The Capital Budgeting Process

Chapter 9
CAPITAL
BUDGETING
PROCESS
Alex Tajirian
Capital Budgeting Process 9-2
1. INTRODUCTION
# Working with the left-hand-side of a balance sheet
# CAPITAL BUDGETING /INVESTING in Long-term Assets

! Definitions
" Capital: Fixed assets used in production
" Budget: Plan of in- and outflows during some period
" Capital Budget: A list of planned investment (i.e.,
expenditures on fixed assets)
outlays for different projects.
" Capital Budgeting: Process of selecting viable

investment projects.
" Financial investment vs. economic investment
! In this course, investments are needed in order to:

" Expand in existing markets.
" Enter new markets.
" Replace existing capital assets.
© morevalue.com, 1997
Alex Tajirian
! Where do these projects come from?

" Suggested by managers of plants & divisions
" Upper management
! Upper management approves these projects
! Investment and financing decisions are independent.
! Some common errors:

" Expansion without incorporating cost of financing
" Cost cutting without looking at revenue side
" Ignoring alternative uses of capital
# TOOLS CAN BE USED IN:

! M&As
! Divestitures & spin-offs
! Correct-sizing
! Other
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# CAPITAL BUDGETING OUTLINE

! Develop tools & criteria of selecting projects (Ch. 8): Given
Q Relevant CFs
Q The required return of the project (i.e., the risk of use of
project CFs)
! Determine which CFs are relevant in project analysis (Ch. 10)
! Introduce possibility of forecast error in CF data used in

analysis (Chapter 11)
! Assume that k (cost of financing) is known until Ch. 12
Alex Tajirian
FINANCIAL MANAGEMENT
PROCESS
Given your
Type of Business Line of Business
List Potential
Projects
Type of
Internal External Divestitures
Projects
Expansion (M&A) & Spin Offs
Choose Viable
Capital Budgeting Projects
Choose Appropriate
Capital Structure Financing
Short-term financial Choose Appropriate

Management Working capital
Optimal
Dividend Policy Dividend policy
Alex Tajirian
CAPITAL BUDGETING &

FINANCING
INVESTMENT FINANCING
DECISION DECISION
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MANAGERIAL TALENT &

INVESTMENTS
Capital Managerial &

Budgeting Entrepreneurial
Skills
Alex Tajirian
2. TOOLS OF INVESTMENT DESIRABILITY

2.1 BASIC INTUITION
(1) Criteria
How fast you re-coup initial investment?
Benefits > Costs
Compare PV of cash inflows & PV of cash expenditure
Compare return on investment & cost of financing project
(2) A word of Caution

A manager needs to make a decision today (t=0) given
estimated/forecasted cash flows. Obviously there is no
guarantee that the decision would always turn out as
anticipated. However, what is important is that the manager
has to make the best decision at t=0 given all the relevant
information.
2.2 INDEPENDENT vs. MUTUALLY EXCLUSIVE PROJECTS:

# Independent: A project that has nothing to do with other projects
under investigation.
Example: Replace copy machine and build a new plant.
# Mutually Exclusive: You only need one of these alternative

projects.
Example: Buy IBM or Apple PC?
Alex Tajirian
2.3 TOOLS
3.1 Payback Period Method:
Criterion: For two mutually exclusive projects, choose the one that
pays you back your initial cost the sooner.
Example: Calculating Payback Period

Given the following CFs, and k = 10%, we get:
Investment Initial cost CF1 CF2

A $10,000 0 $14,400
B 10,000 $10,000 2,400
ˆ choose project B, since it pays back initial investment in one

year.
? Is this choice optimal?
Alex Tajirian
3.2 Net Present Value (NPV) method:

L Payback ignores the concept of CFs. Ignores CF after payback
and risk of CFs.
ˆ we need to look at the PV of these CFs net of any initial cost.
ˆ NPV ' PV of all Relevent CFs & Initial Investment
CF1 CF2 CF n
' % % ...% & I0
1 2 n
(1%k) (1%k) (1%k)
j
n CF t
' & I0
t
t'1 (1%k)
' j
n CFt
t'0 (1%k)t
' CF1[PVIFk,1] % CF2[PVIFk,2] % ... % CF n[PVIFk,n] & I0
where,
CFt / Net cash flow (inflow - outflow) at time t
I0 / Initial cost or investment outlays
k / cost of capital (financing)
/ required return reflecting risk of use of CFs
Note: CF0 / I0
Alex Tajirian
Thus,
NPV measures the additional market value that

management expects the project to create (or destroy) if
it is undertaken.
NPV Criteria:
Since the objective of the manager is to maximize value, then for
Independent Projects : Choose All Projects with NPV > 0.
Mutually Exclusive: Choose projects with the highest

