CAPITAL BUDGETING

11/13/2014

IIM INDORE LVR

What we intend to discuss

Investment in long-term assets
We should consider several investment criteria
when making decisions:
1) Payback period
2) Average Accounting Return
3) Net Present Value
4) Internal Rate of return
5) Profitability Index
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Good Decision Criteria

We need to ask ourselves the following
questions when evaluating decision criteria
Does the decision rule adjust for the time
value of money?
Does the decision rule adjust for risk?
Does the decision rule provide information
on whether we are creating value for the
firm?
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Project Example Information

You are looking at a new project and you have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF= 91,080; NI = 29,100
Average Book Value = 72,000
Your cost of capital for assets of this risk is 12%.
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1. Payback Period
How long does it take to get the initial cost
back in a nominal sense? (how long it takes to
recover the cost of investment?)
Computation - Subtract the future cash flows
from the initial cost until the initial investment
has been recovered
Decision Rule Accept if the payback period
is less than some preset limit
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Example
Assume we will accept the project if it pays back within
two years.

Year 1: 165,000 63,120 = 101,880 still to recover

Year 2: 101,880 70,800 = 31,080 still to recover
Year 3: 31,080 91,080 = -60,000 project pays
back in year 3
Payback period = 2 + 31080/91080 = 2.34years
Do we accept or reject the project?

Reject, because payback period> 2 years

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Advantages and Disadvantages of

Payback

Advantages

Disadvantages

Easy to understand
Adjusts for uncertainty
of later cash flows
Biased towards liquidity

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Ignores the time value of

money
Requires an arbitrary cutoff
point
Ignores cash flows beyond
the cutoff date
Biased against long-term
projects.

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2.Average Accounting Return

(AAR)
AAR=Average net income/average book value
Average book value depends on how the asset
is depreciated.
If straight-line=>
Average book value = (Initial cost+Salvage)/2
Need to have a target cutoff rate
Decision Rule: Accept the project if the AAR is
greater than a preset rate.
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Example
Assume we require an average accounting
return of 25%
Average Net Income:
(13,620 + 3,300 + 29,100) / 3 = 15,340

AAR = 15,340 / 72,000 = .213 = 21.3%

Do we accept or reject the project?
Reject, because AAR<25%
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Advantages and Disadvantages of

AAR
Advantages

Disadvantages

Easy to calculate
Needed information
will usually be
available

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Time value of money

is ignored
Uses an arbitrary
benchmark cutoff rate
Based on accounting
net income and book
values, not cash flows
and market values

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3. Net Present Value (NPV)

The difference between the market value of a project
and its cost
How much value is created from undertaking an
investment?
The first step is to estimate the expected future
cash flows (CF).
The second step is to estimate the required return
for projects of this risk level (r).
The third step is to find the present value of the
cash flows and subtract the initial investment.
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NPV Decision Rule

If the NPV is positive, accept the project
A positive NPV means that the project is expected to
add value to the firm and will therefore increase the
wealth of the owners.
Since our goal is to increase owner wealth, NPV is a
direct measure of how well this project will meet our
goal.

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NPV formula
n

CF
t
NPV
t
t 0 (1 r )
NPV CF0

CF1 CF2 ..... CFn

1
2
n
(1 r) (1 r)
(1 r)

NPV = - (Cost of Investment) + PV(Cash flows)

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Example
Using the formulas:
NPV = 165,000 + 63,120/(1.12) +
70,800/(1.12)2 + 91,080/(1.12)3 = $12,627.42
Do we accept or reject the project?
Accept, because NPV= +ve ( >0)

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Decision Criteria Test - NPV

Does the NPV rule account for the time value of
money?
Does the NPV rule account for the risk of the cash
flows?
Does the NPV rule provide an indication about the
increase in value?
Should we consider the NPV rule for our primary
decision criteria?
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Why Use Net Present Value?

Accepting positive NPV projects benefits
shareholders.
NPV uses cash flows
NPV uses all the cash flows of the project
NPV discounts the cash flows properly

Reinvestment assumption: the NPV rule

assumes that all cash flows can be
reinvested at the discount rate.
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The Net Present Value (NPV)

Rule
Net Present Value (NPV) =
Total PV of future CFs + Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs

Minimum Acceptance Criteria: Accept if NPV > 0

Ranking Criteria: Choose the highest NPV
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Calculating NPV with

Spreadsheets
Spreadsheets are an excellent way to compute
NPVs, especially when you have to compute the
cash flows as well.
Using the NPV function:
The first component is the required return entered as a
decimal.
The second component is the range of cash flows
beginning with year 1.
Add the initial investment after computing the NPV.
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The Discounted Payback

Period
How long does it take the project to pay
back its initial investment, taking the time
value of money into account?
Decision rule: Accept the project if it pays
back on a discounted basis within the
specified time.
By the time you have discounted the cash
flows, you might as well calculate the NPV.
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4. Internal Rate of Return (IRR)

This is the most important alternative to NPV
It is based entirely on the estimated cash flows
and is independent of interest rates found
elsewhere
Definition:
IRR is the return that makes the NPV = 0
Decision Rule: Accept the project if the IRR is
greater than the cost of capital
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IRR formula
CF
CF
CF
1
2
n

.....

