CAPITAL BUDGETING

What it is

• Large investment in plant or equipment

with returns over a period of time.

• Investment may take place over a period of time

• A Strategic Investment Decision

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 CAPITAL BUDGETING
Purpose

• Expansion

• Improvement

• Replacement

• R&D
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 CAPITAL BUDGETING
What do we need to think about?
• Location

• Infrastructure

• Labour

• Cash Flows

What is the most important?

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 OVERALL AIM
To maximise shareholders wealth..

Projects should give a return over and above the

marginal weighted average cost of capital.

Projects can be;

• Mutually exclusive
• Independent
• Contingent

Process of Choice

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 IDEAL SELECTION METHOD
Will
• Select the project that maximises
shareholders wealth
• Consider all cash flows
• Discount the cash flows at the appropriate
market determined opportunity cost of
capital
• Will allow managers to consider each
project independently from all others
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 SELECTION METHODS
• Payback

• ARR

• Net Present Value (NPV)

• Internal Rate of Return (IRR)

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 CHOICE
PAYBACK

Project A Project B
Yr 0 - 1,000,000 - 1,000,000
Yr 1 + 1,100,000 + 500,000
Yr 2 + 200,000 + 500,000
Yr 3 - 100,000 + 500,000

Project A = Year .909

Project B = ?
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 PAYBACK

Problems:-
• Ignores overall return

• Ignores impact of large flows

• Ignores timing of flows

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 ARR
Project A Project B
Yr 0 - 1,000,000 - 1,000,000
Yr 1 + 1,100,000 + 500,000
Yr 2 + 200,000 + 500,000
Yr 3 - 100,000 + 500,000
n
RoA Project A = Σ ( cashflows) ÷ Io
t=o n

• (200,000) = 66,666.66 ÷ 1,000,000 = .0666 or 6.67%

3

Project B?
Problems?
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 NET PRESENT VALUE
PROJECT A
Yr CF PV Factor @ 14% Present Value
0 - 1,000,000 1.000 - 1,000,000
1 500,000 .8772 438,600
2 500,000 .7695 384,750
3 500,000 .6750 337,500
4 500,000 .5921 296,050
5 - 500,000 .5194 - 259,700
NPV 197,200

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 NET PRESENT VALUE
PROJECT B

- 1,000,000
900,000
200,000
200,000
100,000
100,000

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 NET PRESENT VALUE
PROJECT B

- 1,000,000 - 1,000,000
900,000 789,480
200,000 153,900
200,000 135,000
100,000 59,210
100,000 51,940
NPV 189,530

Which project should we undertake?

Why?

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 Internal Rate of Return
Project A
Yr CF PVF@ 26% PV PVF@ 27%
0 -1,000,000 1.0000 = - 1,000,000 1.0000 - 1,000,000
1 500,000 .793651 = 396,825 .787401 393,701
2 500,000 .629881 = 314,941 .620001 310,000
3 500,000 .499906 = 249,953 .488190 244,095
4 500,000 .396751 = 198,376 .384401 192,200
5 - 500,000 .314881 = - 157,441 .302678 -
151,339
2,654 -11,343
Interpolation
IRR = 26.19%
Project B
0 -1,000,000 1.0000 = - 1,000,000 1.0000 - 1,000,000
1 900,000 = 714,286 708,661
2 200,000 = 125,976 124,002
3 200,000 = 99,981 97,638
4 100,000 = 39,675 38,440
5 100,000 = 31,488 30,268
IRR = 27% 11,406 - 991 13
 Interpolation
26% 27%
+2,654 -11,343

13,997
Q. Where on the line does 0 fall?

From + 2654 0 = 2654 = .1896 or 18.96% of distance

13997

Since distance = 27-26 = 1% = .1896 of 1%

 Answer = 26 + .1896 = 26.19%

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 Test @ 26.19%

Yr CF PVIF PV
0 - 1,000,000 1.0000 -1,000,000
1 500,000 .7924558 396,228
2 500,000 .6279862 313,993
3 500,000 .4976513 248,826
4 500,000 .3943667 197,183
5 - 500,000 .3125182 - 156,259
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 Comparison of NPV vs. IRR

1. NPV accepts all projects with NPV > 0.

Ranking of projects is by value of NPV.
2. IRR finds the value of the discount rate that
makes NPV = 0. Project will be accepted if
IRR > k (cost of capital)
The big Q?
Will the two methods always give the same
answer?
No, unfortunately not

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 NPV Vs IRR
Relationship between NPV,IRR and
Discount Rates

0 10 20 30 40 50 Disc rate

NPV
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Yr CF PV@10% PV@20%
1 400 363.6 333.3
2 400 330.4 277.76
3 - 1,000 - 751.0 - 578.70
- 57 32.4
IRR = 15.8%

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 Reinvestment Rate Assumption
Project Yr0 Yr1 Yr2 Yr3 C of K NPV IRR
X -10,000 5,000 5,000 5,000 10% 2,430 23.4%
Y -10,000 0 0 17,280 10% 2,977 20.0%

Illustration
Reinvestment
@23.4% End Yr 1 End Yr 2 End Yr 3
5,000 6,170 7,613
5,000 6,170
5,000
18,783

@ 10% 5,000 5,500 6,050

5,000 5,500
5,000
16,550
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 Value Additivity

Project NPV @10% IRR%

1 354 134.5
2 104 125.0
3 309 350.0

1+3 663 212.8

2+3 413 237.5

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 Multiple Rates of Return
• Multiple Rates of Return
NPV
400

200 IRR 15%

Discount Rate
0
IRR – 12%
- 200

- 400
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 NPV Vs IRR
Conclusion

NPV is the correct method to use

But - there are some additional issues

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 Other Issues
• Scale
How do we evaluate between projects of
different scale?
Project Outlay PV @ 10 % NPV
A - 400 572 172
B - 500 683 183
How do we compare?
If we have plenty of capital then it is not a problem.
Both have a positive NPV so do both.