NPV.
Note: NPV > 0 is equivalent to PV of cash inflow > PV of cash

outflow.
Alex Tajirian
Example: Calculating NPV

Given the following CFs, and k = 10%, we get:
Investment Initial cost CF1 CF2

A $10,000 0 $14,400
B 10,000 $10,000 2,400
Solution:
$14,400
NPVA ' & 10,000 ' $1,901
2
(1%k)
10,000 2,400
NPVB ' % &10,000 ' $1,074
1 2
(1%.1) (1%.1)
ˆ choose A, since it has the highest NPV if mutually exclusive,

or both if independent as they are both with NPV >0.
Alex Tajirian
Remarks on payback method:

With payback method, project B is selected. Thus, if you ignore
amount, timing, and risk of CFs, then potentially you would end up
with the wrong valuation.
Both projects would add value to shareholders. However, if you

select project "B", you would not be maximizing shareholder value,
as "A" provides more value to shareholders.
In general, if you accept a project with NPV <0, then you are
destroying shareholder value!
Alex Tajirian
Example: Calculating additional Shareholder Value
Using a project's NPV = $1,901 and assuming that there are 1,000 shares
outstanding, then
NPV
Value created per share '
# of shares outstanding
$1,901
' ' $1.901
1,000
Y If the project is adopted then the price of the stock should increase by
$1.90.
Alex Tajirian
3.3 Internal Rate of Return Method (IRR)

# Motivation:
! “Internal” in that it is a rate of return that depends on the CFs
of the project.
! Return on investment (ROI) is a very intuitively appealing

concept; measured in % terms.
profit
ROI '
investment
! Easy to determine profit if you have single CF in future. What

about if we have multi-period payoffs?
Periods
0 1 2 3
CF from project -100 10 60 80
Profit would be calculated as:

Ending Value - Beginning Value = $80 - $100
But this calculation ignores the intermediate CFs, namely $10

and $60 in periods 1 and 2 respectively.
Alex Tajirian
Thus, when examining the return on a project, we need a

new tool that would incorporate all the cash flows of a
project.
# Definition of IRR : IRR is defined as that particular k, such that

the project breaks-even, i.e., when NPV = 0.
Thus,
CF1 CF2 CF N
NPV ' 0 ' CF0 % % % ... %
(1 % IRR) (1 % IRR)2 (1 % IRR)N
Decision Rule:
IRR Criterion: Choose projects with IRR higher than cost of

financing.
L If [the cost of financing "k"] < IRR Y NPV > 0 Y Additional

value would be created. Obviously the larger the difference between
k & IRR, the higher the NPV.
Note: Use IRR cautiously for mutually exclusive projects!

Limitations of IRR are discussed on p. 21.
Alex Tajirian
Example: Calculating IRR (single future CF)

Given:
Period CF($)
0 -100
1 300
Solution:
300
&100 % ' 0
(1%IRR)
300
Y ' 100
(1%IRR)
Y 100(1%IRR) ' 300
Y 100 % 100IRR ' 300
300&100 200
Y IRR ' ' ' 2 ' 200%
100 100
The ROI is:

$300 & $100
ROI ' ' 200%
$100
Alex Tajirian
Example: Calculating IRR (multiple future CFs)

Given:
Periods
0 1 2 3
CF from project F -100 10 60 80
IRRF = ?
Alex Tajirian
Solution:
L To calculate IRR (just like YTM) there is no simple formula to

use. Thus, we need to use either trial & error method or a
calculator. From definition of IRR,
CF1 CF2 CFN
CF0 % % % ... % ' 0
(1% IRR) (1% IRR) 2
(1% IRR) N
! Guess an IRR, say IRR = 19%, then substituting in above equation

yields:
10 60 80
& 100 % % % < 0
(1% .19) (1% .19) 2
(1% .19) 3
! You have guessed a number too high. Try a smaller #, say IRR =
17%, thus
10 60 80
& 100 % % % > 0
(1% .17) (1% .17) 2
(1% .17) 3
ˆ If you try IRR = 18.1%, you get correct answer.
IRRF = 18.1% (using either trial & error or calculator)
Alex Tajirian
NPV Flow Profile: Relation between NPV, IRR, and "k"
Alex Tajirian
Problems With IRR for Mutually Exclusive Projects:

Problem 1: Consider two projects such that returnA = 15%, returnB =
50%, and k = 10%. Which would you choose?
Now assume that they require the following initial investments:

IA = $1,000,000 while IB = $100
? Which would you choose?
ˆ If initial investments are not equal, IRR ranking can be

misleading.
Problem 2: Possible existence of multiple IRRs. Every time the CFs

change sign, you would get an additional IRR. (See NPV,
IRR, "k" profile)
Problem 3: Possible conflict of ranking with NPV.
Alex Tajirian
3.4 What tools does industry use?
Tool % use of each

Tool
Primary method
NPV 21%
IRR 49
payback 19
AROR 8
Secondary method
NPV 24%
IRR 15
payback 35
AROR 19
AROR ' Accounting Rate of Return
j accounting profit after tax t /N

t'1
'
(initial outlays % salvage value)/2
where t is time, and N = # of periods
Source: Kim, Crick, and Kim, "Do executives Practice What Academics Preach?"
Management Accounting (November 1986), pp. 49-52.
Alex Tajirian
So Why Does Industry Still use IRR Despite Problems?
< percentage results are more intuitive than a $NPV; 50% return vs.
NPV = $500,000
< Since IRR gives you break-even cost of financing:

The number itself is of interest to managers; you want simply
to ask at what financing cost does project break-even?
< If a project's break-even is 100%, in a "normal" situation, you

wouldn't need to go through the trouble of estimating all the CFs, as
100% is considerably higher than a “normal” financing rate.
? Why Do Managers Use Payback with All of its

Problems?
Alex Tajirian
3. SUMMARY
T Payback Period
T NPV
# Independent Projects
# Mutually exclusive
# NPV = sum of discounted CFs, where the discount rate is
the cost of financing the project.
# NPV criterion is equivalent to PV of cash inflow > PV of

cash outflow
T IRR
# Criterion
Two equivalent ways to look at it
Break-even or ROI > cost of financing project
# Calculation
! Trial & error
! Calculator
Alex Tajirian
4. QUESTIONS
I. True/Disagree-Explain
1. According to the NPV criterion, you should choose all projects with NPV > 0.
2. According to the IRR criterion, you should choose projects with IRR < cost of financing.
3. Ignoring brokerage fees, purchasing a stock in an efficient market is a zero NPV transaction.
4. Capital budgeting tools can be used to analyze the merits of "flextime."
5. A NPV > 0 project might not be undertaken because of its high risk, despite the manager's
confidence in the accuracy of the CF estimates.
6. If a company is expanding, then it is necessarily creating additional value to shareholders.
7. If buying stocks is a NPV = 0 transaction, then no one would profit from them as an investor's
profits would be zero.
II. Problems
1) Given:
Project S Project L
Cost $10,000 25,000
Annual Benefits $4,000 8,000
# of years 5 5
k 14% 14%
Which of these mutually exclusive projects is better based on NPV and IRR?
Alex Tajirian
ANSWERS TO QUESTIONS
I. Agree/Disagree-Explain
1. Disagree. Only if the projects are independent. If they are mutually exclusive, then you
choose the one with the highest NPV.
2. Disagree. If IRR < cost of financing, then the project would be losing money as it costs more
to finance than to break-even. Such a project will have NPV < 0.
3. Agree. NPV = -market price + PV of dividends. Present value of a stock would be its Agree
worth--value. If you pay (market price) exactly its worth (PV of dividends), then NPV = 0.
4. Agree. Analyzing flextime corresponds to analyzing its impact on a firm's CFs. However, in
practice it is difficult to obtain good estimates of the incremental CFs. Thus, if "flextime"
makes sense, then you would be undertaking a NPV > 0 project.
5. Disagree. The risk of CFs is reflected in the cost of capital (k). Thus, the fact that you obtain
a NPV > 0, and assuming you did the correct calculation, the project should be accepted.
6. Disagree. Only if it is re-investing revenue at a rate higher than the required rate of return.
A simple example would be a company borrowing to finance projects that are not profitable,
NPV <0. Thus, expansion does not necessarily translate into shareholder value creation.
7. Disagree. NPV = 0 implies that an investor is being compensated by an amount

commensurate with the risk and value of the investment, i.e. there are no excess profits.
Alex Tajirian
II. Problems
1)
Step 1 Are CFs of equal length? Yes
Step 2 Calculate NPV

