8/10/2014

Prepared by Phan Ngoc Anh, MBA

Some examples used in the slides are provided by Nguyen Canh Tien, MSc

Understand the capital budgeting process in evaluating

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CAPITAL BUDGETING AND

INVESTMENT CRITERIA

Financial Management

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LECTURE OBJECTIVES

CAPITAL ASSETS AND CAPITAL

BUDGETING

investment proposal, including:

Net present value
Payback period
Discounted payback period (optional wont test)
Internal Rate of Return
Profitability Index
Identify the pros and cons of these different methods

STEPS TO CAPITAL BUDGETING

Capital budgeting:
Analysis of potential additions to fixed assets
Long-term decisions; involves large expenditures
Very important to firms future

Estimate Cash Flows (inflows and outflows)

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Capital assets, what are they?

Assess the riskiness of the cash flows

Determine the appropriate cost of capital
Find NPV/IRR
Accept/reject decisions

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Independent projects: Acceptance/rejection of one

project would not influence the decision regarding other
projects
Mutually exclusive projects: Only one of a number of
projects can be accepted. The acceptance of one
particular project means the rejection of other projects
Contingent projects: Acceptance of one projects depends
on the acceptance of other projects

NORMAL (CONVENTIONAL) vs NON-NORMAL

(UNCONVENTIONAL) CASH FLOWS
Conventional Cash Flow Project:
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INDEPENDENT vs MUTUALLY EXCLUSIVE

vs CONTINGENT PROJECTS

One change of signs

Most common: Cost (negative CF) followed by a
series of positive cash inflows

Unconventional Cash Flow Project:

Two or more changes of signs
Most common: Cost (negative CF), then string of
positive CFs, then cost to close project
Eg: nuclear power plant/strip mine

NET PRESENT VALUE METHOD

UC
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CONVENTIONAL OR
UNCONVENTIONAL CASH FLOWS?

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VALUE OF ASSET TODAY

CAPITAL BUDGETING

= Sum of PVs

of future CFs

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. is to a company what buying stock or bond

is to individuals:

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NET PRESENT VALUE (NPV)

Net present value is the difference between an
investments market value (in todays dollars) and its
cost (also in todays dollars). NPV measures the amount
by which the value of the firms stock will increase if the
project is accepted.

NCFt = after-tax cash flow in year t

Rp = project risk = risk-adjusted discount rate for that
investment

NET PRESENT VALUE OF A PROJECT

Projects Cash Flows
(CFt)

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An investment decision where each want a

return > cost

NPV =

CF2
CF1
CFN
+
+ +
(1 + r )1 (1 + r)2
(1 + r)N

Initial cost

Projects risk-adjusted
cost of capital
(r)

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NET PRESENT VALUE (NPV)

A project requires initial investment of $1,100 and is planned to last

for 2 years. Revenues and expenses for the first year is $1,000 and
$500, respectively; for the second year $2,000 and $1,000. Assume
that all revenues and expenses are cash-basis & required return =
10%. Should the company accept the project?
0

Initial outlay
($1100)

2
Revenues $2000
Expenses 1000
Cash flow $1000

Revenues $1000
Expenses
500
Cash flow
500

$1100.00
$500 x
+454.55

1
1.10
$1000 x

+826.45

1
1.102

+$181.00 NPV

NPV Rule:
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NET PRESENT VALUE (NPV)

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MUTUALLY EXCLUSIVE PROJECTS

(cont)

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Which project is accepted?

Ex: The government is planning to extend the shipping facilities at
Haiphong port.
Option 1: Building a jetty
Option 2: Building a port (deep enough to accommodate a larger
variety of vessels)
The environmental considerations require that only one of the
options be undertaken.
0

Jetty

(1 million)

0.5 mi

0.7 mi

0.8 mi

Port

(3 million)

1.3 mi

1.3 mi

1.3 mi

Assuming a required rate of return of 8% for both projects, which one

of these mutually exclusive projects would you recommend?

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MUTUALLY EXCLUSIVE PROJECTS

Year

Accept all projects with NPV > 0

Reject all projects with NPV < 0
For mutually exclusive projects, choose the
project with the highest NPV

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PROBLEMS WITH NPV

COMPARING PROJECTS WITH DIFFERENT LIVES

PROBLEMS WITH NPV

How to choose mutually exclusive projects with

different life time?
Superior heating
system

Medium heating
system
vs

15 years duration
$20,000

7 years duration
$9,000

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Company faces capital rationing ( have limited fund

and cannot invest in all positive NPV projects)

The equivalent annual annuity (AE) approach calculates the

constant annual cash flow generated by a project over its
lifespan if it was an annuity. The present value of the constant
annual cash flows is exactly equal to the project's net present
value (NPV).

