Chapter 5

Capital Budgeting
Techniques

3-1
 Capital Budgeting
• Capital refers to operating assets used in
production, while a budget is a plan that details
projected cash flows during some future period.
• Capital budgeting, the process of evaluating
specific investment decisions.
• Capital budget is an outline of planned
investments in operating assets, and Capital
budgeting is the whole process of analyzing
projects and deciding which ones to include in the
capital budget.
3-2
 What is
Capital Budgeting?

The process of identifying,

analyzing, and selecting
investment projects whose
returns (cash flows) are
expected to extendmore
than one year.

3-3
 What is
Capital Budgeting?

The process of allocating or budgeting capital is usually more

involved than just deciding on whether or not to buy a
particular fixed asset.
The most fundamental decision a business must make concerns
its
 product line.
 What services will we offer or what will we sell?
 In what markets will we compete?
 What new products will we introduce?
The answer to any of these questions will require that the firm
commit its common and valuable capital to certain types of
assets. As a result, all of these strategic issues fall under the
general heading of capital budgeting.

3-4
 Project Evaluation:
Alternative Methods

 Payback Period (PBP)

 Internal Rate of Return (IRR)
 Net Present Value (NPV)
 Profitability Index (PI)

3-5
 Proposed Project Data

Julie Miller is evaluating a new project

for her firm, Basket Wonders (BW).
She has determined that the after-tax
cash flows for the project will be
$10,000; $12,000; $15,000; $10,000;
and $7,000, respectively, for each of
the Years 1 through 5. The initial
cash outlay will be $40,000.
3-6
 Payback Period (PBP)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

PBP is the period of time required for the cumulative

expected cash flows from an investment project to
equal the initial cash outflow.
OR
How many years do we have to wait until the
accumulated cash flows from this investment equal or
exceed the cost of the investment.

3-7
 Payback Solution (#1)

0 1 2 3 (a) 4 5

-40 K (-b) 10 K 12 K 15 K 10 K(d) 7K

10 K 22 K 37 K(c) 47 K 54 K

Cumulative
Inflows PBP = a + ( b - c ) / d =3
+ (40 - 37) / 10 =3+
(3) / 10 = 3.3 Years

3-8
 PBP Acceptance Criterion
The management of Basket Wonders
has set a maximum PBP of 3.5
years for projects of this type.
Should this project be accepted?

Yes! The firm will receive back the

initial cash outlay in less than 3.5
years. [3.3 Years < 3.5 Year Max.]

3-9
 Internal Rate of Return (IRR)

IRR is the discount rate that equates the

present value of the future net cash
flows from an investment project with
the project’s initial cash outflow.

CF1 CF2 CFn

ICO = + +...+
(1+IRR) (1+IRR)2
1
(1+IRR)n

3-10
 IRR Solution

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the

discounted cash flows to equal $40,000.
3-11
 IRR Solution (Try 10%)

$40,000 = $10,000(PVIF10%,1) +
$12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4)
+ $ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) +
$12,000(.826) + $15,000(.751) +
$10,000(.683) + $ 7,000(.621)
3-12
 IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) +
$12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4)
+ $ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) +
$12,000(.756) + $15,000(.658) +
$10,000(.572) + $ 7,000(.497)
3-13
 IRR Solution (Interpolate)

.10
X
$41,444 $1,444
.05 IRR $40,000 $4,603
.15 $36,841

=
X $1,444 .05
$4,603
3-14
 IRR Solution (Interpolate)

.10
X
$41,444 $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X= X = .0157
($1,444)(0.05)
IRR = .10 + .0157 = .1157 or 11.57%
$4,603
3-15
 IRR Acceptance Criterion
The management of Basket Wonders
has determined that the hurdle rate
is 13% for projects of this type.
Should this project be accepted?

No! The firm will receive 11.57% for

each dollar invested in this project at
a cost of 13%. [ IRR < Hurdle Rate ]
3-16
 Net Present Value (NPV)

NPV Is the difference between

an investment’s market
value and its cost.

CF1 CF2 CFn

NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k)n

3-17
 NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)

3-18
 NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $
7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) + $
7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428
3-19
 NPV Acceptance Criterion
The management of Basket Wonders
has determined that the required
rate is 13% for projects of this type.
Should this project be accepted?

No! The NPV is negative. This means

that the project is reducing shareholder
wealth. [Reject as NPV < 0 ]
3-20
 Profitability Index (PI)

PI is the ratio of the present value of

a project’s future net cash flows to
the project’s initial cash outflow.
CF1 CF2 CFn
PI = + +...+ ICO
(1+k)1 (1+k)2 (1+k)n
<< OR >>

PI = 1 + [ NPV / ICO ]
3-21
 PI Acceptance Criterion
PI = $38,572 / $40,000
= .9643 (Method #1, 13-33)

Should this project be accepted?

No! The PI is less than 1.00. This

means that the project is expected to
produce $.9643 for each $1 investment.
[Reject as PI < 1.00 ]
3-22
 Evaluation Summary

Basket Wonders Independent Project

Method Project Comparison Decision
PBP 3.3 3.5 Accept
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
3-23
 Example
The fish flaking facility provide
initial cash outflow of $100000,
the fish farm expected to
generate new cash flows of
$34432,$39530,$39359,and $32219
over the next four years and the
required rate or return is 12%.the
payback period for the project is
3 years.
3-24