Vicentiu Covrig FIN303

The basics of capital

budgeting
(chapter 11)
Should we
build this
plant?

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What is capital budgeting?
Analysis of potential additions to fixed assets
Long-term decisions; involve large expenditures

Independent projects if the cash flows of one are

unaffected by the acceptance of the other
(see text page 372)

Mutually exclusive projects if the cash flows of one can

be adversely impacted by the acceptance of the other
(see text page 372)

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Steps to capital budgeting

1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.

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What is the payback period?

The number of years required to recover a projects cost, or How

long does it take to get our money back?
Calculated by adding projects cash inflows to its cost until the
cumulative cash flow for the project turns positive.
Strengths
- Provides an indication of a projects risk and liquidity.
- Easy to calculate and understand.
Weaknesses
- Ignores the time value of money.
- Ignores CFs occurring after the payback period.

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Calculating payback
0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

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Discounted payback period

Uses discounted cash flows rather than raw
CFs.
0 10% 1 2 2.7 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79

Disc PaybackL == 2 + 41.32 / 60.11 = 2.7 years

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Net Present Value (NPV)
Sum of the PVs of all cash inflows and outflows of a project:
n
CFt
NPV t
t 0 ( 1 k )

Advantages:
1. Uses cash flows
2. Uses ALL cash flows of the project
3. Discounts ALL cash flows properly
Reinvestment assumption: the NPV rule assumes that all cash
flows can be reinvested at the discount rate
The BEST capital budgeting method

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What is Project Ls NPV?

Year CFt PV of CFt
0 -100 -$100
1 10 9.09
2 60 49.59
3 80 60.11
NPVL = $18.79

NPVS = $19.98

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Solving for NPV:
Financial calculator solution
Enter CFs into the calculators CF register.
For Texas Instruments:
Press CF key
- CF0 = -100 Enter
- C01 = 10 Enter
- F01 = 1 Enter
- C02 = 60 Enter
- F02 = 1 Enter
- CF3 = 80 Enter
Press NPV key
10 (I) Enter
CPT
to get NPVL = $18.78.

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Internal Rate of Return (IRR)
IRR is the discount rate that forces PV of inflows equal to
cost, and the NPV = 0:
n
CFt
0 t
t 0 ( 1 IRR )

Solving for IRR with a financial calculator:

- Enter CFs in CF register.
- Press IRR key
- CPT
- to get IRRL = 18.13% and IRRS = 23.56%.

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Rationale for the IRR method
If IRR > WACC, the projects rate of return is greater than its costs. There is
some return left over to boost stockholders returns.
If IRR > k, accept project.
If IRR < k, reject project.
If projects are independent, accept both projects, as both IRR > k = 10%.
If projects are mutually exclusive, accept S, because IRRs > IRRL
Advantages:
- Easy to understand and communicate
Disadvantages:
- IRR may not exist or there may be multiple IRR
- Problems with mutually exclusive investments

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The Scale Problem
Mutually exclusive vs independent projects
Would you rather make 100% or 50% on your investments?

What if the 100% return is on a $1 investment while the 50% return is

on a $1,000 investment?

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

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Learning objectives
Know the steps to capital budgeting
Know how to calculate payback period, discounted payback period, NPV, IRR;
the advantages and disadvantages of each method
Sections 11.6, 11.7 will NOT be on the exam
Recommended end-of-chapter questions: 11-2,11-3, 11-4, 11-8
Recommended end-of-chapter problems:ST-2 (without MIRR); 11-1, 11-2,11-4,
11-5, 11-6, 11-7 (without MIRR), 11-10,11-11,11-12;

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