PROBLEMS WITH NPV

COMPARING PROJECTS WITH DIFFERENT LIVES

Machine A costs $3,000 and then $1,000 per annum

for the next four years
Machine B costs $6,000 and then $1,200 for the next
eight years.
The required rate of return for both projects is 10
per cent. If either of the machines wears out, the
company would have to replace with a new one.
Which is the better project the company should choose? Note:
Assume that the two projects bring the same benefits (profits)
to the company.

Step 1. Calculate the NPV for each project

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So, we compare the ANNUAL EQUIVALENT (AE) , or

the annual annuity with the same NPV

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PROBLEMS WITH NPV

COMPARING PROJECTS WITH DIFFERENT LIVES

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When comparing two mutually-exclusive projects

with different lives, it is necessary to make
comparisons over the same time period.

Step 2. Convert the NPVs for each project into an Annual

Equivalent annuity

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PROBLEMS WITH NPV

COMPARING PROJECTS WITH DIFFERENT LIVES

PROBLEMS WITH NPV

COMPARING PROJECTS WITH DIFFERENT LIVES

P&G must decide which of the two machines it should use to

produce its new line of products new generation of
shampoo called Maxxhairr
Machine A costs $100,000, has a useful life of 4 years, and
generates after-tax cash flows of $40,000 per year
Machine B costs $65,000, has a useful life of 3 years, and
generates after-tax cash flows of $35,000 per year
Assume that the discount rate is 10% per year. Which
machine P&G should buy ?

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CLASS EXERCISE

22

A DECISION TREE FOR EVALUATION OF

COMPETING PROJECTS ON A CONTINUING CYCLE

23

Select all projects

with NPV >0

Yes

Mutually exclusive
No
Do projects have
equal lives ?
No
Select project with
highest NPV annual
equivalent

Yes
Select projects with
the highest +NPV

PAYBACK METHOD
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Are projects
independent ?

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PAYBACK ILLUSTRATION

PAYBACK PERIOD
The payback period is the amount of time required for
the firm to recover its initial investment

Initial investment = $1,000

If the projects payback period is less than the

maximum acceptable payback period, accept the
project
If the projects payback period is greater than the
maximum acceptable payback period, reject the
project

Management determines maximum acceptable

payback period (cut-off point)
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Year

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PAYBACK ILLUSTRATION

Cash flow

$200

2
3

400
600

Year

Accumulated
Cash flow

1
2
3
Payback period =

$200
600
1200
22/3 years

PAYBACK PROS AND CONS

Advantages of payback method:

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Project

CF0

CF1

CF2

CF3

Payback

-2,000

+1,000

+1,000

+10,000

$7,249

-2,000

+1,000

+1,000

-264

-2,000

+2,000

-347

What do you think about these 3 projects ?

NPV (at 10%)

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Example:

Extremely simple
Helps prevent cash flow problems
Since cash is recovered as quickly as possible
Useful when technology changes rapidly
Cost of machinery is recovered before new model comes out

Disadvantages of payback method:

Ignores the time value of money
Ignores cash flows after the payback period
Arbitrary acceptance criteria
A project is accepted based on the payback criteria may
not have a positive NPV
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DISCOUNTED PAYBACK (optional)

How long does it take the project to pay back its initial
investment taking the time value of money into account?

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DISCOUNTED PAYBACK METHOD

400

331

700

526

300

205

1
2
3
4

Accumulated
discounted cash flows
$182
513
1,039
1,244

Discounted payback period is just under three

years

DISCOUNTED PAYBACK PROS AND

CONS

Initial investment = $300

R = 12.5%
Cash Flow

Advantages
Accumulated Cash Flows

Year

Undiscounted

Discounted

Undiscounted

Discounted

1
2
3
4
5

$ 100
100
100
100
100

$ 89
79
70
62
55

$ 100
200
300
400
500

$89
168
238
300
355

Ordinary payback?
Discounted payback?

