FINANCIAL MANAGEMENT – Module 1

FINANCIAL MANAGEMENT – Module 6

 CAPITAL BUDGETING

Under Uncertainty
PROCESS

DECISIONS

TECHNIQUES
Under Certainty
 WHAT IS CAPITAL BUDGETING

 Process of planning
expenditures with
returns that extend
beyond one year
 Conducted under
conditions of certainty
or uncertainty
 WHAT IS CAPITAL BUDGETING

 Capital Budget - The

list of planned
investment projects.
The Decision Process
1. Develop and rank all investment projects = The Capital Budget
2. Authorize projects based on:
 Outlays required by law or company policy
 Maintenance or cost reduction
 Capacity expansion in existing business
 Investment for new products
 WHY PLAN CAPITAL EXPENDITURES

 Huge amount of outlay

 Long gestation period
 Risky
 Availability of financing
 Unpredictability of returns
 Unpredictability of cashflow
 Decision choices
 Rationing/allocation of capital
 Conditions of certainty vs. certainty
 Capital Budgeting Process

 Capital Budgeting Problems

 Ensuring that forecasts are consistent
 Eliminating conflicts of interest
 Reducing forecast bias
 Sorting the wheat from the chaff - Selection
criteria (NPV and others)
UNDER WHAT FRAMEWORK SHOULD CAPITAL
BUDGETING BE INTEGRATED

Integrated with:

STRATEGIC PLANNING
FRAMEWORK
WHAT ARE THE CATEGORIES OF CAPITAL
BUDGETING DECISIONS

 Project size
 Effect on business risk
 Cost reduction & revenue increase
 Replacements
 Expansion
 Growth
 Mandatory/intangible investments
 Degree of independence
 Administrative aspects
 CAPITAL BUDGETING TECHNIQUES

 Project Evaluation
and Selection
 Potential Difficulties
 Capital Rationing
 Project Monitoring
 Post-Completion
Audit
WHAT ARE THE EVALUATION CRITERIA FOR
RANKING CAPITAL BUDGETS

 Cash payback (CP)

 Discounted cash
payback (DCP)
 Accounting rate of
return (ARR)
 Net present value
(NPV)
 Internal rate of return
(IRR)
 Profitability index (PI)
WHAT ARE THE GENERAL PRINCIPLES
IN ARRIVING AT OPTIMAL
CAPITAL BUDGETING DECISIONS

 Consider all cash flows

 Discount cash lows at appropriate market-
determined cost of capital
 Select projects that maximizes shareholder’s
wealth
 Allow managers to consider each project
independently from all others (known as
value additivity principle)
 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.
 Independent Project
 For this project, assume that it is
independent of any other potential
projects that Basket Wonders may
undertake.
 Independent -- A project whose
acceptance (or rejection) does not prevent
the acceptance of other projects under
consideration.
 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.
 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
 Payback Solution (#2)
0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K
-40 K -30 K -18 K -3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K
Cumulative = 3.3 Years
Cash Flows Note: Take absolute value of last
negative cumulative cash flow value.
 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.]
 PBP Strengths
and Weaknesses
Strengths: Weaknesses:
 Easy to use and  Does not account
understand for TVM
 Can be used as a  Does not consider
measure of cash flows
liquidity beyond the PBP
 Easier to forecast  Cutoff period is
ST than LT flows subjective
 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
 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.
 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)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
 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)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
 IRR Solution (Interpolate)
.10 $41,444
X $1,444
.05 IRR $40,000
$4,603
.15 $36,841

X $1,444
=
.05 $4,603
 IRR Solution (Interpolate)
.10 $41,444
X $1,444
.05 IRR $40,000
$4,603
.15 $36,841

X $1,444
=
.05 $4,603
 IRR Solution (Interpolate)
.10 $41,444
X $1,444
.05 IRR $40,000
$4,603
.15 $36,841

X= ($1,444)(0.05) X = .0157
$4,603
IRR = .10 + .0157 = .1157 or 11.57%
 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 ]
IRRs on the Calculator
We will use the cash
flow registry to
solve the IRR for
this problem quickly
and accurately!
 Actual IRR Solution Using
Your Financial Calculator
Steps in the Process
Step 1: Press CF key
Step 2: Press 2nd CLR Work keys
Step 3: For CF0 Press -40000 Enter  keys
Step 4: For C01 Press 10000 Enter  keys
Step 5: For F01 Press 1 Enter  keys
Step 6: For C02 Press 12000 Enter  keys
Step 7: For F02 Press 1 Enter  keys
Step 8: For C03 Press 15000 Enter  keys
Step 9: For F03 Press 1 Enter  keys
 Actual IRR Solution Using
Your Financial Calculator
Steps in the Process (Part II)
Step 10:For C04 Press 10000 Enter  keys
Step 11:For F04 Press 1 Enter  keys
Step 12:For C05 Press 7000 Enter  keys
Step 13:For F05 Press 1 Enter  keys
Step 14: Press   keys
Step 15: Press IRR key
Step 16: Press CPT key

Result: Internal Rate of Return = 11.47%

 IRR Strengths
and Weaknesses
Strengths: Weaknesses:
 Accounts for  Assumes all cash
TVM flows
 Considers all reinvested at the IRR
cash flows
 Less  Difficulties with
subjectivity project rankings
and Multiple IRRs
 Net Present Value (NPV)
NPV is the present value of an investment project’s
net cash flows minus the project’s initial cash outflow.

