Categories of Plans

1.

Replacement Projects: decisions to replace old equipment those are among the easier of
capital budgeting techniques. It is important to decide whether to replace the equipment when
it wears out or to invest in repairing the machine.

2.

Expansion Projects: These are decisions whether to increase the size of business or not
they are more uncertain than replacement projects.

3.

New products and services: These are decisions whether to introduce new products and
services or not they are more uncertain than both replacement and expansion projects.

4.

Safety and environmental projects: These are the projects required by governmental
agencies and insurance companies these projects might not generate revenue and are not
for profits; however, sometimes it is important to analyze the cash flows because the costs
might be very high that they require analysis.

Basic Principles of Capital Budgeting

Capital budgeting usually uses the following assumptions:
1.

Decisions are based on cash flows not income

2.

Timing of cash flows is important

3.

Cash flows are based on opportunity cost: cash flows that occur with an investment
compared to what they would have been without the investment

4.

Cash flows are analyzed on after-tax basis:

5.

Financing costs are ignored because they are incorporated in WACC that is why counting
them twice would be considered double counting

Costs Concepts of Capital Budgeting

Some important capital budgeting concepts that managers find very useful are given below:
1.

Sunk costs: costs that already incurred (i.e. paid for marketing research study) Today costs
should not be affected by sunk costs

2.

Opportunity costs: what a resource is worth for next-best use Those costs should be
considered (i.e. if you use a warehouse, the current market value should be considered)

3.

Incremental cash flow: the cash flow that is realized with the project that is, the cash flow
with a decision minus the cash flow without the decision

4.

Externality: the effect of an investment on other things apart from the investment. Those can
be positive or negative and should both be considered.

Cannibalization is an example of an externality where an investment takes customers and

sales from another part of the company those should be considered in the analysis because
they are incremental cash flows (i.e. they wouldnt occur unless for the project)

More about projects

Some important comparisons in capital budgeting are:
Conventional versus nonconventional cash flows:

Conventional: Initial outflow followed by series of inflows (i.e. change of sign only occurs
once). That is, you can have + + + + + +, + + +, or + and still be considered
conventional cash flows because the sign changes only once.

Nonconventional: Initial outflow followed by series of inflows and outflows (i.e. change of
sign occurs more than once). Examples of those include + + + -, + + -, or + + +.

Independent versus mutually exclusive projects:

Independent projects: Cash flows are independent of each other. You can use both A and
B; there isnt overlap between projects. Projects here are being evaluated that could potentially
all be selected as long as their projected cash flows will produce a positive NPV or generate an
IRR greater than the firms hurdle rate.

Mutually exclusive projects: Projects that compete directly with each other (i.e. you own
some manufacturing equipment that must be replaced. Two different suppliers present a
purchase and installation plan for your consideration). Sometimes there are more than two
projects and you select one from group.

Unlimited funds versus capital rationing

Unlimited funds: It assumes the company can raise funds for all profitable projects.

Capital rationing: It exists when a company has fixed amounts of funds to invest. If the
company has more project than funds, it must allocate the funds among the projects.

Project sequencing:

One last important concept here is project sequencing where many projects are evaluated
through time; that is, investing in one project gives the option to invest for other projects in the
future. For example, you can decide to open a mall this year and if the financial results are
favorable after 5 years, you will build a hotel next to the mall.

Investment Decision Criteria

We need to ask ourselves the following questions when evaluating decision criteria:
1.

Does the decision rule adjust for the time value of money?

2.

Does the decision rule adjust for risk?

3.

Does the decision rule provide information on whether we are creating value for the firm?

Investment Decision Criteria: (1) Payback Period

Payback is the number of periods after which the initial investment is covered. The main question
used in the payback period is: how long does it take to get the initial cost back in a nominal sense?
Computation Method:
1.

Estimate the cash flows

2.

