CAPITAL

BUDGETING
So, What is Capital Budgeting?

It is the process of determining which real

investment projects should be accepted and given
an allocation of funds from the firm.

Long-term decisions; involve large expenditures.

Very important to firm’s future.

 THE CAPITAL BUDGETING DECISION
PROCESS

1 2 3
Identifying potential Reviewing, analyzing, Implementing and
investments and selecting from the monitoring the
proposals proposals that have
been selected
 T H E C API TAL B UDG ET I NG
DE CI SION PROCE SS –
DE TAI L ED ST E PS Replacement Expansion
Projects Projects

Estimate cash flow Account for risk

Regulatory, Safety,
New Products and
and Environmental
Services
Projects

Determine Evaluate Cash Flows

appropriate using Appropriate
Discount Rate Techniques Other

Arrive at investment
decisions that Rank competing
maximize projects CLASSIFYING
shareholders’ wealth PROJECTS
 BASIC PRINCIPLES OF CAPITAL
BUDGETING

Decisions are based The timing of cash

on cash flows. flows is crucial.

Cash flows are Cash flows are on

incremental. an after-tax basis.

Financing costs are

ignored.
 • Cash that will
Initial occur only at the
Types of Investment
Outlay: start of a
Cash Flows project’s life

• the changes in day-to-

CASH FLOWS day cash flows that
result from the
Incremental
Operating purchase of a capital
Cash Flow: project and continue
until the firm disposes
of the asset

Terminal • the net cash flows that

Incremental Cash Flows: Problems in Determining Cash Flow: occur only at the end
Incremental Cash Flows of a project’s life

• An Incremental Cash • Sunk Cost

Flow is the change in
a firm’s net cash flow
attributable to an
investment project.
• Opportunity Cost
• Externalities
• Shipping and
Installation Costs
• Inflation
INCREMENTAL CASH FLOWS
 PROPOSED PROJECT

• Total depreciable cost

– Equipment: $200,000 • Life of the project
– Shipping and installation: $40,000 – Economic life: 4 years

• Changes in operating working capital – Depreciable life: MACRS 3-year class

– Salvage value: $25,000
– Inventories will rise by $25,000
– Accounts payable will rise by $5,000 • Tax rate: 40%

• Effect on operations • WACC: 10%

– New sales: 100,000 units/year @ $2/unit
– Variable cost: 60% of sales
 DETERMINING PROJECT VALUE

• Estimate relevant cash flows

– Calculating annual operating cash flows.

– Identifying changes in net operating working capital.

– Calculating terminal cash flows: after-tax salvage value and return of NOWC.

0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF4

Costs +
Terminal
CFs
FCF0 FCF1 FCF2 FCF3 FCF4
 INITIAL YEAR INVESTMENT OUTLAYS

• Find NOWC.
–  in inventories of $25,000
– Funded partly by an  in A/P of $5,000
– NOWC = $25,000 – $5,000 = $20,000
• Initial year outlays:
Equipment cost -$200,000
Installation -40,000
CAPEX -240,000
NOWC -20,000
FCF0 -$260,000
 DETERMINING ANNUAL DEPRECIATION
EXPENSE

Year Rate x Basis Deprec.

1 0.33 x $240 $ 79
2 0.45 x 240 108
3 0.15 x 240 36
4 0.07 x 240 17
1.00 $240

Due to the MACRS ½-year convention, a 3-year asset is depreciated over 4

years.
 PROJECT OPERATING CASH FLOWS

(Thousands of dollars) 1 2 3 4
Revenues 200.0 200.0 200.0 200.0
– Op. costs -120.0 -120.0 -120.0 -120.0
– Depreciation -79.2 -108.0 -36.0 -16.8
EBIT 0.8 -28.0 44.0 63.2
– Taxes (40%) 0.3 -11.2 17.6 25.3
EBIT(1 – T) 0.5 -16.8 26.4 37.9
+ Depreciation 79.2 108.0 36.0 16.8
EBIT(1 – T) + DEP 79.7 91.2 62.4 54.7

12-13
 TERMINAL CASH FLOWS

(Thousands of dollars)
Salvage value $25
– Tax on SV (40%) 10
AT salvage value $15
+ NOWC 20
Terminal CF $35

FCF4 = EBIT(1 – T) + DEP – CAPEX – NOWC

= $54.7 + $35
= $89.7
12-14
 SHOULD FINANCING EFFECTS BE
INCLUDED IN CASH FLOWS?