CF0
1
2
n
(1 IRR ) (1 IRR )
(1 IRR )

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Example
CF0

CF1
CF2
CFn

.....

1
2
n
(1 IRR ) (1 IRR )
(1 IRR )

165,000

63120

(1 IRR )

70800

(1 IRR )

91080

(1 IRR )

If IRR =15%==>
CF0 =63120/(1.15)+70800/(1.15)2+91080/(1.15)3=168308

if IRR =16%==>
CF0 =63120/(1.16)+70800/(1.16)2+91080/(1.16)3=165380

if IRR =17%==>
CF0 =63120/(1.17)+70800/(1.17)2+91080/(1.17)3=162536

16%<IRR<17% ==>IRR=16.13%

Do we accept or reject the project?

Accept since IRR=16.13% > r = 12%
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Computing IRR For The Project

with Constant Cash Flow
Example: A project has the following Cash Flows:
Year 0 = -$994.76, Year 1-3 = $400, Calculate the IRR.
994.76

400

(1 IRR )

400

(1 IRR )

400

(1 IRR )

Annuity: PV = C*PVIFA(r%,t)
994.76 = 400*PVIFA(IRR%, 3)
2.4869 = PVIFA(IRR%,3)
From Appendix : IRR =10%

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NPV Profile For The Project

IRR = 16.13%

70,000
60,000
50,000

NPV

40,000
30,000
20,000
10,000
0
-10,000 0

0.02 0.04 0.06 0.08

0.1

0.12 0.14 0.16 0.18

0.2

0.22

-20,000
Discount Rate
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Advantages of IRR
Knowing a return is intuitively appealing
It is a simple way to communicate the value of a
project to someone who doesnt know all the
estimation details
If the IRR is high enough, you may not need to
estimate a required return, which is often a
difficult task

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Internal Rate of Return (IRR)

Disadvantages:

Does not distinguish between investing and

borrowing
IRR may not exist, or there may be multiple
IRRs
Problems with mutually exclusive investments

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IRR: Example
Consider the following project:

0
-$200

$50

$100

$150

The internal rate of return for this project is 19.44%

$50
$100
$150
NPV 0 200

2
(1 IRR ) (1 IRR ) (1 IRR ) 3
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NPV Payoff Profile

0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
44%
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$100.00
$73.88
$51.11
$31.13
$13.52
($2.08)
($15.97)
($28.38)
($39.51)
($49.54)
($58.60)
($66.82)

NPV

If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
$120.00
$100.00
$80.00
$60.00
$40.00
$20.00
$0.00
($20.00)
-1%
($40.00)
($60.00)
($80.00)

IRR = 19.44%
9%

19%

29%

39%

Discount rate
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Calculating IRR with

Spreadsheets
You start with the cash flows the same as
you did for the NPV.
You use the IRR function:
You first enter your range of cash flows,
beginning with the initial cash flow.
You can enter a guess, but it is not necessary.
The default format is a whole percent you
will normally want to increase the decimal
places to at least two.
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Problems with IRR

Multiple IRRs

Are We Borrowing or Lending

The Scale Problem

The Timing Problem

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Mutually Exclusive vs. Independent

Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g., acquiring an
accounting system.
RANK all alternatives, and select the best one.

Independent Projects: accepting or rejecting one

project does not affect the decision of the other
projects.
Must exceed a MINIMUM acceptance criteria
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Multiple IRRs
There are two IRRs for this project:
$200

NPV

0
-$200

$800

Which one should

we use?
3
- $800

$100.00

100% = IRR2

$50.00
$0.00
-50%
0%
($50.00)
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($100.00)

50%

0% = IRR1

100%

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150%
200%
Discount rate
32

NPV Profiles
A graphical representation of project NPVs at
various different costs of capital.
WACC
0
5
10
15
20
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NPVL
$50
33
19
7
(4)
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NPVS
$40
29
20
12
5
33

Drawing NPV profiles

NPV 60
($)

.
40 .
50

30

.
.

20

Crossover Point = 8.7%

10

IRRL = 18.1%

..

0
5
-10
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10

15

.
.

