7/11/2022

TOPIC 5
CAPITAL
BUDGETING
TECHNIQUES

Basic Terminology: Independent versus Mutually 3

Exclusive Projects
• Independent Projects
✓The acceptance of an investment does not preclude the acceptance of other
investments.
✓ Donot compete with the firm’s resources.
✓As long as the investments meet the relevant capital budgeting criterion, all
investments could be accepted.

• Mutually ExclusiveProjects
✓The acceptance of an investment would automatically lead to rejection of other
investments.
✓ Investments that compete in some way for a company’s resources. (capital
rationing restrictions)
✓ Only one investment could be undertaken at a particular time.

Basic Terminology: Accept-Reject versus Ranking 5

Approaches
• The accept-reject approach involves the evaluation of capital expenditure
proposals to determine whether they meet the firm’s minimum acceptance
criteria.
• The ranking approach involves the ranking of capital expenditures on the
basis of some predetermined measure, such as the rate of return.

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Basic Terminology: Conventional versus 6

Nonconventional Cash Flows

• Conventional cash flows are cash flows which contain one cash outflow in
the initial stage followed by a series of cash inflows. The sign only changes
once. (- + + + + + )

0 1 2 3 4 5

-10,000 3,300 3,300 3,300 3,300 3,300

Basic Terminology: Conventional versus 7

Nonconventional Cash Flows (cont.)

• Non-conventional cash flows are where the cash flows sign changes more
than once. (- + - + + +)
• Cash outflows followed by cash inflows & outflows

0 1 2 3 4 5

-10,000 3,000 -1,000 3,500 3,500 3,500

1 2 3

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Payback Period (PP)

• “How long does it take to get our money back?”
• The number of years required to recover a project’s cost (initial outlay).

(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8

Payback Period = Initial investment/annual cash flow

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Payback Period (cont.)

• Mixed stream cash flow – yearly cash flow is accumulated until the initial
investment is recovered
(45,000) 28K 12K 10K 10K 10K

0 1 2 3 4 5

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Payback Period (cont.)

• Is it acceptable?
Decision Rule:
Payback Period <Cut-off Accept
Payback Period >Cut-off Reject
• If our senior management had set a cut-off of 4 years for projects like ours,
what would be our decision?
• Accept both projects.

Mutually exclusive - choose the shortest

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Strengths & Weaknesses of Payback Period

• Strengths
• Provides an indication of a project’s risk and liquidity.
• Easy to calculate and understand.
• Weaknesses
• Ignores the time value of money.
• Ignores CFs occurring after the payback period.
• Does not consider any required rate of return.

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Discounted Payback Period (DPP)

• Discounts the cash flows at the firm’s required rate of return.
• Payback period is calculated using these discounted net cash flows.
• Focus on investment liquidity.
Problems:
• Cutoffs are still subjective.
• Still does not examine all cash flows.

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Discounted Payback Period (DPP) (cont.)

(500) 250 250 250 250 250
The Discounted
Payback
0 1 2 3 4 5 is ??? years
Discounted
Year Cash Flow CF(14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.37 2 years
88.33 88.33/168.74

3 250 168.74 .52 years

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Other Methods
1) Net Present Value (NPV)
2) Profitability Index (PI)
3) Internal Rate of Return (IRR)

Consider each of these decision-making criteria:

• All net cash flows.
• The time value of money.
• The required rate of return.

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Net Present Value (NPV)

• PV of the stream of future CFs from a project minus the project’s net
investment
• CFt –cash flow year t, n – life of the project (years), r – cost of capital, INV –
initial investment

n CFt
NPV =  − INV •Discount rate
•Required rate
t = 1 (1+ r) t of return
•Opportunity cost
(minimum return to
be earned)

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NPV Decision Rule

• NPV  0 accept, < 0 reject
• Mutually exclusive investments
• Select the project with the largest NPV with a positive value.
• Positive NPV shows increase in share price and shareholder wealth.

