Capital budgeting

What is Capital budgeting

• The process of identifying, analyzing and
selecting investment projects whose
returns(cash flows) are expected to extend
beyond one year.
 The Capital Budgeting Process
• Generate investment proposals consistent
with the firm’s strategic objectives.

• Estimate after-tax incremental operating cash

flows for the investment projects.

• Evaluate project incremental cash flows.

 The Capital Budgeting Process
• Select projects based on a value-maximizing
acceptance criterion.

• Reevaluate implemented investment projects

continually and perform post audits for
completed projects.
 Classification of Investment Project
Proposals
1. New products or expansion of existing
products
2. Replacement of existing equipment or
buildings
3. Research and development
4. Exploration
 Sunk cost
• A cost that has already been incurred and thus
cannot be recovered. A sunk cost differs from
other, future costs that a business may face,
such as inventory costs or R&D expenses,
because it has already happened. Sunk costs
are independent of any event that may occur
in the future.
 Sunk Cost Example
• When making business or investment decisions,
individuals and organizations typically look at the
future costs that they may incur, by following a
certain strategy. A company that has spent $5
million building a factory that is not yet complete,
has to consider the $5 million sunk, since it cannot
get the money back. It must decide whether
continuing construction to complete the project will
help the company regain the sunk cost, or whether
it should walk away from the incomplete project.
 Opportunity Cost
• The cost of an alternative that must be forgone in
order to pursue a certain action. Put another way,
the benefits you could have received by taking an
alternative action.
• Say you invest in a stock and it returns a partly 2%
over the year. In placing your money in the stock,
you gave up the opportunity of another investment -
say, a risk-free government bond yielding 6%. In this
situation, your opportunity costs are 4% (6% - 2%).
 Capital Budgeting Techniques
– Payback Period (PBP)
– Internal Rate of Return (IRR)
– Net Present Value (NPV)
– Profitability Index (PI)
 Net Present Value
• The difference between the present value of cash
inflows and the present value of cash outflows. NPV
is used in capital budgeting to analyze the
profitability of an investment or project.
• When cash flows are even
1 − (1 + i)-n
− Initial
NPV = R* Investment
i
When cash flows are uneven
R1 R2 R3
−
Initial
NPV = + + + ...
(1 + i) 1
(1 + i) 2
(1 + i) 3 Invest
ment
 Decision rule
If... It means... Then...

the investment would add value

NPV > 0 the project may be accepted
to the firm

the investment would subtract

NPV < 0 the project should be rejected
value from the firm

We should be indifferent in the decision

the investment would neither
NPV = 0 gain nor lose value for the firm
whether to accept or reject the project. This
project adds no monetary value. Decision should
be based on other criteria, e.g., strategic
positioning or other factors not explicitly
included in the calculation.
Example
• Suppose you are establishing a fertilizer business.
You believe that cash received from that business is
$20000/year. Cash costs(including taxes) will be
$14000/ year. You will wind down the business in
eight years. the plant will be worth $2000 as salvage
at that time. The project cost is $30000 to launch.
You use a 15% discount rate. And there are 1000
shares of stock outstanding. calculate NPV?
 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 or decrease in value?
• Should we consider the NPV rule for our primary
decision rule?
Pay back period

• The length of time required to recover the cost of

an investment. The payback period of a given
investment or project is an important determinant
of whether to undertake the position or project, as
longer payback periods are typically not desirable
for investment positions.
Calculated as:
Payback Period = Cost of Project(remaining) / Annual
Cash Inflows
 Decision rule
• How long does it take to get the initial cost back in a
nominal sense?
• Computation
– Estimate the cash flows
– 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
 Example
• You are looking at a new project and you have
estimated the following cash flows:
– Year 0: CF = -165,000……………cash outflow
– Year 1: CF = 63,120
– Year 2: CF = 70,800
– Year 3: CF = 91,080
• We will accept the project if it pays back within two
years.
Example Payback
• 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
• The payback period is year 3 if you assume that the cash flows
occur at the end of the year as we do with all of the other
decision rules.

• If we assume that the cash flows occur unevenly throughout the

year, then the project pays back in 2.34 years (31080/91080).

• Do we accept or reject the project?