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 Other Issues
Scale
• Suppose we only have 600 worth of capital.
Which project should we take?
• Work out the Profitability Index
Present Value = PI
Cost
• Project A = 572 = 1.43
400
Project B = 683 = 1.37
500

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 Other Issues
Scale
• Now work out the weighted PI
• For A (1.43 x 400) + (1 x 200) = 1.2866
600 600
.9533 .3333

For B (1.37 x 500) + (1 x 100) = 1.3084

600 600
Therefore take Project B
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 Other Issues
Project Lives
• What if projects take place over different
time scales?
Yr Project A Project B
0 - 17,500 -17,500
1 10,500 7,000
2 10,500 7,000
3 8,313
NPV @ 10% 723 894
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 Other Issues
Project Lives
• How to choose
• Assume you are able to repeat the projects
until they have the same end date
0 2 4 6A
3 B

723
597 723 (discount at 10%)
598 723 (discount at 10%)
1813
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 Project Lives
• Project B
0 2 4 6
3
894
672 894 (discount at 10%)
1566

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 Project Lives
• This approach is fine for simple project
lives but what if they are complex?
• E.g.lives of 7 years, 9 years and 13 years
• Answer make them all last for ever!
• NPV(n, to inf) = NPVn (1+ k)n
(1+ k)n – 1

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 Project Lives
• E.g. NPV2 to inf = 723 (1.1)2 = 723 x 1.21
(1.1)2 - 1 .21
723 x 5.76 = 4,165

NPV3 to inf = 894 (1.1)3 = 894 x 1.331

• (1.1)3 – 1 .331

894 x 4.02 = 3,596

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 Cash Flows
Example –
Consider the following new project:-
Initial capital investment of £15m.
It will generate sales for 5 years.
Variable Costs equal 70% of sales.
Fixed cost of project =£200,000 P.A.
A feasibility study, cost £5000, has already been carried out.
Discount rate = 12%.
Should we take the project?
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 Cash Flows
£000's 2000 2001 2002 2003 2004 2005

SALES 14000 16000 18000 20000 22000 90000

VARIABLE COSTS -9800 -11200 -12600 -14000 -15400 -63000

OPERATING EXPENSES -200 -200 -200 -200 -200 -1000

EQUIPMENT COSTS -15000 -15000

CASHFLOWS -15000 4000 4600 5200 5800 6400 11000

DF @ 12% 1.00 0.893 0.797 0.712 0.636 0.567

NPV -15000 3571 3667 3701 3686 3632 3257

19.75 1.00 0.84 0.70 0.58 0.49 0.41

IRR = 19.75% -15000 3340 3208 3028 2820 2599 -4

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 Cash Flows
Treatment of depreciation in NPV analysis.
-We only use cashflows in investment appraisal.
-Depreciation is not a cashflow.
-However, depreciation (capital allowances) is allowable against
tax (see income statement), which affects cashflow.
For cashflow, add depreciation back:-

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 Treatment of Depreciation
£000's 2000 2001 2002 2003 2004 2005

SALES 14000 16000 18000 20000 22000 90000

VARIABLE COSTS -9800 -11200 -12600 -14000 -15400 -63000

OPERATING EXPENSES -200 -200 -200 -200 -200 -1000

EQUIPMENT COSTS -15000 -15000

DEPRECIATION -3000 -3000 -3000 -3000 -3000
NOI -15000 1000 1600 2200 2800 3400 11000
NOI AFTER TAX 800 1280 1760 2240 2720 8800
ADD BACK DEPN (= NCF) 3800 4280 4760 5240 5720 23800

DF @ 12% 1.00 0.893 0.797 0.712 0.636 0.567

-15000 3393 3412 3388 3330 3246 1769

NPV -15000 3266 3162 3022 2859 2683 -8

DF 16.35 1.00 0.86 0.74 0.63 0.55 0.47

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 Issues to Consider
Cash Flows
• But not in detail!
• Cash flows should be incremental
- include all incidental effects (redundancy)
- Do not forget working capital
- Do forget sunk costs!
- Be careful with allocated overheads

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 Issues to Consider
Cash Flows
• ‘Uncertainty means more things can happen
than will happen’ Brealy and Myers.
• How do we obtain a feel for what the cash flows
are most likely to be?
• - Sensitivity Analysis
• - Scenario Analysis
• - Break Even Analysis
• - Simulation
• - Decision Trees
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 Issues to Consider
Discount Rate
• We also need to consider what discount
rate to use as this will also effect the
outcome.

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