Chapt

er

12

The Capital Budgeting

Decision

Prepared by P Chua
April 5, 2005

Based on Slides by:

Terry Fegarty,
Carol Edwards,
Lawrence J. Gitman,
and Sean Hennessey

McGraw-Hill Ryerson

2003 McGraw-Hill
Ryerson
Limited
2003 McGraw-Hill
Ryerson
Limited

Chapter 12 - Outline

PPT 12-2

What

is Capital Budgeting?
Stages in Capital Budgeting Process
Decision-making Criteria in Capital Budgeting
Capital Budgeting Selection Strategies
Methods of Evaluating Investment Proposals
Payback Period
Net Present Value (NPV)
Profitability Index
Internal Rate of Return (IRR)
Capital Rationing
NPV vs IRR
Summary and Conclusions
2003 McGraw-Hill Ryerson Limited

What is Capital Budgeting?

PPT 12-3

Capital

Budgeting is the process of evaluating and

selecting long-term investment projects that achieve
the goal of owner wealth maximization.
The purposes of Capital Budgeting Projects include:
to expand, replace, or renew fixed assets over a long
period.
Examples of Capital Budgeting projects:
buying a new computer system,
expanding the production capacity of an existing
plant or
modernizing its operations.
2003 McGraw-Hill Ryerson Limited

What is Capital Budgeting?

Capital

Budgeting requires intensive planning. Once

a Capital budgeting decision is made, it sets a
strategic direction that is difficult to change.

Because

capital budgeting decisions involve a firms

commitment of sizable financial resources to a
project on a long-term basis, it is extremely
important that a firm makes the right decision.

A wrong

decision can lead to huge financial distress

and even bankruptcy for a firm.
2003 McGraw-Hill Ryerson Limited

What is Capital Budgeting?

PPT 12-3

The longer the time horizon associated with a

capital expenditure, the greater the uncertainty.
Areas of uncertainty include:
Annual outflows and inflows
Product life
Economic conditions
Cost of capital
Technological change

2003 McGraw-Hill Ryerson Limited

Stages in Capital Budgeting

Process
1.
2.

3.
4.

Finding Projects
Estimating the incremental cash flows
associated with projects
Evaluating and selecting projects
Implementing and monitoring projects

2003 McGraw-Hill Ryerson Limited

Decision-making Criteria in
Capital Budgeting

The Ideal Evaluation Method:

considers the time value of money,
focuses on resultant cash flows,
uses a firms cost of capital as the discount
rate to evaluate a project.

2003 McGraw-Hill Ryerson Limited

PPT 12-5

Converting Accounting Flow to Cash

Flow
Earnings before amortization and taxes (EBAT)
Amortization (non-cash expense) . . . .
Earnings before taxes . . . . . . . .
Taxes (50%) . . . . . . . . . .
Earnings aftertaxes . . . . . . . .
Amortization . . . . . . . . . .
Cash flow . . . . . . . . . . .

.
.
.
.
.
.
.

.
.
.
.
.
.
.

.
.
.
.
.
.
.

.
.
.
.
.
.
.

$20,000
5,000
15,000
7,500
7,500
+ 5,000
$12,500

Alternative method of cash flow calculation

EBAT
. . . . . . . . . .
Taxes
. . . . . . . . . .
Cash flow . . . . . . . . . .

.
.
.

.
.
.

. .
. .
. .

$20,000
7,500
$12,500

.
.
.

2003 McGraw-Hill Ryerson Limited

PPT 12-7

Methods of Evaluating
Investment Proposals
Payback

Period (PP)
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)

2003 McGraw-Hill Ryerson Limited

PPT 12-10

Project Data
Net Cash Inflows
(of a $10,000 investment)
Year
1
2
3
4
5

.
.
.
.
.

.
.
.
.
.

.
.
.
.
.

.
.
.
.
.

.
.
.
.
.

.
.
.
.
.

.
.
.
.
.

