7Basics of

Capital Budgeting

7.1 An Overview of Capital Budgeting

Capital BudgetingCapital budgeting is the process of analyzing

potential expenditures on fixed assets and deciding whether the firm should undertake those investments.

Capital budgeting = Strategic asset allocation

Capital budgeting decision = Strategic long-term investment decision

Capital Budgeting ProcessDetermine the cost of the project.Estimate the expected cash flows from the

project and the riskiness of those cash flows.Determine the appropriate cost of capital at

which to discount the cash flows.Determine the present values of the expected

cash flows and of the project.

7.2 Investment Criteria

Evaluation of Decision CriteriaDoes it consider all cash flows throughout the

entire life of a project?Does it consider the time value of money?Does it consider the risk?Does it provide information on whether you are

creating value for the firm?When it is used to select from a set of mutually

exclusive projects, does it choose the project which maximizes the wealth of the shareholders?

ExampleThe firm is considering a new project with

the following estimated cash flows:Year 0: CF = -158,000Year 1: CF = 54,200; NI = 12,100Year 2: CF = 66,900; NI = 5,800Year 3: CF = 89,300; NI = 27,600Average Book Value = 64,000

The required return is 11%.

Net Present Value (NPV)The NPV of an investment is the difference

between the market value of a project and its cost.

StepsThe first step is to estimate the expected future

cash flows.The second step is to estimate the required return

for projects of this risk level.The third step is to find the present value of the

cash flows and subtract the initial investment.Decision Rule : If the NPV is positive, accept the

project. If the NPV is negative, reject the project.

Net Present Value (NPV): ExampleNPV = -$158,000 + 54,200/(1.11) +

66,900/(1.11)2 + 89,300/(1.11)3 = $10,421.76NPV is positive.Do you accept the project? Yes!

Net Present Value (NPV)NPV has no serious flaws.NPV selects the project which adds the

most to shareholder wealth.NPV is the preferred decision criterion.When there is a conflict between NPV and

another decision rule, you should always use NPV.

Payback PeriodThe payback period is the length of time until

the sum of an investment’s cash flows equals to its cost.

StepsEstimate the cash flows.Subtract the future cash flows from the initial cost

until the initial investment has been recovered.Decision Rule: If the payback period is less

than some prespecified cutoff, accept the project.

Payback Period: ExampleAssume you will accept the project if it

pays back within two years.Year 1: $158,000 – 54,200 = $103,800 Year 2: $103,800 – 66,900 = $36,900Year 3: $36,900/89,300=0.41The project pays back in year 2.41 years.

The payback period is more than the prespecified cutoff.

Do you accept the project? No!

Advantages and Disadvantages of Payback Period

AdvantagesEasy to understandAdjusts for

uncertainty of later cash flows

Biased toward liquidity

DisadvantagesIgnores the time

value of moneyRequires an arbitrary

cutoff pointIgnores cash flows

beyond the cutoff date

Biased against long-term projects, such as research and development, and new projects

Discounted Payback PeriodThe discounted payback period is the

length of time until the sum of an investment’s discounted cash flows equals its cost.

Decision Rule: If the discounted payback period is less than some prespecified cutoff, accept the project.

Discounted Payback Period: ExampleAssume you will accept the project if it pays

back on a discounted basis in 2 years.Year 1: $158,000 – 54,200/1.111 =

$109,171.17Year 2: $109,171.17 – 66,900/1.112 =

$54,873.63Year 3: $54,873.63 / (89,300/1.113)= 0.84The project pays back in 2.84 years .

The discounted payback period is more than the prespecified cutoff.

Do you accept the project? No!

Advantages and Disadvantages of Discounted Payback Period

AdvantagesIncludes time value

of moneyEasy to understandDoes not accept

negative estimated NPV investments

Biased towards liquidity

DisadvantagesMay reject positive

NPV investmentsRequires an arbitrary

cutoff pointIgnores cash flows

beyond the cutoff dateBiased against long-

term projects, such as research and development, and new products

Average Accounting Return (AAR)The AAR is a measure of accounting profit

relative to book value.One form of the AAR is:

Average net income / average book valueDecision Rule: If the AAR exceeds a target

AAR, accept the project.

Average Accounting Return (AAR): ExampleAssume the firm requires an average

accounting return of 25%($12,100 + 5,800 + 27,600) / 3 =

$15,166.67AAR = 15,166.67 / 64,000 = 23.70%

The AAR is less than the target AAR.Do you accept the project? No!

Advantages and Disadvantages of AAR

AdvantagesEasy to calculateNeeded information

will usually be available

DisadvantagesNot a true rate of

return; time value of money is ignored

Uses an arbitrary benchmark cutoff rate

Based on book values, not cash flows and market values

Internal Rate of Return (IRR)The IRR is the discount rate that makes the

estimated NPV of an investment equal to zero.It is sometimes called the discounted cash

flow (DCF) return.Decision Rule: if the IRR exceeds the required

return, accept the project.

It is the most important alternative to NPV. It is very popular in practice, more so than

even the NPV.

Internal Rate of Return (IRR): ExampleTrial and error or using a financial

calculator or using a spreadsheet. -158,000 + 54,200/(1+r) +

66,900/(1+r)2 + 89,300/(1+r)3 =0IRR = 14.45% > 11%

The IRR exceeds the required return.Do you accept the project? Yes!

NPV Profile for the Project

(30,000.00)

(20,000.00)

(10,000.00)

0.00

10,000.00

20,000.00

30,000.00

40,000.00

50,000.00

60,000.00

Discount Rate

NP

V

IRR = 14.45%

Summary of Decisions for the ProjectDo you accept the project?

Net Present Value –YesPayback Period – NoDiscounted Payback Period – NoAverage Accounting Return – NoInternal Rate of Return – Yes

The final decision should be based on the NPV.

You should accept the project.

NPV vs. IRRNPV and IRR usually lead to identical decisions.

The project’s cash flows must be conventional: the first cash flow is negative and all the rest are positive.

The project must be independent: a project whose cash flows are unaffected by the decision to accept or reject some other project.

ExceptionsNonconventional cash flowsMutually exclusive projects

IRR and Nonconventional Cash FlowsWhen the cash flows change sign more than

once, there is more than one IRR.This is the multiple rates of return problem.You need to look at the NPV profile.

IRR and Mutually Exclusive ProjectsMutually exclusive projects

A set of projects of which only one can be accepted.

Decision rulesNPV – choose the project with the

higher NPVIRR – choose the project with the higher

IRRYou need to look at the NPV profile.

Mutually Exclusive Projects: ExamplePeriod Project

AProject B

0 $-1000 $-800

1 650 650

2 650 400

IRR 19.43% 22.17%

NPV $128.10 $121.49

The required return for both projects is 10%.

Which project should you accept and why?

NPV Profiles

0 0.05 0.1 0.15 0.2 0.25 0.3

($100.00)

($50.00)

$0.00

$50.00

$100.00

$150.00

$200.00

$250.00

$300.00

$350.00

A

B

Discount Rate

NP

V

IRR for A = 19.43%

IRR for B = 22.17%

Crossover Rate = 11.8%

Mutually Exclusive Projects: ExampleThe crossover rate is the discount rate the

makes the NPVs of two projects equal.When there is a conflict between NPV and

another decision rule, you should always use NPV.

If the required return is less than the crossover rate of 11.8%, then you should choose A.

If the required return is greater than the crossover rate of 11.8%, then you should choose B.

Advantages and Disadvantages of IRR

AdvantagesClosely related to

NPV, often leading to identical decisions

Easy to understand and communicate

DisadvantagesMay result in

multiple answers or not deal with nonconventional cash flows.

May lead to incorrect decisions in comparisons of mutually exclusive investments

Modified Internal Rate of Return (MIRR) The MIRR is a modification to the IRR. Steps:

A project’s cash flows are modified by: Discounting the negative cash flows back to the

present. Compounding cash flows to the end of the

project’s life. Combining the above two.

Compute the IRR on the modified cash flows.It avoids the multiple rate of return problem,

but it is unclear to interpret them.

Profitability Index (PI)The PI is the ratio of present value to cost.It is also called the benefit-cost ratio.It measures the present value of an

investment per dollar invested.Decision rule: If the PI exceeds 1, accept the

project.

Advantages and Disadvantages of PIAdvantages

Closely related to NPV, generally leading to identical decisions

Easy to understand and communicate

May be useful when available investment funds are limited

DisadvantagesMay lead to

incorrect decisions in comparisons of mutually exclusive investments

Capital Budgeting in PracticeFirm use multiple criteria for evaluating a

proposal.NPV and IRR are the most commonly used

primary investment criteria.Payback period is a commonly used

secondary investment criteria.Less commonly used were discounted

payback period, AAR and PI.