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Ridha ESGHAIER
Principles of Corporate
Finance
CHAPTER 2: DISCOUNTED
CASH FLOW APPLICATIONS
(Capital Budgeting)
Course Plan
11-2
A. What is capital
budgeting?
Capital budgeting is the process of
identifying and analyzing projects, and
deciding which ones to include in the
capital budget.
Is the process by which the firm decides
which long-term investments to make.
It is a Long-term decision that involves
large expenditures, and thus, is very
important to firm’s future.
B. Classification of investments
According to their degree of homogeneity
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Dr. Ridha ESGHAIER
Independent investments
Independent investments serve different purposes
and do not compete with each other.
The cash flows of one are unaffected by the
acceptance of the other.
For example, a heavy engineering company may be
considering expansion of its plant capacity to
manufacture additional excavators and addition of new
production facilities to manufacture a new product light
commercial vehicles. Depending on their profitability and
availability of funds, the company can undertake both
investments.
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Dr. Ridha ESGHAIER
Contingent investments
Contingent investments are dependent projects; the
choice of one investment necessitates undertaking one or
more other investment.
For example, if a company decides to build a factory in
a remote, backward area, it may have to invest in
houses, roads, hospitals, and many more for employees
to attract the work force. Thus, building of factory also
requires investment in facilities for employees. The total
expenditure will be treated as one single investment.
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Dr. Ridha ESGHAIER
11-9
C. Criteria of investment
choice: the Financial techniques
0 1 2 3
Project L
-100 10 60 80
0 1 2 3
Project S
-100 70 50 20
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Calculating regular payback
Project L’s Payback
Calculation 0 1 2 3
CFt -100 10 60 80
Cumulative -100 -90 -30 +50
Payback (L) =
Payback (S) =
Dr. Ridha ESGHAIER
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Dr. Ridha ESGHAIER
Calculating payback
The Linear interpolation System
Project L’s Payback
Calculation
0 1 2 3
CFt -100 10 60 80
Cumulative -100 -90 -30 +50
NPV Calculation 0 r%
1 2 … n
…
CFn/(1+r)n
CF1 CF2 CFn
NPV = CF0 + + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) n
Years 0 1 2 3
CFs Project L $-100 $10 $60 $80
CFs Project K $-100 $30 $40 $50
0 1 2 3
Project L’s NPV 10%
-100 10 60 80
Calculation
10/(1.1)1
Sum of PV of CF0-3
60/(1.1)2
80/(1.1)3
NPV= 18.79
CF1 CF2 CF3
NPV = CF0 + + +
(1 + r )1 (1 + r ) 2 (1 + r )3
NPV (L) =
NPV (K) =
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Dr. Ridha ESGHAIER
Strengths
All the CFs are taken into account.
The timing of CFs is considered.
The required rate of return on the project is
considered (Through the discounting rate).
Weaknesses
Is very sensitive to the choice of the discounting rate.
Does not allow to compare projects with different
economic lives and different sizes.
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Dr. Ridha ESGHAIER
CF2/(1+IRR)2
ΣPV of CF1-n = -CF0
…
CFn/(1+IRR)n
NPV = 0
CF1 CF2 CFn
NPV = CF0 + + + ... + =0
(1 + IRR) (1 + IRR)
1 2
(1 + IRR)n
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We can represent this project as follows:
0 1 2 3
10%
x(1+5%)1
$400 420
x(1+5%)2
$500 551.25
x(1+5%)3
$600 694.575
∑=I0=$1,500
0 1 2 3
10%
x(1+5%)-1
$400 420
x(1+5%)-2
$500 551.25
x(1+5%)-3
$600 694.575
∑=I0=$1,500
420 551.25 694.575
Which means that: 1,500 = + +
(1 + 5%)1 (1 + 5%) 2 (1 + 5%) 3
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Dr. Ridha ESGHAIER
Dr. Ridha ESGHAIER
11-28
IRR approximation
CF1 CF2 CFn
NPV = CF0 + + + ... + =0
(1 + IRR) (1 + IRR)
1 2
(1 + IRR)n
1- Guess the value of r and calculate the NPV of the project at that value.
2- If NPV is close to zero then IRR is equal to r.
3- If NPV is greater than 0 then increase r and jump to step 5.
4- If NPV is smaller than 0 then decrease r and jump to step 5.
5- Recalculate NPV using the new value of r and go back to step 2.
