Chapter 7: Capital Budgeting

MCQ

MIRR is generally between the financing rate and IRR for normal projects. (False)
Definition
Capital Budgeting is the process of making long-term investment decisions that maximizes the
wealth of the shareholders.
Initial Assumptions

 Projects belong to the same risk class

 Project discount rate remains unchanged throughout project life
 Project lives are identical
 Project sizes are roughly identical
 Project decisions are not affected by the project financing decisions. All projects are
financed according to the company’s target capital structure.

To make value enhancing long-term investment decisions in accordance with the company’s
growth-maximization goal, we need to do three things:
1. Estimate project cash flows: The cash flow of a project in a particular year is the excess
of cash flows with the project over the cash flows without the project, otherwise known
as the incremental cash flows.
2. Estimate the cost of capital: Using the company’s WACC implies that all capital applied to
a project is done at the ratios which match the company’s target capital structure.
3. Apply a decision rule to determine if the project will indeed create value for the
company and its shareholders.

Decision Criteria/Criteria for evaluating capital budgeting projects

 Payback period and discounted payback period:

The payback period is the amount of time it will take to recover the initial
investment. The decision rule for payback period is simply that the shorter the
payback period, the better it is. The payback period does not give a final and clear-
cut answer whether a project will be considered or not. It only says that if the
payback period meets the company established requirement, then only it will be
analyzed further. Therefore, it can be seen as a filtering or screening tool. This is used
to weed out projects with long payback periods, which presumably are riskier.
 Payback Formula:
Payback period = Year with last negative cumulative cash flow+ (Last Negative
Cumulative Cash Flow(Absolute value)/Cash flow in the Payback year
Drawbacks of the Payback Period
1. It does not consider the time value of money.
2. It does not consider the difference in the riskiness of the cash flows
3. It ignores the cash flows after the payback year. These cash flows are
probably safer, and hence, more valuable.

 Net present value (NPV)

NPV is the excess of the present value of project of project inflows over the present
value of project outflows. In an equation form:
NPV=PV of cash inflows-PV of cash outflows
Most projects will have just the initial outflow, CF0 or IO, for initial investment. The
equation reduces to the following in that case:
NPV=PV of cash inflows-IO
NPV=∑ CFt / (1+r) ᵗ-IO
Thus, to compute the NPV, we need a discount rate, and we will use the cost of
capital figure as the discount rate.
Decision
If the NPV is positive, it creates wealth equivalent to the NPV. If the NPV is negative,
the project destroys value or wealth and should be rejected.

NPV Profile
The NPV profile of the project is a chart that depicts the NPV of the project at a wide range
of discount rates. In the process, it provides us with some very useful additional
information.
For a normal project, the NPV profile slopes downwards to the right with a slight curve. This
expectation is not applicable when the project is not normal.
Cross-over Rate
The NPV profile becomes more informative when you have two mutually exclusive projects
and you draw their NPV profile in the same chart. These are the steps to determine the
crossover rate when two mutually exclusive projects are normal.
 Compute the differences between the cash flows
 Determine the IRR of the differences in cash flows. This is the cross-over rate.
 Internal rate of return (IRR)

IRR is the rate that equates the initial investment, CF0 or IO, with the present values
of future cash flows. In other words, at a discount rate equal to IRR, CF0 is equal to
the PV of future CF, or more simply, the Net present value is zero.

IRR=∑ [-CFt / (1+i) ᵗ] =∑ [CFt / (1+i) ᵗ]

On the left side of the equation, all the negative cash flows are discounted for the
appropriate time and on the right side, only the positive flows are discounted. IRR is
the i that makes both sides of the equation equal.

Decision
The decision rule for IRR is that a project that has an IRR exceeding the cost of
capital, it is generating a return higher than the minimum required by investors and
creates wealth for them and should be funded. If you were to rank the projects, the
project with the higher IRR (provided it exceeds the cost of capital) is ranked higher.

IRR Facts
 Normal projects have a unique IRR, Non Normal projects may have no IRR or
multiple IRRs.
 Small projects tend to have high IRRs even though they are not very valuable.
 When we have multiple IRRs, it is difficult to tell which one we should use as the
right measure of annual return.
 IRR computation assumes that all interim flows will also earn IRR.

 Modified Internal rate of return (MIRR)

MIRR avoids the problem of multiple IRR by defining the IRR (that is MIRR) as the rate
that makes the present value of inflows equal to the present value of all outflows by
assuming a reinvested rate equal to the company’s cost of capital. MIRR will always be
somewhere between the IRR and reinvested rate.
  Profitability Index (PI)
The profitability index is the ratio of the total present value of future inflows to the initial
investment, that is,
PI= PV (inflows)/IO
When the project has just one outflow in the initial year, the computation process may
be simplified as follows:
PI= (NPV+IO)/IO

Mutually Exclusive Projects

In mutually exclusive situation, we will pick only one of the two or more alternatives, the
best one according to the set decision rules, if we find them desirable. Therefore, once a
selection is made, all the others are automatically rejected.
Independent Project
When the projects are independent, we evaluate each project without comparing with any
other project, and therefore, decision made on a project does not affect another project.
Normal Project Vs Non-Normal project
A normal project will have outflows in the early life of the project and will have inflows after
that. The sign of the flows, from negative to positive happens exactly once. If this condition
is not satisfied, the project is categorized as a non-normal project.
Replacement project
Replacement projects are generally less risky as we are already familiar with the production
process, supply chain issues, and marketing process.
New project
If it is a brand-new project, it may entail uncertainties from various sources. The process of
estimating cash flows will be different in these two types of projects.
 Chapter 8: Estimating Cashflows
Some critical concepts:
 Sunk Cost: Anything that has occurred in the past is referred to as a sunk cost
and should be excluded from relevant cash flows. Only cash flows that arise
because of the decision being made should be included. It is usually added to
the initial outlay or the initial investment.
 Salvage value: Salvage value is the estimated value of an asset at the end of
its useful life. It represents the amount that a company could sell the asset
for after it has been fully depreciated. In a replacement project, the format
used assumes the equipment that is replaced to have a salvage value.
 Opportunity cost: Opportunity costs are the revenues that are lost (or
additional costs that arise) from moving existing resources from their current
use and are therefore considered to be incremental cash flows arising in the
future to be taken into account. The opportunity costs generated by a project
should always be included in the incremental cash flow for that project. The
most valuable opportunity forgone due to the decision to undertake a project
is the lost opportunity. Often these are difficult to measure and sometimes
difficult to recognize.
 Incremental Cash flow: Incremental cash flow is the potential increase or
decrease in a company's cash flow related to the acceptance of a new project
or investment in a new asset. Positive incremental cash flow is a good sign
that the investment is more profitable to the company than the expenses it
will incur.
The formula for incremental cash flow is: Incremental Cash Flow = Revenues
– Expenses – Initial Cost.
To ascertain a project's incremental cash flows, one has to look at what
happens to the cash flows of the firm with the project and without the
project. The difference between the two reflects the incremental cash flows
attributable to the project.
 Investment Tax Credit: