Handout Corporate Finance

Capital Budgeting Techniques

CORPORATE FINANCE Capital Budgeting Techniques

Project Evaluation and Selection

Capital Budgeting Potential Difficulties
Capital Rationing
Techniques Project Monitoring
A. Kuswardono, S.E., M.B.A. Post-Completion Audit

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Project Evaluation: Alternative Methods Proposed Project Data

Julie Miller is evaluating a new project for her firm

Payback Period (PBP) The Company (TC). She has determined that the
after-tax cash flows for the project will be $10,000,
Internal Rate of Return (IRR) $12,000, $15,000, $10,000, and $7,000 respectively
Net Present Value (NPV) for each of the Years 1 through 5. The initial cash
outlay will be $40,000.
Profitability Index (PI)

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Independent Project Payback Period (PBP)

0 1 2 3 4 5
For this project, assume that it is
independent of any other potential - 40 K 10 K 12 K 15 K 10 K 7K
projects that The Company may
undertake. PBP is the period of time
required for the cumulative
Independent -- A project whose
acceptance (or rejection) does not
expected cash flows from an
prevent the acceptance of other projects investment project to equal the
under consideration. initial cash outflow.
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Capital Budgeting Techniques

Payback Solution (#1) Payback Solution (#2)

0 1 2 3 (a) 4 5 0 1 2 3 4 5

- 40 K (-b) 10 K 12 K 15 K 10 K (d) 7 K - 40 K 10 K 12 K 15 K 10 K 7K
10 K 22 K 37 K (c) 47 K 54 K
- 40 K - 30 K -18 K -3K 7K 14 K
Cumulative
Inflows PBP = a + (b -c ) / d PBP = 3 + ( 3K ) / 10K
= 3 + (40 - 37) / 10 Cumulative = 3.3 Years
Cash Flows
= 3 + (3) / 10 Note: Take absolute value of last
= 3.3 Years negative cumulative cash flow value.

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PBP Acceptance Criterion PBP Strengths and Weaknesses

The management of Basket Wonders has Strengths: Weaknesses:

set a maximum PBP of 3.5 Years for Does not account for
Easy to use and
projects of this type. understand TVM
Should this project be accepted? Can be used as a Does not consider
measure of liquidity cash flows beyond the
Yes! The firm will receive back the initial PBP
Easier to forecast ST
cash outlay in less than 3.5 Years. [3.3 Cutoff period is
than LT flows
Years < 3.5 Year Max.] subjective

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Internal Rate of Return (IRR) IRR Solution

IRR is the discount rate that equates the
$40,000 = $10,000 $12,000
present value of the future net cash flows + +
from an investment project with the (1+IRR)1 (1+IRR)2
project’s initial cash outflow. $15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR) 4 (1+IRR)5
CF 1 CF 2 CF n
ICO = + +...+ Find the interest rate (IRR) that causes the
(1+IRR)1 (1+IRR)2 (1+IRR) n
discounted cash flows to equal $40,000.

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Capital Budgeting Techniques

IRR Solution (Try 10%) IRR Solution (Try 15%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $40,000

$40,000 = $10,000(PVIF 15%,1) + $12,000(PVIF 15%,2 ) +
$15,000(PVIF10%,3) + $10,000(PVIF 10%,4) + $15,000(PVIF 15%,3) + $10,000(PVIF 15%,4 ) +
$ 7,000(PVIF10%,5) $ 7,000(PVIF 15%,5)
$40,000 = $10,000(.909) + $12,000(.826) + $40,000
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.751) + $10,000(.683) + $15,000(.658) + $10,000(.572) +
$ 7,000(.621) $ 7,000(.497)
$40,000 = $9,090 + $9,912 + $11,265 + $40,000
$40,000 = $8,700 + $9,072 + $9,870 +
$6,830 + $4,347 $5,720 + $3,479
= $41,444 [Rate is too low!!] = $36,841 [Rate is too high!!]