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Advantages and Disadvantages of the NPV 19

Method
• Advantages
• Consistent with shareholder wealthmaximization
• Consider both magnitude and timing of cash flows
• Indicates whether a proposed project will yield the investor’s required rate of return
• Disadvantage
• Many people find it difficult to work with a dollar return rather than a percentage
return
• Discount rate hard to determine & change over the life

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NPV Example – Even Cash Flow

• Suppose we are considering a capital investment that costs $250,000 and
provides annual net cash flows of $100,000 for five years. The firm’s
required rate of return is 15%.

(250,000) 100,000 100,000 100,000 100,000 100,000

0 1 2 3 4 5

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NPV Example – Uneven Cash Flow

• The firm’s required rate of return is 10%.

(550,000) 200,000 200,000 300,000 300,000 100,000

0 1 2 3 4 5

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Profitability Index (PI)

• Ratio of the PV of expected cash flows over the life of the project to the
INV
• Interpreted as present value return for each dollar of initial investment.

n
CF
 (1 + r ) t
t =1
PI =
INV

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Profitability Index (cont.)

n
Cash Flowt
PI=  ÷ INV
(1 + k)t
t =1

= PV of Cash Flow ÷ INV

Decision Rule:
PI ≥1 Accept
PI <1 Reject

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Profitability Index (cont.)

• FROM NPV EXAMPLE – EVEN CASHFLOW (i = 15%)

(250,000) 100,000 100,000 100,000 100,000 100,000

0 1 2 3 4 5

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Internal Rate of Return (IRR)

• Rate of discount that equates the PV of net cash flows of a project with the
PV of the INV
• Discount rate to obtain NPV of 0
• Present value of net cash flow equals to INV
n
CFt
 (1+ r )
t =1
t
= INV

• IRR: The return on the firm’s invested capital. IRR is simply the rate of return
that the firm earns on its capital budgeting projects.

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Internal Rate of Return (IRR) (cont.)


n Cash Flowt
0= - INV
(1 + IRR) t
t=1
• IRR is the rate of return that makes the PV of the cash flows equal to the
initial investment.
• This looks very similar to our Yield to Maturity formula for bonds. In fact,
YTM is the IRR of a bond.

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Approximate IRR Calculation

IRR ≈ ra + [(NPVa / (NPVa – NPVb)](rb – ra)

IRR : Internal rate of return
ra : Lower interest rate (Arbitrary figure)
rb : Higher interest rate (Arbitrary figure)
NPVa : Net present value at lower interest rate
NPVb : Net present value at higher interest rate
If you want an accurate IRR answer, use the financial calculator
or relevant softwares on the internet.

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IRR Decision Rule

• IRR  COC (cost of capital, WACC) acceptable,
• IRR < COC, then reject the project
• Mutually exclusive projects
• Accept the project with the highest IRR which is  COC

Decision Rule:
IRR> COC Accept
IRR< COC Reject

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Calculating IRR
• Looking again at our problem:
• The IRR is the discount rate that makes the PV of the projected cash flows
equal to the initial outlay.

(250,000) 100,000 100,000 100,000 100,000 100,000

0 1 2 3 4 5
Cost of capital = 15%

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Advantages and Disadvantages

• Advantages
• People feel more comfortable withIRR
• Considers both the magnitude and the timing of cash flows
• Disadvantages
• Multiple internal rates of return with unconventional cash flows
• Reinvestment assumption

• IRR is a good decision-making tool as long as cash flows are conventional

cash flow
• If there are multiple sign changes in the cash flow stream, we could get
multiple IRRs.

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NPV Versus IRR

• Reinvestment assumption
• NPVreinvested at k (cost of capital)
• IRR reinvested at r
• Can lead to conflictsin ranking of mutually exclusive projects
• Crossover
• NPV is superior to IRR when choosing among mutually exclusive
investments, since k is more realistic reinvestment rate than computed
internal rate of return. This is due to k is the opportunity cost of capital to
the firm.

