Capital Budgeting

Integrative Case Analysis: Lasting Impressions

Dr. C. Bulent Aybar

Professor of International Finance

Proposal
Generation
Proposal Generation
is the origination of proposed
capital projects for the firm by
individuals at various levels of
the organization.
Capital Budgeting Process
Review Implementation
Decision
& and
Making
Analysis Follow-up
is the formal process of Decision making is the Implementation of the project
assessing the step where the proposal is begins after the project has
appropriateness and compared against been accepted and funding is
economic viability of the predetermined criteria and made available.
project in light of the either accepted or Follow-up is the post-
firm’s overall objectives. rejected. implementation audit of
This is done by expected and actual costs and
estimating cash flows revenues generated from the
arising from the project project to determine if the
and evaluating them return on the proposal meets
through capital budgeting pre-implementation projections
techniques. Risk factors
are also incorporated into
the analysis phase.
 Integrative Capital Budgeting Case

• Lasting Impressions (LI) Company is a medium- sized commercial

printer of promotional advertising brochures, booklets, and other direct-
mail pieces.
• The firms' major clients are ad agencies based in New York and Chicago.
The typical job is characterized by high quality and production runs of
more than 50,000 units. LI has not been able to compete effectively with
larger printers because of its existing older, inefficient presses. The firm
is currently having problems in meeting demand cost effectively and
quality requirements of the industry.
• The general manager has proposed the purchase of one of two large, six-
color presses designed for long, high- quality runs. The purchase of a
new press would enable LI to reduce its cost of labor and therefore the
price to the client, putting the firm in a more competitive position.
© Dr. C. Bulent Aybar
 Existing Equipment (Old Equipment)

• Old press Originally purchased 3 years ago at an installed

cost of $ 400,000, it is being depreciated under MACRS
using a 5- year recovery period.
• The old press has a remaining economic life of 5 years. It
can be sold today to net $ 420,000 before taxes; if it is
retained, it can be sold to net $ 150,000 before taxes at the
end of 5 years.

© Dr. C. Bulent Aybar

 Alternative-1: Press-A
• This highly automated press can be purchased for $ 830,000 and will
require $ 40,000 in installation costs.
• It will be depreciated under MACRS using a 5- year recovery period. At
the end of the 5 years, the machine could be sold to net $ 400,000 before
taxes.
• If this machine is acquired, it is anticipated that the following current
asset changes would result:

Cash $25,400

A/R $120,000

Inventories ($20,000)

A/P $35,000

© Dr. C. Bulent Aybar

 Alternative-2: Press-B

• This press is not as sophisticated as press A. It costs

$640,000 and requires $20,000 in installation costs.
• It will be depreciated under MACRS using a 5- year
recovery period.
• At the end of 5 years, it can be sold to net $ 330,000 before
taxes.
• Acquisition of this press will have no effect on the firm’s net
working capital investment.

© Dr. C. Bulent Aybar

Earning Projections Before Depreciation Interest and Taxes

EBITDA
Year Old Press Press A Press B
1 $120,000 $250,000 $210,000

2 $120,000 $270,000 $210,000

3 $120,000 $300,000 $210,000

4 $120,000 $330,000 $210,000

5 $120,000 $370,000 $210,000

The firm is subject to a 40% tax rate. The firm’s cost of

capital, r, applicable to the proposed replacement is 14%.
 Tasks
• For each of the two proposed replacement presses, determine:
– ( 1) Initial investment. ( 2) Operating cash inflows ( 3) Terminal cash flow

• Using the data developed in part a, find and depict on a time line the relevant cash flow
stream associated with each of the two proposed replacement presses, assuming that each is
terminated at the end of 5 years.
• Using the data developed in part b, apply each of the following decision techniques:
– ( 1) Payback period (2) Discounted Payback Period (3) NPV (4) IRR (5) MIRR (6) Profitability Index

• Draw net present value profiles for the two replacement presses on the same set of axes,
and discuss conflicting rankings of the two presses, if any, resulting from use of NPV and
IRR decision techniques.
• Recommend which, if either, of the presses the firm should acquire if the firm has
( 1) unlimited funds ( 2) capital rationing.
• What is the impact on your recommendation of the fact that the operating cash inflows
associated with press A are characterized as very risky in contrast to the low- risk operating
cash inflows of press B?