• No, dividends and interest expense should not be included in the analysis.
• Financing effects have already been taken into account by discounting cash
flows at the WACC of 10%.
• Deducting interest expense and dividends would be “double counting”
financing costs.
 SHOULD A $50,000 IMPROVEMENT
COST FROM THE PREVIOUS YEAR BE
INCLUDED IN THE ANALYSIS?
• No, the building improvement cost is a sunk cost and should not be
considered.
• This analysis should only include incremental investment.
 IF THE FACILITY COULD BE LEASED
OUT FOR $25,000 PER YEAR,
WOULD THIS AFFECT THE
ANALYSIS?
• Yes, by accepting the project, the firm foregoes a possible annual cash flow of
$25,000, which is an opportunity cost to be charged to the project.
• The relevant cash flow is the annual after-tax opportunity cost.
A-T opportunity cost:
= $25,000(1 – T)
= $25,000(0.6)
= $15,000

12-17
 IF THE NEW PRODUCT LINE DECREASES THE
SALES OF THE FIRM’S OTHER LINES, WOULD THIS
AFFECT THE ANALYSIS?
• Yes. The effect on other projects’ CFs is an “externality.”
• Net CF loss per year on other lines would be a cost to this project.
• Externalities can be positive (in the case of complements) or negative
(substitutes).

12-18
 PROPOSED PROJECT’S CASH FLOW TIME
LINE

(Thousands of dollars)
0 1 2 3 4

-260 79.7 91.2 62.4 89.7

• If I =10%.
NPV = -$4.03

IRR = 9.3%

MIRR = 9.6%

Payback = 3.3 years

12-19
 IF THIS WERE A REPLACEMENT RATHER
THAN A NEW PROJECT, WOULD THE
ANALYSIS CHANGE?

• Yes, the old equipment would be sold, and new equipment purchased.
• The incremental CFs would be the changes from the old to the new
situation.
• The relevant depreciation expense would be the change with the new
equipment.
• If the old machine was sold, the firm would not receive the SV at the end of
the machine’s life. This is the opportunity cost for the replacement project.

12-20
 PROBLEM

Project S Project L
Cost of Equipment $9000000
Data Applicable to both Machines In ‘000s
Increase in Inventory $175000 Sales revenue $2500
Increase in Accounts Payable $75000 Expected Life of Machine 4 Years
Life of Project 4 Years Discount Rate 10%
Expected Sales in Year 1,2, 3 and 4 is 2685, 2600, 2525 and 2450 Tax Rate 40%
(in ‘000s) units respectively. Selling price is $2 per unit
Data Applicable to Old Machine
Fixed Costs for producing the new product $2000
Market (Salvage Value of old Machine today $400
Variable cost of producing one unit of product will rise from
$1.018 in 2014 to $1.221 in 2017 Old labour, material and other costs per $1000
year
Depreciation Method WDV
Company expects to recover entire WC at end of project
Annual Depreciation $100
Salvage value of Equipment $50000 Data Applicable for New Machine
Tax rate 40% Cost of New machine (Depreciation @ $2000
33% WDV)
Discount Rate 10%
New labour, material and other costs per $400
year
 OVERVIEW OF CAPITAL BUDGETING:
BASIC TERMINOLOGY

Independent versus Mutually Exclusive Projects

• Independent projects are projects whose cash flows are unrelated to
(or independent of) one another; the acceptance of one does not
eliminate the others from further consideration.
• Mutually exclusive projects are projects that compete with one
another, so that the acceptance of one eliminates from further
consideration all other projects that serve a similar function.
 OVERVIEW OF CAPITAL BUDGETING:
BASIC TERMINOLOGY (CONT.)

Unlimited Funds versus Capital Rationing

• 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.
 OVERVIEW OF CAPITAL BUDGETING:
BASIC TERMINOLOGY (CONT.)

Accept-Reject versus Ranking Approaches

• An accept–reject approach is the evaluation of capital expenditure
proposals to determine whether they meet the firm’s minimum
acceptance criterion.
• A ranking approach is the ranking of capital expenditure projects on
the basis of some predetermined measure, such as the rate of return.
 CAPITAL BUDGETING TECHNIQUES

Bennett Company is a medium sized metal fabricator that is

currently contemplating two projects: Project A requires an
initial investment of $42,000, project B an initial investment
of $45,000. The relevant operating cash flows for the two
projects are presented in the following table and depicted on
the time lines in Figure
CAPITAL EXPENDITURE DATA FOR
BENNETT COMPANY
BENNETT COMPANY’S PROJECTS A
AND B
 PAYBACK PERIOD

The payback method is the amount of time required for a firm to recover its
initial investment in a project, as calculated from cash inflows.
Decision criteria:
• The length of the maximum acceptable payback period is determined by management.
• 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.
 PAYBACK PERIOD (CONT.)

We can calculate the payback period for Bennett Company’s projects A

and B using the data in Table 10.1.
• For project A, which is an annuity, the payback period is 3.0 years ($42,000
initial investment ÷ $14,000 annual cash inflow).
• Because project B generates a mixed stream of cash inflows, the calculation of its
payback period is not as clear-cut.
• In year 1, the firm will recover $28,000 of its $45,000 initial investment.
• By the end of year 2, $40,000 ($28,000 from year 1 + $12,000 from year 2) will have
been recovered.
• At the end of year 3, $50,000 will have been recovered.
• Only 50% of the year-3 cash inflow of $10,000 is needed to complete the payback of the
initial $45,000.
• The payback period for project B is therefore 2.5 years (2 years + 50% of year 3).
 PAYBACK PERIOD: PROS AND CONS
OF PAYBACK ANALYSIS

• The payback method is widely used by large firms to evaluate small

projects and by small firms to evaluate most projects.
• Its popularity results from its computational simplicity and intuitive
appeal.
• By measuring how quickly the firm recovers its initial investment, the
payback period also gives implicit consideration to the timing of cash
flows and therefore to the time value of money.
• Because it can be viewed as a measure of risk exposure, many firms use
the payback period as a decision criterion or as a supplement to other
decision techniques.
 PAYBACK PERIOD: PROS AND CONS
OF PAYBACK ANALYSIS (CONT.)

• The major weakness of the payback period is that the appropriate

payback period is merely a subjectively determined number.
• It cannot be specified in light of the wealth maximization goal because it is not
based on discounting cash flows to determine whether they add to the firm’s
value.
• A second weakness is that this approach fails to take fully into
account the time factor in the value of money.
• A third weakness of payback is its failure to recognize cash flows
that occur after the payback period.
 DISCOUNTED PAYBACK PERIOD

• The discounted payback period is the length of time it

takes for the cumulative discounted cash flows to equal the
initial outlay.
• In other words, it is the length of time for the project to reach NPV
= 0.
 Net present value (NPV) is found by subtracting a project’s initial
investment from the present value of its cash inflows discounted at a rate
equal to the firm’s cost of capital.
NPV = Present value of cash inflows – Initial investment

NET PRESENT
VALUE (NPV)
where
CFt = After-tax cash flow at time t
r = Required rate of return for the investment
CF0 = Initial Outlay / Investment cash flow at time zero
 NET PRESENT VALUE (NPV) (CONT.)

Decision criteria:
• If the NPV is greater than 0, accept the project.
• Capital project adds value
• If the NPV is less than 0, reject the project.
• Capital project destroys value

If the NPV is greater than 0, the firm will earn a return greater than its cost of
capital. Such action should increase the market value of the firm, and therefore
the wealth of its owners by an amount equal to the NPV.
C ALCULATION OF NPVS FOR BENNETT
COMPANY’S C APITAL EXPENDITURE
ALTERNATIVES
 THE PROFITABILITY INDEX (PI)

Total PV of Future Cash Flows

PI 
Initial Investent
Advantages:
• Minimum Acceptance Criteria: May be useful when available investment funds
• Accept if PI > 1 are limited
Easy to understand and communicate
Correct decision when evaluating independent
• Ranking Criteria: projects
• Select alternative with highest PI
 INTERNAL RATE OF RETURN (IRR)

The Internal Rate of Return (IRR) is a sophisticated capital budgeting

technique; the discount rate that equates the NPV of an investment opportunity
with $0 (because the present value of cash inflows equals the initial investment);
it is the rate of return that the firm will earn if it invests in the project and receives
the given cash inflows.
 INTERNAL RATE OF RETURN (IRR)

Decision criteria:
• If the IRR is greater than the cost of capital, accept the project.
• Capital project adds value

• If the IRR is less than the cost of capital, reject the project.
• Capital project destroys value

These criteria guarantee that the firm will earn at least its required return. Such an outcome
should increase the market value of the firm and, therefore, the wealth of its owners.
A C ALCULATION OF IRRS FOR BENNETT COMPANY’S
C APITAL EXPENDITURE ALTERNATIVES

IRR for Project A: 19.9%

IRR for Project B: 21.7%
 CALCULATE IRR

$200 $800 There are two IRRs for this project:

0 1 2 3 Which one should

-$200 - $800 we use?
NPV

$100.00

100% = IRR2
$50.00

$0.00
-50% 0% 50% 100% 150% 200%
($50.00) Discount rate

0% = IRR1
($100.00)
 NPV AND IRR RELATIONSHIP

Discount rate NPV for A NPV for B

-10% -87.52 234.77
0% 0.00 150.0
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52
 NPV PROFILES

NPV
$400

$300
IRR 1(A) IRR (B) IRR 2(A)
$200

$100

$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100)