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Modified Internal Rate of Return (MIRR)

• MIRR is the discount rate which causes the PV of a project’s terminal value
(TV) to equal the PV of costs.
• TV is found by compounding (FV) inflows at the WACC.
• Thus, MIRR assumes cash inflows are reinvested at the WACC.
• 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.

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MIRR Example

0 1 2 3
10%

-100 10.0 60.0 80.0

10%
66.0
10%
12.1
-100 158.1
PV outflows TV inflows

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MIRR Example (Cont.)

0 1 2 3

MIRR = 16.5%
-100 158.1

PV outflows TV inflows

$100 = $158.1
(1+MIRRL)3
MIRRL = 16.5%

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Example
• The following is the cash flows of a project. Using a discount rate of 15%, find NPV,
IRR, MIRR and PI.

(900) 300 400 400 500 600

0 1 2 3 4 5

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Problems with Project Ranking

1.Size disparity problem: Mutually exclusive projects of unequal size
• The NPV decision may not agree with IRR
or PI.
• Solution: ???

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Size Disparity Example (Required return = 12% )

ProjectA
Year Cash flow
0 (135,000)
1 60,000
2 60,000
3 60,000
ProjectB
Year Cash flow
0 (30,000)
1 15,000
2 15,000
3 15,000

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Example (Required return = 12% )

ProjectA
Year Cash flow
0 (48,000)
1 1,200
2 2,400
3 39,000
4 42,000
ProjectB
Year Cash flow
0 (46,500)
1 36,500
2 24,000
3 2,400
4 2,400

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Problems with Project Ranking

2. Time disparity problem: Mutually exclusive projects of differing timing of
cash flows. The after-tax cash flowsare:

Year Machine 1 Machine 2

0 (45,000) (45,000)
1 20,000 12,000
2 20,000 12,000
3 20,000 12,000
4 12,000
5 12,000
6 12,000

Assumea required return of 14%.

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Step 1: Calculate NPV

• NPV1 = $1,433
• NPV2 = $1,664

• So, does this mean #2 is better?

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Step 2: Equivalent Annual Annuity (EAA) method

• If we assume that each project will be replaced an infinite number of times
in the future, we can convert each NPV to an annuity.
• EAA: Simply annuities the NPV over the project’s life.

NPV
EAA =
PVIFA i ,n

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Calculate EAA with financial calculator

• Simply “spread the NPV over the life of the project”

• Machine 1: PV = 1433, N = 3, I = 14,

solve: PMT = -617.24.
Machine 2: PV = 1664, N = 6, I = 14,
solve: PMT = -427.91.

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Calculate EAA with financial calculator (cont.)

• EAA1 = $617
• EAA2 = $428

This tells us that

• NPV1 = annuity of $617 per year.
• NPV2 = annuity of $428 per year.
• So, we’ve reduced a problem with different time horizon to a couple of
annuities.
• Decision Rule: Select the highest EAA. We would choose machine #1.

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Step 3: Convert back to NPV (Optional)

• Assuming infinite replacement, the EAAs are actually perpetuities. Get the
PV by dividing the EAA by the required rate of return.
• NPV 1 = 617/.14 = RM4,407
• NPV 2 = 428/.14 = RM3,057 PMT/i

• This doesn’t change the answer, of course; it just converts EAA to an NPV
that can be compared.

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Replacement Chain
• Calculate NPV after extending the lives of project, to have equal lives
• If the project has no common life, extend the lives of both projects. (i.e.
3yrs vs 5yrs)
• If the project has common life, extend project with shorter lives to equate
with longer life of project. (i.e. 3yrs vs 6yrs)

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Replacement Chain (cont.)

The after-tax cash flowsare:
Year Machine 1 Machine 2
0 (45,000) (45,000)
1 20,000 12,000
2 20,000 12,000
3 20,000 + (45,000)= (25,000) 12,000
4 20,000 12,000
5 20,000 12,000
6 20,000 12,000

Assumea required return of 14%.

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