Capital Budgeting Techniques

How do firms make decisions about whether

to invest in costly, long-lived assets?
How does a firm make a choice between two
acceptable investments when only one can
be purchased?
How are different capital budgeting
techniques related?
Which capital budgeting methods do firms
actually use?

Capital Budgeting
Introduction to Capital Budgeting
Payback Period
Net Present Value (NPV)
Internal Rate of Return (IRR)
Comparison of NPV and IRR
NPV/IRR Ranking Conflicts/Cautions

Capital Budgeting
Capital Budgeting Basics and Techniques
rfirms required rate of return

Given

CFcash flows generated by an investment

Capital Budgeting Basics and

Techniques
Compute

rfirms required rate of return

CFcash flows generated by an
investment

Capital Budgeting Basics

Importance of capital budgeting decisions
long-term effectcapital, or long-term funds,
raised by the firms are used to invest in assets
that enable the firm to generate revenues several
years into the future.
timing of a decision is importantdecisions impact
the firm for several years.

Generating ideas for capital budgeting

employees, customers, suppliers, and so forth
based on needs and experiences of the firm and
these groups

Capital Budgeting Basics

Project classificationsreplacement decisions
versus expansion decisions
replacement decisionintended to maintain existing
levels of operations
expansion decisiona decision concerning whether
the firm should expand operations

Project classificationsindependent projects

versus mutually exclusive projects
independent projectaccepting one independent
project does not affect the acceptance of any other
project
mutually exclusive projectsonly one project can be
purchased
5

Capital Budgeting Basics

Capital Budgeting Versus Asset Valuation
Value of an asset = PV of the cash flows the
asset is expected to generate during its life:

Asset CF1
CF2
CFn

1
2
Value (1 r) (1 r)
(1 r)n

An asset is an acceptable investment if the

cost of the asset is less than its value:
Acceptable if: PV of CFs > Cost

Capital Budgeting Techniques

Payback period
Net present value
Internal rate of return

Capital Budgeting Techniques

Illustrative Investment

Year

Cash Flow,CFt

0
1
2
3
4

(7,000)
2,000
1,000
5,000
3,000
r = 15%

Capital Budgeting Example

Cash Flow Time Line
0

15%

(7,000.00) 2,000

1,000

5,000

3,000

1,739.13
PV =
7,498.11

756.14
3,287.58
1,715.26

498.11 =CF0 PV of CF1 PV of CF2 PV of CF3 PV of CF4

Capital Budgeting Techniques

Payback Period
Number of years it takes to recapture
the initial investment.
Year
0
1
2
3
4

Cash Flow
$(7,000)
2,000
1,000
5,000
3,000

Cumulative CF
$(7,000)
(5,000)
(4,000) }
1,000 2<Payback<3
4,000

10

Capital Budgeting Techniques

Payback Period
Year
0
1
2
3
4

Cash Flow Cumulative CF

$(7,000)
$(7,000)
2,000
(5,000)
1,000
(4,000)
}
5,000
1,000
3,000
4,000 2<Payback<3

remaining
# of yearsbefore $ investment
to be recaptured
Payback fullrecoveryof
period originalinvestment
$ cashflowin
yearof payback

2
2.80years

$4,000
$5,000

11

Capital Budgeting Techniques

Payback Period
Accept the project if Payback, PB < some
number of years established by the firm
PB = 2.8 years is acceptable if the firm
has established a maximum payback of
4.0 years

12

Capital Budgeting Techniques

Payback Period
Advantages:
Simple
Cash flows are used
Provides an indication of the liquidity of a
project
Disadvantages:
Does not use time value of money
concepts
Cash flows beyond the payback period are
ignored
13

Capital Budgeting Techniques

Payback Period
Year
0
1
2
3
4
5

Cash Flow
$(7,000)
2,000
1,000
5,000
3,000
1,000,000

Cumulative CF
$(7,000)
(5,000)
(4,000) } PB = 2.80
1,000 yrs
4,000
1,004,000

14

Capital Budgeting
Net Present Value (NPV)
NPV = present value of future cash flows
less the initial investment

CF1
CF2
CFn

NPV CF0
1
2
(1 r) (1 r)
(1 r) n
n

t0

CFt
(1 r) t

An investment is acceptable if NPV > 0

15

Capital BudgetingNPV
$2,000 $1,000 $5,000 $3,000

NPV $7,000
1
2
3
(1.15) (1.15) (1.15) (1.15)4
$1,715.26
$7,000 $1,739.13
$756.14 $3,287.58
$498.11

NPV = $498.11 > 0, so the project is acceptable

16

Capital Budgeting Example

Cash Flow Time Line
0

2,000

1,000

5,000

3,000

15%

(7,000.00)
1,739.13

756.14
3,287.58
1,715.26
498.11 = NPV

17

Capital BudgetingNPV
Advantages:
Cash flows rather than profits are
analyzed
Recognizes the time value of money
Acceptance criterion is consistent with the
goal of maximizing value
Disadvantage:
Detailed, accurate long-term forecasts are
required to evaluate a projects
acceptance
18

