Capital

Budgeting

13-1
 Overview of Capital Budgeting:

Capital long term assets used in production

Budget is a plan that details projected inflows
and outflows during some future period.
Capital Budget - is an outline of planned
investments n fixed assets
Capital Budgeting process of planning
expenditures on assets whose cash flows are
expected to extend beyond one year
Strategic Business Plan - A long-run plan that
outlines in broad terms the firms basic strategy for
the next five to ten years.
13-2
 PROJECT CLASSIFICATION

1. Replacement : maintenance of business

2. Replacement: cost reduction
3. Expansion of existing products or
markets
4. Expansion into new products or markets
5. Safety and/or environmental projects
6. Mergers
7. Other

13-3
 The capital budgeting process
consists of five steps:
1. Proposal generation. Proposals for new investment projects are
made at all levels within a business organization and are
reviewed by finance personnel.
2. Review and analysis. Financial managers perform formal review
and analysis to assess the merits of investment proposals
3. Decision making. Firms typically delegate capital expenditure
decision making on the basis of dollar limits.
4. Implementation. Following approval, expenditures are made and
projects implemented. Expenditures for a large project often
occur in phases.
5. Follow-up. Results are monitored and actual costs and benefits
are compared with those that were expected. Action may be
required if actual outcomes differ from projected ones.

13-4
 Overview of Capital Budgeting:
Basic Terminology

INDEPENDENT - if the cash flows of one

are unaffected by the acceptance of the
other.
MUTUALLY EXCLUSIVE- if the cash
flows of one can be adversely impacted by
the acceptance of the other.
DEPENDENT if a project whose
acceptance depends on the acceptance of
one or more other projects.

13-5
 Overview of Capital Budgeting:
Basic Terminology

UNLIMITED FUNDS - is the financial

situation in which a firm is able to accept
all independent projects that provide an
acceptable return.
CAPITAL RATIONING - is the financial
situation in which a firm has only a fixed
number of dollars available for capital
expenditures, and numerous projects
compete for these dollars.
13-6
 Overview of Capital Budgeting:
Basic Terminology

ACCEPTREJECT APPROACH is the

evaluation of capital expenditure
proposals to determine whether they meet
the firms minimum acceptance criterion.
RANKING APPROACH - is the ranking
of capital expenditure projects on the
basis of some predetermined measure,
such as the rate of return.

13-7
 Project Evaluation:
Alternative Methods

Payback Period (PBP)

Discounted Payback Period (DPP)
Net Present Value (NPV)
Internal Rate of Return (IRR)
MIRR

13-8
 Proposed Project Data

Julie Miller is evaluating a new project

for her firm, Basket Wonders (BW).
She has determined that the after-tax
cash flows for the project will be
$10,000; $12,000; $15,000; $10,000;
and $7,000, respectively, for each of
the Years 1 through 5. The initial
cash outlay will be $40,000.
13-9
 Independent Project
For this project, assume that it is
independent of any other potential
projects that Basket Wonders may
undertake.

13-10
 Payback Period (PBP)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

PBP is the expected number

of years required to recover
the original investment

13-11
 Payback Solution (#1)

0 1 2 3 (a) 4 5

-40 K(-b) 10 K 12 K 15 K 10 K (d) 7K

10 K 22 K 37 K (c) 47 K 54 K

Cumulative
Inflows PBP =a+(b-c)/d
PBP = +( - )/

13-12
 Payback Solution (#2)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K
-40 K -30 K -18 K -3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K
Cumulative = 3.3 Years
Cash Flows
Note: Take absolute value of last
negative cumulative cash flow
13-13 value.
 PBP Acceptance Criterion
The management of Basket Wonders
has set a maximum PBP of 3.5
years for projects of this type.
Should this project be accepted?

Yes! The firm will receive back the

initial cash outlay in less than 3.5
years. [3.3 Years < 3.5 Year Max.]

13-14
 PBP Acceptance Criterion

If the payback period is less than the

maximum acceptable payback period,
accept the project
If the payback period is greater than the
maximum acceptable payback period,
reject the project.