Investment A

Investment B

$5,000

$1,500

5,000

2,000

2,000

2,500
5,000
5,000

cost of capital = 10%

2003 McGraw-Hill Ryerson Limited

PPT 12-9

Payback Period
Payback Period (PP):
computes the amount of time required to
recover the initial investment
a cutoff period is established for comparison
Accept/Reject Decision:
if PP < cutoff period, accept the project
if PP > cutoff period, reject the project
2003 McGraw-Hill Ryerson Limited

Payback Period
Advantages:
Easy to understand and use
Places premium on liquidity
Emphasizes the shorter time-horizon
Disadvantages:
ignores inflows after the cutoff period
fails to consider the time value of money
fails to consider any required rate of return

2003 McGraw-Hill Ryerson Limited

Net Present Value

PPT 12-11

Net Present Value (NPV):

the present value of the cash inflows minus the
present value of the cash outflows
the future cash flows are discounted back over the
life of the investment
the basic discount rate is usually the firms cost of
capital (WACC, assuming similar risk)

Accept/Reject Decision:
if NPV > 0, accept the project
if NPV < 0, reject the project

2003 McGraw-Hill Ryerson Limited

Profitability Index (PI)

Profitability Index (PI):
is computed by dividing the present value of
inflows by the present value of outflows.
Accept/Reject Decision:
if PI > 1, accept the project
if PI < 1, reject the project

2003 McGraw-Hill Ryerson Limited

PPT 12-12

Internal Rate of Return

Internal Rate of Return (IRR):

Is the Rate of Return that equates the initial cash
outflow (cost) with the future cash inflows (benefits)
is the discount rate where the cash outflows equal the
cash inflows (or NPV = 0), that is, IRR is simply the
discount rate at which the NPV of the project equals
zero.
Accept/Reject Decision:
if IRR > cost of capital, accept the project
if IRR < cost of capital, reject the project
2003 McGraw-Hill Ryerson Limited

PPT 12-13

Capital budgeting results

Investment A Investment BSelection
Payback period . . . . 2 years 3.8 years Quickest payback:
Investment A
Net present value . . .
Investment B

$177

Internal rate of return

Investment B

11.18%

Profitability Index . .1.018

$1,413

Highest net

present value:

14.33% Highest yield:

1.141

Highest relative

profitability: Investment B

2003 McGraw-Hill Ryerson Limited

Capital Budgeting Selection

Strategies
Independent

Projects vs. Mutually Exclusive

Projects as investment opportunities.

Unlimited

Funds vs. Capital Rationing to

funding considerations.

Accept/Reject

Approach vs. Ranking

Approach to project selection.
2003 McGraw-Hill Ryerson Limited

PPT 12-17

Capital Rationing
Occurs

when a limit is set on the amount of funds

available to a firm for investment.

Firm

must rank investments based on their NPVs

Those

with positive NPVs greater than the cost of

capital are accepted until all funds are exhausted

2003 McGraw-Hill Ryerson Limited

PPT 12-18

Capital Rationing

Capital
rationing
solution
Best
solution

Project
A

Investment
$2,000,000

B
C

2,000,000
1,000,000

D
E

1,000,000
800,000

800,000

Total
Investment

Net
Present
Value
$400,000

$5,000,000

380,000
150,000

6,800,000

100,000
40,000
(30,000.)

2003 McGraw-Hill Ryerson Limited

NPV most reliable measure

Payback period is the least reliable measure of project
acceptability. NPV, PI and IRR are more reliable measure.
In case of conflict among NPV, PI and IRR, NPV should
prevail. NPV has proven to be the only reliable measure of a
projects acceptability.
So, remember:
NPV is the only measure which always gives the correct
decision when evaluating projects.
Only NPV measures the amount by which a project would
increase the value of the firm.

2003 McGraw-Hill Ryerson Limited

Pitfalls of IRR
High

IRR for a project does not necessarily mean a high

NPV.
Calculate the IRR and NPV for the projects below:
Cash Flows in Dollars
Project:
J
K

C0

C1

-100
+100

+150
-150

IRR
50%
50%

NPV @ 6%
+ $41.5
- $41.5

Both projects have the same IRR

but Project J contributes more to the value of the firm.