© Dr. C. Bulent Aybar

 Initial Investment Outlay

Item Press A Press B

Cost of Old Machine $400,000 $400,000

Cost of New Machine $870,000 $660,000

Proceeds from Old Machine $420,000 $420,000

Book Value of Old Machine $116,000 $116,000

Gains from Sale $304,000 $304,000

Tax Liability $121,600 $121,600

NWC Investment $90,400 $0

Net Initial Outlay $662,000 $361,600

Depreciation of The New and Old Equipment

Depreciation MACR-5Yr Press A Press B Existing Press

1 20% $174,000 $132,000 $48,000
2 32% $278,400 $211,200 $48,000
3 19% $165,300 $125,400 $20,000
4 12% $104,400 $79,200 $0
5 12% $104,400 $79,200 $0
6 5% $43,500 $33,000 $0
 Net Operating Cash Flows: Old Machine

Existing Machine 1 2 3 4 5
EBITDA 120000 120000 120000 120000 120000
Depreciation $48,000 $48,000 $20,000 $0 $0
EBT $72,000 $72,000$100,000 $120,000 $120,000
Taxes $28,800 $28,800 $40,000 $48,000 $48,000
Net Income $43,200 $43,200 $60,000 $72,000 $72,000
Depreciation $48,000 $48,000 $20,000 $0 $0
NOCF $91,200 $91,200 $80,000 $72,000 $72,000
 Net Operating Cash Flows: Press-A

PRESS-A: 1 2 3 4 5

EBITDA $250,000 $270,000 $300,000 $330,000 $370,000

Depreciation 174000 278400 165300 104400 104400

EBT $76,000 -$8,400 $134,700 $225,600 $265,600

Taxes 30400 -3360 53880 90240 106240

Net Income $45,600 -$5,040 $80,820 $135,360 $159,360

Depreciation 174000 278400 165300 104400 104400

NOCF $219,600$273,360 $246,120 $239,760 $263,760

 Net Operating Cash Flows: Press-B

PRESS-B: 1 2 3 4 5

EBITDA $210,000 $210,000 $210,000 $210,000 $210,000

Depreciation 132000 211200 125400 79200 79200

EBT $78,000 -$1,200 $84,600 $130,800 $130,800

Taxes 31200 -480 33840 52320 52320

Net Income $46,800 -$720 $50,760 $78,480 $78,480

Depreciation 132000 211200 125400 79200 79200

NOCF $178,800 $210,480 $176,160 $157,680 $157,680

Incremental Operating Cash Flows for Press A & B

IOCF=Incremental Operating Cash Flows

Column1 1 2 3 4 5
Existing Machine $91,200 $91,200 $80,000 $72,000 $72,000
Press-A $219,600 $273,360 $246,120 $239,760 $263,760
Press-B $178,800 $210,480 $176,160 $157,680 $157,680
Press A IOCF $128,400 $182,160 $166,120 $167,760 $191,760
Press B IOCF $87,600 $119,280 $96,160 $85,680 $85,680
 Terminal Cash Flows

Terminal Cash Flows Press A Press B Old Mach.

Proceeds from Liquidation $400,000 $330,000 $150,000
BV at Liquidation $43,500 $33,000 $0
Profit from Sale $356,500 $297,000 $150,000
Tax Liability $142,600 $118,800 $60,000
Net Proceeds from Sale $257,400 $211,200 $90,000
Recall NWC Investment $90,400 $0 $0
Net Terminal Cash Flows $347,800 $211,200 $90,000
Net Incremental TCF $257,800 $121,200

347,800-90,000=257,800 211,200-90,000=121,200
Relevant Cash Flow for the Projects

Year Press A Press B

0 -$662,000 -$361,600
1 $128,400 $87,600
2 $182,160 $119,280
3 $166,120 $96,160
4 $167,760 $85,680
5 $449,560 $206,880

Year 5 cash flows include terminal cash flows

Cash Flows on a Time Line
 Pay Back Period Analysis

Cumulative Cash Flows

PAYBACK PERIOD
ANALYSIS Press A Press B
1 $128,400 $87,600
2 $310,560 $206,880
3 $476,680 $303,040
4 $644,440 $388,720
5 $1,094,000 $595,600