20

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IRRS = 23.6%
Discount Rate (%)

23.6
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Comparing the NPV and IRR methods

If projects are independent, the two
methods always lead to the same
accept/reject decisions.
If projects are mutually exclusive
If WACC > crossover rate, the methods lead
to the same decision and there is no conflict.
If WACC < crossover rate, the methods lead
to different accept/reject decisions.
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Reasons why NPV profiles cross

Size (scale) differences the smaller project
frees up funds at t = 0 for investment. The
higher the opportunity cost, the more valuable
these funds, so a high WACC favors small
projects.
Timing differences the project with faster
payback provides more CF in early years for
reinvestment. If WACC is high, early CF
especially good, NPVS > NPVL.
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Reinvestment rate assumptions

NPV method assumes CFs are reinvested at the
WACC.
IRR method assumes CFs are reinvested at
IRR.
Assuming CFs are reinvested at the
opportunity cost of capital is more realistic, so
NPV method is the best. NPV method should
be used to choose between mutually exclusive
projects.
Perhaps a hybrid of the IRR that assumes cost
of capital reinvestment is needed.
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Since managers prefer the IRR to the NPV

method, is there a better IRR measure?

Yes, MIRR is the discount rate that causes

the PV of a projects terminal value (TV) to
equal the PV of costs. TV is found by
compounding inflows at WACC.
MIRR assumes cash flows are reinvested at
the WACC.

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Calculating MIRR
0

10%

-100.0

10.0

60.0

80.0
66.0
12.1

10%

10%
MIRR = 16.5%

-100.0
PV outflows

$100 =

$158.1
(1 + MIRRL)3

158.1
TV inflows

MIRRL = 16.5%
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Why use MIRR versus IRR?

MIRR assumes reinvestment at the
opportunity cost = WACC. MIRR also
avoids the multiple IRR problem.
Managers like rate of return comparisons,
and MIRR is better for this than IRR.

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5. Profitability Index (PI)

Measures the benefit per unit cost, based on
the time value of money
A profitability index of 1.1 implies that for
every $1 of investment, we create an additional
$0.10 in value
This measure can be very useful in situations
where we have limited capital
Decision Rule: Accept the project if the PI
greater than 1 (implies NPV is positive)
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The Profitability Index (PI)

Total PV of Future Cash Flows
PI
Initial Investent
Minimum Acceptance Criteria:
Accept if PI > 1

Ranking Criteria:
Select alternative with highest PI
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Profitability Index
Profitability Index=PV(future cash flow)/Initial
Cost
PI=(NPV+Initial Cost)/Initial cost
=(12627.42+165000)/165000
=1.0765

Do we accept or reject the project?

Accept since PI > 1

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Advantages and Disadvantages

of Profitability Index
Advantages

Disadvantages

Closely related to
NPV, generally leading
to identical decisions
Easy to understand and
communicate
May be useful when
available investment
funds are limited
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May lead to incorrect

decisions in
comparisons of
mutually exclusive
investments

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NPV versus IRR

NPV and IRR will generally give the same
decision.
Exceptions:
Non-conventional cash flows cash flow signs
change more than once
Mutually exclusive projects
Initial investments are substantially different
Timing of cash flows is substantially different
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Sowhat is the decision?

1. Payback Period
2. Average Accounting Return
3. Net Present Value
4. Internal Rate of Return
5. Profitability Index

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Reject
Reject
Accept
Accept
Accept

46

Conflicts Between NPV and IRR

NPV directly measures the increase in value
to the firm
Whenever there is a conflict between NPV
and another decision rule, you should
always use NPV
IRR is unreliable in the following situations
Non-conventional cash flows
Mutually exclusive projects
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The Practice of Capital Budgeting

Varies by industry:
Some firms use payback, others use accounting
rate of return.

The most frequently used technique for

large corporations is IRR or NPV.

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Summary Discounted Cash Flow

Net present value

Difference between market value and cost

Accept the project if the NPV is positive
Has no serious problems
Preferred decision criterion

Internal rate of return

Discount rate that makes NPV = 0

Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with non-conventional cash flows or mutually exclusive
projects

Profitability Index

Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing

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Summary Payback Criteria

Payback period
Length of time until initial investment is recovered
Take the project if it pays back in some specified period
Doesnt account for time value of money, and there is
an arbitrary cutoff period

Discounted payback period

Length of time until initial investment is recovered on a
discounted basis
Take the project if it pays back in some specified period
There is an arbitrary cutoff period
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Summary Accounting
Criterion
Average Accounting Return
Measure of accounting profit relative to book
value
Similar to return on assets measure
Take the investment if the AAR exceeds some
specified return level
Serious problems and should not be used

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