The Basics of Capital Budgeting

Should we
build this
plant?

10-1

Learning Outcomes
Explain the capital budgeting process.
Learn different methods of capital budgeting
(NPV, IRR, MIRR, Payback period, Discounted
Payback & Profitability index.
Difference between independent project and
Mutually exclusive project.
Conflict between IRR and NPV decision.
Multiple IRR problem (mutually exclusive
project with different cash flow pattern/ projects
of different scale)
10-2

What is capital budgeting?

Analysis of potential additions to fixed
assets.
Long-term decisions; involve large
expenditures.
Very important to firms future.

10-3

Steps to capital budgeting

1.
2.

3.
4.
5.

Estimate CFs (inflows & outflows).

Assess riskiness of CFs.
Determine the appropriate cost of capital.
Find NPV and/or IRR.
Accept if NPV > 0 and/or IRR > WACC.

10-4

Investment Decision Criteria

Analyst use several important criteria to evaluate
capital investments.
Two most comprehensive measures are:
Net Present Value (NPV) and
Internal Rate of Return (IRR)

Four other criteria that are frequently used are:

Payback Period
Discounted Payback Period
Modified Internal Rate of Return (MIRR)
Profitability Index
10-5

What is the difference between independent

and mutually exclusive projects?
Independent projects if the cash flows of
one are unaffected by the acceptance of the
other.
Mutually exclusive projects if the cash
flows of one can be adversely impacted by
the acceptance of the other.

10-6

Payback Period
The payback period is the number of years
required to recover the original investment in a
project. The payback period is based on cash
flows.
Payback
Period:

Years before full recovery

+ Unrecovered cost at start of year

Cash flow during the year

10-7

Calculating payback
Project L
CFt
Cumulative

PaybackL
Project S
CFt
Cumulative
PaybackS

0
-100
-100

== 2

2.4

10
-90

60
-30

100
0

80

30 / 80

1.6

-100
-100

== 1

70
-30

= 2.375 years
2

100 50
0 20

30 / 50

50

3
20
40

= 1.6 years
10-8

Discounted payback period

Uses discounted cash flows rather than raw
CFs.
2.7 3
0
2
10% 1
CFt
PV of CFt
Cumulative

-100
-100
-100

Disc PaybackL ==

10
9.09
-90.91
+

60
49.59
-41.32

41.32 / 60.11

80
60.11
18.79
= 2.7 years
10-9

Self Test
Which of the following statements about the
payback period is NOT correct?
A) The payback method considers all cash flows
throughout the entire life of a project.
B) The payback period provides a rough measure of
a project's liquidity and risk.
C) The payback period is the number of years it
takes to recover the original cost of the investment.
The correct answer is A.
The payback period does not take any cash flows
after the payback point into consideration
10-10

Self Test
A company is considering the purchase of a copier that costs
$5,000. Assume a cost of capital of 10 percent and the following
cash flow schedule:
Year 1: $3,000
Year 2: $2,000
Year 3: $2,000
Determine the project's payback period and discounted payback
period.
Payback Period
Discounted Payback Period
A) 2.0 years
1.6 years
B) 2.0 years
2.4 years
C) 2.4 years
1.6 years
The correct answer is B
10-11

Net Present Value (NPV)

Sum of the PVs of all cash inflows and
outflows of a project:

CFt
NPV
t
t 0 ( 1 k )
n

10-12

What is Project Ls NPV?

Year
0
1
2
3

CFt
-100
10
60
80
NPVL =

PV of CFt
-$100
9.09
49.59
60.11
$18.79

NPVS = $19.98
10-13

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.
10-14

Self Test
A firm is reviewing an investment opportunity that
requires an initial cash outlay of $336,875 and promises
to return the following irregular payments:
Year 1: $100,000, Year 2: $82,000, Year 3: $76,000
Year 4: $111,000, & Year 5: $142,000
If the required rate of return for the firm is 8%, what is
the net present value of the investment?
Cash Flow PV of Cash flow at 8%
Year
A) $99,860.
-336,875.00
-336,875.00
0
100,000.00
92,592.59
1
B) $86,133.
82,000.00
70,301.78
2
76,000.00
60,331.25
3
C) $64,582.
111,000.00
81,588.31
4
142,000.00
96,642.81
5
The correct answer is C) $64,582.Net Present Value
64,581.74
In order to determine the net present value of the
investment, given the required rate of return; we can
discount each cash flow to its present value, sum the
present value, and subtract the required investment.
10-15