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IRR Solution (Interpolate) IRR Solution (Interpolate)

0.10 $41,444
0.10 $41,444 X $1,444
X $1,444 0.05 IRR $40,000 $4,603
0.05 IRR $40,000 $4,603
0.15 $36,841
0.15 $36,841

X $1,444
X $1,444 =
= 0.05 $4,603
0.05 $4,603

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IRR Solution (Interpolate) IRR Acceptance Criterion

0.10 $41,444 The management of The Company has
X $1,444
0.05 IRR $40,000 $4,603 determined that the hurdle rate is 13% for
0.15 $36,841 projects of this type.
Should this project be accepted?
($1,444)(0.05)
X= X = 0.0157 No! The firm will receive 11.57% for each
$4,603
dollar invested in this project at a cost of
IRR = 0.10 + 0.0157 = 0.1157 or 11.57% 13%. [ IRR < Hurdle Rate ]

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Capital Budgeting Techniques

IRR Strengths and Weaknesses Net Present Value (NPV)

Strengths: Weaknesses: NPV is the present value of an investment

 Assume all cash project’s net cash flows minus the project’s
 Accounts for TVM
flows reinvested at initial cash outflow.
 Considers all cash
the IRR
flows
 Difficulties
with
 Less Subjectivity CF1 CF 2 CFn
project rankings NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k) n
and Multiple IRRs

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NPV Solution NPV Solution

The Company has determined that the NPV = $10,000(PVIF13%,1 ) + $12,000(PVIF13%,2) +
appropriate discount rate (k) for this project $15,000(PVIF13%,3 ) + $10,000(PVIF13%,4) +
is 13%. $ 7,000(PVIF13%,5 ) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$10,000 $12,000 $15,000 $15,000(.693) + $10,000(.613) +
NPV = + + +
(1.13)1 (1.13)2 (1.13)3 $ 7,000(.543) - $40,000

$10,000 $7,000 NPV = $8,850 + $9,396 + $10,395 +

+ - $40,000 $6,130 + $3,801 - $40,000
(1.13)4 (1.13) 5
= - $1,428
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NPV Acceptance Criterion NPV Strengths and Weaknesses

The management of The Company has
Strengths: Weaknesses:
determined that the required rate is 13% for
 Cash flows assumed  May not include
projects of this type.
to be reinvested at managerial options
Should this project be accepted? hurdle rate. embedded in the
project.
 Accounts for TVM
No! The NPV is negative. This means that
the project is reducing shareholder wealth.  Considers all cash
[Reject as NPV < 0 ] flows.

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Capital Budgeting Techniques

Net Present Value Profile Profitability Index (PI)

$000s
Sum of CF’s Plot NPV for each PI is the ratio of the present value of a
15
discount rate. project’s future net cash flows to the
Net Present Value

T hr
ee o
10
f th
ese project’s initial cash outflow.
p oi
nt s
are
eas
y no CF 1 CF2 CFn
5 IRR
NPV@13%
w!
PI = 1
+
2
+...+ ICO
(1+k) (1+k) (1+k)n
0
<< OR >>
-4
0 3 6 9 12 15
PI = 1 + [ NPV / ICO ]
Discount Rate (%)

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PI Acceptance Criterion PI Strengths and Weaknesses

PI = $38,572 / $40,000 Strengths: Weaknesses:

= 0.9643  Same as NPV  Same as NPV

Should this project be accepted?  Allows comparison  Provide only relativ

of different scale profitability
No! The PI is less than 1.00. This means that project  Potential
Ranking
the project is not profitable. Problems
[Reject as PI < 1.00 ]

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Evaluation Summary Other Project Relationships

The Company Independent Project  Dependent -- A project whose
acceptance depends on the acceptance
Method Project Comparison Decision
of one or more other projects.
PBP 3.3 3.5 Accept
IRR 11.57% 13% Reject  Mutually Exclusive -- A project whose
acceptance precludes the acceptance of
NPV -$1,428 $0 Reject
one or more alternative projects.
PI .96 1.00 Reject