Subtract the future cash flows from the initial cost until the initial investment has been
recovered

Decision Rule:
The decision rule is to accept if the payback period is less than some preset limit.
Pros and Cons:
Pros

1.

Cons

Easy to understand.

1.

Ignores the time value of money.

2.

Biased towards liquidity.

2.

Uses an arbitrary cutoff point.

3.

Ignores cash flows beyond the cutoff date.

4.

Biased against long-term projects such as R&D and new

projects.

Example:
Estimate the payback period for:
Year

CF

-10,000

4,500

4,500

3,000

2,000

Solution:
To find the payback period, we need to find the cumulative cash flows first
Year

CF

-10,000

4,500

4,500

3,000

2,000

CCF

-10000

-5500

-1000

2000

4000

The payback period occurs when the cumulative cash flows changes from negative to positive. That
is, it occurs between years 2 and 3. Because we still have to recover 1000 after second year, the
payback period is: 2 + 1000/3000 = 2.33 years.
Investment Decision Criteria: (2) Discounted Payback Period
Discounted payback is the number of periods for the cumulative discounted cash flows to recover the
initial investment. The main question used in the discounted payback period is: how long does it take
to get the initial cost back in a real sense?
Computation Method:
1.

Estimate the cash flows

2.

Discount these cash flow

3.

Subtract the future discounted cash flows from the initial cost until the initial investment has
been recovered

Decision Rule:
The decision rule is to accept all projects with the discounted payback period less than a preset
limit.
Pros and Cons:
Pros

Cons

1.

Considers time value of money.

2.

Easy to grasp.

3.

Biased towards liquidity.

1.

If you discount values, then you might want to use NPV

because discounted payback wont be easier to analyze.

2.

It may reject projects with NPV > 0.

3.

Uses an arbitrary cut-off point

4.

It ignores cash flows after cut-off point.

5.

Biased against long-term projects (new R&D projects).

Example:
Estimate the discounted payback period at 10% discount rate for:
Year

CF

-10,000

4,500

4,500

3,000

2,000

Solution:
To find the discounted payback period, we need to find the cumulative discounted cash flows first:
Year

CF

-10,000

4,500

4,500

3,000

2,000

DCF

-10,000

4,090.91

3,719.01

2,253.94

1,366.03

CDCF

-10,000

-5,909.09

-2,190.08

63.86

1,429.89

The discounted payback period occurs when the cumulative discounted cash flows changes from
negative to positive. That is, it occurs between years 2 and 3. Because we still have to recover
2,190.08 after second year, the payback period is: 2 + 2190.08/2253.94 = 2.97 years.
Investment Decision Criteria: (3) Average Accounting Return
There are many different definitions for average accounting return. The most commonly used one is
the average net income to average book value. Note, however, that the average book value depends
on how the asset is depreciated.
Computation Method:
1.

Estimate the net incomes

2.

Estimate the book values

3.

Estimate average net incomes

4.

Estimate average book value (i.e. for straight-line depreciation, average book value is
[historical value salvage value]/2)

Decision Rule:
We accept the project if the AAR is greater than a preset rate.
Pros and Cons:
Pros

Cons

1.

Easy to calculate.

1.

It is not a true rate of return.

2.

Needed information will usually be available.

2.

Time value of money is ignored.

3.

Uses an arbitrary cut-off point.

4.

Example:

Based on accounting net income and book values, not cash

flows and market values.

Assume a company invests 400,000 in project depreciated using straight-line method over 4 years
with zero salvage value. The following table shows the revenues and operating expenses. Calculate
AAR using 40% tax rate:
Year

Revenue

200,000

250,000

300,000

320,000

Operating Expenses

90,000

100,000

120,000

90,000

Solution:
First, we find the net income where depreciation = (book value salvage value)/ useful life.
Deprecation is 400,000/4 = 100,000
Year

Revenue

200,000

250,000

300,000

320,000

Operating Expenses

90,000

100,000

120,000

90,000

Depreciation

100,000

100,000

100,000

100,000

Taxes = 0.4 (R-OE-D)

4,000

20,000

32,000

52,000

Net Income

6,000

30,000

48,000

78,000

Average net income = (6,000 + 30,000 + 48,000 + 78,000)/4= 40,500

Average book value = (400,000-0)/2= 200,000

Investment Decision Criteria:

(4) Net Present Value (NPV)
The net present value (NPV) is the present value of future after-tax cash flows minus initial
investment. It reflects the difference between the market value of the project and its cost.