NPVS = -10,000 + 4,000(PVIFA14%,5) = 3,732
NPVL = -25,000 + 8,000(PVIFA14%,5) = 2,465
ˆ L
Using IRR: IRRS = 28.6% and IRRL = 18%
Since cost of capital for each = 14% < IRR. Y Accept S as it has a higher IRR.
Obviously, you should choose both if they were independent.
Alex Tajirian
ELIMINATIONS
a. APPROACHES TO CAPITAL BUDGETING
! Top Down Approach
! Bottom up Approach
INTER-DEPENDENCE OF INVESTMENT &

FINANCING DECISIONS
Illustration 1:
Project 1: ATT owes you $100, and makes you an offer of $100 today or
$107 next year. Which would you choose? Assume that return
on similar risky investments is 6%.
Project 2: Suppose, in addition to the ATT opportunity, you have a "great

deal" that requires a $100 investment that is expected to payoff
$300 in a year.
Case 1: Assume: you can borrow at a cost of 10%.

Action: Take both projects (independent)
Alex Tajirian
ˆ choose $107 as
$107
PVATT ' ' 100.94 > $100 Y
(1 % .06)
NPVATT ' & 100 % 100.94 ' $.94
PVATT '
1.06
300
NPVgreat deal ' & 100 % ' $172.7
Thus, if you borrow, in effect you would be undertaking both

projects.
ˆ Total NPVindependent = NPVATT + NPVgreat deal

= 0.94 + 172.7 = 173.64
Case 2: You cannot borrow, or cost of borrowing is 400% and

assume that a project with same risk as "great deal" has
a return of 12%.
Action: Mutually exclusive projects
Alex Tajirian
300
NPV"great deal" ' & 100 %
(1 % 4)
' & 100 % 60 ' & 40 < PVIRS
Alex Tajirian
Obviously, in this case you are better off taking $100 from ATT. Thus, ˆ
300
NPV ' & 100 % ' & 100 % 267.8 ' 167.8 < NPVindependent
1% .12
Choose project with highest NPV Y choose "great deal".
Notes:
! You discount at 12%, since it is the return you have to forego
if you invest in a project with same risk as ATT.
! NPVindependent > NPVmutually exclusive
Alex Tajirian
b. RELATIONSHIP BETWEEN P, DIVIDENDS, g, & NPV
p0 = PV (CF of existing business) + NPV ( dividend growth due to

investment of future earnings)
EPS1
% NPVGO ..................................................
k
Let RR' Retention Ratio Y D1 ' (1& RR)(EPS1)
Y return on retained earnings ' (RR)(EPS1)(ROE)
EPS1
where ROE '
book equity per share
Y NPV1 ' & I0 % PV of increases CFs
(RR)(EPS1)(ROE)
' & (RR)(EPS1) %
k
ROE
' (RR)(EPS1) & 1 % . . . .......(( ( )
k
Y NPV1, NPV2,.... are growing at a rate (RR)(ROE) ' g
NPV1
Y NPVGO '
k & g
EPS1 NPV1 D1
ˆ p0 ' % '
k k & g k & g
Substitute NPVGO in (*), we get
Conclusions: NPVGO depends on

a. EPS1: current earnings size
Alex Tajirian
b. RR
c. Relative magnitudes of ROE and k; see equation (**) above.
d. Growth, (RR)(ROE), does not necessarily imply NPV _.
Alex Tajirian
c. WHERE DO NPV> 0 PROJECTS COME FROM?
# In long-run NPV = 0 ] excess economic profit = 0
# Sources of NPV > 0 (Sources of competitive advantage)

! Barriers to entry
! product differentiation
! economies of scale
! better distribution channels
! luck
INVESTMENT UNDER UNCERTAINTY
Classical micro-economic theory
Observations:
# Firms use cost of capital "hurdle rate" in NPV > 3 times cost of
capital ] firms invest only if price is substantially > LRAC
(Summers '87)
# Firms stay in business even after p < AVC
# First quarter of '85 $ started `. By end of '87, $ was at '78 level.

