.4: Non-existent IRR

no IRR !!!

Source: M. Buckle (2011) Principle of Banking and Finance, ch7 85 T7a-pg39

85
Topic 7a -Capital Budgeting and Valuation

Internal Rate Of Return (IRR)

x IRR method has limitations when evaluating real assets with the
objective of maximising shareholders’ wealth.
 However, nowadays many companies use the IRR technique.
 Although IRR seems easier to understand by non-financial managers,
caution has to be used because of the limitations.
x The main concern is related to the drawbacks of the IRR rule in evaluating
mutually exclusive projects, because of the inability of non-financial
managers to evaluate all the possible projects.

86

86

Exam Focus
PYQ-QA7- Capital Budgeting + Stock & Bond Valuation
16 Critically assess the usefulness of the internal rate of return criterion2013-6d-ZA
for investment appraisal. (6 marks)
17 Explain the limitations of the internal rate of return method of2015-5e-ZB
investment appraisal. (5 marks)
18 Discuss the reinvestment assumptions of the NPV & IRR methods 2011-5d-ZA
19 Compare the reinvestment assumptions of the NPV&IRR methods. 5m 2016-5e-ZB
20 Critically assess the usefulness of the internal rate of return criterion 2017-5d-ZB
for investment appraisal. (6 marks)
21 Discuss the limitations of the internal rate of return method of 2018-5F-
investment appraisal. (5 marks) ZAB
22 Compare and contrast the three investment appraisal methods used in2016-5e-ZA
parts (a), (c) and (d). (8 marks)

T7a-pg40

87
Topic 7a -Capital Budgeting and Valuation

5(e) Explain the limitations of the internal rate of return method of investment
appraisal. (5 marks) 2015-5e-ZB

See subject guide, Chapter 7, pp.146–48.

Approaching the question
This part is asking for an explanation of the limitations of the IRR method.

The main limitations are:

i. Rankings not based on scale of return – when choosing between mutually
exclusive projects.
ii. Solution may not exist.
iii. Multiple solutions when more than one sign change in cash flows over
project life.

Better answers would use a diagram to illustrate each of the above limitations.

88

5(d) Critically assess the usefulness of the internal rate of return criterion
for investment appraisal. (6 marks) 2017-5d-ZB

5(d) The internal rate of return (IRR) is the rate at which the present values of
the cash in-flows associated with a project equal the cash investment. The
calculated IRR of a project is compared to a hurdle rate { where IRR > hurdle
rate the project is accepted. Where the hurdle rate is equal to the firm's cost
of capital then NPV and IRR should give the same decision. However, there
are exceptions to this and some other problems with the IRR method.
• Reinvestment rate implicit in the IRR method is not compatible with well-
functioning capital markets.
• When choosing between mutually exclusive projects (i.e. the projects have
to be ranked) the IRR method may not always give the same decision as
NPV. IRR may give no solution or multiple solutions.

T7a-pg41

89
Topic 7a -Capital Budgeting and Valuation

Part A: Capital Budgeting

1) Net Present Value
2) Internal Rate of Return

3)Payback Period Method

90

90

(3) Payback [year] Key concept

Payback < ________________ period Yr CF DF[10%] PV
2 < 3 years  accept 0 -150 1 -150
1 100 0.9090 90.90
2 > 1.5 year  reject 2 50/ 100 0.8260 60 /82.6
3 100
Advantages ** Discounted
Payback
√ _______ to understand & calculate 1 + 50/100 Payback
√ Useful [year] [screening device] = 1.5 yr 1 + 60/82
= 1.73 yr
√ Consider _________ ≈2 yr
≈2 yr

Disadvantages
X Ignores the time value of money Yr CF
0 -500
X Subjective cutoff period
1 150
X Ignores the cash flows after the payback 2 150
3 150
4 50/150 = 0.33
5 -300
6 150
T7a-pg42

91
Topic 7a -Capital Budgeting and Valuation

Payback Period Method

• The payback period method evaluates real assets based on the
number of years needed to recover the initial capital investment for the
project.
• The firm decides a fixed payback period, for example 2 years.
• The project is accepted if it generates enough cash flows in the first 2 years
to repay the initial investment. Payback < cutoff period  accept

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Example: Payback Period Method

Consider the following projects F and G:
Project C0 C1 C2 C3
F -2200 600 500 2000
G -2200 350 2100 0

The payback period is 3 years for project F, and 2 years for project G.
If the payback period criteria is 2 years, project G would be accepted
(positive cash flows of $2,450 higher than the initial investment of $2,200) whereas
project F would be rejected
(positive cash flows of $1,100 lower than the initial capital investment of $2,200).
Cost of capital is 9%,
the NPV of project F is +$314, while the NPV of project G is -$111. Accept project F.
The payback period supports an investment decision opposite to the NPV method.

