Capital Budgeting Decisions

Dr. Avinash Ghalke, CFA

 Independent vs. mutually
exclusive projects
 Relevant when multiple projects are evaluated
 Independent projects are projects in which the
acceptance of one project does not prevent the acceptance
of the other project(s).
 Mutually exclusive projects are projects in which the
acceptance of one project prevents the acceptance of
another or other project(s).

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 Project sequencing
 Projects may be sequenced
 Project contains an option to invest in another project.
 Projects often have real options associated with them;
 Pilot projects can be run
 Company can choose to expand or abandon the project based
on pilot project outcome

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 Capital rationing
 Companies have many profitable projects
 But Capital is a limited resource
 Capital rationing is when the amount available for capex
less than total outlay for all the projects
 Company’s management must determine the priority order
for selecting projects.
 The objective is to maximize owners’ wealth, subject to
the constraint on the capital budget.
 Capital rationing could also result in the rejection of profitable
projects.

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 Conventional cash flows
Only one change in sign

Today 1 2 3 4 5

| | | | | |
| | | | | |

–CF +CF +CF +CF +CF +CF

–CF –CF +CF +CF +CF +CF

–CF +CF +CF +CF +CF

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 Nonconventional cash flows
More than one change in sign

Today 1 2 3 4 5

| | | | | |
| | | | | |

–CF +CF +CF +CF +CF –CF

–CF +CF –CF +CF +CF +CF

–CF –CF +CF +CF +CF –CF

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 Investment decision criteria
Payback Period

Average Accounting Rate of Return (AAR)

Discounted Payback Period

Net Present Value (NPV)

Profitability Index (PI)

Internal Rate of Return (IRR)

Modified Internal Rate of Return (MIRR)

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Payback Period
 Length of time it takes to recover the initial
investment amount

Period Cash Flow (millions)

0 –$2,000
1 300
2 400
3 500
4 600
5 700

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Payback Period
 Advantages
 Easy to calculate
 Easy to understand
 Disadvantages
 Ignores the time value of money
 Ignores the cash flows beyond the payback period

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Discounted Payback Period
 The discounted payback period is the length of time
it takes to recover the initial investment after
accounting for time value of money.

Cash Flow (millions)

Period Project A Project B
0 –$2,000 –$2,000
1 300 300
2 400 400
3 500 500
4 600 600
5 700 0

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Average Accounting Rate of Return (AAR)
 The average accounting rate of return is the average
Net income divided by average book value of assets
 Return on equity for the project.
 Advantages
 Easy to calculate
 Easy to understand
 Disadvantages
 Not based on cash flows
 Ignores the time value of money
 No objective decision criteria

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Net Present Value (NPV)
 Difference between the present values of all inflows
and outflows
 Alternatively, we calculate the present value of all the
future cash flows as on today and net out the
investment today
T
Ci
NPV  C 0   i
i 1 (1  r )

 Decision :
 Accept Project if NPV >0
 Reject Project if NPV <0

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Net Present Value (NPV)
 Calculate the NPV assuming a discount rate of 8%

Period Cash Flow (millions)

0 –$1,500
1 230
2 410
3 570
4 660
5 820

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Net Present Value (NPV)
 Advantages
 Easy to understand (i.e., value added)
 Considers the time value of money
 Considers all project cash flows
 Disadvantages
 Result is a monetary amount, not a return

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Profitability Index (PI)
 PI is the ratio of the present value of future
cashflows to the initial outlay.

PV of cash flows NPV

PI   1
Initial outlay Initial Outlay
 Decision
 PI > 1.0, Accept the Project
 PI < 1.0, Reject the Project

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Internal Rate of Return (IRR)
 IRR is the rate of discounting that makes the NPV as zero
 The internal rate of return is the geometric average return
on a project.

