The Basics of Capital Budgeting

Should we
build this
plant?

10-1
Capital Budget

• The term capital refers to the long term assets.

• While budget is a plan that details projected inflows and outflows

during some future period.

10-2
What is capital budgeting?

• Analysis of potential additions to fixed assets.

• Long-term decisions; involve large expenditures.
• Very important to firm’s future.

10-3
Definition of Capital Budgeting'

• The process in which a business determines whether projects (such

as building a new plant or investing in a long-term venture) are worth
pursuing.

•  Oftentimes, a prospective project's lifetime cash inflows and

outflows are assessed in order to determine whether the returns
generated meet a sufficient target benchmark.   

Also known as "investment appraisal".

10-4
Project Classification

• Replacement: Maintenance of business

• Replacement: Cost Reduction
• Expansion of Existing products
• Expansion into new products/markets
• Safety and/or environmental projects ( aka mandatory investment)

10-5
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.

10-6
 What is the difference between independent
and mutually exclusive projects?

• Independent projects –
• Mutually exclusive projects –

10-7
Methods to decide weather the project should
be accepted or not .
• Payback Period
• Discounted Payback Period
• NPV
• IRR
• Profitability Index

10-8
What is the payback period?

• The number of years required to recover a project’s cost, or “How

long does it take to get our money back?”

• Calculated by adding project’s cash inflows to its cost until the

cumulative cash flow for the project turns positive.

10-9
 Calculating payback

0 1 2 2.4 3
Project L
CFt -100 10 60 100 80

PaybackL == 2 + 30 / 80 = 2.375 years

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

PaybackS == 1 + 30 / 50 = 1.6 years

10-10
Formula to calculate PBP

• Payback = Year before full recovery+ Uncovered Cost at start of

year/Cash flow during year
• = 2+$100/$300
=2.33 years

10-11
Strengths and weaknesses of payback
• Strengths
• Provides an indication of a project’s risk and liquidity.
• Easy to calculate and understand.
• Weaknesses
• Ignores the time value of money.
• Ignores CFs occurring after the payback period.(Example)

10-12
Discounted payback period

• The length of time required for an investment’s cash flows,

discounted at the investment’s cost of capital, to cover its cost.

10-13
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

Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years

10-14
WHAT IS THE DIFFERENCE BETWEEN THE
REGULAR AND DISCOUNTED PAYBACK
PERIODS?

• The regular payback does not consider the cost of capital.

• The discounted payback does consider capital costs-it shows
breakeven year after covering debt and/or equity costs.

• DISCOUNTED PAYBACK IS SIMILAR TO PAYBACK EXCEPT THAT

DISCOUNTED RATHER THAN RAW CASH FLOWS ARE USED.

10-15
Net Present Value

 NPV is used in capital budgeting to analyze the profitability of an

investment or project. 

 NPV analysis is sensitive to future cash inflows that an investment or

project will yield.

  NPV compares the value of a dollar today to the value

of that same dollar in the future.
-the current worth of future cash flows (Time value of
money)
 The difference between the present value of cash inflows and the present
value of cash outflows.

10-16
Discount Rate

• The rate used to discount future cash flows to the present value is a
key variable of this process.

• A firm's Weighted average cost of capital (after tax) is often used, but
many people believe that it is appropriate to use higher discount
rates to adjust for risk or other factors. 

10-17
Selection of discount rate

• To some extent, the selection of the discount rate is dependent on

the use to which it will be put.

• If the intent is simply to determine whether a project will add value

to the company, using the firm's weighted average cost of capital
may be appropriate.

• If trying to decide between alternative investments in order to

maximize the value of the firm, the corporate reinvestment rate
would probably be a better choice.

10-18
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 )

10-19
What is Project L’s 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

10-20
Solving for NPV:
Financial calculator solution
• Enter CFs into the calculator’s CFLO register.
• CF0 = -100
• CF1 = 10
• CF2 = 60
• CF3 = 80

• Enter I/YR = 10, press NPV button to get NPVL = $18.78.

