Capital Budgeting

Capital budgeting
 Capital budgeting is the process of
analyzing and evaluating projects to
determine if they should be included in
the capital budget.
 it is the process of making decisions
regarding the long term investment.
Three basic types of Capital
Budgeting decisions.
 Accept-reject decision: it is the fundamental
decisions of whether to invest in a proposed project.
Every asset the firm acquires must successfully pass
this decision
 Mutually exclusive project: given a set of competing
investment alternatives, only one of which may be
selected, which should the firm take?
 capital rationing: it refers to the situation where the
firm has many acceptable investment projects, but
insufficient funds to undertake all of them at once.
This amounts to having a budget constraint.
Investment decisions criteria
 Non-DCF criteria
 DCF criteria
 Expected Net Cash Flows
Year Project L Project S
 0  <$100>
<$100>
 1 10  70
 2 60  50
 3 80  20

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Payback
 Payback is defined as the number of
years it takes to recover a project’s net
investment through incremental cash
flow.
 it is the best known non-DCF criteria
 Payback = year before full recovery+
(uncovered cost at start of year/cash
flow during year)
 Payback for Franchise L

0 1 2 2.4 3

CFt -100 10 60 80

PaybackL = 2 + $30/$80 = 2.375 years

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 Payback for Franchise S

0 1 1.6 2 3

CFt -100 70 50 20

PaybackS = 1 + $30/$50 = 1.6 years

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Accept-reject decision
 if payback>required payback standard,
reject the project
 if payback<required payback standard,
accept the project
 The shorter the payback period, the
better.
Deficiencies
 the payback standard can be determined
only subjectively
 the payback does not account for the timing
of the cash flows that occur within the
payback period
 it ignores any cash flow that occur after the
investment is recovered
 it just measures the speed of capital
recovery rather than the return on capital
Discounted payback period
 It is defined as the number of years
required to recover the investment from
discounted net cash flows.
 Discounted Payback: Uses
Discounted CFs
0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + $41.32/$60.11 = 2.7 yrs

Recover investment + capital costs in 2.7 yrs.

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Net Present Value (NPV)
 it is the difference between the
discounted cash outflows and the
discounted cash inflows for an
investment project.
NPV: Sum of the PVs of All
Cash Flows
N CFt
NPV = Σ
(1 + k)t
t=0

Cost often is CF0 and is negative.

N CFt
NPV = Σ – CF 0
(1 + k) t
t=1
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Accept-reject decision
 if NPV>0, accept the project
 NPV<0, reject the project.
 the larger the NPV, the better the
project is .
 What’s Franchise L’s NPV?

0 1 2 3
L’s CFs: 10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
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Using NPV method, which
franchise(s) should be accepted?
 If Franchises S and L are mutually
exclusive, accept S because NPVs >
NPVL.
 If S & L are independent, accept
both; NPV > 0.
 NPV is dependent on cost of capital.

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NPV profile
 graph shows the relationship between
the discount rate and NPV
Internal rate of return
 it is defined as that discount rate that
equates the present value of a project’s
expected cash inflows with its initial
cost.
N CFATt
Σ (1 + IRR) t
= CFAT0
t=0
 Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces

PV inflows = PV costs.

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Procedure
 CFAT is a series of equal payment. In
this case divide the initial cost by the
CFAT to determine the PVIFAk,n. find this
from table appropriate to years
 if CFAT is a series of unequal payment,
trial error process is involved
 IRR Solution (Try
15%)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
 IRR Solution
(Interpolate)
.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X $1,444
.05 $4,603
=
 IRR Solution
(Interpolate)
.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X $1,444
.05 $4,603
=
 IRR Solution
(Interpolate)
.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

($1,444)(0.05)
X= $4,603 X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

 What’s Franchise L’s IRR?
0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV IRRL = 18.13%. IRRS =
23.56%.
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Accept-reject decision
 if IRR>k, accept the project
 IRR<k, reject the project.
Rationale for the IRR Method
 If IRR > WACC, then the project’s rate
of return is greater than its cost-- some
return is left over to boost stockholders’
returns.
 Example:
WACC = 10%, IRR = 15%.
 So this project adds extra return to
shareholders.
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Decisions on Franchises S
and L per IRR
 If S and L are independent, accept
both: IRRS > r and IRRL > r.
 If S and L are mutually exclusive,
accept S because IRRS > IRRL.
 IRR is not dependent on the cost of
capital used.

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Profitability index
 it is defined as the present value of
future cash inflows divided by the initial
investment.
 PI= SUM CFATt/(1+k)t
CFAT0
Accept-reject decision
 if PI>1.0, accept the project
 PI<1.0, reject the project.
Capital rationing
 it refers to the situation where a
budget ceiling is imposed on the size of
the capital budget and the firm may not
invest in all acceptable projects
Example
Project Initial PV of future NPV PI
investment cash flows
A $ 50000 $ 65000
B 50000 61000
C 50000 58000
D 50000 56000
E 100000 150000
F 100000 120000