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Capital Budgeting Techniques

Potential Problems Under Mutual Exclusivity A. Scale Differences

Compare a small (S) and a large (L) project.
Ranking of project proposals may create
contradictory results.
Net Cash Flows
End of Year
A. Scale of Investment Project “S” Project “L”

B. Cash-flow Pattern 0 - $ 100 - $ 100,000

1 0 0
C. Project Life $ 400 $ 156,250
2

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Scale Differences B. Cash Flow Pattern

Calculate the PBP, IRR, NPV@10%, and PI@10%. Let us compare a decreasing cash -flow (D)
project and an increasing cash-flow (I) project.
Which project is preferred? Why?
Net Cash Flows
End of Year
Project PBP IRR NPV PI Project “D” Project “I”
0 - $ 1,200 - $ 1,200
“S” 0.50 Yrs 100% $ 231 3.31 1 1,000 100
2 500 600
“L” 1.28 Yrs 25% $ 29,132 1.29 3 100 1,800

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Cash Flow Pattern Examine NPV Profile

Calculate the IRR, NPV@10%, and PI@10%.
6 00

Plot NPV for each

Net Prese nt Value ($ )

Which project is preferred? project at various

discount rates.
4 00

NPV@10%
Project IRR NPV PI
2 00

IRR
“D” 23% $ 198 1.17
0

“I” “D”
“I” 17% $ 198 1.17
-200

0 5 10 15 20 25
Discount Rate (%)
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Capital Budgeting Techniques

Fisher’s Rate of Intersection (Crossover Rate) Comparison of NPV and IRR

Independent project
600
Ne t Pres ent Value ($)

 IRR and NPV methods always give the same accept or reject
At k<10%, I is best! Fisher’s Rate of decision
Intersection
0 200 400

 IRR > required rate: Accept; otherwise: Reject

(Crossover Rate)

At k>10%, D is best! Mutually exclusive project

 Sometimes IRR and NPV methods give different accept or reject
decision
“I” “D”  In this case, if cost of capital (k) > the crossover rate, choose “D”
-20 0

0 5 10 15 20 25  If cost of capital (k) < the crossover rate, choose “I”

Discount Rate ($)

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C. Project Life Differences Comparison of NPV and IRR

Let us compare a long life (X) project and a short Independent project
life (Y) project.  IRR and NPV methods always give the same accept or reject
decision
Net Cash Flows  IRR > required rate: Accept; otherwise: Reject
End of Year
Project “X” Project “Y”
0 - $ 1,000 - $ 1,000 Mutually exclusive project
1 0 2,000  Sometimes IRR and NPV methods give different accept or reject
decision
2 0 0
 In this case, if cost of capital > the crossover rate, choose A
3 3,375 0

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Project Life Differences Another Way to Look at Things

Calculate the PBP, IRR, NPV@10%, and PI@10%. 1. Adjust cash flows to a common terminal year if
project will not be replaced.
Which project is preferred? Why?
Compound Project Y, Year 1 @10% for 2 years.

Project PBP IRR NPV PI Year 0 1 2 3

Cash Flows - $ 1,000 $0 $0 $ 2,420
“X” 0.89 Yrs 50% $ 1,536 2.54
Result: IRR = 34.26% NPV = $ 818
“Y” 0.50 Yrs 100% $ 818 1.82
*Lower IRR from adjusted cash-flow stream. “X” is still Best.

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Capital Budgeting Techniques

Replacing Projects with Identical Projects Capital Rationing

2. Use Replacement Chain Approach when project will Capital Rationing occurs when a constraint (or
be replaced. budget ceiling) is placed on the total size of capital
0 1 2 3 expenditures during a particular period.
Suppose that you have evaluated 5 capital
-$ 1,000 $ 2,000 investment project for your company.
- $ 1,000 $ 2,000
- $ 1,000 $ 2,000
Suppose that the VP of Finance has given you a
limited capital budget.
-$ 1,000 $ 1,000 $ 1,000 $ 2,000

Results: IRR* = 100% NPV = $2,238.17 How do you decide which projects to select?
*Lower IRR from adjusted cash flow stream. Y is Best.