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Year

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ORDINARY AND DISCOUNTED PAYBACK

(optional)

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Initial investment = $1,000

R = 10%
PV of
Year
Cash flow Cash flows
1
$200
$182

- Includes time value of

money
- Easy to understand
- Does not accept
negative estimated NPV
investments
-Biased towards liquidity
- Used by large companies
when they are making
relatively minor decisions

Disadvantages
-May reject positive NPV
investments
-Arbitrary determination of
acceptable payback period
-Ignores cash flows beyond the cutoff date
-Biased against long-term and new
products

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INTERNAL RATE OF RETURN

Internal rate of return (IRR) is the discount rate that
results in a zero NPV for the project
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INTERNAL RATE OF RETURN

NPV = 0 = CF0 +

CF3
CF1
CF2
CFT
+
+
+ .... +
2
3
(1 + IRR) (1 + IRR) (1 + IRR)
(1 + IRR)T

IRR found by computer/calculator or manually by trial

and error

The IRR decision rule is:

If IRR is greater than the cost of capital, accept the
project
If IRR is less than the cost of capital, reject the project

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INTERNAL RATE OF RETURN ILLUSTRATION

INTERNAL RATE OF RETURN ILLUSTRATION

Trial and Error

Initial investment = $200

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Discount rates

Cash flow

1
2
3

$ 50
100
150

Find the IRR such that NPV = 0

50
0 = 200 +

100

(1+IRR) 1

50
200 =

(1+IRR) 1

(1+IRR) 2

100
+

150

(1+IRR) 2

(1+IRR) 3

150
+

(1+IRR) 3

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Year

NPV

0%

$100

5%

68

10%

41

15%

18

20%

IRR is just under 20%about 19.44%

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THE NPV PAYOFF PROFILE FOR THIS

EXAMPLE

PROBLEMS WITH IRR

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Three key problems encountered in using IRR:

Borrowing or lending ?
Multiple IRRs
Mutually exclusive projects
IRR and NPV rankings do not always agree
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PROBLEMS WITH IRR

BORROWING OR LENDING?

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IRR

Project will have multiple rates of returns in case of

unconventional cash flows (there is more than one negative
cash flows)

NPV at 10%
discount rate

-1,000

1,500

50%

363.64

1,000

-1,500

50%

-363.64

Both projects have an IRR = 50%, but only project A is

acceptable !

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Project

PROBLEMS WITH IRR

MULTIPLE RATES OF RETURNS

Year

Cash flows

$252

1431

3035

2850

1000

40

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PROBLEMS WITH IRR

MULTIPLE RATES OF RETURNS

PROBLEMS WITH IRR

MULTIPLE RATES OF RETURNS
at 25.00%:

NPV =

at 33.33%:

NPV =

at 42.86%:

NPV =

at 66.67%:

NPV =

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Whats the IRR? Find the rate at which

the computed NPV = 0:

Two questions:
1. Whats going on here?
2. How many IRRs can there be?

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PROBLEMS WITH IRR

MUTUALLY EXCLUSIVE PROJECTS

When you solve for IRR

you are solving for the
root of an equation and
when you cross the x
axis more than once,
there will be more than
one return that solves
the equation.

NPV <0

If you have more than

one IRR, you cannot use
any of them to make
your decision.

The scale problem

IRR

NPV

-5,000

8,000

60%

2,273

-5,000

9,800

40%

3,099

Despite having a higher IRR, Project A is less valuable

than project B !

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NPV > 0

PROBLEMS WITH IRR

MUTUALLY EXCLUSIVE PROJECTS

The timing problem

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When the cash flows

change sign more than
once, there is more
than one IRR.

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Year

IRR

NPV

Small
project

-1

+1.5

50%

0.43

Large
project

-100

+110

10%

4.76

IRR does not take into account project scale (size)

In the above example, we would recommend the small project
based on IRR, but recommend the large project based on NPV
assume 5% required rate of return

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NPV vs. IRR RULES

However, IRR can be in conflict with NPV if

Investing or Financing decisions
Projects are mutually exclusive
Projects differ in scale of investment
Cash flows pattern of projects are different

Projects have unconventional cash flows

If IRR and NPV conflict, use NPV approach

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PROFITABILITY INDEX METHOD

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Usually, NPV and IRR are consistent with each other. If

IRR says accept the project, then NPV will also say
accept the project.

PROFITABILITY INDEX

PROFITABILITY INDEX

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Capital rationing: Limit set on the amount of funds

available for investment. Sometimes the amount of
capital that an organisation can invest in long-term
projects is limited.
Solution: Management will obviously wish to select
those projects that will give the greatest return per
dollar invested (highest profitability index).

Profitability Index expresses a projects benefits

relative to its initial cost
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Why in the first place exists this variation of Net

Present Value ?

CF1
CF2
CFT
+
+ ... +
2
PV of cash flows (1 + r ) (1 + r )
(1 + r ) T
PI =
=
Initial investment
CF0

Acceptance criteria: Accept a project with a PI > 1.0

48

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PROFITABILITY INDEX

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PROFITABILITY INDEX

49

50

This is a good project

because the present
value of the inflows
exceeds the outlay.
Each dollar invested
generates $1.1645 in
value

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