93 T7a-pg43

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Topic 7a -Capital Budgeting and Valuation

Example: Payback Period Method

Consider the following projects F and G: Project C0 C1 C2 C3
Cost of capital is 9%,
F -2200 600 500 2000
G -2200 350 2100 0
F PV (9%) G PV (9%)
0 -2200 -2200 -2200 -2200
1 600 550.459 350 321.101
2 500 420.839 2100 1767.527
3 2000 1544.367 0
2+900/2000= 2.4 yr NPV= $315.66 Accept F 1+1850/2100 = 1.88 yrs Accept G NPV =-$111.37
The payback period is 3 years for project F, and 2 years for project G.
If the payback period criteria is 2 years, project G would be accepted
(positive cash flows of $2,450 higher than the initial investment of $2,200) whereas
project F would be rejected
(positive cash flows of $1,100 lower than the initial capital investment of $2,200).
Cost of capital is 9%,
the NPV of project F is +$314, while the NPV of project G is -$111. Accept project F.
The payback period supports an investment decision opposite to the NPV method.
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94

Example: Payback Period Method

Consider the following projects F and G: Project C0 C1 C2 C3
F -2200 600 500 2000
G -2200 350 2100 0
F PV (9%) G PV (9%)

0 -2200 -2200 -2200 -2200

1 600 550.459 350 321.101
2 500 420.839 2100 1767.527
3 2000 1544.367 0
2+900/2000= 2.4 yr NPV= $315.66 Accept F 1+1850/2100 = 1.88 yrs Accept G NPV =-$111.37

The payback period is 3 years for project F, and 2 years for project G.
If the payback period criteria is 2 years, project G would be accepted
(positive cash flows of $2,450 higher than the initial investment of $2,200) whereas
project F would be rejected
(positive cash flows of $1,100 lower than the initial capital investment of $2,200).
Cost of capital is 9%,
the NPV of project F is +$314, while the NPV of project G is -$111. Accept project F.
95 T7a-pg44
The payback period supports an investment decision opposite to the NPV method.
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Topic 7a -Capital Budgeting and Valuation

Activity 7.5- Payback Period Method

Consider the three projects I, L, M:
If Cutoff = 3 yrs
Project C0 C1 C2 C3 C4
Payback
I -1500 300 550 600 400
L -300 100 200 200 -100
M -6200 2000 3000 2000 5500

1. Calculate the payback period of each project.

2. Which project does the firm accept if the cut-off period is 3 years?

3. If the firm invests in projects with the shortest payback period,

which project would it invest in?
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Activity 7.5- Payback Period Method

Consider the three projects I, L, M:
If Cutoff = 3 yrs
Project C0 C1 C2 C3 C4
Payback
I -1500 300 550 600 400 3+ 50/400 =3.125 yr 4 yr
L -300 100 200 200 -100 (No) (No 2 yr (accept)
M -6200 2000 3000 2000 5500 2+1200/2000 = 2.6 yr  3 yr
1. Calculate the payback period of each project. (accept)
See above
2. Which project does the firm accept if the cut-off period is 3 years?
L&M

3. If the firm invests in projects with the shortest payback period,

which project would it invest in?
L

97 T7a-pg45

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Topic 7a -Capital Budgeting and Valuation

Payback Period Method

Disadvantages of payback 20105d

x 1) It ignores the cash flows after the cut-off date.