Self Test
Tapley Acquisition, Inc., is considering the purchase of
Tangent Company. The acquisition would require an initial
investment of $190,000, but Tapley's after-tax net cash flows
would increase by $30,000 per year and remain at this new
level forever. Assume a cost of capital of 15%. Should Tapley
buy Tangent?
A) No, because k > IRR.
B) Yes, because the NPV = $30,000.
C) Yes, because the NPV = $10,000.
The correct answer is C) Yes, because the NPV = $10,000.
This is perpetuity.
PV = PMT / I = 30,000 / 0.15 = 200,000
200,000 190,000 = 10,000
10-16

Self Test
An analyst has gathered the following data about a company
with a 12% cost of capital:
Cost
Life
Cash Flows

Project A
$15,000
5 Years
$5,000/Yr

Project B
$25,000
5 years
$7,500/Yr

Projects A and B are mutually exclusive. What should the

company do?
A) Reject A, Accept B.
B) Accept A, Reject B.
C) Reject A, Reject B.
The correct answer is B) Accept A, Reject B.
For mutually exclusive projects accept the project with the
highest NPV. In this example the NPV for Project A (3,024) is
higher than the NPV of Project B (2,036). Therefore accept
Project A and reject Project B.
10-17

Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:

CFt
0
t
(
1

IRR
)
t 0
n

10-18

Example: IRR

10-19

How is a projects IRR similar to a bonds

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.

10-20

Rationale for the IRR method

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

10-21

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.

10-22

Self Test

10-23

NPV Profiles
A graphical representation of project NPVs at
various different costs of capital.
k
0
5
10
15
20

NPVL
$50
33
19
7
(4)

NPVS
$40
29
20
12
5

10-24

Drawing NPV profiles

NPV 60
($)

.
40 .
50

30

.
.

20

Crossover Point = 8.7%

10

IRRL = 18.1%

..

0
5

10

15

.
.

20

IRRS = 23.6%
Discount Rate (%)

23.6

-10

10-25

Comparing the NPV and IRR methods

If projects are independent, the two
methods always lead to the same
accept/reject decisions.
If projects are mutually exclusive
If k > crossover point, the two methods lead
to the same decision and there is no conflict.
If k < crossover point, the two methods lead
to different accept/reject decisions.

10-26

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.
Perhaps a hybrid of the IRR that assumes
cost of capital reinvestment is needed.
10-27

Self Test
The underlying cause of ranking conflicts between the net present
value (NPV) and internal rate of return (IRR) methods is the
underlying assumption related to the:
A) initial cost.
B) cash flow timing.
C) reinvestment rate.
The correct answer is C) reinvestment rate.
The IRR method assumes all future cash flows can be reinvested at
the IRR. This may not be feasible because the IRR is not based on
market rates. The NPV method uses the weighted average cost of
capital (WACC) as the appropriate discount rate.

10-28

Some managers prefer the IRR to the NPV

method, is there a better IRR measure?
Yes, MIRR is the discount rate that causes the
PV of a projects terminal value (TV) to equal the
PV of costs. TV is found by compounding
inflows at WACC.
MIRR assumes cash flows are reinvested at the
WACC.

10-29

Calculating MIRR
0

10%

-100.0

10.0

60.0

80.0
66.0
12.1

10%

10%
MIRR = 16.5%

-100.0
PV outflows

$100 =

$158.1
(1 + MIRRL)3

158.1
TV inflows

MIRRL = 16.5%
10-30

Profitability Index (PI)

The Profitability Index (PI) is the present value
of a projects future cash flows divided by the
initial investment. It can be expressed as:

10-31

10-32

10-33