The Basics of Capital Budgeting:

Evaluating Cash Flows

Should we
build this
plant?
 Capital Budgeting: the process of
planning for purchases of long-
term assets.
 example:
Suppose our firm must decide whether to
purchase a new plastic molding machine
for Rs125,000. How do we decide?
 Will the machine be profitable?
 Will our firm earn a high rate of return
on the investment?
Decision-making Criteria in
Capital Budgeting

How do we decide
if a capital
investment
project should
be accepted or
rejected?
 Decision-making Criteria in
Capital Budgeting
 The Ideal Evaluation Method should:

a) include all cash flows that occur during

the life of the project,
b) consider the time value of money,
c) incorporate the required rate of return
on the project.
 Future value

FVn  PV1  i .
n

What’s the FV of an initial Rs 100

after 3 years if i = 10%?
After 3 years:

FV3 = PV(1 + i)3

= Rs 100(1.10)3
= Rs 133.10.
 Present value
 What’s the PV of Rs 100 due in 3 years if i =
10%?

FVn  1 n
PV = = FVn  
1+ in  1+ i
3
 1 
PV = 100  
 1.10 
= Rs 75.13.
 Payback Period
 The number of years needed to
recover the initial cash outlay.
 How long will it take for the project
to generate enough cash to pay for
itself?
 Payback Period
 How long will it take for the project
to generate enough cash to pay for
itself?
(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8
 Payback Period
 How long will it take for the project
to generate enough cash to pay for
itself?
(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8

Payback period = 3.33 years.

 Is a 3.33 year payback period good?
 Is it acceptable?
 Firms that use this method will
compare the payback calculation to
some standard set by the firm.
 If our senior management had set a
cut-off of 5 years for projects like
ours, what would be our decision?
 Accept the project.
 Drawbacks of Payback Period:

 Firm cutoffs are subjective.

 Does not consider time value of money.
 Does not consider any required rate of
return.
 Does not consider all of the project’s
cash flows.
 Drawbacks of Payback Period:

 Does not consider all of the project’s

cash flows.
(500) 150 150 150 150 150 (300) 0 0

0 1 2 3 4 5 6 7 8

Consider this cash flow stream!

 Drawbacks of Payback Period:

 Does not consider all of the project’s

cash flows.
(500) 150 150 150 150 150 (300) 0 0

0 1 2 3 4 5 6 7 8
This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion!
 Discounted Payback

 Discounts the cash flows at the firm’s

required rate of return.
 Payback period is calculated using
these discounted net cash flows.
 Problems:
 Cutoffs are still subjective.
 Still does not examine all cash flows.
 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30
 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38
 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250 168.75
 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250 168.75 .52 years
 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
The Discounted
0 -500 -500.00
Payback
1 250 219.30 1 year
is 2.52 years
280.70
280.70
2 250 192.38 2 years
88.32
3 250 168.75 .52 years
 Other Methods

1) Net Present Value (NPV)

2) Profitability Index (PI)
3) Internal Rate of Return (IRR)

Each of these decision-making criteria:

 Examines all net cash flows,
 Considers the time value of money, and
 Considers the required rate of return.
 Net Present Value

 NPV = the total PV of the annual net

cash flows - the initial outlay.

 Decision Rule:

 If NPV is positive, ACCEPT.

 If NPV is negative, REJECT.
 NPV Example
 Suppose we are considering a capital investment
that costs Rs276,400 and provides annual net
cash flows of Rs 83,000 for four years and
Rs116,000 at the end of the fifth year. The
firm’s required rate of return is 15%.

83,000 83,000 83,000 83,000 116,000

(276,400)

0 1 2 3 4 5
Internal Rate of Return (IRR)

 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.
 Internal Rate of Return (IRR)


ACFt
NPV = - IO
(1 + k) t
t=1
 Internal Rate of Return (IRR)


ACFt
NPV = - IO
(1 + k) t
t=1

n
ACFt
IRR:

t=1
(1 + IRR) t = IO
 Internal Rate of Return (IRR)
n
ACFt
IRR:
t=1
(1 + IRR) t = IO

 IRR is the rate of return that makes the

PV of the cash flows equal to the initial
outlay.
 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.

83,000 83,000 83,000 83,000 116,000

(276,400)

0 1 2 3 4 5
 83,000 83,000 83,000 83,000 116,000
(276,400)

0 1 2 3 4 5
 This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR)

= 276,400
 83,000 83,000 83,000 83,000 116,000
(276,400)

0 1 2 3 4 5
 This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR)

= 276,400
You should get IRR = 17.63%!
 This way, we have to solve for IRR by trial
and error.
 IRR
 Decision Rule:

 If IRR is greater than or equal

to the required rate of return,
ACCEPT.
 If IRR is less than the required
rate of return, REJECT.
Thanks