IMPORTANCE OF

CAPITAL BUDGETING

 Large amounts are involved

 Funds are committed for long periods
 Errors can be costly
 TYPES OF CAPITAL
INVESTMENT
 Maintenance
 Cost reduction
 Expansion (existing products)
 Expansion (new products/markets)
 Mandatory
 Miscellaneous
INVESTMENT APPRAISAL
PROCESS
 Estimate the investment required
 Estimate cash flows from the investment
 Compare the investment with the cash
flows from the investment, using one or
more decision rules:
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index
 Payback Period
 NET PRESENT VALUE (NPV)
Suppose an investment has the following cash flows:
Year 0 Year 1 Year 2 Year 3
(100) 30 55 65
If the opportunity cost of this investment is 9%, the future
cash flows must be discounted to make them comparable
with the initial investment of 100:

The present value of the future cash flows, discounted at

9% is 124, which is greater than the present value invested
(i.e. 100), so the investment will increase present wealth by
124 – 100 = 24. This figure of 24 is called the NPV – as long
as the NPV of an investment is positive, it is worthwhile.
 DISCOUNT RATE:
THE COST OF CAPITAL
The appropriate discount rate is the rate
of return that investors could get from an
investment of similar risk and growth
opportunities.

This is the minimum rate of return

required by investors to compensate them
for their opportunity cost, and is called
the ‘cost of capital’.
 NPV equation

CF1 CF2 CFn

NPV    ...   I0
1  k (1  k) 2
(1  k) n

n
CFt
  I0
t  0 (1  k)
t
 Advantages of NPV
 It takes into account the time value of money.
 It considers all financial information relevant
to the decision, for the entire period of the
investment.
 It directly measures the prospective increase
in the value of the firm, and consequently the
shareholders’ wealth (maximisation of which is
the firm’s main objective).
 It is clear, unambiguous and simple to use.
 Problems with NPV
 It is difficult to accurately forecast
future cash flows far into the future
 It is difficult to accurately estimate the
cost of capital, i.e. the discount rate for
the project.
 An absolute measure of NPV may not be
suitable for ranking projects when capital
is scarce, such as in capital rationing
situations (e.g. when a ceiling on capital
expenditure is imposed within a firm).
 USE OF PROFITABILITY INDEX (PI)
Three projects, but capital availability limited to £100,000

Project Yr 0 Yr 1 PV @ NPV NPV PI PI

8% Rank (PV/Inv) Rank

A (100) 162 150 50 1 1.5 3

B (60) 108 100 40 2 1.67 2
C (40) 75.6 70 30 3 1.75 1
According to NPV ranking, if capital available is only £100,
only A will be selected, giving an NPV of 50. But total
investment for B&C together is also only £100, but their
total NPV is 70 (i.e. 40 + 30). In this example, PI ranking
reverses the NPV ranking.
But PI will only work well in such situations if projects are
divisible - i.e. fractional implementation of projects is possible.
 Internal Rate of Return (IRR)
IRR is the discount rate that makes the NPV equal to zero.
Suppose you invest £100 and get back £147 after 5 years.
If your opportunity cost is 7% the NPV would be:

Suppose the opportunity cost goes up to 8%:

Suppose the opportunity cost goes up further to 9%:

Thus, as the discount rate goes up, the NPV comes down
– the discount rate which makes NPV zero is the IRR.
Using IRR in Investment Appraisal
 IRR is the discount rate that makes
NPV = 0.
 So if the actual cost of capital is
higher than IRR, NPV will be < 0.
 And if the actual cost of capital is
lower than IRR, NPV will be > 0.
 Hence:
• If IRR is < cost of capital, reject;
• If IRR is > cost of capital, accept.
 Problems with IRR
 IRR must be used with care when comparing
projects that are mutually exclusive (i.e. when
only one of the projects can be selected).
 This is because. depending on the pattern of the
cash flows, a project may have a higher NPV, but
a lower IRR, than another project.
 This could be due to a combination of factors:
• The cash inflows of one project occurring later in
time than those of the other project – the
discounting impact on later cash flows is affected
because NPV applies the opportunity cost of capital
throughout, but IRR applies the IRR throughout.
• One project requiring a larger initial investment
than the other project (relative measure effect).
Consider the following projects at a discount rate of 10%:
Project A: Invest £100 now, get back £120 after one year
Project B: Invest £100 now, get back £400 after 10 years
NPV of Project A: 120/1.101 – 100 = 9.09
NPV of Project B: 400/1.1010 – 100 = 54.22
Project B increases your present wealth much more than
Project A –Project B should therefore be selected.
But what does the IRR decision rule tell us?
IRR of Project A: 100 x (1 + r) = 120
\ r = 120/100 – 1 = 0.20 or 20%
IRR of Project B: 100 x (1 + r)10 = 400
\ r = 10(400/100) – 1 = 0.1487 or, say, 14.9%
Project A has a higher IRR than Project B, so it
appears superior – i.e. there seems to be a conflict
between the NPV and IRR techniques.
 NPV
54.22 B