But, import volume did not ` until 2 years later. (Krugman &
Baldwin '87)
Alex Tajirian
# U.S. firms abandon project earlier than Japanese (TV, VCR, semi-
conductors)
Explanation:
Agree NPV = NPV + flexibility option
Sources of option value:

# sunk costs in abandonment decision
! Severance pay for workers (-)
! scarp value (+) (Myers & Majd '85)
" capital used is industry specific (eg. steel mills) Y Who
is going to buy machinery when entire industry is
suffering?!
" lemon problem
" stop and re-start needs additional costs (McDonald &
Siegel '85)
# Uncertainty: product price, operating costs, interest rates

Y value in option to wait (Pindyck '91, Ross & Ingersoll '92)
! parameters:
" if uncertainly is high Y value of waiting _
" if k is low Y future outcomes valued more Y value of
option to wait and resolve future uncertainty _.
" What happens if there are other firms in industry? Y
"balance" between waiting and implementing
(Fudenburg & Tirole '83, Stiglitz '89)
" if k ` does not Y Investment _ as cost of waiting `
" Why did U.S. abandon color TVs, VCRs and semi-
conductors?
The value of waiting to invest is governed by
downside risk. But Japanese government supports
Alex Tajirian
firms during downside through cartelization to

avoid destructive competition. (Bernake '83)
! Sequential investing , as in drug industry
# Remarks
! If 400% (in above illustration) is the cost of borrowing, maybe
that is the Agree cost of financing.
! If a project sounds "too good to be Agree," it probably is "too
good to be Agree."
! Role of market in information processing vs. personal
borrowing market.
Alex Tajirian

The Capital Budgeting Process

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Chapter 9

# Working with the left-hand-side of a balance sheet

# CAPITAL BUDGETING /INVESTING in Long-term Assets

" Capital Budgeting: Process of selecting viable

" Financial investment vs. economic investment

! In this course, investments are needed in order to:

! Where do these projects come from?

! Upper management approves these projects

! Investment and financing decisions are independent.

! Some common errors:

# TOOLS CAN BE USED IN:

# CAPITAL BUDGETING OUTLINE

! Determine which CFs are relevant in project analysis (Ch. 10)

! Introduce possibility of forecast error in CF data used in

! Assume that k (cost of financing) is known until Ch. 12

Short-term financial Choose Appropriate

CAPITAL BUDGETING &

MANAGERIAL TALENT &

Capital Managerial &

2. TOOLS OF INVESTMENT DESIRABILITY

(2) A word of Caution

2.2 INDEPENDENT vs. MUTUALLY EXCLUSIVE PROJECTS:

Example: Replace copy machine and build a new plant.

# Mutually Exclusive: You only need one of these alternative

Example: Buy IBM or Apple PC?

Example: Calculating Payback Period

Investment Initial cost CF1 CF2

ˆ choose project B, since it pays back initial investment in one

? Is this choice optimal?

3.2 Net Present Value (NPV) method:

ˆ we need to look at the PV of these CFs net of any initial cost.

ˆ NPV ' PV of all Relevent CFs & Initial Investment

NPV measures the additional market value that

Since the objective of the manager is to maximize value, then for

Independent Projects : Choose All Projects with NPV > 0.

Mutually Exclusive: Choose projects with the highest

Note: NPV > 0 is equivalent to PV of cash inflow > PV of cash

Example: Calculating NPV

Investment Initial cost CF1 CF2

ˆ choose A, since it has the highest NPV if mutually exclusive,

Remarks on payback method:

Both projects would add value to shareholders. However, if you

Example: Calculating additional Shareholder Value

3.3 Internal Rate of Return Method (IRR)

! Return on investment (ROI) is a very intuitively appealing

! Easy to determine profit if you have single CF in future. What

Profit would be calculated as:

But this calculation ignores the intermediate CFs, namely $10

Thus, when examining the return on a project, we need a

# Definition of IRR : IRR is defined as that particular k, such that

IRR Criterion: Choose projects with IRR higher than cost of

L If [the cost of financing "k"] < IRR Y NPV > 0 Y Additional

Note: Use IRR cautiously for mutually exclusive projects!

Example: Calculating IRR (single future CF)

The ROI is:

Example: Calculating IRR (multiple future CFs)

L To calculate IRR (just like YTM) there is no simple formula to

! Guess an IRR, say IRR = 19%, then substituting in above equation

ˆ If you try IRR = 18.1%, you get correct answer.

IRRF = 18.1% (using either trial & error or calculator)

NPV Flow Profile: Relation between NPV, IRR, and "k"

Problems With IRR for Mutually Exclusive Projects:

Now assume that they require the following initial investments: