The Basics of Capital

Budgeting
 What is Capital Budgeting?
• The process of planning and evaluating
expenditures on assets whose cash flows are
expected to extend beyond one year
– Analysis of potential additions to fixed assets
– Long-term decisions which involve large
expenditures
– Analysis of replacement of existing equipment
or processes
– Very important to firm’s future
 Generating Ideas for Capital Projects

• A firm’s growth and its ability to remain

competitive depend on a constant flow of
ideas for new products, ways to make existing
products better, and ways to produce output
at a lower cost.
• Procedures must be established for evaluating
the worth of such projects.
 Project Classifications

• Replacement Decisions: whether to purchase

capital assets to take the place of existing
assets to maintain or improve existing
operations
• Expansion Decisions: whether to purchase
capital projects and add them to existing
assets to increase existing operations (grow
the firm)
 Project Classifications

• Independent Projects: Projects whose cash

flows are not affected by decisions made
about other projects
• Mutually Exclusive Projects: A set of projects
where the acceptance of one project means
the others cannot be accepted
 Normal and non-normal cash flow
streams
• Conventional cash flow stream – Cost
(negative CF) followed by a series of positive
cash inflows. One change of signs.
• Unconventional cash flow stream – Two or
more changes of signs. Most common: Cost
(negative CF), then string of positive CFs, then
cost to close project. Nuclear power plant,
strip mine, etc.
 Steps to capital budgeting

1. Estimate the cash flows expected from the

project.
2. Evaluate the riskiness of cash flows.
3. Determine the appropriate cost of capital
4. Compute the present value of the expected
cash flows to obtain as estimate of the asset’s
value to the firm.
5. Compare the present value of the future
expected cash flows with the initial investment.
 Capital Budgeting Criteria

1. Regular Payback Period

2. Discounted Payback Period
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)
5. Modified Internal Rate of Return (MIRR)
 Regular Payback Period

• The length of time it takes to recover the

original cost of an investment from its
expected cash flows
• Payback period =
 Payback-Decision Rule

• The firm sets a minimum acceptable payback

period (the choice is purely arbitrary, e.g. 2 or
3 years etc.)
• Decision rule: Will Accept the project if
payback period is within the minimum
acceptable payback, and reject if otherwise
 Calculating Regular payback

0 1 2 3
Project L
CFt -100 10 60 80

0 1 2 3
Project S
CFt -100 70 50 20
 Calculating Regular payback

0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

 Payback-Decision

• If the firm chooses 2 years as a minimum

acceptable payback for project L and S,
then;
• Project S will be accepted because its
payback(1.6 years) is less than 2 years
minimum acceptable payback ,and L
rejected.
 Strengths and weaknesses of
payback
• Strengths
– Provides an indication of a project’s risk and
liquidity.
• Weaknesses
– Ignores the time value of money.
– Ignores CFs occurring after the payback period.
– Requires an arbitrary cutoff point
– Biased against long-term projects, such as
research and development, and new projects
 Discounted payback period

• The length of time it takes for a project’s

discounted (PV of) cash flows to repay the cost of
the investment
• Compute the present value of each cash flow and
then determine how long it takes to payback on a
discounted basis
• Decision Rule – A project is acceptable if
Discounted payback period < Project’s useful life.
 Discounted payback period

• A project’s Discounted payback period is less

than the project’s useful life, when the present
value of future cash flows of the project exceed
initial cost of project.
• Discount payback period calculation uses
discounted cash flows rather than raw CFs
 Discounted payback period

.
0 10% 1 2 2.7 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79

Disc PaybackL == 2 + 41.32 / 60.11 = 2.7 years

 Discounted payback period

0 1 2 3
Project S
CFt -100 70 50 20

• Calculate the discounted payback period

for project S assuming a required rate of
return of 10%.
 Discounted payback period

.
0 10% 1 1.88 2 3

CFt -100 70 50 20
PV of CFt -100 63.64 41.32 15.03
Cumulative -100 -36.36 4.96 19.09

Disc PaybackS == 1 + 36.36 / 41.32 = 1.88 years

 Advantages and Disadvantages of
Discounted Payback period
• Advantages
– Includes time value of money
– Biased towards liquidity
• Disadvantages
– Biased against long-term projects, such as R&D
and new products
 Net Present Value

• The difference between the market value of a project

and its cost
• How much value is created from undertaking an
investment?
– The first step is to estimate the expected future cash flows.
– The second step is to estimate the required return for projects
of this risk level.
– The third step is to find the present value of the cash flows and
subtract the initial investment.
• Best decision criteria-tells how much value each project
contribute to shareholders wealth
 NPV – Decision Rule

• If the NPV is positive, accept the project

• A positive NPV means that the project is expected
to add value to the firm and will therefore
increase the wealth of the owners.
• Since our goal is to increase owner wealth, NPV is
a direct measure of how well this project will
meet our goal
 Calculating Net Present Value
(NPV)
• Sum of the PVs of all cash inflows and
outflows of a project:

NPV = CF0 + CF1 + CF2 +….+ CFN

1 2 n
(1 + k) (1 + k) (1 + k)
n
CFt
NPV   t
t 0 ( 1  k )
 Calculating Net Present Value
(NPV)
Using the formula:
• What is NPV for project L?
• NPV=PV of inflows-Cost
• NPVL= 10/(1,10)1+ 60/(1,10)2+ 80/(1,10)3– 100
= $18.79
• Project L has positive NPV, therefore it is
accepted if independent of other projects.
 Calculating Net Present Value
(NPV)
Using financial tables
• What is Project L’s NPV? i=10%
Year CFt PVIF(i,n) PV of CFt
0 -100 1 -$100
1 10 0.909 1 9.09
2 60 0.8264 49.59
3 80 0.7513 60.11
NPVL = $18.79
 Calculating Net Present Value
(NPV)

0 1 2 3
Project S
CFt -100 70 50 20

• Calculate the Net Present Value for project

S assuming a required rate of return of 10%.
 Calculating Net Present Value
(NPV)
Using the formula:
• NPV=PV of inflows-Cost
• NPVS= 70/(1,10)1+ 50/(1,10)2+ 20/(1,10)3– 100
= $19.99
• Project S has positive NPV, therefore it is
accepted if independent of other projects.
 Calculating Net Present Value
(NPV)
Using financial tables

Year CFt PVIF(i,n) PV of CFt

0 -100 1 -$100
1 70 0.909 1 63.64
2 50 0.8264 41.32
3 20 0.7513 15.03
NPVS = $19.99
 NPV – Decision Rule

NPV= PV of inflows – Cost = Net gain/loss in wealth

• If projects are independent, accept if the project
NPV > 0.
• If projects are mutually exclusive, accept projects
with the highest positive NPV, those that add the
most value.
• In this example, would accept S if mutually
exclusive (NPVs > NPVL), and would accept both if
independent.
 Internal Rate of Return (IRR)

• This is the most important alternative to NPV

• It is often used in practice and is intuitively
appealing
• Definition: IRR is the return that makes the
NPV = 0
• Decision Rule: Accept the project if the IRR is
greater than the required return
 Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:
n
CFt
0 t
t 0 ( 1  IRR )

Solving for IRR

•Trial and Error Method
•Linear interpolation method
• Use of financial calculator
 Trial and Error Method: IRR

• It is easy to calculate the IRR for a single

investment period. However if its more than
one period it requires a different approach.
• Suppose there is an investment opportunity
with the following cash flows;
– Project cost P100 and net cash flows of P10
year 1, P60 year 2 and P80 year 3 .
– What is the IRR of the investment
opportunity?
 Trial and Error Method: IRR

NPV = 0
100  10 /(1  IRR)  60 /(1  IRR)  80 /(1  IRR)
2 3

The only way to find the IRR is through trial and

error.
If we try a rate of 0 our NPV is P50

NPV  10 /(1  0)  60 /(1  0)  80 /(1  0)  100  P50

2 3

33
 Trial and Error Method: IRR

If we try a rate of 10% our NPV is P18.78

NPV  10 /(1.1)  60 /(1.1) 2  80 /(1.1) 3  100  P18.78

We can try a number of rates and then have a

table as shown below.

NPV 50.00 33.05 18.78 6.67 0.26 (1.75) (12.64)

Disc Rate 0% 5% 10% 15% 18% 19% 25%

34
 Trial and Error Method: IRR

• From the calculations the discount rate is between

18% and 19%.
• The IRR could be found by plotting the curve of the
NPV and discount rate on a graph using the points
on the table.
• The y-axis will be the NPV and x-axis discount rate.
• The IRR will be at the point where curve crosses the
x-axis when the NPV is equal to zero.
• The IRR is 18.13%
35
 Trial and Error Method: IRR
NPV Profile
60.00

50.00

40.00

30.00
NPV

20.00

10.00

-
0% 5% 10% 15% 18% 19% 25%
(10.00)

(20.00) Discount Rate

 Linear Interpolation Method: IRR

• The steps in linear interpolation are:

• Calculate two NPVs for the project at two
different discount rates resulting positive and
negative NPVs.
• NPVs should be closer to zero.
Formula
NL
IRR  L  x ( H  L)
NL  NH

37
 Linear Interpolation Method: IRR

Where:
L = Lower discount rate
H = Higher discount rate
NL = NPV at lower discount rate
NH= NPV at higher discount rate

38
 Linear Interpolation Method: IRR

Answer for the previous example using linear

interpolation formula
0.26
IRR  0.18  x(0.19  0.18)
0.26  (1.75)
IRR  0.1813

= 18.13%

39
 Linear Interpolation Method: IRR

0 1 2 3
Project S
CFt -100 70 50 20

• Calculate the IRR for project S using the

linear interpolation method.
 Linear Interpolation Method: IRR

Project S: IRR
If we try a rate of 10% our NPV is P19.99
NPV  70 /(1.1)  50 /(1.1) 2  20 /(1.1) 3  100  P19.99
We can try a number of rates and then have a table
as shown below.

NPV 40.00 19.99 11.83 4.63 0.71 (0.54) (1.76)

Disc Rate 0% 10% 15% 20% 23% 24% 25%

41
 Linear Interpolation Method: IRR

Project S: IRR

0.71
IRR  0.23  x(0.24  0.23)
0.71  (0.54)
IRR  0.2356
= 23.56%

42
 IRR Acceptance Criteria
• If IRR > Weighted Average Cost of Capital (WACC),
the project’s rate of return is greater than its costs.
There is some return left over to boost
stockholders’ returns.
• If IRR > k, accept project & If IRR < k, reject project.
• IRRL = 18.13% and IRRS=23.56%
• If projects are independent, accept both projects,
as both IRR > k = 10%.
• If projects are mutually exclusive, accept S, because
IRRs > IRRL.
43
 NPV Profiles
• Project NPVs at various different costs of capital.

k NPVL NPVS
0% $50 $40
5% 33 29
10% 19 20
15% 7 12
20% (4) 5

44
 Drawing NPV profiles

NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

10 .. S IRRS = 23.6%
L . .
0 . Discount Rate (%)
5 10 15 20 23.6
-10
45
 Comparing the NPV and IRR methods

• If projects are independent, the two

methods always lead to the same
accept/reject decisions.
• If projects are mutually exclusive …
– If k > crossover point, the two methods
lead to the same decision and there is no
conflict.
– If k < crossover point, the two methods
lead to different accept/reject decisions.
46
 Reasons why NPV profiles cross

• Size (scale) differences – the smaller project

frees up funds at t = 0 for investment. The
higher the opportunity cost, the more valuable
these funds, so high k favors small projects.
• Timing differences – the project with faster
payback provides more CF in early years for
reinvestment. If k is high, early CF especially
good, NPVS > NPVL.

47
 Reinvestment rate assumptions

• NPV method assumes CFs are reinvested at k,

the opportunity cost of capital.
• IRR method assumes CFs are reinvested at IRR.
• Assuming CFs are reinvested at the
opportunity cost of capital is more realistic, so
NPV method is the best. NPV method should
be used to choose between mutually exclusive
projects.
• Perhaps a hybrid of the IRR that assumes cost
of capital reinvestment is needed.

