LECTURE 6:

Capital Budgeting Techniques

MSc. Ngo Nguyen Bao Tran
Learning P R O J E C T E VA L U AT I O N A N D S E L E C T I O N
• Payback Period
Outcomes •
•
Internal Rate of Return
Net Present Value
• Profitability Index

P O T E N T I A L D I F F I C U LT I E S
• Dependency and Mutual Exclusion
• Ranking Problems
• Multiple Internal Rates of Return
• Capital Rationing
• Single-Point Estimates

PROJECT MONITORING
• Progress Reviews
• Post-Completion Audits
PROJECT EVALUATION AND SELECTION

Payback Period (PBP):

The number of years required to recover our initial cash

investment based on the project’s expected cash flows.
PROJECT EVALUATION AND SELECTION

Payback Period (PBP) Example:

Payback Period (PBP) = 2 years + (100,000-73,962)/39,359

= 2.66 years
PROJECT EVALUATION AND SELECTION
Payback Period (PBP) Exercise:
Company C is planning to undertake a project requiring initial investment (Initial Cash
Outflow – ICO)of $50 million and is expected to generate $10 million net cash flow in Year
1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year
5. Calculate the payback period of the project.
Payback Period (PBP) = 3 years + (50,000-39,000)/19,000
= 3.58 years
YEAR CASHFLOW ACCUMULATED INFLOW
0 (50,000,000)
1 10,000,000 10,000,000
2 13,000,000 23,000,000
3 16,000,000 39,000,000
4 19,000,000 58,000,000
5 22,000,000 80,000,000
PROJECT EVALUATION AND SELECTION

Payback Period (PBP):

Acceptance Criterion:
• If the payback period calculated is less than some
maximum acceptable payback period, the proposal is
accepted;
• if not, it is rejected.
 Payback Period (PBP) – Problem 1:

Project A Project B
• Initial Cash Outflow: $10,000 • Initial Cash Outflow: $10,000

• Year 1: $5000 • Year 1: $5000

• Year 2: $5000 • Year 2: $5000

• Year 3: $0 • Year 3: $5000

• Year 4: $0 • Year 4: $5000

=> it fails to consider cash flows occurring after the expiration of the payback
period; consequently, it cannot be regarded as a measure of profitability
 Payback Period (PBP) – Problem 2:

Project A Project B
• Initial Cash Outflow: $10,000 • Initial Cash Outflow: $10,000

• Year 1: $7000 • Year 1: $3000

• Year 2: $3000 • Year 2: $7000

• Year 3: $0 • Year 3: $0

• Year 4: $0 • Year 4: $0

=> the method ignores the time value of money

 Payback Period (PBP) – Problem 3:

The maximum acceptable payback period,

which serves as the cutoff standard, is a purely
subjective choice
 Payback Period (PBP) – Problems

=> Using discounted cash flow methods to

capture differences in the timing of cash flows
for various projects through the discounting
process.
PROJECT EVALUATION AND SELECTION

Discounted cash flow :

• Any method of investment project evaluation and selection that
adjusts cash flows over time for the time value of money
• The three major discounted cash flow methods are:
 the internal rate of return (IRR),
 the net present value (NPV),
 the profitability index (PI)
PROJECT EVALUATION AND SELECTION

Internal Rate of Return (IRR):

The discount rate that equates the present value of the

expected net cash flows (CFs) with the initial cash outflow
(ICO).
PROJECT EVALUATION AND SELECTION

Internal Rate of Return (IRR) Example:

PROJECT EVALUATION AND SELECTION

Internal Rate of Return (IRR) Example:

Interpolation: Solving for the internal rate of return, IRR, sometimes

involves a trial-anderror procedure using present value tables.
PROJECT EVALUATION AND SELECTION

Internal Rate of Return (IRR) Example:

Interpolation: Solving for the internal rate of return, IRR, sometimes

involves a trial-anderror procedure using present value tables.
PROJECT EVALUATION AND SELECTION
Payback Period (PBP) Exercise:
Company C is planning to undertake a project requiring initial investment (Initial Cash
Outflow – ICO)of $50 million and is expected to generate $10 million net cash flow in Year
1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year
5. Calculate the IRR of the project.