T
Ci
 C0   i
0
i 1 (1  IRR )

 Decision
 Accept the project : IRR > Cost of Capital
 Reject the project : IRR < Cost of Capital

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Internal Rate of Return (IRR)
 Calculate the internal rate of return

Period Cash Flow (millions)

0 –$1,500
1 230
2 410
3 570
4 660
5 820

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Internal Rate of Return (IRR)
 Advantages
 Easy to understand (i.e., return)
 Considers the time value of money
 Considers all project cash flows

 Disadvantages
 Solved iteratively

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NPV versus IRR Conflict
 When projects need to be prioritized, different metrics are
used to organize projects in order
 When projects are mutually exclusive, the acceptance
decision by NPV and IRR criteria may produce divergent
views
 The source of the problem is different reinvestment rate
assumptions
 Net present value: Reinvest cash flows at the required rate of return
 Internal rate of return: Reinvest cash flows at the internal rate of
return
 The problem is evident when there are different patterns of
cash flows or different scales of cash flows

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NPV versus IRR Conflict

A B
0 -300 -300
1 0 125
2 0 125
3 395 125

 Calculate the NPV and IRR for the following cashflows.

 Assume discount rate of 4%, 7%, 10% and 13% for NPV
calculation.

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NPV versus IRR Conflict
A B
0 -300 -300
1 0 125
2 0 125
3 395 125
IRR 9.6% 12.0%
NPV @4% 51.15 46.89
NPV @7% 22.44 28.04
NPV @10% (3.23) 10.86
NPV @13% (26.25) (4.86)

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Multiple IRR Problem
 When cash flows are non-conventional, there may be
more than one rate that can force the present value of the
cash flows to be equal to zero.
 This scenario is called the “multiple IRR problem.”
 There is no unique IRR if the cash flows are
nonconventional.

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 Example: The multiple IRR problem
Consider the fluctuating capital project with the following
end of year cash flows, in millions:
Year Cash Flow
0 –550
1 490
2 490
3 490
4 –940

What is the IRR of this project?

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 Example: The Multiple IRR Problem

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Modified Internal Rate of Return (MIRR)
 MIRR is a variation of the IRR formula where explicit
reinvestment and finance rates are assumed
 Any positive cashflow is assumed to be reinvested at
reinvestment rate
 Any negative cashflow is assumed to be discounted at finance
rate
 MIRR reduces the series of cash flows into
 A single initial investment amount at the present time
 A total accumulated capital amount at the end of the holding
period.

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MIRR Solution
 Lets solve the previous question using the MIRR metric.
Assume reinvestment rate – 15%, Finance rate – 8%

0 1 2 3 4
Cashflows (550) 490 490 490 (940)
Reinvestment rate15% 745 648 564
Finance Rate8% (691)
Final CF (1241) 0 0 0 1957
MIRR 12.1%

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Which method to use ?
 NPV and IRR are preferred over other methods.
 Larger companies tend to prefer NPV and IRR over the
payback period method.
 The payback period is still used, despite its failings.
 NPV is the estimated added value from investing in the
project; this added value should be reflected in the
company’s stock price.

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 Example: Capital rationing
 Consider the following projects, all with a required rate of return of 4%:
Initial
Project NPV PI IRR
Outlay
One –$100 $20 1.20 15%
Two –$300 $30 1.10 10%
Three –$400 $40 1.10 8%
Four –$500 $45 1.09 5%
Five –$200 $15 1.08 5%

Which projects, if any, should be selected if the capital budget is:

1. $100?
2. $200?
3. $300?
4. $400?
5. $500?

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Example: Unequal lives, Mutually exclusive
Consider two projects, Project X and Project Y, both with a
required rate of return of 10%:
End-of-Year
Cash Flows
Year Project X Project Y
0 –$150 –$125
1 75 75
2 80 200
3 180
Which project should be selected, and why?