Note that the cost for Press A (662,000) can be recovered only sometime
between 4th and 5th year. The portion recovered in the 5th year is
(662,000-644,440)/449,560=0.0391. Therefore payback period for the
Press A is 4 years + 0.09 Years or 4.04 years. The recovery for press B is faster
as initial investment of 361,600 can be recovered in 3.68 years.
 Discounted Payback Period

Cumulative Cumulative
Press A Press B
Cash Flows A Cash Flows B
Year
0 (662,000) (361,600) (662,000) (361,600)
1 112,632 76,842 112,632 76,842
2 140,166 91,782 252,798 168,624
3 112,126 64,905 364,924 233,529
4 99,327 50,729 464,251 284,259
5 233,487 107,447 697,739 391,706
Discounted Payback
Period 4.85 4.72

Discounted Payback period requires discounted value of each cash

flow. Each cash flow is discounted to time 0 at the cost of capital,
and payback period is calculated by using these discounted cash
flows. In this particular case, method favors project “B” as in the
standard Payback Period method.
 NPV Analysis

Year Press A Press B NPVA 

128, 400

182,160

166,120

(1  0.14) (1  0.14)
1 2
(1  0.14)3
0 -$662,000-$361,600 167, 760 449,560
  662, 000  35, 738.82
(1  0.14) 4
(1  0.14)5
1 $128,400 $87,600

2 $182,160 $119,280
87, 600 119, 280 96,160
NPVB    
(1  0.14) (1  0.14)
1 2
(1  0.14)3
3 $166,120 $96,160
85,860 206,880
  361, 600  30,105.88
(1  0.14) 4
(1  0.14)5
4 $167,760 $85,680

5 $449,560 $206,880

NPVPress-A=35,738.82>NPVPress-B=30,105.88
Since both projects have 5 year life spans there is no need to consider
Annualized NPV, but have we had done it, ANPV-A would have been
higher than ANPV-B.
 IRR

• Project A’s IRR is 15.8,

128, 400 182,160 166,120 167, 760 449,560

662, 000     
(1  IRRA )1 (1  IRRA ) 2 (1  IRRA )3 (1  IRRA ) 4 (1  IRRA )5

• Project B’s IRR is 17.06.

87, 600 119, 280 96,160 85,860 206,880
361, 600     
(1  IRRB )1 (1  IRRB ) 2 (1  IRRB )3 (1  IRRB ) 4 (1  IRRB )5

• Both projects have IRR above cost of Capital. If we used IRR to choose the
projects, Press B would be favored by the IRR method. Note that IRR assumes
that cash flows can be reinvested at the IRR.
• A consideration of reinvestment at cost of capital (MIRR) suggest that ranking
does not change. MIRR-A=15% MIRR-B=16%

© Dr. C. Bulent Aybar

 Cost of Capital and NPV

Cost of Capital NBV Press A NPV Presss B

0.11 $100,287 $63,653.89
0.12 $77,808 $51,988.82
0.13 $56,309 $40,814.89
0.14 $35,739 $30,105.88
0.15 $16,046 $19,837.23
0.16 -$2,816 $9,985.92
0.17 -$20,891 $530.34
0.18 -$38,221 -$8,549.78
0.19 -$54,843 -$17,273.48

As the above table shows, when cost of capital is approximately

Below 15%, press A has higher NPV than Press B.
But this changes when the cost of capital Increases to 15% and
Beyond. This suggest a cross-over point between 14 and 15% (14.59)
cost of capital.
 NPV and Cost of Capital

$300,000

Cross-over point=14.59%
$200,000 Project A

$100,000

Project B
$0

-$100,000

-$200,000

-$300,000
NPV_A NPV_B
 Profitability Index

• Profitability index reflects the benefit cost ratio of a project.

It is the ratio of PV of project cash flows to the project cost.
N
CF
 (1  k ) t
PI  t 1 WACC

I
• LI’s two projects have PIA=1.05 and PIB=1.08 . While
profitability index suggests that project B generates more
value per dollar invested, the total value created by project A
is higher.