($200)
Project A
Discount rates
Cross-over Rate Project B
 COMPARING NPV AND IRR TECHNIQUES:
TIMING OF THE C ASH FLOW
Notice how the IRR and NPV methods provide
different preferences for investment options A or
B. This has to do with differences in the timing
of cash flows.
• When much of a project’s cash flows arrive
early in its life, the project’s NPV will not
be particularly sensitive to the discount
rate.
• On the other hand, the NPV of projects
with cash flows that arrive later will
fluctuate more as the discount rate changes.
• The differences in the timing of cash flows
between the two projects does not affect
the ranking provided by the IRR method.
WHICH IS BETTER?
On a purely theoretical basis, NPV is the better approach
because:
• NPV measures how much wealth a project creates (or
destroys if the NPV is negative) for shareholders.
• Wide fluctuations in cash flow may cause a project to have
multiple IRRs— such as more than one IRR resulting from
a capital budgeting project with nonconventional cash flow
patterns.
Despite its theoretical superiority, however, financial
managers prefer to use the IRR approach just as often as
the NPV method because of the preference for rates of
return.
 CALCULATE CROSSOVER RATE

$10,000 $1,000 $1,000

Project A
0 1 2 3
-$10,000

$1,000 $1,000 $12,000

Project B
0 1 2 3
-$10,000
 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
https://www.investopedia.com/video/play/capital-budgeting-which-better-irr-or-npv/
 EXAMPLE OF INVESTMENT RULES

Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100 Project A Project B
3 -$800 $150
NPV = $41.92 $90.80
IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
 MODIFIED INTERNAL RATE OF RETURN
- MIRR

Modified internal rate of return (MIRR) assumes that positive cash flows are reinvested at the
firm's cost of capital, and the initial outlays are financed at the firm's financing cost. By contrast,
the traditional internal rate of return (IRR) assumes the cash flows from a project are reinvested
at the IRR. The MIRR more accurately reflects the cost and profitability of a project.
 HOW TO CALCULATE MODIFIED
INTERNAL RATE OF RETURN?

• 1. Discount all the negative cash flows at firm’s financing cost and add them.
• 2. Compounds all the positive cash flows at the firm’s cost of capital and add them.
• 3. Now, we have one initial cash outlay on year 0 and one future cash inflow at the
end the last year. Assume all the cash flows in between as 0.
• 4. Calculate like normal Internal Rate of Return (IRR)
 EXAMPLE

Cash Flows PV of FV of
Year MIRR
(CF) Negative CFs Positive CFs
0 -2,000.00 -2,000.00 -4,630.06
1 1,000.00 1,762.34 0.00
2 1,000.00 1,573.52 0.00
3 -4,000.00 -2,630.06 0.00
4 3,000.00 3,763.20 0.00
5 3,000.00 3,360.00 0.00
6 3,000.00 3,000.00 13,459.06
-4,630.06 13,459.06 19.46%

Using the formula also, we get following

MIRR = (13459.06/4630.06)^(1/6) – 1
MIRR = 19.46%
 ADVANTAGES AND
DISADVANTAGES OF MIRR

• Advantage: MIRR is a better and improved method for project evaluation as it

obviates all the shortcomings of normal IRR and NPV methods. It takes into
consideration the practically possible reinvestment rate. The calculation is also
not a rocket science.
• Disadvantage: The disadvantage of MIRR is that it asks for two additional
decisions i.e. determination of financing rate and cost of capital. These can be
estimates again and the managers in real life may hesitate in involving these
two additional estimates.
Investment Projects Plotted According to
Expected Return and Risk
Using a Single Hurdle Rate May Lead
to Decision Errors
Projected Cash Flows and NPVs for a
Set of Six Hypothetical Investment Projects
($ in 000s)
Cash Flow Graphs
for Hypothetical
Projects A–F
The Set of Hypothetical Investment Projects
Ranked by NPV and IRR ($ in 000s)
Feasible Project
Combinations with a
Budget of $2 Million
($ in 000s)
Projects with Equal IRRs May Have Very
Different NPVs ($ in 000s)

IRR Can Be Misleading Even for Projects

of the Same Size ($ in 000s)
Projects A–F Ranked by NPV and
Profitability Index ($ in 000s)
 CHAPTER SUMMARY

• Capital budgeting techniques are the tools used to assess project acceptability and
ranking. Applied to each project’s relevant cash flows, they indicate which capital
expenditures are consistent with the firm’s goal of maximizing owners’ wealth.
• The payback period is the amount of time required for the firm to recover its initial
investment, as calculated from cash inflows. Shorter payback periods are preferred. Its
weaknesses include lack of linkage to the wealth maximization goal, failure to consider
time value explicitly, and the fact that it ignores cash flows that occur after the payback
period.
• NPV measures the amount of value created by a given project; only positive NPV
projects are acceptable. The rate at which cash flows are discounted in calculating NPV
is called the discount rate, required return, cost of capital, or opportunity cost.
• Like NPV, IRR is a sophisticated capital budgeting technique. IRR is the compound
annual rate of return that the firm will earn by investing in a project and receiving the
given cash inflows. We accept only projects with IRRs in excess of the firm’s cost of
capital to enhance its market value and the wealth of its owners.