10-21
Rationale for the NPV method

NPV = PV of inflows – Cost

= Net gain in wealth
• If projects are independent, accept if the
project NPV > 0.
• If projects are mutually exclusive, accept
projects with the highest positive NPV, those
that add the most value.
• In this example, would accept S if mutually
exclusive (NPVs > NPVL), and would accept both
if independent.
10-22
 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 whether

the investment would neither gain
NPV = 0
nor lose value for the firm
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.

10-23
Internal Rate of Return (IRR)

• IRR is defined as the discount rate that equates the present value of
a project’s expected cash inflows to the present value of the
project’s cost.

• PV (Inflows)=PV (Investment Costs)

OR

• The rate that forces the NPV to equal zero.

10-24
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 CFLO register.
• Press IRR; IRRL = 18.13% and IRRS = 23.56%.

10-25
How is a project’s IRR similar to a
bond’s YTM?
• They are the same thing.

• Think of a bond as a project. The YTM on the bond would be

the IRR of the “bond” project.
• EXAMPLE: Suppose a 10-year bond with a 9% annual coupon
sells for $1,134.20.
• Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

10-26
• IRR IS THE EXPECTED RATE OF RETURN ON THE PROJECT, JUST AS
THE YTM IS THE PROMISED RATE OF RETURN ON A BOND.

10-27
Rationale for the IRR method

• Hurdle Rate:
• The discount rate (cost of capital) that IRR must exceed if a
project is to be accepted.

• If IRR > WACC, the project’s rate of return is greater than its
costs. There is some return left over to boost stockholders’
returns.

10-28
IRR Acceptance Criteria

• 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.

10-29
• If an independent project is being evaluated, then the NPV and IRR
criteria always lead to the same accept/reject decision.

• If IRR says accept, NPV also says accept.

• Because whenever a project’s cost of capital is less than its IRR , its
NPV is positive.

10-30
• However when evaluating mutually exclusive projects, the NPV
method should be used.

10-31
WOULD THE PROJECTS’ IRRs CHANGE IF
THE COST OF CAPITAL CHANGED?

 
• ANSWER: IRRs ARE INDEPENDENT OF THE COST OF CAPITAL.
THEREFORE IRR WILL NOT CHANGE IF k CHANGES.

• HOWEVER, THE ACCEPTABILITY OF THE PROJECTS COULD CHANGE.

10-32
Advantages of IRR

• IRR compares what an investment is likely to earn to the firm’s

“benchmark” and measures profitability in percentage terms, which
is preferred by managers.
• • Considers all cash flows
• • Considers time value of money
• • Comparable with hurdle rate

10-33
 Problems with IRR

• There are a number of projects for which using IRR is not as effective as
using NPV to discount cash flows: it uses one single discount rate to
evaluate the whole investment. (discount rate usually changes with
time).

• When same project gives a mixture of multiple positive and negative

cash flows over a period of time, IRR calculations are ineffective- this
would lead to multiple IRR for the same project, that would be of no
use.

10-34
• The advantage to using the NPV method here is that NPV can handle
multiple discount rates without any problems.

10-35
 Drawing NPV profiles

NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

.. S IRRS = 23.6%
10
L . .
0 . Discount Rate (%)
5 10 15 20 23.6
-10
10-36
Reinvestment rate assumptions

• NPV method assumes CFs are reinvested at k,

the opportunity cost of capital.

• 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.

10-37
 Project P has cash flows (in 000s): CF0 = -
$800, CF1 = $5,000, and CF2 = -$5,000. Find
Project P’s NPV and IRR.
0 1 2
k = 10%

-800 5,000 -5,000

• Enter CFs into calculator CFLO register.

• Enter I/YR = 10.
• NPV = -$386.78.
• IRR = ERROR Why?

10-38
Multiple IRRs

NPV NPV Profile

IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
10-39
Why are there multiple IRRs?

