Capital Budgeting

Corporate Finance – I ( Unit III)

Structure
• Meaning and Nature
• Importance of Capital Budgeting decisions
• Methods of Evaluating Capital Budgeting Proposals
• Risk analysis in Capital Budgeting
• Final Comments
• Numerical solving exercises
The Balance Sheet Model
The Capital Budgeting Decision
(Investment Decision) Current
Liabilities
Current Assets
Long-Term
Debt

What long-
Fixed Assets
term
1 Tangible investments
should the Shareholders’
2 Intangible firm engage Equity
in?
Typical Capital Budgeting
Decisions
Plant expansion

Equipment selection Equipment replacement

Lease or buy Cost reduction

Meaning of Capital budgeting
• Capital Budgeting is the process of determining which real investment projects should be
accepted and given an allocation of funds from the firm.
• To evaluate capital budgeting processes, their consistency with the goal of shareholder
wealth maximization is of utmost importance.
• Company prepares a capital expenditure budget to allocate funds towards investment in
fixed assets
• Funds may have to be rationed across various projects through the Budget , this process is
called as capital rationing
Why capital budgeting proposals are most
important
• Long Term
• Irreversible
• Large amount of investment involved
Methods of Evaluating capital budgeting proposals

• The main DCF techniques for capital budgeting include: Net Present Value (NPV), Internal Rate of
Return (IRR), Profitability Index (PI) and Discounted Payback period ( DPP)
• Each except DPP requires estimates of expected cash flows (and their timing) for the project.
• Including cash outflows (costs) and inflows (revenues or savings) – normally tax effects are also
considered.
• Each except DPP requires an estimate of the project’s risk so that an appropriate discount rate
(opportunity cost of capital) can be determined.
• The discussion of risk will be deferred until later. For now, we will assume we know the relevant
opportunity cost of capital or discount rate.
• Sometimes the above data is difficult to obtain – this is the main weakness of all DCF
techniques.
Calculation of Cash Inflows, Outflows and
the Discounting Rate.
• Demonstrated on Board
• Cash Inflows are calculated and then discounted with the discounting
rate
• Could there be a situation where cash outflows also have to be
discounted ?
The Net Present Value Method

To determine net present value we . . .

• Calculate the present value of cash
inflows,
• Calculate the present value of cash
outflows,
• Subtract the present value of the
outflows from the present value of
the inflows.
The Net Present Value Method

If the Net Present

Value is . . . Then the Project is . . .
Acceptable because it promises
Positive . . . a return greater than the
required rate of return.

Acceptable because it promises

Zero . . . a return equal to the required
rate of return.

Not acceptable because it

Negative . . . promises a return less than the
required rate of return.
Typical Cash Outflows

Repairs and
maintenance

Working Initial
capital investment

Incremental
operating
costs
Typical Cash Inflows

Salvage
value

Release of
Reduction
working
of costs
capital

Incremental
revenues
 The Net Present Value Method

Lester Company has been offered a five year contract

to provide component parts for a large manufacturer.
Cost and revenue information
Cost of special equipment $160,000
Working capital required 100,000
Relining equipment in 3 years 30,000
Salvage value of equipment in 5 years 5,000
Annual cash revenue and costs:
Sales revenue from parts 750,000
Cost of parts sold 400,000
Salaries, shipping, etc. 270,000
The Net Present Value Method

At the end of five years the working capital will

be released and may be used elsewhere by
Lester.

Lester Company uses a discount rate of 10%.

Should the contract be accepted?

The Net Present Value Method

Annual net cash inflow from operations

Sales revenue $ 750,000

Cost of parts sold (400,000)
Salaries, shipping, etc. (270,000)
Annual net cash inflows $ 80,000
 The Net Present Value Method
Cash 10% Present
Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 0.621 3,105
Working capital released 5 100,000 0.621 62,100
Net present value $ 85,955

Accept the contract because the project has a

positive net present value.
NPV: Strengths and Weaknesses

• Strengths
• Resulting number is easy to interpret: shows how wealth will change if the project is accepted.
• Acceptance criteria is consistent with shareholder wealth maximization.
• Relatively straightforward to calculate
• Weaknesses
• Requires knowledge of finance to use.
• An improper NPV analysis may lead to the wrong choices of projects when the firm has capital rationing
– this will be discussed later.
Internal Rate of Return (IRR)

• IRR is the rate of return that a project generates. Algebraically, IRR can be determined by setting up
an NPV equation and solving for a discount rate that makes the NPV = 0.
• Equivalently, IRR is solved by determining the rate that equates the PV of cash inflows to the PV of
cash outflows.
• If IRR ≥ opportunity cost of capital (or hurdle rate), then accept the project; otherwise reject it.
Internal Rate of Return Method
• Decker Company can purchase a new machine
at a cost of $104,320 that will save $20,000 per
year in cash operating costs.
• The machine has a 10-year life.
Internal Rate of Return Method

Future cash flows are the same every year in this

example, so we can calculate the internal rate of return as
follows:

PV factor for the Investment required

=
internal rate of return Annual net cash flows

$104, 320 = 5.216

$20,000
Internal Rate of Return Method
Using the present value of an annuity of $1 table . . .

Find the 10-period row, move across

until you find the factor 5.216. Look
at the top of the column and you
find a rate of 14%.

Periods 10% 12% 14%

1 0.909 0.893 0.877
2 1.736 1.690 1.647
. . . . . . . . . . . .
9 5.759 5.328 4.946
10 6.145 5.650 5.216
Internal Rate of Return Method

• Decker Company can purchase a new machine at a cost of

$104,320 that will save $20,000 per year in cash operating
costs.
• The machine has a 10-year life.

The internal rate of return on

this project is 14%.

If the internal rate of return is equal to

or greater than the company’s required
rate of return, the project is acceptable.
IRR: Strengths and Weaknesses

• Strengths
• IRR number is easy to interpret: shows the return the project generates.
• Acceptance criteria is generally consistent with shareholder wealth maximization.
• Weaknesses
• It is possible that there exists no IRR or multiple IRRs for a project and there are several
special cases when the IRR analysis needs to be adjusted in order to make a correct decision.
Profitability Index (PI)

• Method: PVCash flows after the initialinvestment

PI 
Initial Investment
• Note: PI should always be expressed as a positive number.
• If PI ≥ 1, then accept the real investment project; otherwise, reject it.
PI: Strengths and Weaknesses
• Strengths
• PI number is easy to interpret: shows how many $ (in PV terms) you get back per $ invested.
• Acceptance criteria is generally consistent with shareholder wealth maximization.
• Relatively straightforward to calculate.
• Useful when there is capital rationing

• Weaknesses
• Method needs to be adjusted when there are mutually exclusive projects (to be discussed later).
Ranking Investment Projects
Project Net present value of the project
=
profitability Investment required
index
Project A Project B
Net present value (a) $ 1,000 $ 1,000
Investment required (b) $ 10,000 $ 5,000
Profitability index (a) ÷ (b) 0.10 0.20

The higher the profitability index, the

more desirable the project.
The Payback Period Method ( Discounted
Payback period)
• The payback period is the period within which the project recovers
back its initial investment( cost)
• Projects with lower payback periods are preferred? Why ??
• A major limitation of this method is that it does not talk about cash
flows post the payback period and therefore is not consistent with the
objective of Shareholder wealth maximization

Investment required
Discounted Payback period =
Discounted Annual net cash inflow
Limitation of Payback Period Method
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
Project X has a payback period of 2 years.
Project Y has a payback period of slightly more than 2 years.
Which project do you think is better?