FINA2010 Financial Management

Lecture 4: Capital Budgeting I

Instructor: Prof. Jangwoo Lee

CUHK Business School

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 Housekeeping Item
• Assignment #1 Deadline Extended to 11:59
PM on the 10th
(Please submit your assignment via
blackboard, if you haven’t)

• Midterm Exam: at YIA LT1 on the 23rd of

February, 2022., 18:30 – 20:00
(subject to change)
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 Last Lecture
• Future Value and Present Value

• Multiple Cash Flows

• Annuity and Perpetuity

• Annual Percentage Rate and Effective Annual

Rate
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 Review: Capital Budgeting
• Capital budgeting has to do with long-term
investments
E.g., what fixed assets should the company buy?

• As a financial manager, you should maximize the

current shareholder value

• Since long-term investment involves cash flows

over multiple periods, it is crucial to take time
value of money into account
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 Lecture Outline
• Net Present Value (NPV)

• Payback and Discounted Payback Period

• Average Accounting Return (AAR)

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 Learning Objectives
• Be able to compute the net present value and
understand why it is the best decision
criterion
• Be able to compute payback and discounted
payback and understand their shortcomings
• Be able to compute average accounting return
and understand its shortcomings

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 Example: Capital Budgeting Decision
• Hong Kong Airlines Hints at Boeing Dreamliner Order
• Hong Kong Airlines has hinted it will order new Boeing long-
haul aircraft to speed up its ambitious global expansion to
rival Cathay Pacific Airways.
• As part of the its global expansion to compete against
Cathay Pacific Airways, the company is due to launch flights
to Los Angeles, San Francisco, New York and London.
• Hong Kong Airlines last month got its hands on the first of
21 state-of-the-art long-haul Airbus A350 planes. Adding a
new aircraft model would drive up costs and defy
conventional wisdom for smaller airlines.
• Source: 21 October 2017, South China Morning Post

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 Example: Capital Budgeting Decision

• What type of analysis was carried out in order

to reach this decision to purchase the aircraft?

Should we
build this
plant?

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 A First Look at Capital Budgeting
• The over-riding rule of capital budgeting is to
accept all projects for which the cost is less
than, or equal to, the benefit:

• Accept if cost ≤ benefit

• Reject if cost > benefit

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 What Are Good Decision Criteria?
• Since value must take into account when cash flows are
received and the likelihood associated with receiving
those cash flows, and the amount of cash flows
received, we need to ask ourselves the following
questions when evaluating decision criteria:
• 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?
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 Net Present Value (NPV)
• Net Present Value: the difference between an
investment’s market value (intrinsic value) and its cost.

• How much value is created from undertaking an

investment?

• If PV(Cash Inflows) > PV(Cash Outflows) → positive

NPV, this means that taking on the project will increase
the value of firm.

• Since our goal is to increase owners’ wealth, NPV is a

direct measure of how well this project will meet our
goal.
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 The NPV Decision Making Recipe
• Estimate the expected future cash flows.
– Amount and timing (use a timeline)
• Estimate the required return for projects of this
risk level.
• Find the present value of the cash flows and
subtract the initial investment.

• NPV Decision Rule: accept the project if NPV > 0.

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 Capital Budgeting Example A
• Cash revenues from our fertilizer business will be
$20,000 per year, assuming everything goes as expected.
• Cash costs (including taxes) will be $14,000 per year. We
shall wind down the business in eight years. Plant,
property and equipment will be worth $2,000 as salvage
at that time.
• The project costs $30,000 to launch. We use a 15 percent
discount rate on new projects such as this one. Is this a
good investment?
• If there are 1,000 shares of equity outstanding, what will
be the effect on the share price of taking this
investment?
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14
 Capital Budgeting Example A

• Initial cost: $30,000

• Cash revenue: $20,000 per year
• Cash cost: $14,000 per year
• Salvage value: $2,000
• Number of time periods: 8 years
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Example: NPV (Method I)

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 Example: NPV (Method II)
• The total present value is:

= 6,000 × [1  (1/1.158)]/0.15 + (2,000/1.158)

= 26,924 + 654 = $27,578
• When we compare this to the $30,000
estimated cost, we see that the NPV is:
• NPV = 27,578 − 30,000 = −$2,422
Reject!
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 Example: NPV
• Based on our estimates, taking it would
decrease the total value of the equity by
$2,422.
• With 1,000 shares outstanding, our best
estimate of the impact of taking this project is
a loss of value of 2,422/1,000 = $2.42 per
share.

