CHAPTER 3

CAPITAL BUDGETING

The Faculty of Finance

University of Economics, The University of Danang

1
 Reading
• Chapter 5,6,9&10, Fundamentals of Corporate
Finance; Stephen A. Ross, Randolph W.
Westerfield, Bradford D. Jordan; McGraw-Hill
(2010).

2
 Chapter Outline
• Future Value and Compounding
• Present Value and Discounting
• Project Cash Flows, Incremental Cash Flows
• Pro Forma Financial Statements and Project
Cash Flows
• More about Project Cash Flow
• Alternative Definitions of Operating Cash Flow
• Net Present Value
• The Payback Rule
• The Discounted Payback
• The Internal Rate of Return 3
 Key Concepts and Skills
• Time value of money: Be able to compute the future
value of an investment made today, the present value of
cash to be received at some future date
• Cash Flow: Understand how to determine the relevant
cash flows for various types of proposed investments;
Understand the various methods for computing operating
cash flow
• Capital Investment Decision Criteria: Be able to
compute net present value, internal rates of return,
payback, discounted payback and understand their
strengths and weaknesses
More details:
https://www.fao.org/3/w4343e/w4343e07.htm#chapter%206%20%2
0%20investment%20decisions%20%20%20capital%20budgeting
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Future Value

and

Present Value

5
 Basic Definitions
• Present Value – earlier money on a time line
• Future Value – later money on a time line
• Interest rate – “exchange rate” between
earlier money and later money
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return

More details: https://www.youtube.com/watch?v=zR3L5mLTi7s

6
 Future Values
• Suppose you invest $1,000 for one year at 5% per
year. What is the future value in one year?
– Interest = 1,000(.05) = 50
– Value in one year = principal + interest
= 1,000 + 50 = 1,050
– Future Value (FV) = 1,000(1 + .05) = 1,050
• Suppose you leave the money in for another year.
How much will you have two years from now?
– FV = 1,000(1.05)(1.05) = 1,000(1.05)2
= 1,102.50
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 Future Values: General Formula
• FV = PV(1 + r)t
– FV = future value
– PV = present value
– r = period interest rate, expressed as a
decimal
– t = number of periods
• Future value interest factor = (1 + r)t

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 Effects of Compounding
• Simple interest
• Compound interest
• Consider the previous example
– FV with simple interest = 1,000 + 50 + 50
= 1,100
– FV with compound interest = 1,102.50
– The extra 2.50 comes from the interest of
.05(50) = 2.50 earned on the first interest
payment

9
 Present Values
• How much do I have to invest today to have some
amount in the future?
– FV = PV(1 + r)t
– Rearrange to solve for PV = FV / (1 + r)t
• When we talk about discounting, we mean finding
the present value of some future amount.
• When we talk about the “value” of something, we
are talking about the present value unless we
specifically indicate that we want the future value.

10
 Present Value – One Period
Example
• Suppose you need $10,000 in one year for the down
payment on a new car. If you can earn 7% annually,
how much do you need to invest today?
• PV = 10,000 / (1.07)1 = 9,345.79
• Calculator
– 1 N; 7 I/Y; 10,000 FV
– CPT PV = -9,345.79

11
 Present Values – Example 2
• You want to begin saving for your daughter’s
college education and you estimate that she will
need $150,000 in 17 years. If you feel confident
that you can earn 8% per year, how much do you
need to invest today?

– N = 17; I/Y = 8; FV = 150,000

– CPT PV = - 40,540.34 (remember the sign convention)

12
Present Values – Example 3
• Your parents set up a trust fund for you
10 years ago that is now worth
$19,671.51. If the fund earned 7% per
year, how much did your parents invest?

– N = 10; I/Y = 7; FV = 19,671.51

– CPT PV = -10,000

13
 Present Value – Important
Relationship I
• For a given interest rate – the longer the time
period, the lower the present value
– What is the present value of $500 to be received in
5 years? 10 years? The discount rate is 10%

– 5 years: N = 5; I/Y = 10; FV = 500

CPT PV = -310.46

– 10 years: N = 10; I/Y = 10; FV = 500

CPT PV = -192.77

14
 Present Value – Important
Relationship II
• For a given time period – the higher the interest rate,
the smaller the present value
– What is the present value of $500 received in 5
years if the interest rate is 10%? 15%?

• Rate = 10%: N = 5; I/Y = 10; FV = 500

CPT PV = -310.46

• Rate = 15%; N = 5; I/Y = 15; FV = 500

CPT PV = -248.59

15
 Quick Quiz
• What is the relationship between present value
and future value?
• Suppose you need $15,000 in 3 years. If you
can earn 6% annually, how much do you need to
invest today?
• If you could invest the money at 8%, would you
have to invest more or less than at 6%? How
much?