Solving for NPV

Numerical (equation) solution
Financial Calculator solution
Spreadsheet solution

19

Solving for NPV

Numerical Solution
$2,000 $1,000 $5,000 $3,00

NPV $7,000
1
2
3
(1.15) (1.15) (1.15) (1.15)4
$1,715.26
$7,000 $1,739.13
$756.14 $3,287.58
$498.11

20

Solving for NPV

Financial Calculator Solution
Input the following into the cash flow
register:
CF0
= -7,000
CF1
= 2,000
CF2
= 1,000
CF3
= 5,000
CF4
= 3,000
Input I = 15
Compute NPV = 498.12
21

Capital Budgeting
Discounted Payback Period
Payback period computed using the present
values of the future cash flows.

Cumulative
Year Cash Flow PV of CF @15%
PV
of0CF$(7,000)
$(7,000.00) $(7,000.00)
1
2,000
1,739.13
(5,260.87)
2
1,000
756.14
(4,504.73)
3
5,000
3,287.58
(1,217.14)
} PBdisc= 3.71
4
3,000
1,715.26
498.12

A project is acceptable if PBdisc < projects life

22

Capital Budgeting
Internal Rate of Return (IRR)
If NPV>0, projects return > r

IRR > 15%

Example:
Initial investment

= $7,000.00 NPV = $498.12

PV of future cash flows = $7,498.12 r = 15%

If IRR = projects rate of return

IRR = the rate of return that causes the NPV of
the project to equal zero, or where the present
value of the future cash flows equals the initial
investment.
23

Capital Budgeting
Internal Rate of Return (IRR)

NPV CF0

CF1
1

(1 IRR)

CF0

CF2
(1 IRR)

CF1
1

(1 IRR)

(1 IRR)

CF2
(1 IRR)

CFn

CFn
(1 IRR) n

A project is acceptable if its IRR > r

24

Capital Budgeting
Internal Rate of Return (IRR)
NPV 7,000

$7,000

2,000
1,000
5,000
3,000

0
1
2
3
4
(1 IRR)
(1 IRR)
(1 IRR)
(1 IRR)

$2,000
$1,000
$5,000
$3,000

(1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR)4

25

Internal Rate of Return (IRR)

Cash Flow Time Line
0

2,000

1,000

5,000

3,000

IRR = ?

(7,000)

of PVs = 7,000

0 = NPV

26

Capital BudgetingIRR
Advantages:
Cash flows rather than profits are analyzed
Recognizes the time value of money
Acceptance criterion is consistent with the
goal of maximizing value
Disadvantages:
Detailed, accurate long-term forecasts are
required to evaluate a projects acceptance
Difficult to solve for IRR without a financial
calculator or spreadsheet

27

Solving for IRR

Numerical Solution
Using the trial-and-error method plug in
values for IRR until the left and right side of
the following equation become equal.
$7,000

$2,000
$1,000
$5,000
$3,000

(1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR)4

28

Solving for IRR

Numerical Solution
Rate of Return
15%
16
17
18
19

NPV
498.12
327.46
162.72
3.62
(150.08)

} 18<IRR<19

29

Solving for IRR

Financial Calculator Solution
Input the following into the cash flow
register:
CF0

= -7,000

CF1

= 2,000

CF2

= 1,000

CF3

= 5,000

CF4

= 3,000

Compute IRR = 18.02%

30

NPV versus IRR

When NPV > 0, a project is acceptable
because the firm will increase its value,
which means the firm earns a return greater
than its required rate of return (r) if it
invests in the project.
When IRR > r, a project is acceptable
because the firm will earn a return greater
than its required rate of return (r) if it
invests in the project.
When NPV > 0, IRR > r for a projectthat is,
if a project is acceptable using NPV, it is also
acceptable using IRR.
31

Accept/Reject Decisions Using NPV,

Discounted Payback, and IRR
Technique
Acceptable?
NPV
IRR
Discounted PB

Evaluation
Evaluation Result
Result
NPV >
> 0
0
IRR > r
PBdisc < projects life

YES
YES
YES

32

NPV Profile
A graph that shows the NPVs of a
project at various required rates of
return.
Rate of Return
NPV
15%
16
17
18
19
20
21

498.12
327.46
162.72
3.62
(150.08)
(298.61)
(442.20)