Lets call:
ra: the lower discount rate chosen at which NPVa > 0
rb: the higher discount rate chosen at which NPVb < 0
NPVa
IRR = ra + (rb − ra )
NPVa + NPVb
0 1 2 3
Project L’s IRR IRR
-100 10 60 80
Calculation
10/(1+IRR)1
Sum of PV of CF1-3 60/(1+IRR)2
= 100
80/(1+IRR)3
NPV= 0
- The NPV at a rate of 10% is :
10 60 80
NPV10% (L) = − 100 + + + = $18.79 > 0
(1 + 10%) (1 + 10%)
1 2
(1 + 10%) 3
► At a rate of 10% NPV (L) is >0, it is then necessary to choose a higher discount
rate to obtain an NPV equal to zero.
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- Let’s try with 18% :
10 60 80
at 18% NPV (L) = − 100 + + + = 0.26 > 0
(1 + 18%) 1
(1 + 18%) 2
(1 + 18%) 3
► At 18%, the NPV (L) is still >0, Let’s try with 19% :
10 60 80
at 19% NPV (L) = − 100 + + + = − 1.75 < 0
(1 + 19%) 1
(1 + 19%) 2
(1 + 19%) 3
IRRL = 18.13%
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Dr. Ridha ESGHAIER
Application 6:
Consider the following investment:
Investment amount : $9,000
CF1= $2,400
CF2= $2,900
CF3= $3,500
CF4= $4,000
If the investor demands 17% as a
minimum return (RRR), will he accept to
finance this project?
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Solution 6:
2 ways to answer the question:
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2400 2900 3500 4000
► NPV (17%) = − 9000 + + + + = $ − 510.33 < 0
(1.17) 1 (1.17) 2 (1.17) 3 (1.17) 4
Since at 17%, the NPV is negative, the IRR must be lower than 17%
► - To compute the IRR we should use a discount rate lower than 17% that
provides a positive NPV. Let’s try with 15% discount rate…
2400 2900 3500 4000
NPV (15%) = − 9000 + 1
+ 2
+ 3
+ 4
= $ − 131.9 still < 0
(1.15) (1.15) (1.15) (1.15)
- It is then necessary to choose a lower discount rate to obtain a positive
NPV. Let’s try with 14%...
2400 2900 3500 4000
NPV (14%) = − 9000 + + + + = $67.44 > 0
(1.14) 1 (1.14) 2 (1.14) 3 (1.14) 4
At 15%, NPV= -131.9 IRR − 14% 0 − 67.44
IRR? , NPV=0 = = 0.3383
15% − 14% − 131.9 − 67.44
At 14%, NPV= 67,44
IRR = 14% + (1% × 0.3383) ≈ 14.34%
IRR < 17%, refuse the project 11-37
Application 7 : Dr. Ridha ESGHAIER
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Application 8 : Dr. Ridha ESGHAIER
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Solution 8: Dr. Ridha ESGHAIER
I0 =
If the Investor knows the future cash flows of the project and the
rate of return he wants to earn, he can calculate the maximum
investment amount that he will accept to pay.
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NPV, IRR and Discounted Payback
interpretation
Application 9:
Consider the following investment project:
Investment amount (I0) : $1,000
CF1= $100
CF2= $300
CF3= $400
CF4= $675
1. If the investor demands 10% as a minimum return
rate (RRR), will he accept to finance this project?
2. Compute the annual rate of return of this project.
3. Calculate the discounted payback period. Interpret.
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Dr. Ridha ESGHAIER
Solution 9: Dr. Ridha ESGHAIER
► Since the NPV is positive, the investor will accept to finance the
project. This project will offer an annual rate of return (IRR) higher than
the Required rate of return of 10%.
2. To compute the IRR we should use a discount rate higher than 10% that
provides a negative NPV. Let’s try with 13% discount rate…
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Dr. Ridha ESGHAIER
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Dr. Ridha ESGHAIER
CF1 CF2 CFn
We know that: NPV = − I 0 + + + ... +
(1 + RRR)1 (1 + RRR)2 (1 + RRR)n
100 300 400 675
NPV = - 1,000 + + + + = $100.4 > 0
(1 + 10%)1 (1 + 10%)2 (1 + 10%)3 (1 + 10%)4
► Since at 10% RRR the NPV is positive, there is a Moment before the
end of the life of the project at which The NPV of the project is equal to
zero (when I0 is equal to the sum of the future cash flows discounted at
the required rate of return RRR)
► This moment is the Discounted payback period which represents the
moment at which the investment amount I0 is exactly recovered by the
future cash flows discounted at the RRR. In other words, the discounted
payback period is the moment at which the investor earns exactly the rate
of return (RRR) he demanded.
► After 3 years, 9 months and 11 days the NPV of the project is equal to
Zero. In other words, this is the length of time required to earn the
demanded rate of return of 10% by the investor. If we reach the end of
the life of he project (end of year 4), the return obtained will be the IRR
(13.55%)
► The Discounted Payback Period is the moment at which
11-45
the NPV of the project is equal to zero.