16
 The Basic PV Equation -
Refresher
• PV = FV / (1 + r)t
• There are four parts to this equation
– PV, FV, r and t
– If we know any three, we can solve for the fourth
• If you are using a financial calculator, be sure to
remember the sign convention or you will
receive an error (or a nonsense answer) when
solving for r or t

17
 Discount Rate
• Often we will want to know what the implied
interest rate is on an investment
• Rearrange the basic PV equation and solve for r
– FV = PV(1 + r)t
– r = (FV / PV)1/t – 1
• If you are using formulas, you will want to make
use of both the yx and the 1/x keys

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 Discount Rate – Example 1
• You are looking at an investment that will pay
$1,200 in 5 years if you invest $1,000 today.
What is the implied rate of interest?
– r = (1,200 / 1,000)1/5 – 1 = .03714 = 3.714%
– Calculator – the sign convention matters!!!
• N=5
• PV = -1,000 (you pay 1,000 today)
• FV = 1,200 (you receive 1,200 in 5 years)
• CPT I/Y = 3.714%

19
 Discount Rate – Example 2
• Suppose you are offered an investment that will
allow you to double your money in 6 years. You
have $10,000 to invest. What is the implied rate
of interest?
– N=6
– PV = -10,000
– FV = 20,000
– CPT I/Y = 12.25%

20
 Discount Rate – Example 3
• Suppose you have a 1-year old son and you
want to provide $75,000 in 17 years towards
his college education. You currently have
$5,000 to invest. What interest rate must you
earn to have the $75,000 when you need it?
– N = 17; PV = -5,000; FV = 75,000
– CPT I/Y = 17.27%

21
 Quick Quiz
• What are some situations in which you might
want to know the implied interest rate?
• You are offered the following investments:
– You can invest $500 today and receive $600 in 5
years. The investment is low risk.
– You can invest the $500 in a bank account paying
4%.
– What is the implied interest rate for the first choice,
and which investment should you choose?

22
 Finding the Number of Periods
• Start with the basic equation and solve for
t (remember your logs)
– FV = PV(1 + r)t
– t = ln(FV / PV) / ln(1 + r)
• You can use the financial keys on the
calculator as well; just remember the sign
convention.

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 Number of Periods – Example 1
• You want to purchase a new car, and you
are willing to pay $20,000. If you can invest
at 10% per year and you currently have
$15,000, how long will it be before you have
enough money to pay cash for the car?

– I/Y = 10; PV = -15,000; FV = 20,000

– CPT N = 3.02 years

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 Number of Periods – Example 2
Suppose you want to buy a new house. You
currently have $15,000, and you figure you need to
have a 10% down payment plus an additional 5%
of the loan amount for closing costs. Assume the
type of house you want will cost about $150,000
and you can earn 7.5% per year. How long will it
be before you have enough money for the down
payment and closing costs?

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 Number of Periods – Example
2 Continued
• How much do you need to have in the future?
– Down payment = .1(150,000) = 15,000
– Closing costs = .05(150,000 – 15,000) = 6,750
– Total needed = 15,000 + 6,750 = 21,750

• Compute the number of periods

– PV = -15,000; FV = 21,750; I/Y = 7.5
– CPT N = 5.14 years

• Using the formula

– t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years
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 Quick Quiz
• When might you want to compute the
number of periods?
• Suppose you want to buy some new
furniture for your family room. You
currently have $500, and the furniture you
want costs $600. If you can earn 6%, how
long will you have to wait if you don’t add
any additional money?

27
 Spreadsheet Example
• Use the following formulas for TVM calculations
– FV(rate,nper,pmt,pv)
– PV(rate,nper,pmt,fv)
– RATE(nper,pmt,pv,fv)
– NPER(rate,pmt,pv,fv)
• The formula icon is very useful when you can’t
remember the exact formula
• Click on the Excel icon to open a spreadsheet
containing four different examples.

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Table 3.1

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 Comprehensive Problem
• You have $10,000 to invest for five years.
• How much additional interest will you earn if the
investment provides a 5% annual return, when
compared to a 4.5% annual return?
• How long will it take your $10,000 to double in
value if it earns 5% annually?
• What annual rate has been earned if $1,000
grows into $4,000 in 20 years?

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Cash Flow

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Where Do the CFs Come From?