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Financial Calculator Solution I
• Press <CF> and use <↓> and <↑> to enter
the cash flow values.
• CF0: 30,000 <+/−> <ENTER> → CF0 = −30,000
• <↓> C01: 6,000 <ENTER> → CF1 = 6,000
• <↓> F01: 1 → frequency of receiving CF1 is 1
• <↓> C02: 6,000 <ENTER> → CF2 = 6,000
• <↓> F02: 1
• C03 to C07 are the same as C01, C02
• F03 to F07 are the same as F01, F02
• <↓> C08: 8,000 <ENTER> → CF8 = 8,000
• <↓> F08: 1
• Press <NPV> to display the discount rate (I).
• I: 15 <ENTER> → I = 15, discount rate 15%
• <↓> NPV: 0 → to reach the NPV function
• <CPT> NPV: −2,422.27 → NPV = −$2,422.27

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 Financial Calculator Solution II

Inputs 8 15 6,000 2,000

N I/Y PV PMT FV
Compute −27,577.73

• N: 8 periods (enter as 8)
• I/Y: 15% discount rate per period (enter as 15)
• PMT: 6,000 (net inflow per period)
• FV: 2,000 (salvage value)
• PV: compute (resulting answer is negative)
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 NPV Rules With Multiple Projects

• There are different types of situations with

multiple projects
– Independent projects: firms can choose to
undertake a project regardless of their decision on
other projects
– Mutually exclusive projects: firms can choose to
undertake at most one project

• Q: If there are two projects (A,B), what can

firms choose to do in each situation? 21
 Quick Review MCQ
• Mutually exclusive projects are best defined as
competing projects which:
A. would commence on the same day.
B. have the same initial start-up costs.
C. both require the total use of the same limited
resource.
D. both have negative cash outflows at time zero.
E. have the same life span.

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 Mutually Exclusive Projects
• Consider the following cash flows from two mutually
exclusive investments. Assume the discount rate is
10%. Calculate the NPV’s.
Year Investment A ($) Investment B ($)
0 −100 −100
1 50 20
2 40 40
3 40 50
4 30 60

• NPV of Project A: 29.06, NPV of Project B: 29.79

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 Example: Mutually Exclusive Projects
• Project B is better because it creates more value
($29.79) for shareholders than Project A ($29.06).

• In general, a firm should choose the project with the

highest NPV among mutually exclusive projects

• Q: What should the firm do if these projects were

independent?

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 Strengths of NPV Rule

Uses Cash Uses All Cash Discounts Cash

Flows Flows Flows
• Cash flows • Many • Fully
are better approaches incorporates
than earnings ignore cash the time
flows beyond value of
a certain date money

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 Evaluating NPV as a Capital Budgeting
Decision Criteria
• Does the NPV rule account for the time value
of money? YES
• Does the NPV rule account for the risk of the
cash flows? YES
• Does the NPV rule provide an indication about
the increase in value? YES
• Should we consider the NPV rule as our
primary decision criteria? YES

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 Potential Downside of the NPV Rule
• What are some potential downsides of the NPV rule?
• Let’s revisit the example with two mutually exclusive
investments. Assume the discount rate is 15% and
obtain the NPV’s. Year Investment A ($) Investment B ($)
0 −100 −100
1 50 20
2 40 40
3 40 50
4 30 60

•NPV of Project A: 17.18, NPV of Project B: 14.82

• Recall that Project B is better when the discount rate is
10%! Different discount rates give different answers. 27
 Quick Review Questions
• Which one of the following will decrease the
net present value of a project? 
A. increasing the value of each of the project's
discounted cash inflows
B. moving each of the cash inflows back to a later
time period
C. decreasing the required discount rate
D. increasing the project's initial cost at time zero
E. increasing the amount of the final cash inflow

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 Lecture Outline
• Net Present Value (NPV)

• Payback and Discounted Payback Period

• Average Accounting Return (AAR)

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 Payback Period
• Payback Period: the amount of time required for an
investment to generate cash flows sufficient to
recover its initial cost.
– How long does it take to get the initial cost back in a
nominal sense?
– E.g., the initial investment is $50,000. This investment
‘pays for itself’ in exactly two years.