A project may fail to meet the criteria of the cut-off period
but generates large cash flow after the cut-off period.
x 2) It ignores the time value of money.
Example:
Consider the same project G of the previous example and project H,
Project
with the sameC0 cashC1flows, butC2 Paybackdates. NPV (9%)
C3 occurrence
with reversed
G -2200 +350 +2100 0 2 yrs (√) -$111 (X )
H -2200 +2100 +350 0 2 yrs (√) +21 (√)

The payback rules suggests that both projects G and H should be accepted.
However, the NPV of project H (+ $21) is positive, while
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the NPV of project G (-$111) is negative !!! Reject it !
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Payback Period Method

• Drawback could be avoided by using a discounted payback period which
take into account the time value of money by discounting the cash flows
generated during the payback period.
• However, it does not avoid the first limitation of the payback period
method.
• Overall, the payback period is a particularly simple ad hoc method, with
theoretical limits much stronger than the ones of the IRR method
Example –Discounted payback
Year Cash Flow Discounted CF (14%)
0 -500 -500.00
1 250 219.30 1 year
2 250 192.37 2 years
3 250 168.74 years
Discounted Payback = 2.52 years 99 T7a-pg46

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Topic 7a -Capital Budgeting and Valuation

Topic 7a-NPV, IRR, payback Exam focus

a) Calculation
b) Critically discuss [Adv + disadv]
Features
NPV IRR Payback
Opportunity cost of Re-investment assumption Adv +
capital Adv + disadv [4 limiations] + disadv
Max. s/h wealth graph
Additivity property

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Concept Check Activity

Payback Period Method
Payback evaluates real assets based on the number of _____ needed to
recover the initial capital investment for the project.
Advantages S_________, easy to understand
Disadvantages 1) It ignores the c________ f__________ after the cut-off date.
2) It ignores the t__________ v_________ of m______________.
evaluates real assets based on the number of years needed to
____________ recover the initial capital investment for the project.
take into account the time value of money
Payback
by discounting the cash flows generated during the payback period.

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Topic 7a -Capital Budgeting and Valuation

Exam Focus
PYQ-QA7- Capital Budgeting + Stock & Bond Valuation
23 Explain the payback method of investment appraisal and discuss its2010-5d-ZB
advantages and disadvantages. (5 marks)
24 Explain the payback method of investment appraisal and discuss its2013-6f-ZB
limitations.(4 marks)
25 Explain the payback method of investment appraisal and discuss2017-5d-ZA
its advantages and disadvantages. (5 marks)
26 5(e) Discuss the advantages and disadvantages of the payback rule of2018-Q5e-
investment appraisal. (4m) ZAB
27 (e) Discuss the advantages and disadvantages of the payback2019-7e-ZAB
rule of investment appraisal. (4 marks)

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5(d) Explain the payback method of investment appraisal and discuss its
advantages and disadvantages. (5 marks) Review Ex7 pg7 20105d
(d) refer to pp.129–30 of the subject guide.
• The payback method identifies how quickly project cashflows pay
back the initial investment.

The main disadvantages are:

a) does not take into account the time value of money
b) ignores cashflows after the payback point

The main advantages are:

a) simple to calculate & understand
b) useful if firm capital constrained
c) focuses on near cashflows, hence accounts for risk in a simple way.
T7a-pg48

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Topic 7a -Capital Budgeting and Valuation

5(e) Compare and contrast the three investment appraisal methods used in
parts (a), (c) and (d). (8 marks) 2016-5e-ZA

• See subject guide, Chapter 7, sections headed `NPV and the valuation of
real assets‘, `Internal rate of return' and `Payback period method'.
• NPV and IRR are discounting methods therefore the time value of money is
taken into account. Payback is not a discounting method.
• NPV shows the scale of the return.
• IRR shows the return on the initial amount invested but with reinvestment
of cash flows at the project's IRR.
• IRR has some practical problems, for example may have multiple or no IRR.
• Payback is simple to use and takes into account risk (by only considering
near-term cash flows). However, it ignores cash flows after the payback
point.

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Revision Exercise
Topic 7- Capital Budgeting + Stock and Bond Valuation
• Compare and contrast the 3 investment appraisal methods. [=definition,
adv, disadvantages] (8 marks)
NPV
1. What type of cash flows have to be discounted in the NPV method?
Explain why.(5 marks)
2. Explain what is meant by the ‘opportunity cost of capital’ in the context of
the NPV method. (4,4,,5m)
[or +Examine the factors that a firm might consider in determining the
discount rate to use in the NPV calculation. (4 marks)
3. Explain why the NPV decision rule is consistent with the objective of the
firm to maximise shareholder wealth. (3,3,4,4m)
4. Explain the additivity property of the NPV method and explain why this
property makes the NPV method useful for investment106 appraisal when T7a-pg49
funds are limited. (3, 4,5,5,7 marks)
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Topic 7a -Capital Budgeting and Valuation