YEAR CASHFLOW ACCUMULATED INFLOW

0 (50,000,000)
1 10,000,000 10,000,000
2 13,000,000 23,000,000
3 16,000,000 39,000,000
4 19,000,000 58,000,000
5 22,000,000 80,000,000
PROJECT EVALUATION AND SELECTION

Internal Rate of Return (IRR) for Annuity:

PROJECT EVALUATION AND SELECTION

Internal Rate of Return (IRR):

Acceptance Criterion:
• Hurdle rate: The minimum required rate of return on an
investment in a discounted cash flow analysis; the rate at
which a project is acceptable.
• IRR > Hurdle Rate => The Project is accepted
PROJECT EVALUATION AND SELECTION

Internal Rate of Return (IRR):

Acceptance Criterion:
• The required rate of return is the return investors expect the firm to earn on the
project
 a project with an internal rate of return in excess of the required rate of return
should result in an increase in the market price of the stock.
 the firm accepts a project with a return greater than that required to maintain
the present market price per share.

=> IRR > Hurdle Rate => The Project is accepted

PROJECT EVALUATION AND SELECTION

Net Present Value (NPV):

The present value of an investment project’s net cash flows

minus the project’s initial cash outflow.

where k is the required rate of return and all the other variables remain as previously defined
PROJECT EVALUATION AND SELECTION

Net Present Value (NPV) Example:

where k = 12%
PROJECT EVALUATION AND SELECTION

Net Present Value (NPV) Example:

PROJECT EVALUATION AND SELECTION
Net Present Value (NPV) Exercise:
Company C is planning to undertake a project requiring initial investment (Initial Cash
Outflow – ICO)of $50 million and is expected to generate $10 million net cash flow in Year
1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year
5. Calculate the NPV of the project with k=8%.

YEAR CASHFLOW ACCUMULATED INFLOW

0 (50,000,000)
1 10,000,000 10,000,000
2 13,000,000 23,000,000
3 16,000,000 39,000,000
4 19,000,000 58,000,000
5 22,000,000 80,000,000
PROJECT EVALUATION AND SELECTION

Net Present Value (NPV):

Acceptance Criterion:
• If an investment project’s net present value is zero or more,
the project is accepted;
• If not, it is rejected.
PROJECT EVALUATION AND SELECTION

Net Present Value (NPV):

NPV Profile: A graph showing the relationship between a

project’s net present value and the discount rate employed.
PROJECT EVALUATION AND SELECTION
Net Present Value (NPV):
NPV Profile:
• The discount rate at that point
represents the internal rate of
return: the project’s NPV = 0

• For discount rates greater than the

internal rate of return: the project’s
NPV < 0

=> If the required rate of return is less

than the internal rate of return, we
would accept the project using either
method
PROJECT EVALUATION AND SELECTION

Profitability Index (PI):

The ratio of the present value of a project’s future net cash

flows to the project’s initial cash outflow.

where k is the required rate of return and all the other variables remain as previously defined
PROJECT EVALUATION AND SELECTION

Profitability Index (PI):

PROJECT EVALUATION AND SELECTION
Profitability Index (PI) Exercise:
Company C is planning to undertake a project requiring initial investment (Initial Cash
Outflow – ICO)of $50 million and is expected to generate $10 million net cash flow in Year
1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year
5. Calculate the PI of the project with k=8%.

YEAR CASHFLOW ACCUMULATED INFLOW

0 (50,000,000)
1 10,000,000 10,000,000
2 13,000,000 23,000,000
3 16,000,000 39,000,000
4 19,000,000 58,000,000
5 22,000,000 80,000,000
PROJECT EVALUATION AND SELECTION

Profitability Index (PI):

Acceptance Criterion:
• As long as the profitability index is 1.00 or greater, the
investment proposal is acceptable.
• A profitability index greater than 1.00 implies that a project’s
present value is greater than its initial cash outflow which, in
turn, implies that net present value is greater than zero.)