• At very low discount rates, the PV of CF2 is large

& negative, so NPV < 0.
• At very high discount rates, the PV of both CF1
and CF2 are low, so CF0 dominates and again
NPV < 0.
• In between, the discount rate hits CF2 harder
than CF1, so NPV > 0.
• Result: 2 IRRs.

10-40
Profitability Index (Benefit-cost Ratio)

• Profitability index (PI), is the ratio of payoff to

investment of a proposed project.
• It is a useful tool for ranking projects because it allows
you to quantify the amount of value created per unit
of investment.

• The ratio is calculated as follows:

PI= PV of future Cash flows/Initial investment

• A profitability index of 1 indicates breakeven

10-41
Rules for selection or rejection of a
project:

• If PI > 1 then accept the project

• If PI < 1 then reject the project

10-42
EXAMPLE:
• PROJECT OUTLAY £10M
• PRESENT VALUE £14M
• NPV £4M
• PI = £14M / £10M = 1.4

• IT IS NORMALLY ASSUMED THAT THE BIGGER THE PI THE BETTER.

• WHY?

10-43
• IF THE GOAL IS ASSUMED TO MAXIMISE THE SHARE PRICE
THEN THIS IMPLIES MAXIMISING NPV FOR THE MINIMUM
AMOUNT OF INVESTMENT.

• NPV IS SEEN AS THE BENEFIT AND THE OUTLAY AS A

“COST.

• A HIGH PI WOULD THEREFORE BE VIEWED AS DESIRABLE.

10-44
• HOWEVER,
• IF THE GOAL IS MAX V│MAX P THEN THIS TELLS US TO MAXIMISE THE
SCALE OF THE BUSINESS, ie TO MAX PV AS WELL AS NPV.

• THAT IS, FOR A GIVEN NPV, WE WISH THE PV TO BE AS HIGH AS

POSSIBLE.

• IN EXAMPLE ABOVE WE WOULD PREFER THE PROJECT TO BE

£24M/£20M WITH A PI OF 1.2.

• IT FOLLOWS THAT, FOR A GIVEN NPV, WE WANT P.I. TO BE AS LOW AS

POSSIBLE.
• WHY?

10-45
• BECAUSE OUTLAY IS NOT A COST BUT REPRESENTS THE SIZE OF THE
INVESTMENT.

• THEREFORE UNDER NON-RATIONING, FOR A GIVEN NPV, WE WANT

THE PI TO BE AS LOW AS POSSIBLE.

10-46
• THE DENOMINATOR REPRESENTS THE SIZE OF THE INVESTMENT i.e.
£10M

• WE OBVIOUSLY WANT THE NUMERATOR TO BE AS HIGH AS POSSIBLE

(wealth creation).

• BUT SINCE THE AMOUNT OF WEALTH CREATION DEPENDS ON THE SIZE

OF THE INVESTMENT WE ALSO WANT THE DENOMINATOR TO BE AS
HIGH AS POSSIBLE.

10-47
• FINALLY, UNDER CAPITAL RATIONING THE GOAL IS MAX V│MAX P (AND
THEREFORE MAX PV│MAX NPV) SUBJECT TO THE AMOUNT OF CAPITAL
AVAILABLE.

• THE EMPHASIS NOW IS ON MAX NPV WHILST KEEPING THE

INVESTMENT OUTLAY WITHIN THE BUDGET.

• NOW, FOR THE GIVEN PV, WE WANT AS HIGH A P.I. AS POSSIBLE.

10-48
CONCLUSION
• UNDER NORMAL, NON-RATIONING CONDITIONS P.I. IS A TOTALLY
MISLEADING RATIO, SINCE, FOR A GIVEN NPV, A LOW P.I. IS BETTER
THAN A HIGH ONE

• UNDER RATIONING IT IS AT BEST A USEFUL ARITHMETIC DEVICE TO

HELP MAXIMISE NPV.

10-49
• Post Audit
-improve forecasts
-improve operations.

Compare actual results with the predicted results.

10-50