33

NPV Profile
NPV

$5,000
$4,000
$3,000
$2,000
$1,000

IRR = 18.02%
NPV > 0

$0
($1,000)

5%

10%

15%

20%

NPV < 0

25%

($2,000)

34

Capital Budgeting Techniques

Illustrative Projects A & B
Year
0
1
2
3
4

Cash Flow,CFt
Project B
Project A

(7,000.00)
(7,000.00)
2,000.00
2,000.00
1,000.00
1,000.00
5,000.00
5,000.00
3,000.00
3,000.00
PB =
2.80
NPV =
498.12
IRR =
18.02%
r = 15%

(8,000.00)
6,000.00
3,000.00
1,000.00
500.00
1.67
429.22
19.03%

35

NPV Profiles for Projects A & B

NPV

5000
4000

Project A

3000

Crossover = 16.15

2000
1000

Project B

IRRB = 19.03
r

0
5%

10%

15%

20%

25%

-1000
-2000

IRRA = 18.02

36

NPV ProfileProjects A & B

Rate of Return
15%
16
17
18
19
20
21

NPVA

NPVB

498.12
327.46
162.72
3.62
(150.08)
(298.61)
(442.20)

429.22
318.71
210.94
105.82
3.26
(96.84)
(194.55)

37

Capital Budgeting Techniques

Illustrative Projects A & B

Cash Flow,CFt

CFA Year
Project A
Project
B
CF
B
1,000
0
(7,000)(8,000)
(4,000)
1
2,0006,000
(2,000)
2
1,0003,000
4,000
3
5,0001,000
2,500
4
3,000500
IRR of (CFA CFB) Cash Flow Stream =
16.15%
At r = 16.15%, NPVA = NPVB = 302.37
38

NPV/IRR Ranking Conflicts

Traditional PB
Discounted PB
NPV
IRR

Asset
Asset A
A
2.80
2.80 yrs
yrs
3.71 yrs
$498.12
18.02%

Asset B
1.67 yrs
2.78 yrs
$429.22
19.03%

Which asset(s) should be purchased? Asset

A, because it has the higher NPV.

39

NPV/IRR Ranking Conflicts

Ranking conflicts result from:
Cash flow timing differences
Size differences
Unequal lives

Reinvestment rate assumptions

NPVreinvest at the firms required rate
of return
IRRreinvest at the projects internal rate
of return, IRR

40

Multiple IRRs
Conventional cash flow patterncash outflow(s)
occurs at the beginning of the projects life,
followed by a series of cash inflows.
Unconventional cash flow patterncash
outflow(s) occurs during the life of the project,
after cash inflows have been generated.
An IRR solution occurs when a cash flow pattern is
interrupted; if a cash flow pattern is interrupted
more than once, then more than one IRR solution
exists.

41

Multiple IRRsExample
Year

Cash Flow

(15,000)

40,150

(13,210)

(16,495)

IRR1 = 22.5%
IRR2 = 92.0%

42

Modified Internal Rate of Return

(MIRR)
Generally solves the ranking conflict and
the multiple IRR problem

TV
PV of cash outflows =
(1+ MIRR)n
n

COFt

(1 r) t
t 0

CIFt (1 r ) n t

t 0

(1 MIRR ) n

43

MIRRExample
Year
0
1
2
3
4
Discounted PB
NPV
IRR

Project A
(7,000)
2,000
1,000
5,000
3,000
3.71 yrs
$498.12
18.02%

Project B
(8,000)
6,000
3,000
1,000
500
2.78 yrs
$429.22
19.03%

44

MIRRExample
Year
0
1
2
3
4

Project A
(7,000)
2,000
1,000
5,000
3,000

Project B
(8,000)
6,000
3,000
1,000
500

2,000(1.15) 3 1,000(1.15) 2 5,000(1.15)1 3,000(1.15) 0

13,114 .25
7,000

(1 MIRR A )
(1 MIRR A )

Project Acalculator solution: N = 4, PV = -7,000, PMT =

0, FV = 13,114.25; I/Y = 16.99 = MIRRA
Project Bcalculator solution: N = 4, PV = -8,000, PMT =
0, FV = 14,742.75; I/Y = 16.51 = MIRRB
45

Capital BudgetingThe Answers

How do firms make decisions about
whether to invest in costly, long-lived
assets?
Firms use decision-making methods that are
based on fundamental valuation concepts

How does a firm make a choice between

two acceptable investments when only
one can be purchased?
The decision should be consistent with the
goal of maximizing the value of the firm

46

Capital BudgetingThe Answers

How are different capital budgeting
techniques related?
All techniques except traditional payback
period (PB) are based on time value of
money

Which capital budgeting methods do

firms actually use?
Most firms rely heavily on NPV and IRR to
make investment decisions

47

Thank you for

your sharing