© Dr. C. Bulent Aybar

 Impact of Capital Rationing on the Decision

• In this case we are considering mutually exclusive projects. It does

not make sense for the firm to implement both projects
simultaneously.
• However, if had we considered projects that are not necessarily
mutually exclusive, we could use two methods:
• IRR Method
– Rank Projects wrt their IRR, select the projects with IRRs exceeding
cost of capital up to a point where the capital budget is consumed. If
the last qualified project partially exceeds capital budget, drop that
project as well.
• NPV Method
– Rank Projects wrt their NPV, select all the positive NPV projects in
order until the capital budget is consumed © Dr. C. Bulent Aybar
 Mutually Exclusive Projects and Capital Rationing

• When investments are independent and decision is simply to

adopt or abandon, decision rules like NPV, IRR and
Profitability Index provide competent guidance.
• However when investments are mutually exclusive, the
guidance provided by these decision rules should be
carefully considered.
• One reason for possible conflicting recommendations is the
insensitivity of PI and IRR to the scale of investment.
• This may lead to decisions that are not consistent with value
maximization objective.

© Dr. C. Bulent Aybar

 Example

Consider the two projects above with different initial outlays and cash
flow structures. The company in question should choose one of these
two service station projects. Which one should company adopt?
Since these are mutually exclusive projects, it does not make sense to
adopt both.

NPV at 10% PI at 10% IRR

Inexpensive Project 92,500 1.18 14%
Expensive Project 98,200 1.09 12%
 Mutually Exclusive Projects and NPV

NPV at 10% PI at 10% IRR

Inexpensive Project 92,500 1.18 14%
Expensive Project 98,200 1.09 12%
While the expensive project’s direct contribution to shareholder wealth is
larger, inexpensive project earns higher return on each dollar invested,
and has a higher return. The impressive performance of inexpensive
project documented in PI and IRR obviously in conflict with the value
maximization objective.
What should company do? If company invests $1.1m it creates $7,700
more value! However, investing $522,000 makes $578,000 available. If
the company had an opportunity to deploy this amount to create NPV in
excess of $7,700 by taking same level of risk, inexpensive project would
be viable. Otherwise, the firm should go for the expensive project. Scale
insensitivity of PI and IRR confirms the use of NPV as appropriate figure
or merit.
© Dr. C. Bulent Aybar
 Capital Rationing

• Under capital rationing, the company has a fixed investment budget that
it may not exceed.
• Capital rationing requires us to rank investments rather than simply
accept or reject them.
• In mutually exclusive alternatives, capital is available but, for technical
reasons, the company cannot make all investments.
• Under capital rationing, it may be technically possible to make all
investments, but there is limited capital. This has a fundamental impact
on the ranking processes.
• When capital is constrained, the objective is to get best possible benefit
per dollar.

© Dr. C. Bulent Aybar

 Example: Mutually Exclusive Projects
Investment A B C
Initial Cost $ 5,500,000 $ 3,000,000 $ 2,000,000
Expected Life (yr) 10 10 10
NPV @15% $ 340,000 $ 300,000 $ 200,000
PI @ 15% 1.06 1.10 1.10
IRR 20% 30% 40%

• If the company can raise large amounts of money at an annual cost of

15%, and if the investments are mutually exclusive, which project should
the company undertake?

Answer:
Undertake investment A because it has the highest NPV, and NPV is a direct
measure of the increase in wealth from undertaking the investment

© Dr. C. Bulent Aybar

 Example: Capital Rationing
Investment A B C
Initial Cost $ 5,500,000 $ 3,000,000 $ 2,000,000
Expected Life (yr) 10 10 10
NPV @15% $ 340,000 $ 300,000 $ 200,000
PI @ 15% 1.06 1.10 1.10
IRR 20% 30% 40%

• Considering only these three investments, if the company has a fixed

capital budget of $5.5 million, and if the investments are independent of
one another, which projects should the company undertake?
If the capital budget is fixed at $5.5 million, invest in C and B, and put the
remaining $500,000 in A if possible. This is the bundle of investments with
the highest total NPV. One can select this bundle by ranking investments by
their IRR, or occasionally more accurately by their PI (or Benefit Cost Ratio
or BCR)

© Dr. C. Bulent Aybar