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Where Do the CFs Come From? (cont)

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Where Do the CFs Come From? (cont)

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Where Do the CFs Come From? (cont)

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Where Do the CFs Come From? (cont)

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 Computing Depreciation

• Straight-line depreciation
– D = (Initial cost – salvage) / number of years
– Very few assets are depreciated straight-line for
tax purposes
• MACRS
– Need to know which asset class is appropriate for
tax purposes
– Multiply percentage given in table by the initial
cost
– Depreciate to zero
– Mid-year convention

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Net Working Capital

38
Taxation

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Disposal of a Asset

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 After-tax Salvage

• If the salvage value is different from the book

value of the asset, then there is a tax effect
• Book value = initial cost – accumulated
depreciation
• After-tax salvage = salvage – T(salvage – book
value)

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 Relevant Cash Flows
• The cash flows that should be included in a
capital budgeting analysis are those that will
only occur (or not occur) if the project is
accepted
• These cash flows are called incremental cash
flows
• The stand-alone principle allows us to analyze
each project in isolation from the firm simply
by focusing on incremental cash flows

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 Pro Forma Statements
and Cash Flow
• Capital budgeting relies heavily on pro forma
accounting statements, particularly income
statements
• Computing cash flows – refresher
– Operating Cash Flow (OCF) = EBIT + depreciation –
taxes
– OCF = Net income + depreciation (when there is no
interest expense)
– Cash Flow From Assets (CFFA) = OCF – net capital
spending (NCS) – changes in NWC

More details: https://www.youtube.com/watch?v=M8cuAJYYnTM

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 Table 3.2 Pro Forma Income Statement

Sales (50,000 units at $4.00/unit) $200,000

Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 12,000
Depreciation ($90,000 / 3) 30,000
EBIT $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780
 Table 3.3 Projected Capital Requirements

Year

0 1 2 3

NWC $20,000 $20,000 $20,000 $20,000

NFA 90,000 60,000 30,000 0

Total $110,000 $80,000 $50,000 $20,000

 Table 3.4 Projected Total Cash Flows

Year
0 1 2 3

OCF $51,780 $51,780 $51,780

Change -$20,000 20,000
in NWC
NCS -$90,000

CFFA -$110,00 $51,780 $51,780 $71,780

 Example: Depreciation and
After-tax Salvage
• You purchase equipment for $100,000, and it
costs $10,000 to have it delivered and
installed. Based on past information, you
believe that you can sell the equipment for
$17,000 when you are done with it in 6 years.
The company’s marginal tax rate is 40%.
What is the depreciation expense each year
and the after-tax salvage in year 6 for each of
the following situations?

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 Example: Straight-line
• Suppose the appropriate depreciation
schedule is straight-line
– D = (110,000 – 17,000) / 6 = 15,500 every
year for 6 years
– BV in year 6 = 110,000 – 6(15,500)
= 17,000
– After-tax salvage = 17,000 - .4(17,000 –
17,000) = 17,000

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 Example: Three-year MACRS
Year MACRS D
percent
1 .3333 .3333(110,000) = 36,663

2 .4445 .4445(110,000) = 48,895

3 .1481 .1481(110,000) = 16,291
4 .0741 .0741(110,000) = 8,151

BV in year 6 = 110,000 – 36,663 – 48,895 – 16,291 – 8,151 = 0

After-tax salvage =17,000 - .4(17,000 – 0) = $10,200

 Example: Seven-Year MACRS
Year MACRS Percent
1 .1429
2 .2449
3 .1749
4 .1249
5 .0893
6 .0892
D
.1429(110,000) = 15,719
.2449(110,000) = 26,939
.1749(110,000) = 19,239
.1249(110,000) = 13,739
.0893(110,000) = 9,823
.0892(110,000) = 9,812

BV in year 6 = 110,000 – 15,719 – 26,939 – 19,239 – 13,739

– 9,823 – 9,812 = 14,729
After-tax salvage = 17,000 – .4(17,000 – 14,729) = 16,091.60
 Methods for Computing OCF
• Bottom-Up Approach
– Works only when there is no interest expense
– OCF = NI + depreciation
• Top-Down Approach
– OCF = Sales – Costs – Taxes
– Don’t subtract non-cash deductions
• Tax Shield Approach
– OCF = (Sales – Costs)(1 – T) + Depreciation*T

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WHAT TO DISCOUNT?

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Common Types of CFs to Watch
Out For

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Common Types of CFs …

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Common Types of CFs …

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Common Types of CFs …

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Common Types of CFs …

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Common Types of CFs …

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Common Types of CFs …

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Cash Flow Analysis

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Cash Flow Analysis…

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Cash Flow Analysis…

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Cash Flow Analysis…

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Cash Flow Analysis…

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Cash Flow Analysis…

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Cash Flow Analysis…

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 Comprehensive Problem
A $1,000,000 investment is depreciated using a
seven-year MACRS class life. It requires $150,000
in additional inventory and will increase accounts
payable by $50,000. It will generate $400,000 in
revenue and $150,000 in cash expenses annually,
and the tax rate is 40%. What is the incremental
cash flow in years 0, 1, 7, and 8?