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 The Payback Decision Making Recipe

• Estimate the cash flows.

• Add the future cash flows to the initial cost
until the initial investment has been
recovered.
• Payback Period Decision Rule: accept the
project if the payback period is less than some
pre-specified limit (determined arbitrarily).

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 Capital Budgeting Example A

• Initial cost: $30,000

• Cash revenue: $20,000 per year
• Cash cost: $14,000 per year
• Salvage value: $2,000
• Number of time periods: 8 years
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Computing Payback For Example A
• Assume we will accept the project if it pays back
within six years.
• Year 1: −30,000 + 6,000 = −24,000 still to recover
• Year 2: −24,000 + 6,000 = −18,000 still to recover
• Year 3: −18,000 + 6,000 = −12,000 still to recover
• Year 4: −12,000 + 6,000 = −6,000 still to recover
• Year 5: −6,000 + 6,000 = 0, project pays back in year
5
• Do we accept or reject the project? Accept!
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 Example: Payback Period
• Consider cash flows for five different projects.

• Project A:
– Year 1: −100 + 30 = −70 still to recover
– Year 2: −70 + 40 = −30 still to recover
– Year 3: −30 + 50 = 20, project pays back in year 3
– To be more precise, 30/50 = 0.6, project pays back in 2.6 years

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 Example: Payback Period
• Consider cash flows for five different projects.

• Project B: it never pays back, because the cash flows

never total up to the original investment.
– 40 + 20 + 10 = 70 < 200
• Project C: has a payback of exactly four years.
– 40 + 20 + 10 + 130 = 200

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 Example: Payback Period
• Consider cash flows for five different projects.

• Project D: has negative cash flow in year 3, and two

different payback periods, two years and four years. Both
of them are correct → the way the payback period is
calculated doesn’t guarantee a single answer.

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 Example: Payback Period
• Consider cash flows for five different projects.

• Project E: pays back in six months, illustrating the point

that a rapid payback does not guarantee a good
investment.

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 Evaluating Payback Period as a Capital
Budgeting Decision Criteria
• Does the payback rule account for the time
value of money? NO
• Does the payback rule account for the risk of
the cash flows? NO
• Does the payback rule provide an indication
about the increase in value? NO
• Should we consider the payback rule as our
primary decision criteria? NO

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 Payback Period Rule
• Advantages • Disadvantages
– Quick and easy to
calculate
– Easy to understand
– Biased towards liquidity
– Adjusts for uncertainty
of later cash flows
– Ignores the time value of
money
– Requires an arbitrary
cut-off point
– Ignores cash flows
beyond the cut-off date
– Biased against long-term
projects, such as R&D,
and new products
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 Quick Review Questions
• Western Beef Exporters is considering a project
that has an NPV of $32,600, a payback period of
3.2 years. The required payback period is 3 years.
• If you apply the NPV criterion, should the firm
accept the project?
– Accept
• If you apply the payback criterion, should the
firm accept the project?
– Reject

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 Quick Review Questions
• A project has a required payback period of three years.
Which one of the following statements is correct concerning
the payback analysis of this project? 
A. The cash flows in each of the three years must exceed one-third
of the project's initial cost if the project is to be accepted.
B. The cash flow in year three is ignored.
C. The project's cash flow in year three is discounted by a factor of
(1 + R)3.
D. The cash flow in year two is valued just as highly as the cash flow
in year one.
E. The project is acceptable whenever the payback period exceeds
three years.

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 Discounted Payback Period
• Discounted Payback Period: the length of time
required for an investment’s discounted cash
flows to equal its initial cost.
• Compute the present value of each cash flow and
then determine how long it takes to payback on a
discounted basis.
• Discounted Payback Decision Rule: accept the
project if it pays back on a discounted basis within
the pre-specified time (again arbitrarily selected).

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Example: Ordinary and Discounted Payback
• Suppose we require a 12.5 percent return on new
investments. We have an investment that costs $300 and has
cash flows of $100 per year for five years.

100/1.125 =
100/1.1252 = 89 + 79 =

• Ordinary Payback: 3 years

• Discounted Payback: 4 years
• NPV = 355 − 300 = $55 → CF after the discounted payback
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 Evaluating Discounted Payback as a Capital
Budgeting Decision Criteria
• Does the discounted payback rule account for
the time value of money? Yes
• Does the discounted payback rule account for
the risk of the cash flows? Yes
• Does the discounted payback rule provide an
indication about the increase in value? Partially
yes
• Should we consider the discounted payback rule
as our primary decision criteria? No
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 Discounted Payback Period Rule
• Advantages • Disadvantages
– Includes time value of – May reject positive NPV
money investments
– Easy to understand – Requires an arbitrary
– Does not accept cut-off point
negative estimated NPV – Ignores cash flows
investments beyond the cut-off point
– Biased towards liquidity – Biased against long-term
projects, such as R&D
and new products

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 Average Accounting Return (AAR)
• Average Accounting Return: an investment’s
average net income divided by its average
book value.
• Note that the average book value depends on
how the asset is depreciated.
• AAR Decision Rule: accept the project if the
AAR is greater than a target AAR (determined
arbitrarily).

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 Example: Average Accounting Return

• Suppose we are deciding whether to open a

store in a new shopping mall. The required
investment in improvements is $500,000. The
store would have a five-year life because
everything reverts to the mall owners after
that time. The required investment would be
100 percent depreciated (straight-line) over
five years. The tax rate is 25 percent.

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 Example: Average Accounting Return

• AAR = 50,000/250,000 = 20%

• Assume we require an AAR of 25%, do we accept or reject the
project? Reject!
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 Evaluating AAR as a Capital Budgeting
Decision Criteria
• Does the AAR rule account for the time value
of money? No
• Does the AAR rule account for the risk of the
cash flows? No
• Does the AAR rule provide an indication about
the increase in value? No
• Should we consider the AAR rule as our
primary decision rule? No

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 Average Accounting Return
• Advantages • Disadvantages
– Easy to calculate
– Needed information will
usually be available
– Not a true rate of return;
time value of money is
ignored
– Uses an arbitrary
benchmark cut-off rate
– Based on accounting net
income and book values,
not cash flows and
market values
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 Quick Review Questions
• You have analyzed two mutually exclusive projects of similar size and has
compiled the following information. Both projects have 3- year lives.
Your recommendation should be to accept:

A. both projects.
B. project B because it has the shortest payback period.
C. project B and reject project A based on their net present values.
D. project A and reject project B based on their average accounting returns.
E. neither project.

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 Quick Review Questions
• Applying the discounted payback decision rule to
all projects may cause: 
A. some positive net present value projects to be rejected.
B. the most liquid projects to be rejected in favor of the
less liquid projects.
C. projects to be incorrectly accepted due to ignoring the
time value of money.
D. a firm to become more long-term focused.
E. some projects to be accepted which would otherwise
be rejected under the payback rule.

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Quick Review Questions

• An investment project costs $21,500 and has
annual cash flows of $4,200 for 6 years. If the
discount rate is 20 percent, what is the
discounted payback period? 
A. 4.41 years
B. 4.67 years
C. 5.12 years
D. 5.40 years
E. never
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 Quick Review Questions
• Which one of the following is an advantage of
the average accounting return method of
analysis? 
A. easy availability of information needed for the
computation
B. inclusion of time value of money considerations
C. the use of a cutoff rate as a benchmark
D. the use of pre-tax income in the computation
E. use of real, versus nominal, average income
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 Summary
• Net Present Value
– Difference between market value and cost
– Take the project if the NPV is positive.
– Preferred decision criterion

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 Summary (Cont’d)
• Payback Period
– Length of time until initial investment is recovered
– Take the project if it pays back in some specified period.
– Doesn’t account for time value of money and there is an
arbitrary cut-off 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 cut-off period.

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 Summary (Cont’d)
• Average Accounting Return
– Measure of accounting profit relative to book
value
– Similar to return on assets measure
– Take the investment if the AAR exceeds some
specified return level.
– Serious problems and should not be used.

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