EBF 2054 Capital Budgeting

EBF 2054 Financial Management
CAPITAL BUDGETING
The Basics of Capital

Budgeting
Should
we
build this
factory?
Capital Budgeting
Capital Budgeting
Decision to invest in capital - fixed assets

Capital long term assets used in production
Budget- plan with details projected expenditures during
future period
Capital Budgeting
The process of planning expenditures on assets whose
cash flows are expected to extend beyond one year.long term investment decision.
What is capital budgeting?
Analysis of potential
additions to fixed assets.
Long-term decisions;
involve large expenditures.
Very important to firms

future.
Capital Budgeting: The process of

planning for purchases of long-term
assets.
For example: Suppose our firm must decide

whether to purchase a new plastic molding
machine for $125,000. How do we decide?
Will the machine be profitable?

Will our firm earn a high rate of return on the
investment?
Decision-making Criteria
in Capital Budgeting
How do we decide
if a capital
investment
project should
be accepted or
rejected?
Decision-making Criteria
in Capital Budgeting
The ideal evaluation method should:
a) include all cash flows that occur during
the life of the project,
b) consider the time value of money, and
c) incorporate the required rate of return on
the project.
3 methods of ranking
investments
1.
2.
3.
Payback method
Net present value (NPV)
Internal rate of return (IRR)
1st method not conceptually sound, is often used.

2nd & 3rd approaches are more acceptable.
Time value of money is used to equate future cash flows to
present
Cost of capital as basic discount rate
What is the payback period?
The number of years

required to recover a
projects cost, or How
long does it take to get

our money back?
Calculated by adding
projects cash inflows to its
cost until the cumulative
cash flow for the project
turns positive.
Payback Period
How
long will it take for the project to

generate enough cash to pay for itself?
(500)
150 150 150 150 150 150 150
Payback period = 3.33 years
150
Payback Period
Is a 3.33 year payback period good?

Is it acceptable?
Firms that use this method will compare
the payback calculation to some standard
set by the firm.
If our senior management had set a cutoff of 5 years for projects like ours, what
would be our decision?
Accept
the project.
Drawbacks of Payback
Period
Firm cutoffs are subjective.

Does not consider time value of money.
Does not consider any required rate of
return.
Does not consider all of the projects
cash flows.
Drawbacks of Payback Period

Does not consider all of the projects cash flows.
Cash flows
(of $ 10 000 investment)
Year Investment Investment
A
B
1
5000
1500
5000
2000
500
2500
500
5000
500
10000
Initial investment = $10 000

Payback period for:
Inv. A
(5000+5000)
= 2 years
Inv. B
(1500+2000+2500) + 4000/5000
1y
2y
3y
= 3 years + 0.8 year

= 3.8 years
Strengths and weaknesses of

payback
Strengths
Provides an indication of a
projects risk and liquidity.
Easy to calculate and
understand.
Weaknesses
Ignores the time value of money.

Ignores CFs occurring after the
payback period.
Discounted Payback
Uses discounted cash flows rather than raw CFs.
Discounts the cash flows at the firms

required rate of return.
Payback period is calculated using
these discounted net cash flows.
Problems:
Cutoffs are still subjective.
Still does not examine all cash flows.
Example:
Discounted payback period
Uses discounted cash flows rather than raw CFs.

0
CFt
PV of CFt
Cumulative
10%
-100
-100
-100
Disc Payback =
1
10
9.09
-90.91
41.32
60
49.59
80
60.11
18.79
-41.32
/ 60.11
= 2.7 years
Other Methods
1) Net Present Value (NPV)

2) Internal Rate of Return (IRR)
Consider each of these decision-making criteria:
All net cash flows.
The time value of money.
The required rate of return.
Steps to capital budgeting

(NPV & IRR methods)
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.
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.
A set of projects where only one can be accepted.
What is the difference between normal

and nonnormal cash flow streams?
Normal cash flow stream
Cost (negative CF) followed by a series of positive

cash inflows. One change of signs.
Nonnormal cash flow stream
Two or more changes of signs.
Most common:
Cost (negative CF), then string of positive CFs, then
cost to close project. Nuclear power plant, strip
mine, etc.
Net Present Value (NPV)
NPV direct measure of the projects contribution to

shareholder wealth.
Find PV of each cash flow, including the cost, discounted at

projects cost of capital
Sum of these discounted cash flows is defined as projects
NPV.
Sum of the PVs of all cash inflows and outflows of a

project:
N
NPV
t0
CFt
t
(1 r )
What is Project Ls NPV?

(r=10%)
Example: 2 projects long term (L) & short term (S)
Year
0
1
2
3
CFt
-100
10
60
80
NPV
PV of CFt
-$100
9.09
49.59
60.11
=
(initial cost in year 1)
$18.79
* r = cost of capital (WACC) @ discounted rate (i) eg:10%
Cash flow time line

0
r=10%
-$100
10
60
80 (cash flows)
9.09
49.59
60.11
= $18.79 Net present value ,NPV
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.
EG: (NPVA $19.98 and NPVB $18.79
accept A if mutually exclusive (NPVA $19.98 > NPVB $18.79), and

accept both if independent.
Net Present Value (NPV)
NPV =
Total PV of the
annual net cash
flows
NPV =
t=1
the initial outlay
FCFt
t
(1 + k)
- IO
Net Present Value
Decision Rule:
If NPV is positive, accept.

If NPV is negative, reject.
NPV Example
Suppose we are considering a

capital investment that costs
$250,000 and provides annual
net cash flows of $100,000 for
five years. The firms required
rate of return is 15%.
NPV Example
capital investment costs $250,000

annual net cash flows of $100,000 for five years.
required rate of return is 15%.
(250,000) 100,000 100,000 100,000 100,000 100,000
NPV = PV of the annual cash flows - initial outflow.
Mathematical Solution:
NPV = PMT (PVIFA i, n ) - IO
NPV = 100,000 (PVIFA .15, 5 ) - 250000 (use PVIFA table)
= 100,000 (3.352) 250000
= 335200- 250000 =$85,200
OR
NPV =
PMT
NPV = 100,0000
1-
1.15
1
(1 + i)n
i
- IO
Accept
@
reject??
1
(1.15 )5 - 250,000 = $335,216 - $250000
= $85,216
Decision Rule:
If NPV is positive, accept.

If NPV is negative, reject.
Since the NPV = $85,216,
so we should
ACCEPT this investment (project)
Internal Rate of Return (IRR)
IRR:
The return on the firms

invested capital. IRR is simply
the rate of return that the firm
earns on its capital budgeting
projects.
NPV =
t=1
IRR:
t=1
FCFt
(1 + k) t
FCFt
t
(1 + IRR)
- IO
= IO
IRR:
FCFt
t
(1 + IRR)
= IO
t=1
IRR is the rate of return that makes the PV

of the cash flows equal to the initial outlay.
Calculating IRR
Looking again at our problem:

The IRR is the discount rate that makes
the PV of the projected cash flows equal
to the initial outlay.
(250,000) 100,000 100,000 100,000 100,000 100,000
When, calculate IRR, we let the NPV=0
Mathematical Solution:
NPV
= PMT (PVIFA i, n ) - IO
0
= 100,000 (PVIFA .IRR, 5 ) - 250000
(PVIFA .IRR, 5 ) = 250,000 / 100,000
= 2.5 (use PVIFA table)
from PVIFA table, we will get IRR 25 - 30%
OR
1
NPV= PMT
1 - (1 + i)n
- IO
i
0 = 100,0000
IRR
1-
IRR = 28.65%
1
(1+IRR )5
- 250,000
Decision Rule:
If IRR is greater than or

equal to the required rate
of return, accept.
If IRR is less than the
required rate of return,
reject.
Since in this example IRR =
28.65%, the required rate of
return is 15%.so, we
ACCEPT this investment.
IRR
is a good decision-making tool

as long as cash flows are
conventional.
(- + + + + +)
Problem: If there are multiple sign
changes in the cash flow stream, we
could get multiple IRRs. (- + + - + +)
Multiple IRR
The situation where a project has two or more

IRRs.
Occurs when the project has nonnormal cash
flows.
Examples:
Normal : - +++++ or - - - +++++
Nonnormal: - +++++- or - +++ - +++
Example
Suppose a firm is considering

the development of a strip mine
(project P). The mine will cost $
0.8 million, then it will produce a
cash flow of $5 million at the end
of year 1. At the end of year 2,
the firm must spend $5 million to
restore the land to its original
condition.
cash flow :
( - + -)
NPV Vs IRR, which one is better???

Reinvestment rate assumptions
NPV method assumes CFs are reinvested at the

required rate of return.
IRR method assumes CFs are reinvested at IRR.
Assuming CFs are reinvested at the opportunity
cost of capital (required rate of return ,k) 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.
Since managers prefer the IRR to the NPV method,

is there a better IRR measure?
Yes, Modified Internal Rate of Return

(MIRR)
discount rate that causes the PV of
a projects terminal value (TV) to
equal the PV of costs.
PV of TV = PV cost
TV is found by compounding
inflows at required rate of return
(WACC).
MIRR assumes cash flows are

reinvested at the required rate of
return (WACC).
Modified Internal Rate of Return (MIRR)
IRR assumes that all cash flows

are reinvested at the IRR.
MIRR provides a rate of return
measure that assumes cash flows
are reinvested at the required rate
of return, k.
MIRR Steps:
Calculate the PV of the cash outflows.
Calculate the FV of the cash inflows at the last year

of the projects time line. This is called the terminal
value (TV).
Using the required rate of return,k.
Using the required rate of return.
MIRR: the discount rate that equates the PV of the

cash outflows with the PV of the terminal value, ie,
that makes:
PVoutflows = PVinflows
Calculating MIRR
0
-100.0
10%
10.0
60.0
80.0
66.0
12.1
10%
10%
MIRR = 16.5%
-100.0
PV outflows
$100 =
$158.1
(1 + MIRR)3
MIRR = 16.5%
158.1
TV inflows
Calculating MIRR
0
-100.0
10%
10.0
60.0
80.0
66.0
12.1
10%
10%
MIRR = 16.5%
-100.0
PV outflows
$100 =
$158.1
(1 + MIRR)3
MIRR = 16.5%
158.1
TV inflows
Why use MIRR versus IRR?
MIRR assumes reinvestment at

the opportunity cost = WACC.
MIRR also avoids the multiple
IRR problem.
Managers like rate of return

comparisons, and MIRR is
better for this than IRR.
End of Lecture
Thank you for your

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EBF 2054 Financial Management

The Basics of Capital

Decision to invest in capital - fixed assets

What is capital budgeting?

Very important to firms

Capital Budgeting: The process of

For example: Suppose our firm must decide

Will the machine be profitable?

1st method not conceptually sound, is often used.

What is the payback period?

The number of years

long does it take to get

long will it take for the project to

150 150 150 150 150 150 150

Payback period = 3.33 years

Is a 3.33 year payback period good?

Firm cutoffs are subjective.

Drawbacks of Payback Period

Initial investment = $10 000

= 3 years + 0.8 year

Strengths and weaknesses of

Ignores the time value of money.

Discounts the cash flows at the firms

Uses discounted cash flows rather than raw CFs.

1) Net Present Value (NPV)

Steps to capital budgeting

Estimate CFs (inflows & outflows).

What is the difference between independent and

if the cash flows of one are unaffected by the acceptance of the

Mutually exclusive projects-

if the cash flows of one can be adversely impacted by the

A set of projects where only one can be accepted.

What is the difference between normal

Normal cash flow stream

Cost (negative CF) followed by a series of positive

Nonnormal cash flow stream

Two or more changes of signs.

Net Present Value (NPV)

NPV direct measure of the projects contribution to

Find PV of each cash flow, including the cost, discounted at

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

What is Project Ls NPV?

(initial cost in year 1)

* r = cost of capital (WACC) @ discounted rate (i) eg:10%

Cash flow time line

Rationale for the NPV

If projects are independent, accept if the project NPV >

accept A if mutually exclusive (NPVA $19.98 > NPVB $18.79), and

Net Present Value (NPV)

the initial outlay

Net Present Value

If NPV is positive, accept.

Suppose we are considering a

capital investment costs $250,000

(250,000) 100,000 100,000 100,000 100,000 100,000

NPV = PV of the annual cash flows - initial outflow.

If NPV is positive, accept.

Since the NPV = $85,216,

ACCEPT this investment (project)