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Capital Investment
Decision Criteria

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 Good Decision Criteria
• We need to ask ourselves the following
questions when evaluating capital
budgeting decision rules:
– Does the decision rule adjust for the time
value of money?
– Does the decision rule adjust for risk?
– Does the decision rule provide information on
whether we are creating value for the firm?

69
 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.

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 Project Example Information
• You are reviewing a new project and have
estimated the following cash flows:
– Year 0: CF = -165,000
– Year 1: CF = 63,120; NI = 13,620
– Year 2: CF = 70,800; NI = 3,300
– Year 3: CF = 91,080; NI = 29,100
– Average Book Value = 72,000
• Your required return for assets of this risk level is
12%.

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 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.

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 Computing NPV for the Project
• Using the formulas:
– NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 = 12,627.41
• Using the calculator:
– CF0 = -165,000; C01 = 63,120; F01 = 1; C02 =
70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12;
CPT NPV = 12,627.41
• Do we accept or reject the project?

More examples: https://www.youtube.com/watch?v=hG68UMupJzs

https://www.youtube.com/watch?v=iWIhy3guYt4
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 Advantages and Disadvantages
of NPV
• Advantages • Disadvantages
- Consider time value of – Difficult to choose the
money. most approriate discount
- Consider all cash flow rate -> eliminate good
components involved project
through the project’s life
- Can rank mutually
exclusive projects

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 Payback Period
• How long does it take to get the initial cost back
in a nominal sense?
• Computation
– Estimate the cash flows
– Subtract the future cash flows from the initial cost until
the initial investment has been recovered
• Decision Rule – Accept if the payback period
is less than some preset limit

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 Computing Payback for the
Project
• Assume we will accept the project if it pays back
within two years.
– Year 1: 165,000 – 63,120 = 101,880 still to recover
– Year 2: 101,880 – 70,800 = 31,080 still to recover
– Year 3: 31,080 – 91,080 = -60,000 project pays back
in year 3
• Do we accept or reject the project?

More examples: https://www.youtube.com/watch?v=FJjGi7gsK3A

https://www.youtube.com/watch?v=6NhAeD39QDA

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 Advantages and Disadvantages
of Payback
• Advantages • Disadvantages
– Easy to understand – Ignores the time value of
money
– Adjusts for uncertainty
of later cash flows – Requires an arbitrary
cutoff point
– Biased toward
– Ignores cash flows beyond
liquidity
the cutoff date
– Biased against long-term
projects, such as research
and development, and
new projects

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 Discounted Payback Period
• Compute the present value of each cash flow
and then determine how long it takes to pay
back on a discounted basis
• Compare to a specified required period
• Decision Rule - Accept the project if it pays
back on a discounted basis within the
specified time

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 Computing Discounted Payback
for the Project
• Assume we will accept the project if it pays back
on a discounted basis in 2 years.
• Compute the PV for each cash flow and
determine the payback period using discounted
cash flows
– Year 1: 165,000 – 63,120/1.121 = 108,643
– Year 2: 108,643 – 70,800/1.122 = 52,202
– Year 3: 52,202 – 91,080/1.123 = -12,627
project pays back in year 3
• Do we accept or reject the project?

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 Advantages and Disadvantages
of Discounted Payback
• Advantages • Disadvantages
– Includes time value – May reject positive NPV
of money investments
– Easy to understand – Requires an arbitrary
– Does not accept cutoff point
negative estimated – Ignores cash flows
NPV investments beyond the cutoff point
when all future cash – Biased against long-
flows are positive term projects, such as
– Biased towards R&D and new products
liquidity

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 Internal Rate of Return
• This is the most important alternative to
NPV
• It is often used in practice and is intuitively
appealing
• It is based entirely on the estimated cash
flows and is independent of interest rates
found elsewhere

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 IRR – Definition
and Decision Rule

• Definition: IRR is the return that makes the NPV =

0
• Decision Rule: Accept the project if the IRR is
greater than the required return

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 Computing IRR for the Project
• If you do not have a financial calculator, then this
becomes a trial and error process
• Calculator
– Enter the cash flows as you did with NPV
– Press IRR and then CPT
– IRR = 16.13% > 12% required return
• Do we accept or reject the project?