CF1 CF2 CFn

NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k)n
 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)
 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
 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 ]
NPV on the Calculator
We will use the cash
flow registry to solve
the NPV for this
problem quickly and
accurately!

Hint: If you have not

cleared the cash flows
from your calculator, then
you may skip to Step 15.
 Actual NPV Solution Using
Your Financial Calculator
Steps in the Process
Step 1: Press CF key
Step 2: Press 2nd CLR Work keys
Step 3: For CF0 Press -40000 Enter  keys
Step 4: For C01 Press 10000 Enter  keys
Step 5: For F01 Press 1 Enter  keys
Step 6: For C02 Press 12000 Enter  keys
Step 7: For F02 Press 1 Enter  keys
Step 8: For C03 Press 15000 Enter  keys
Step 9: For F03 Press 1 Enter  keys
 Actual NPV Solution Using
Your Financial Calculator
Steps in the Process (Part II)
Step 10:For C04 Press 10000 Enter  keys
Step 11:For F04 Press 1 Enter  keys
Step 12:For C05 Press 7000 Enter  keys
Step 13:For F05 Press 1 Enter  keys
Step 14: Press   keys
Step 15: Press NPV key
Step 16: For I=, Enter 13 Enter  keys
Step 17: Press CPT key
Result: Net Present Value = -$1,424.42
 NPV Strengths
and Weaknesses
Strengths: Weaknesses:
 Cash flows  May not include

assumed to be managerial
reinvested at options
the hurdle rate. embedded in the
 Accounts for TVM. project. See
Chapter 14.
 Considers all
cash flows.
 Net Present Value Profile
$000s
Sum of CF’s Plot NPV for each
15 discount rate.
Net Present Value

Thre
e of th
10 ese
poin
t s ar
e ea
sy n
5 IRR ow!
NPV@13%
0
-4
0 3 6 9 12 15
Discount Rate (%)
Creating NPV Profiles
Using the Calculator

Hint: As long as you

do not “clear” the cash
flows from the registry,
simply start at Step 15
and enter a different
discount rate. Each
resulting NPV will
provide a “point” for
your NPV Profile!
 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.
Method #1:
CF1 CF2 CFn
PI = + +...+ ICO
(1+k)1 (1+k)2 (1+k)n
<< OR >>
Method #2:
PI = 1 + [ NPV / ICO ]
 PI Acceptance Criterion
PI = $38,572 / $40,000
= .9643 (Method #1, 13-34)

Should this project be accepted?

No! The PI is less than 1.00. This

means that the project is not profitable.
[Reject as PI < 1.00 ]
 PI Strengths
and Weaknesses
Strengths: Weaknesses:
 Same as NPV  Same as NPV
 Allows  Provides only
comparison of relative profitability
different scale  Potential Ranking
projects Problems
 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
WHAT ARE THE APPROACHES TO CAPITAL
BUDGETING UNDER UNCERTAINTY

 Sensitivity Analysis
 Monte Carlo Simulation
 Decision Tree
 CAPM
 HOW IS DECISION TREE
ANALYSIS ILLUSTRATED

Demand PV of Less Possible Probable

Action Cond. Prob CV Initial NPV NPV
(1) (2) (3) (4) Cost (4)-(5) (3)x(6)
Build big
plant at H 50 P8.8 M P5.0 M P3.8 M P1.900 M
P5.0 M M 30 P3.5 M P5.0 M (P1.5 M) (P0.450 M)
1
L 20 P1.4 M P5.0 M (P3.6 M) (P0.720 M)
Expected NPV P0.730 M
Decision
H 50 P2.6 M P2.0 M P0.6 M P0.300 M
2 M 30 P2.4 M P2.0 M P0.4 M P0.120 M
L 20 P1.4 M P2.0 M (P0.6 M) (P0.120 M)
Build small
Expected NPV P0.300 M
plant at
P2.0 M
 VALUATION APPROACHES
How are assets valued/priced

 Present Value Method

 Capitalization Method
 Book Value Method
 Net Asset Value Method
 Price-Earnings Method
 Dirty Asset Value Method
END OF MODULE 6