48
 Since managers prefer the IRR to the NPV
method, is there a better IRR measure?
• Yes, MIRR is the discount rate that causes the
PV of a project’s terminal value (TV) to equal
the PV of costs. TV is found by compounding
inflows at Weighted Average Cost of Capital
(WACC) i.e. sum of FV of inflows.
• MIRR assumes cash flows are reinvested at the
WACC.

49
 Calculating MIRR

TV inflows
• PV cash outflows
= (1 + MIRR)n

• TV inflows =

t n
COFt
• PV outflows = 
t  0 (1  k )
t

50
 Calculating MIRR

0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% 12.1
MIRR = 16.5%
158.1
-100.0 $158.1 TV inflows
$100 =
(1 + MIRRL)3
PV outflows
MIRRL = 16.5%

51
 Why use MIRR versus IRR?

• MIRR correctly assumes reinvestment at

opportunity cost = WACC. MIRR also avoids
the problem of multiple IRRs.
• Managers like rate of return comparisons, and
MIRR is better for this than IRR.

52
 Find Project P’s NPV and IRR.

0 1 2
k = 10%

-800 5,000 -5,000

• Enter CFs into calculator CFLO register.

• Enter I/YR = 10.
• NPV = -$386.78.
• IRR = ERROR Why?
53
 Multiple IRRs

NPV NPV Profile

IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
54
 Why are there multiple IRRs?

• At very low discount rates, the PV of CF2 is large &

negative, so NPV < 0.
• At very high discount rates, the PV of both CF1 and
CF2 are low, so CF0 dominates and again NPV < 0.
• In between, the discount rate hits CF2 harder than
CF1, so NPV > 0.
• Result: 2 IRRs.

55
 When to use the MIRR instead of the IRR?
Accept Project P?

• When there are unconventional cash flows

and more than one IRR, use MIRR.
– PV of outflows @ 10% = -$4,932.2314.
– TV of inflows @ 10% = $5,500.
– MIRR = 5.6%.
• Do not accept Project P.
– NPV = -$386.78 < 0.
– MIRR = 5.6% < k = 10%.

56
 EXERCISE

A proposed overseas expansion has the following

cash flows for years 0 to 4 respectively;-P34,000,
16,500, 14,000, 10,000, and 6,000. The policy
regarding the use of payback method for the
company is to reject all projects whose payback is
more than 3 years.
i. Calculate the payback, discounted payback, and
NPV at a required rate of 10%.
ii. Indicate if the project would be undertaken under
each of the above capital budgeting criteria.
57
 EXERCISE
XYZ Ltd intends investing in a new machine. The
following details relating to the machine apply:
• Cost of machine P360 000
• Expected useful life 6 years
• Scrap value P60 000
• Method of depreciation Straight-line
• Cost of Capital 11%

58
 EXERCISE
• Year Profit
• 1 P6 000
• 2 P18 000
• 3 P100 000
• 4 P66 000
• 5 P112 000
Additional information
The company has a cut-off payback period policy of 4
years on all its new capital investment projects.
59
 EXERCISE
Required
i. Compute the annual cash flows for the new
machine.
ii. Calculate the regular payback period and
advise management whether or not the
project is acceptable
iii. Calculate the Net Present Value (NPV) of the
project. Should management accept the
project based on the NPV calculations?
60
 EXERCISE
• The Costa Rican Coffee Company is evaluating the within-
plant distribution system for its new roasting, grinding,
and packing plant.
• The two alternatives are (1) a conveyor system with a
high initial cost but low annual operating costs and (2)
several forklift trucks, which cost less but have
considerably higher operating costs.
• The decision to construct the plant has already been
made, and the choice here will have no effect on the
overall revenues of the project. The cost of capital for the
plant is 8 percent, and the projects’ expected net costs
are listed below: 61
 EXERCISE

EXPECTED NET CASH COSTS

YEAR CONVEYOR FORKLIFT
• 0 (P350,000) (P140,000)
• 1 (71,000) (88,000)
• 2 (71,000) (88,000)
• 3 (71,000) (88,000)
• 4 (71,000) (88,000)
• 5 (71,000) (88,000)
Required
What is the present value of costs of each alternative? Which
method should be chosen?
62