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Mutually exclusive projects with unequal lives
 Comparing projects with different useful lives
 Comparing NPVs not sufficient
 Timing of replacing the projects would be different

 Approaches for Equalizing

1. Replacement Chain - Determine the least common life for a
finite number of replacements and calculate NPV for each
project.
2. Determine the Annual Equivalent Value that is equivalent to
investing in each project ad infinitum

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 NPV with a Finite number of replacements
Project X 0 1 2 3 4 5 6
0 1 2 3 4 5 6
-150 75 80 180
-150 75 80 180
CF - X -150 75 80 30 75 80 180

NPV-X 209.3
Project Y 0 1 2 3 4 5 6
-125 75 200
-125 75 200
-125 75 200
CF - Y -125 75 75 75 75 75 200

NPV-Y 272.20

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 Annual Equivalent Value
Project X Project Y
PV = 119.53 PV = 108.47
N=3 N=2
I = 10% I = 10%
Solve for PMT Solve for PMT

PMT = 48.07 PMT = 62.5

Therefore, Project Y is preferred (higher equivalent annual annuity).

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Investment Timing
 Projects may not be unprofitable always
 Not feasible today
 May be feasible if postponed

Time period 0 1 2 3 4
when project
taken
1 -100 85 125
2 -110 150 125
3 -121 100 150

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Investment Timing

Time period 0 1 2 3 4 NPV

when project Today
taken

1 -100 85 125
80.58

2 -110 150 125

117.88

3 -121 100 150

77.58
Cash Flow for Investment Analysis

Dr. Avinash Ghalke, CFA

Capital Budgeting

“The process of identifying, analyzing, and selecting

investment projects whose returns (cash flows) are
expected to extend beyond one year”

 Capital budgeting deals with allocation of funds to long-

lived capital projects.
 Capital is provided in terms of debt or equity
Capital Budgeting
 A company’s capital budgeting process and prowess are
important in valuing a company.
 The projects primarily deal with
 Replacement projects
 Expansion projects
 New products or services
 Research and development
 Exploration
Basic principles of Capital Budgeting
 Decisions are based on cash flows.
 The timing of cash flows is crucial.
 Cash flows are incremental.
 Cash flows are on an after-tax basis.
Principles for estimation
 Ignore sunk costs
 Cost has already occurred, so it cannot be part of the
incremental cash flows
 Include project-driven changes in working capital net of
spontaneous changes in current liabilities
 Cash is consumed / stuck
 Include effects of inflation
Calculating the Incremental Cash Flows

 Initial cash outflow – the initial net cash investment.

 Interim incremental net cash flows – those net cash flows
occurring after the initial cash investment but not including
the final period’s cash flow.
 Terminal-year incremental net cash flows – the final
period’s net cash flow.
Depreciable Basis
In tax accounting, the fully installed cost of an asset. This
is the amount that, by law, may be written off over time
for tax purposes.
Depreciable Basis =
Cost of Asset + Capitalized Expenditures

Capitalized Expenditures are expenditures that may

provide benefits into the future and therefore are treated as
capital outlays and not as expenses of the period in which
they were incurred.
Examples: Shipping and installation
Sale or Disposal of a Depreciable Asset
 Sale of a capital asset generates
 Capital gain (asset sells for more than book value) or
 Capital loss (asset sells for less than book value)
 Capital gains may be taxed at different tax rates than the
corporate tax rate
 Initial Cash Outflow – Expansion

1. Cost of “new” assets

2. + Capitalized expenditures
3. + (–) Increased (decreased) NWC
4. = Initial cash outflow
 Incremental Cash Flows – Expansion