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You could rank the projects by IRR: Capital Rationing

IRR Example Julie Miller must determine what
Our budget is limited investment opportunities to undertake for The
25% Company (TC). She is limited to a maximum
so we accept only expenditure of $32,500 only for 200X.
20%
projects 1, 2, and 3.
15%
10%

5% 1 2 3 4 5

$X $
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Available Projects for The Company Choosing by IRRs for The Company

Projects ICO ($) IRR NPV ($) PI Project ICO ($) IRR NPV ($) PI
A 500 18% 50 1.10
C 5,000 37% 5,500 2.10
B 5,000 25% 6,500 2.30
F 15,000 28% 21,000 2.40
C 5,000 37% 5,500 2.10 E 12,500 26% 500 1.40
D 7,500 20% 5,000 1.67 B 5,000 25% 6,500 2.30
E 12,500 26% 500 1.04
Project C, F, and E have the three largest IRRs.
F 15,000 28% 21,000 2.40
The resulting increase in shareholder wealth is $27,000 with a
G 17,500 19% 7,500 1.43 $32,500 outlay.
H 25,000 15% 6,000 1.24

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Choosing by NPVs for The Company Choosing by PIs for The Company
Projects ICO ($) IRR NPV ($) PI
Project ICO ($) IRR NPV ($) PI
F 15,000 28% 21,000 2.40
F 15,000 28% 21,000 2.40
B 5,000 25% 6,500 2.30
G 17,500 19% 7,500 1.43
C 5,000 37% 5,500 2.10
B 5,000 25% 6,500 2.30
D 7,500 20% 5,000 1.67

G 17,500 19% 7,500 1.43

Project F and G have the two largest NPVs.
The resulting increase in shareholder wealth is $28,500 with a Project F, B, C and E have the four largest PIs.
$32,500 outlay.
The resulting increase in shareholder wealth is $38,000 with a
$32,500 outlay.

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Summary of Comparison Post-Completion Audit

A formal comparison of the actual costs and
Projects Accepted Value Added benefits of a project with original estimates.
PI F, B, C, and D $38,000
NPV F and G $28,500 Important to follow up all capital budgeting decisions
IRR C, F and E $27,000  Identify any project weaknesses
Compare the actual results to the projected result
 Explain the variances
PI generates the greatest increase in shareholder
wealth when a limited capital budget exists for a  Develop a possible set of corrective actions
single period .  Provide appropriate feedback
Result: Making better future decisions!
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Multiple IRR Problem NPV Profile -- Multiple IRRs

Let us assume the following cash flow pattern for a 75 Multiple IRRs at
project for Years 0 to 4: k = 12.95% and 191.15%
Net P resent Value

50
-$100 +$100 +$900 -$1,000
($000s)

How many potential IRR’s could this project have? 25

Two!! There are as many potential IRRs as there -100

0 40 80 120 160 200
are sign changes.
Discount Rate (%)

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Capital Budgeting Techniques

Decision Rule for IRR Business Practices

 Independent Projects  Based on 1993 surveys, 99% of the Fortune

Accept Projects with IRR ≥Required Rate 500 companies use IRR while 85% use NPV.
Thus most firms actually use both method

 Mutually Exclusive Projects

 In summary, the different measures provide
different type of information to decision
Accept Project with highest IRR ≥Required Rate makers
 All should be considered in the decision
process

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NPV vs IRR

 The basis of the NPV rule is to accept projects that

have an NPV greater than zero; depents on
independent vs mutually exclusive;
 If we use the IRR cretarion, we accept any project
that has an IRR greater than the opportunity cost of
capital

NPV is important because it gives a direct measure of

the dollar benefit of the project to shareholders, so
NPV is the best single measure of profitability

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