Obviously, you should prefer Project J!

.

2003 McGraw-Hill Ryerson Limited

Pitfalls of IRR
Lending vs Borrowing
Project J involves lending $100 at 50% interest.
Project K involves borrowing $100 at 50% interest.
Which option should you choose?

Remember:
When you lend money, you want a high
rate of return.
When you borrow money, you want a low
rate of return.
2003 McGraw-Hill Ryerson Limited

Pitfalls of IRR
IRR

can mislead you when choosing among mutually

exclusive projects.
Calculate the IRR and NPV for the following projects:
Cash Flows in Dollars

Project:
H
I

C0

C1

C2

C3

-350
-350

400
16

16

466

IRR
NPV @ 6%
14.29%
$27.36
12.96%
$70.60

Project H has a higher IRR

but Project I contributes more to the value of the firm.

Obviously, you should prefer Project I!

.

2003 McGraw-Hill Ryerson Limited

Pitfalls of IRR

Other Pitfalls with IRR

Some projects will generate multiple internal rates of
return.

Here is an example.

0.............
1.............
2.............
NPV

Cash Flow
-1,528
11,000
-11,000

@20%
-1,528
9,167
-7,639
0

@500%
-1,528
1,833
-305
0

How should you evaluate a project in cases like this?

You should calculate NPV!
.

2003 McGraw-Hill Ryerson Limited

Pitfalls of IRR

Other Pitfalls with IRR

Some projects have no internal rate of return.
For example, there is no IRR for a project that has
cash flows of +$1,000 in year 0, -$3,000 in year 1, and
+$2,500 in year 2.
If you dont believe this, try plotting NPV for
different discount rates.

How should you evaluate a project in cases like this?

You should calculate NPV!
.

2003 McGraw-Hill Ryerson Limited

Net Present Value Profile

PPT 12-19

Net Present Value Profile:

The NPV profile is the relationship between the NPV of a
project and the discount rate used to calculate that NPV.
Since the IRR is the discount rate that makes a projects
NPV zero, the NPV profile also identifies a projects IRR.

a graph of the NPV of a project at different discount rates

shows the NPV at 3 different points:
a zero discount rate
the normal discount rate (or cost of capital)
the IRR

allows an easy way to visualize whether or not an investment

should be undertaken
2003 McGraw-Hill Ryerson Limited

PPT 12-20

Net present value Profile

Net present value ($)
6,000

Investment B

4,000

2,000

IRRB = 14.33%

Investment A

5%

10%

15%

20%

25%

IRRA = 11.16%
Discount rate (percent)
2003 McGraw-Hill Ryerson Limited

Net present value profile with

crossover
Net Cash Inflows
(of a $10,000 investment)
Year
1
2
3
4
5

Investment B
$1,500
2,000
2,500
5,000
5,000

Investment C
$9,000
3,000
1,200

cost of capital = 10%

2003 McGraw-Hill Ryerson Limited

PPT 12-21

Net present value profile with

crossover
Net present value ($)
B

6,000

Investment B

4,000
C

2,000

Investment C

Investment C

0
5%

10%

Investment B

15%

IRRC = 22.49%

20%

25%

IRRB = 14.33%
Crossover point
Discount rate (percent)
2003 McGraw-Hill Ryerson Limited

Net present value profile with

crossover
Cross-Over Rate is the discount rate where
NPV profiles of two (or more) projects intersect,
meaning that they are equal.
When this occurs ranking projects will have
different results depending on what discount
rate is used. A rate below the Cross-Over Rate
will produce one ranking, a rate above it will
produce another ranking.
2003 McGraw-Hill Ryerson Limited

PPT 12-30

Summary and Conclusions

A capital

budgeting decision involves planning cash

flows for a long-term investment
Several methods are used to analyze investment
proposals: payback, net present value, internal rate of
return, and profitability index
The net present value method, in particular, considers
the amount and timing of cash flows
The analysis is based upon estimates of incremental
cash flows aftertax that will result from the investment

2003 McGraw-Hill Ryerson Limited