Computation Method:
1.

Estimate the expected future cash flows.

2.

Estimate the required return for projects of this risk level.

3.

Find the present value of the cash flows and subtract the initial investment.

Where CFt is the cash flow at time t, r is the discount rate

for the investment and outlay is the investment cash flow at time 0.
Decision Rule:
We accept the project if the NPV is greater than zero. A positive NPV means that the project is
expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal
is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.
Pros and Cons:
Pros

1.
2.

Cons

NPV gives importance to the time value of money.

In the calculation of NPV, both after cash flow and before
cash flow over the life span of the project are considered.

1.

NPV is difficult to use.

2.

NPV cant give accurate decision if the amount of

investment of mutually exclusive projects is not equal.

3.

Profitability and risk of the projects are given high priority.

3.

It is difficult to calculate the appropriate discount rate.

4.

NPV helps in maximizing the firms value.

4.

NPV may not give correct decision when the projects are
of unequal life.

Example:
Estimate the NPV at 10% discount rate for:
Year

CF

-10,000

4,500

4,500

3,000

2,000

Solution:

Investment Decision Criteria: (5) Profitability Index (PI)

The profitability index (PI) is very closely related to net present value (NPV). It is the present value of
cash flows dividend by the initial investments.
Computation Method:
1.

Estimate the expected future cash flows.

2.

Estimate the required return for projects of this risk level.

3.

Find the present value of the cash flows and divide by the initial investment.

Where CFt is the cash flow at time t, r is the discount rate for the investment
and outlay is the investment cash flow at time 0.
Decision Rule:
We accept the project if the PI is greater than one. PI greater than one means that the project is
expected to add value to the firm and will therefore increase the wealth of the owners.
Pros and Cons:
Pros

Cons

1.

PI helps in maximizing the firms value.

2.

PI is useful in cases of capital rationing.

1.

2.

Example:
Estimate the PI at 10% discount rate for:

PI cant give accurate decision if the amount of investment of

mutually exclusive projects is not equal.
It may not be easy to understand.

Year

CF

-10,000

4,500

4,500

3,000

2,000

Solution:

Investment Decision Criteria: (6) Internal

Rate of Return (IRR)
This is the most important alternative to NPV; it is often used in practice and is intuitively appealing.
It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere.
Computation Method:
1.

Estimate the expected future cash flows.

2.

Estimate using trial and error the discount rate that makes NPV = 0

Written out in an equation form,

Decision Rule:
Accept the project if the IRR if it is greater than the required return.
Pros and Cons:
Pros

Cons

1.

Knowing a return is intuitively appealing managers like to hear

returns.

2.

It is a simple way to communicate the value of a project to

someone who does not know all the estimation details.

3.

If the IRR is high enough, you may not need to estimate a

required return, which often is a difficult task.

1.

Unrealistic assumption of reinvestment at IRR unlike NPV

which assumes reinvestment at WACC which is a realistic
assumption.

2.

IRR is not good for comparing two mutually exclusive

investments.

Example:
Estimate the IRR at 10% discount rate for:
Year

CF

-10,000

4,500

4,500

3,000

2,000

Solution:
Using trial and error, if we start with discount rate of 17%
We find:

So we use a higher discount rate; lets say we apply a discount rate of18%, we find:

Therefore, the discount rate that makes NPV = 0 is between 17% and 18%. Keeping trial and error,
then IRR = 17.43%