 NPV VS PAYBACK EXAMPLE
Years Long project Short project

0 -250 -250

1 100 100

2 100 200

3 100 0

4 100 0
NPV VS PAYBACK EXAMPLE
• Both projects cost $250 initially but payback on long
project is 2+($50/100)=2.5 years
• payback on short project is 1+($150/200)=1.75
years.so payback for short is preferable.
• NPV(short)=-250+(100/1.15)+(200/1.15^2)=-11.81
• NPV(Long)=-250+(100*{[1-(1/1.15^4)]/.15}=35.50

• From pay back POV short project is desirable but

from NPV POV long project is desirable because it
increases shareholder wealth in long run.
Decision Criteria Test - Payback
• Does the payback rule account for the time value of
money?
• Does the payback rule account for the risk of the
cash flows?
• Does the payback rule provide an indication about
the increase in value?
• Should we consider the payback rule for our
primary decision rule?
Advantages and Disadvantages of Payback
• Advantages
– Easy to understand
– Adjusts for uncertainty of later cash flows
– Biased towards liquidity
• Disadvantages
– Ignores the time value of money
– Ignores cash flows beyond the cutoff date
– Biased against long-term projects, such as
research and development, and new projects
 Discounted Payback Period
• Compute the present value of each cash flow and
then determine how long it takes to payback on a
discounted basis
• Compare to a specified required period
• Decision Rule - Accept the project if it pays back on
a discounted basis within the specified time
 Example DCF
• Assume we will accept the project if it pays back on
a discounted basis in 2 years along with required
return of 12 percent .
• Compute the PV for each cash flow and determine
the payback period using discounted cash flows
– Year 1: 165,000 – 63,120/1.121 = 108,643
– Year 2: 108,643 – 70,800/1.122 = 52,202
– Year 3: 52,202 – 91,080/1.123 = -12,627 project pays
back in year 3
• Do we accept or reject the project?
Decision Criteria Test – Discounted Payback
• Does the discounted payback rule account for
the time value of money?

• Should we consider the discounted payback

rule for our primary decision rule?
Advantages and Disadvantages of Discounted
Payback
• Advantages
– Includes time value of money
– Easy to understand
– Biased towards liquidity
• Disadvantages
– May reject positive NPV investments
– Biased against long-term projects, such as R&D
and new products
 IRR
• The internal rate of return or economic rate of
return is a rate of return used in capital
budgeting to measure and compare the
profitability of investments. It is also called the
discounted cash flow rate of return.

The internal rate of return (IRR) on a project is the

rate of return at which the projects NPV equals
zero.
 Internal rate of return
• Important Point

• If discount rate goes up, value of discounted

cash flows goes down.
Internal Rate of Return
• The discount rate often used in capital budgeting
that makes the net present value of all cash flows
from a particular project equal to zero. Generally
speaking, the higher a project's internal rate of
return(lower discount rate), the more desirable it
is to undertake the project.

• The term internal refers to the fact that its

calculation does not incorporate environmental
factors (e.g., the interest rate or inflation).
 Internal Rate of Return
• 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
• Decision Rule: Accept the project if the IRR is
greater than the required return.

• if we go for required return then it will make

NPV negative
 Example IRR
• A project has total upfront cost of 435.44. cash
flows are 100, 200, 300 in three years respectively.
What is IRR? If company can get 18% return from
other investment. should we take on this
investment?
Disount rate % NPV
0 164.56
5 100.36
10 46.15
15 0.00
20 -39.61
 Example IRR
• The NPV is zero at 15% so its IRR.if we require
an 18% return then we should not take on this
investment the reason is that NPV is negative
at 18% which is (-24.47). So reject it because
15% is below our required return.
 Decision Criteria Test - IRR
• Does the IRR rule account for the time value of
money?
• Does the IRR rule account for the risk of the
cash flows?
• Does the IRR rule provide an indication about
the increase or decrease in value?
• Should we consider the IRR rule for our
primary decision criteria?
 Decision Rule
• The IRR rule accounts for time value because it is finding the rate
of return that equates all of the cash flows on a time value basis.
• The IRR rule accounts for the risk of the cash flows because you
compare it to the required return, which is determined by the
risk of the project.
• The IRR rule provides an indication of value because we will
always increase value if we can earn a return greater than our
required return.
• We should consider the IRR rule as our primary decision criteria,
but as we will see, it has some problems that the NPV does not
have. That is why we end up choosing the NPV as our ultimate
decision rule.
 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 situation
– Mutually exclusive projects
 Profitability Index
• Defined as, “ the ratio of project future net cash
flows to project’s initial cash flows
present value of future cash flows
divided by initial investment.
If a project cost 200 and its cash flow is 220 then PI
will be 220/200=1.1 note that NPV for this project is
$20. so its desirable.it is interpreted as” we will get
1.10 in value for every single dollar invested or 0.10 in
NPV.
 Decision rule
• Profitability Index
– Take investment if PI > 1 or equal to one
– Cannot be used to rank mutually exclusive projects
– May be used to rank projects in the presence of capital
rationing where budget ceiling is imposed.