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 NPV Profile for the Project
70,000
60,000 IRR = 16.13%
50,000
40,000
30,000
NPV

20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

-20,000
Discount Rate

More examples: https://www.youtube.com/watch?v=aS8XHZ6NM3U

https://www.youtube.com/watch?v=xEf0S5W5leA
 Advantages of IRR
• Knowing a return is intuitively appealing
• It is a simple way to communicate the value of a
project to someone who doesn’t know all the
estimation details
• If the IRR is high enough, you may not need to
estimate a required return, which is often a
difficult task

85
 NPV vs. IRR
• NPV and IRR will generally give us the
same decision
• Exceptions
– Nonconventional cash flows – cash flow signs
change more than once
– Mutually exclusive projects
• Initial investments are substantially different (issue
of scale)
• Timing of cash flows is substantially different

86
 IRR and Nonconventional
Cash Flows
• When the cash flows change sign more than
once, there is more than one IRR
• When you solve for IRR you are solving for the
root of an equation, and when you cross the x-
axis more than once, there will be more than
one return that solves the equation
• If you have more than one IRR, which one do
you use to make your decision?

87
 Another Example –
Nonconventional Cash Flows
• Suppose an investment will cost $90,000
initially and will generate the following cash
flows:
– Year 1: 132,000
– Year 2: 100,000
– Year 3: -150,000
• The required return is 15%.
• Should we accept or reject the project?

88
 NPV Profile
IRR = 10.11% and 42.66%
$4,000.00

$2,000.00

$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NPV

($4,000.00)

($6,000.00)

($8,000.00)

($10,000.00)
Discount Rate
 IRR and Mutually Exclusive
Projects
• Mutually exclusive projects
– If you choose one, you can’t choose the other
– Example: You can choose to attend graduate
school at either Harvard or Stanford, but not
both
• Intuitively, you would use the following decision
rules:
– NPV – choose the project with the higher NPV
– IRR – choose the project with the higher IRR
90
 Example With Mutually
Exclusive Projects

Period Project A Project B The required

return for both
0 -500 -400 projects is 10%.

1 325 325

2 325 200 Which project

should you
IRR 19.43% 22.17% accept and why?

NPV 64.05 60.74

 NPV Profiles
$160.00
IRR for A = 19.43%
$140.00
$120.00 IRR for B = 22.17%
$100.00
Crossover Point = 11.8%
$80.00
A
NPV

$60.00
B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate
 Conflicts Between NPV and IRR
• NPV directly measures the increase in value to
the firm
• Whenever there is a conflict between NPV and
another decision rule, you should always use
NPV
• IRR is unreliable in the following situations
– Nonconventional cash flows
– Mutually exclusive projects

93
 Modified IRR
• Calculate the net present value of all cash
outflows using the borrowing rate.
• Calculate the net future value of all cash
inflows using the investing rate.
• Find the rate of return that equates these
values.
• Benefits: single answer and specific rates
for borrowing and reinvestment
More examples: https://www.youtube.com/watch?v=b1cFoh5cMPA
94
 Capital Budgeting In Practice
• We should consider several investment
criteria when making decisions
• NPV and IRR are the most commonly
used primary investment criteria
• Payback is a commonly used secondary
investment criteria

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 Summary – DCF Criteria
• Net present value
– Difference between market value and cost
– Take the project if the NPV is positive
– Has no serious problems
– Preferred decision criterion
• Internal rate of return
– Discount rate that makes NPV = 0
– Take the project if the IRR is greater than the
required return
– Same decision as NPV with conventional cash flows
– IRR is unreliable with nonconventional cash flows or
mutually exclusive projects

96
 Summary – Payback Criteria
• Payback period
– Length of time until initial investment is recovered
– Take the project if it pays back within some specified period
– Doesn’t account for time value of money, and there is an
arbitrary cutoff period
• Discounted payback period
– Length of time until initial investment is recovered on a
discounted basis
– Take the project if it pays back in some specified period
– There is an arbitrary cutoff period

97
 Quick Quiz
• Consider an investment that costs $100,000 and
has a cash inflow of $25,000 every year for 5
years. The required return is 9%, and required
payback is 4 years.
– What is the payback period?
– What is the discounted payback period?
– What is the NPV?
– What is the IRR?
– Should we accept the project?
• What decision rule should be the primary
decision method?
• When is the IRR rule unreliable?
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 Comprehensive Problem
• An investment project has the following cash
flows: CF0 = -1,000,000; C01 – C08 = 200,000
each
• If the required rate of return is 12%, what
decision should be made using NPV?
• How would the IRR decision rule be used for this
project, and what decision would be reached?
• How are the above two decisions related?

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