13-15
 Discounted Payback Period

DPP- the length of time required for an

investments cash flows, discounted at
the investments cost of capital, to
cover its cost.
Example
An initial investment of $1,500,000 is expected to
generate $600,000 per year for 6 years. Calculate the
discounted payback period of the investment if the
discount rate is 11%.

13-16
 Discounted Payback: Uses
Discounted CFs
Year Cash Flow Present Value Discounted Cumulative
n CF Factor Cash Flow Discounted
PV$1=1/(1+i)n CFxPV$1 Cash Flow
0 $-1,500,000 1.0000 $-1,500,000 $-1,500,000
1 600,000 0.9009 540,541 -959,459
2 600,000 0.8116 486,973 -472,486
3 600,000 0.7312 438,715 -33,771
4 600,000 0.6587 395,239 361,468
5 600,000 0.5935 356,071 717,539
6 600,000 0.5346 320,785 1038,324

Discounted Payback Period = 3 + |-33,771|/395,239 = 3.09 years

13-17 Recover investment + capital costs in 3.09 yrs.
 Net Present Value (NPV)
NPV is found by subtracting a projects
initial investment from the present value of its
cash inflows discounted at a rate equal to the
firms cost of capital.
NPV = Present value of cash inflows Initial
investment

CF1 CF2 CFn - ICO

NPV = + +...+
(1+k)1 (1+k)2 (1+k)n

13-18
 NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)

13-19
 Net Present Value (NPV)
CASH FLOWS $10,000 $12,000 $15,000 $10,000 $7,000
CASH OUTLAY $ 40,000

at 13% CF1 CF2 CFn

NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k) n

FV
PV = Total
-
(( 11+ + i ))
0.13 1
3
4
2n
5 = -$38,575.523
$1,424.477
8,849.5575
10,395.752
6,133.1873
9,397.7602
3,799.3196

13-20
 NPV Acceptance Criterion
The management of Basket Wonders
has determined that the required
rate is 13% for projects of this type.
Should this project be accepted?

No! The NPV is negative.

This means that the project is reducing
shareholder wealth. [Reject as NPV < 0 ]

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 NPV RATIONALE
The rationale for the NPV method is
strightforward. An NPV of ZERO signifies that
the projects cash flows are exactly sufficient to
repay the invested capital and to provide the
required rate of return on that capital.
If a project has a POSITIVE NVP, then it is
generating more cash than is needed to service
its debt and to provide the required return to
shareholders.

13-22
 Internal Rate of Return (IRR)

IRR is the discount rate that equates the

present value of the future net cash
flows from an investment project with
the projects initial cash outflow.

CF1 CF2 CFn

ICO = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n

13-23
 IRR Solution

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the

discounted cash flows to equal $40,000.
13-24
 IRR Solution (Try 10%)

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

$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
13-25
 IRR Solution (Try 15%)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841
13-26 [Rate is too high!!]
 IRR Solution (Interpolate)

.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X $1,444
.05 = $4,603

13-27
 IRR Solution (Interpolate)

.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X $1,444
.05 = $4,603

13-28
 IRR Solution (Interpolate)

.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X = ($1,444)(0.05) X = .0157
$4,603
IRR = .10 + .0157 = .1157 or 11.57%
13-29
 IRR Acceptance Criterion
The management of Basket Wonders
has determined that the hurdle rate
is 13% for projects of this type.
Should this project be accepted?

No! The firm will receive 11.57% for

each dollar invested in this project at
a cost of 13%. [ IRR < Hurdle Rate ]
13-30
 Evaluation Summary

Basket Wonders Independent Project

Method Project Comparison Decision
PBP 3.3 3.5 Accept
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
13-31
 Modified Internal Rate of
Return (MIRR)
MIRR is the discount rate that
causes the PV of a projects
terminal value (TV) to equal the
PV of costs.

13-32
 MIRR
0 1 2 3
10%

-100.0 10.0 60.0 80.0

10%
66.0
10%
12.1
-100.0 158.1
PV outflows TV inflows

13-33
 MIRR
0 1 2 3

MIRR = 16.5%
-100.0 158.1

PV outflows TV inflows

$100 $158.1
= (1+MIRRL)3
MIRRL = 16.5%

13-34
 THANK YOU

13-35