1. Net incr. (decr.) in operating revenue less (plus)

any net incr. (decr.) in operating expenses, excluding
depr.
2. – (+) Net incr. (decr.) in tax depreciation
3. = Net change in income before taxes
4. – (+) Net incr. (decr.) in taxes
5. = Net change in income after taxes
6. + (–) Net incr. (decr.) in tax depr. charges
7. -(+) Net incr. (decr.) in working capital
8. = Incremental net cash flow for period
 Terminal-Year Incremental Cash Flows –
Expansion
1. Calculate the incremental net cash flow for the terminal
period (Finite Life)
2. + (–) Salvage value (disposal/reclamation costs) of
any sold or disposed assets
3. – (+) Taxes (tax savings) due to asset sale or
disposal of “new” assets
4. + (–) Decreased (increased) level of “net” working
capital
5. = Terminal year incremental net cash flow
Terminal-Year Incremental Cash Flows
Calculate the incremental net cash flow for the terminal
period (Infinite Life)

Terminal Value (TV) represents the sum of all the cashflows

beyond explicit forecast period, till infinite time
CFn(1  g )
TVn 
g is the long term growth(krate
 g)
k is the cost of capital
n is the last year of the explicit forecast period
Example of an Asset Expansion Project

Fit Garments (FG) is considering the purchase of a new cloth

weaving machine. The machine will cost Rs50,000 plus
Rs20,000 for shipping and installation. The asset will be
depreciated at 20% WDV. Initial NWC will rise by Rs5,000.
Management forecasts that revenues will increase by
Rs110,000 for each of the next 4 years and asset will be sold
(scrapped) for Rs10,000 at the end of the fourth year, when the
project ends. Capital gains are taxed at 23%. Operating costs
will rise by Rs70,000 for each of the next four years. FG is in
the 30% tax bracket.
Initial Cash Outflow

1. -50,000
2. + -20,000
3. + -5,000
4. = Rs -75,000
Incremental Cash Flows

Year 1 Year 2 Year 3 Year 4

1. 40,000 40,000 40,000 40,000
2. – 14,000 11,200 8,960 7,168
3. = 26,000 28,800 31,040 32,832
4. – 7,800 8,640 9,312 9,850
5. = 18,200 20,160 21,728 22,982
6. + 14,000 11,200 8,960 7,168
7. + 0 0 0 0
8. = 32,200 31,360 30,688 30,150
 Terminal-Year Incremental Cash Flows

1. 30,150The incremental cash flow from

the previous slide in Year 4.
2. + 10,000 Salvage Value.
3. + 42950.23*(10,000 – 28672)
4. + 5,000 NWC - Project ends.
5. = 49,445 Terminal-year incremental
cash flow.
Summary of Project Net Cash Flows

Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
–75,000 32,200 31,360 30,688 49,445
Summary of Project Net Cash Flows

Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
–75,000 32,200 31,360 30,688 49,445
Case Study …cont

XYZ Company has decided to rent additional space adjacent to its

current store. The equipment required for the facility will cost
$50,000.
Shipping and installation charges for the equipment are expected to
total $5,000. This equipment will be depreciated on a straight-line
basis over its 5-year economic life to an estimated salvage value of
$0. In order to open the exercise facility, XYZ estimates that it will
have to add about $7,000 initially to its net working capital in the
form of additional inventories of exercise supplies, cash, and
accounts receivable for its exercise customers (less accounts
payable).
Case Study …cont

During the first year of operations, XYZ expects its total revenues
(from yogurt sales and exercise services) to increase by $50,000
above the level that would have prevailed without the exercise
facility addition. These incremental revenues are expected to grow
to $60,000 in year 2, $75,000 in year 3, decline to $60,000 in year
4, and decline again to $45,000 during the fifth and final year of
the project’s life. The company’s incremental operating costs
associated with the exercise facility, including the rental of the
facility, are expected to total $25,000 during the first year and
increase at a rate of 6 percent per year over the 5-year project life.
Case Study

Depreciation will be $11,000 per year ($55,000 installed cost,

assuming no salvage value, divided by the 5-year economic life).
XYZ has a marginal tax rate of 40 percent. In addition, TLC
expects that it will have to add about $5,000 per year to its net
working capital in years 1, 2, and 3 and nothing in years 4 and 5. At
the end of the project, the total accumulated net working capital
required by the project will be recovered.