9.09 A
DISCOUNT
RATE
0 10% 14.9% 20% PROJECT A
PROJECT B

Because B’s cash inflow(s) come later in time, the impact of the exponent
‘n’ in the discount factor results in the present value of the cash inflow(s)
coming down much more sharply as the discount rate increases. But what
is relevant is that B has a higher NPV at the opportunity cost of 10%.
Exhibit 10.11: NPV Profiles for Two Mutually Exclusive Projects
Another technical problem with the IRR is that if there
are sign changes in the cash flows of a project (i.e. some
of the future cash flows are positive while others are
negative) it is possible to generate as many IRRs (i.e.
discount rates at which the NPV becomes zero) as there
are sign changes. E.g. consider the following project:
Year 0 Year 1 Year 2
-40 250 -250

Thus the NPV becomes 0 at 25% and also at 400%.

When the same project has two or more IRRs it may be
difficult to identify the true IRR.
Exhibit 10.10: NPV Profile for Gold-Mining Operation
 NPV, IRR and the Reinvestment Rate Assumption

 The NPV rule assumes that intermediate cash flows on the

project get reinvested at the hurdle rate (which is based
upon what projects of comparable risk should earn).
 The IRR rule assumes that intermediate cash flows on the
project get reinvested at the IRR. Implicit is the assumption
that the firm has an infinite stream of projects yielding
similar IRRs.
 Conclusion: When the IRR is high (the project is creating
significant surplus value) and the project life is long, the
IRR will overstate the true return on the project.
Solution to Reinvestment Rate Problem
 Payback Period
 Assesses how quickly a project pays for itself out
of the cash flows it generates.
 The lower the payback period the better.

 Advantages:
• Simple to calculate and use.
• Easy to understand, even for persons with no
financial background.
• Assesses project liquidity, and thereby roughly takes
account of the time-related risk of projects.
 Disadvantages:
• Ignores time value of money.
• Ignores cash flows beyond the payback date.
 NPV vs. Payback Period
Consider the following projects (opportunity cost 10%):
Yr Yr 1 Yr 2 Yr 3
0
Project A -1000 700 600 0
Project B -1000 400 400 800

NPV method selects Project B

but Payback Period method selects Project A.
 The Accounting Rate of Return
 It is sometimes called the book rate of return.
 This method computes the return on a capital project
using accounting numbers—the project’s net income
(NI) and book value (BV) rather than cash flow data.
 The most common definition is the one given in the
equation below.

Average net income

ARR = (10.3)
Average book value
 The Accounting Rate of Return
 It has a number of major flaws as a tool for evaluating
capital expenditure decisions.
 First, the ARR is not a true rate of return. ARR simply
gives us a number based on average figures from the
income statement and balance sheet.
 It ignores the time value of money.
 There is no economic rationale that links a particular
acceptance criterion to the goal of maximising
shareholders’ wealth.
 Discounted Pay Back Period

PB  Years before cost recovery

Remaining cost to recover

Cash flow during the year

Simple Payback =
10.5 years

Discounted Payback
= 17.7 years
INVESTMENT APPRAISAL METHODS USED

 DCF techniques have grown popular with large firms

 Despite its problems, IRR is more popular than NPV
• Percentage measure may be easier to understand
• Cost of capital can be kept confidential
 Payback is still popular with both small & large
firms
• Evidence of lack of sophistication?
• Evidence of short-termism?
Exhibit 10.12: Capital-Budgeting Techniques
Used by Business Firms