IRR
5. [Critically] assess the usefulness and limitations [+2 graphs]
of the IRR criterion for investment appraisal. (5,6,6m)
6. Discuss the reinvestment assumptions of the NPV & IRR
methods [5,5 marks]
Payback
7. Explain the payback method of investment appraisal and
discuss its advantages and disadvantages. (4,5,5 marks)

107

Bond valuation
8. Explain the relationship between the price, coupon and yield to maturity of a
bond. (6 marks)
• [=Explain the yield to maturity of a bond and explain why it is inversely related
to the price of the bond. (6 marks)]
Stock Valuation
9. Discuss the problems of valuing common stocks, preferred stocks &
corporate bonds. (7,7,7 marks)
• [=Discuss the issues with estimating future cash flows for a stock,
government bond and corporate bond. (6 marks)]
10.Formally derive and discuss the dividend discount model used for the
valuation of common stocks.
• [=Why are capital gains and losses apparently absent from the dividend
discount model used for the valuation of common stocks? (8,9,9,9,9,9 marks)
11.Explain the Gordon growth model as a technique for the valuation of common
stocks and its assumptions and limitations. [/Discuss what kind of stocks this
model is more appropriate/ not appropriate for valuing]. (4, 4,6 marks)
12.Describe the zero growth model. (4 marks) T7a-pg50

108
Topic 7a -Capital Budgeting and Valuation

Summary for Topic 7

• This topic focuses on the various approaches in valuing real assets and
financial assets.
• Capital budgeting is the process to choose among alternative investments in
real assets based on different appraisal methods.
• The NPV method allows companies to choose real assets that maximise the
wealth of shareholders. IRR, on the other hand, is regarded as sub-optimal.
• Financial assets are issued by borrowers (spenders) in financial markets to
raise funds from lenders (savers).
• The money raise is used by companies to buy real assets. The same
concept applies in which future cash flows is discounted to their PVs.
• Investment decisions are also used to value securities for financial assets
such as the price of bonds and common stocks.
• The degree of uncertainty about their future cash flows and the relevant
discount rates used determine the accuracy of their PVs.

109

Sample examination questions

T7a-pg51

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Topic 7a -Capital Budgeting and Valuation

Sample examination questions

111

Sample examination questions

3. At the end of January 2005, the interest rate on US government bonds

maturing in 2008 is about 2%. Value a bond with a 4% coupon maturing in
January 2008.
a. Assume annual coupon payments and annual compounding.
b. Assume semi-annual coupons and a semi-annual discount rate of 1%.
c. Describe the techniques used to value financial assets. Compare and contrast
the methods used in the pricing of bonds and common stocks.

T7a-pg52

112
Topic 7a -Capital Budgeting and Valuation

Sample examination questions

4. Consider the following three stocks:
– Stock A is expected to pay a dividend of $5,000 next year. Thereafter the
dividend growth is expected to be a constant annual rate of 6 per cent
forever.
– Stock B is expected to pay a dividend of $5,000 next year. Thereafter the
dividend growth is expected to be a constant annual rate of 20 per cent
for 6 years (and zero thereafter).
– Stock C is expected to pay a dividend of $1,200 forever.
a. Assuming that the required rate of return on similar equities is 11 per cent,
calculate the price of the three stocks. Which one is more valuable?
b. Derive the dividend discount model for valuing stocks and discuss the
assumptions that can be made to make the model practical.
c. Why are capital gains apparently absent from the dividend discount model?

113

References
• M. Buckle (2011) Principle of Banking and Finance Subject Guide, Chapter 7.

Essential reading
• Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.: MIT
Press, 2001) Chapter 3.
• Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapters 1, 2 and 10.
Further reading
• Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance.
(Boston, London: McGraw-Hill/Irwin, 2010) Chapter 14.
• Buckle, M. and J. Thompson The UK Financial System. (Manchester:
Manchester University Press, 2004) Chapter 1.
• Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.: The
MIT Press, 2008) Chapter 2.
• Saunders, A. and M.M. Cornett Financial Institutions Management: a Risk
Management Approach. (New York, McGraw-Hill/Irwin, 2007) Chapters 2,3, 4, T7a-pg53
5 and 6.
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