Introduction to Capital Budgeting

1. The capital budgeting process:

a) Deciding what long term real assets or projects the firm should invest in to maximize shareholder wealth.

b) The major determinant of the success of the business.

c) Done properly, the capital budgeting process incorporates

i) the cash flow estimation

ii) the time value of money

iii) the concept of beta risk

2. An example of the Capital Budgeting Process

“Biogentechtron Corporation,” a producer of bioengineered drugs, involved in cancer and AIDS research.
Step 1: Broad statement of goals and strategy (5 year plan)
Increase profitability by increasing production capability of Interferon Z (patent pending), the company’s promising new cancer
prevention drug.

Step 2: Proposed projects to increase production capability

Project 1: Proposed by head of research division Increase current lab capacity by 30% over next three years with new hires and
purchase of new equipment and begin construction of new lab facilities. Using available financing, new lab facilities which will
double existing capacity, will be on line within three years.

Project 2: Proposed by marketing research department Increase current lab capacity by 15% this year, increase advertising in trade
journals and trade shows by 15% per year over next three years and begin construction of new lab facilities, new facilities to be on
line within three years.

Project 3: Proposed by bioengineering department Devote maximum amount of resources available to construct new lab facilities
to double existing capacity as soon as possible. New facilities on line within 1 1/2 to 2 years.

Step 3: Detailed cost/benefit analysis of Projects 1 & 3

Information required for Projects 1 & 3:
1. Estimated marginal cash flows associated with each project over the next five years (projected economic life of the project).

2. Calculation of the appropriate discount rate for each project.

3. Calculation of the Present Value (PV) of the cash flows for each project.
Calculation of the Net Present Value (NPV) of the cash flows for each project.
NPV = PV of the cash flows - Initial cost of the project.
Decision Rule: If the project’s NPV 0, the project is acceptable on a cost/benefit basis: accepting the project will increase
shareholder wealth. If the project’s NPV 0, the project is not acceptable and would only be taken if required. If required, choose
the least negative NPV project.
NPV Decision Rule (continued): For multiple projects which are NOT mutually exclusive the firm should undertake _______
projects which have a positive NPV.

For multiple projects which ARE mutually exclusive the firm should choose the project with the _______________________
NPV.

NPV Project 1: $4,500,000 ; NPV Project 3: $3,750,000 What should the firm do?

Step 4: Evaluate the overall financial position of the firm given the set of proposed projects that pass all the prior screens.
Pro Forma statements
Check for external financing needed and consult bankers/investment bankers for financing of all projects jointly; firm up
estimated financing costs and cash requirements at each stage of the projects.
Benchmark

2. Useful classifications of projects:

a) Classification method 1:
 - Mutually exclusive

- Independent

- Interdependent

b) Classification method 2:

- Replacement

- Increasing scale

- New projects or products

- Required projects

4. Other Evaluation Criteria:

a) Payback: Time in years until recover cost of your investment using cash flows from project.
-> Assume CFs received uniformly throughout the year.
-> Decision Rule: Pick project with shortest payback or projects with payback less than some max # years.

┬───────┬───────┬───────┬ Payback
NPV(r=10%)
0 1 2 3
Proj A -$6000 $3000 $4000 $1,000
Proj B -$12,000 $9000 $4000

Payback A: Outflows: $6000 Payback

Year 1 inflow $3000 Remainder needed
Year 2 inflow $4000

Problems: Ignores _______ after payback.

Ignores _______.
Favors projects with _______ payoffs.
Arbitrary cutoff for decision rule.
When comparing projects, project with shortest payback is not
necessarily the one with the highest NPV.

b) Discounted Payback: Time in years until recover cost of investment using PV of future cash flows to calculate payback period.
r = 10% Discounted
┬─────────┬─────────┬─────────┬ NPV(r=10%)
0 1 2 3
Proj A -$6000 $3000 $4000 $1,000,000
PV CF $2727.27 $3305.78 $751,314.8

Proj B -$12,000 $9000 $4000

PV CFs $8181.81 $3305.78

Discounted
Payback A: Outflows: $6000 Payback
PV Year 1 inflow $2727.27 Remainder needed _____________
PV Year 2 inflow $3305.78 ___________ needed/$3305.78 received
Payback (yrs)
Problems: Ignores CFs after payback.
Favors projects with _________ payoffs.
Arbitrary cutoff for decision rule.
No easier to calculate than NPV
When comparing projects, project with shortest discounted payback is not necessarily the one with the highest NPV.

c) Average Accounting Return: (AAR) = Avg. Project NI/Avg. Book Value

Decision Rule: Compare to industry or firm average, accept if greater than industry or firm average.
Project which cost $9000 (capitalized cost), SL depreciation over 3 yr life.
┬───────┬───────┬───────┬
0 1 2 3
Proj NI $3000 $2000 $1000
Proj BV $9000 $6000 $3000 $0
Avg. NI ($3000 + $2000 + $1000)/3 = $
Avg. BV ($9000 + $6000 + $3000 + $0)/4 = $
AAR = ?

d) Internal Rate of Return (IRR): The IRR is the discount rate that makes the NPV of the project = $0.
Decision Rule: USUALLY, accept project if IRR is greater than required rate of return (r).
┬───────┬───────┬───────┬
0 1 2 3
CF Proj. -$10,000 $5000 $6000 $3000
0 = -10,000 + 5000/(1+IRR) + 6000/(1+IRR)2 + 3000/(1+IRR)3
IRR = 20.47% , Accept project if r required < 20.47%.

Conceptual Problems With IRR rule:

The IRR rule is very commonly used but it can cause faulty decisions for three reasons:
1. Weird cash flow patterns
Conventional cash flows are
Cash outflow followed by a series of inflows

Non Conventional cash flows are

any other pattern:

2. Different scale of initial outlay:

Because IRR is a rate of return, a larger project with a lower rate of return could still have a greater $ value (_____) to the firm.

3. Faulty Reinvestment Assumption:

For a firm to actually earn the IRR, the firm must be able to __________ the project’s cash flows as they are received for the
remaining time of the project and earn the _________ on those cash flows.

Illustrations of Problems with IRR rule:

a) Order of cash inflows and outflows affects the decision rule.
┬───────┬
0 1 IRR NPV@r=10% NPV r=30%
CF Proj. A -$1000 $1200 20% + $90.91 -$76.92
CF Proj. B +$1000 -$1200 20% - $90.91 +$76.92

b) Multiple IRRs may exist, or NO IRRs may exist.

┬───────┬───────┬
0 1 2
CF Proj. A -$4000 +$25,000 -$25,000
0 = -4,000 + 25,000/(1+IRR) + -25,000/(1+IRR)2
IRR ?
 ┬───────┬───────┬
0 1 2
CF Proj. A -$4000 +$5,000 -$5,000
0 = -4,000 + 5,000/(1+IRR) + -5,000/(1+IRR)2
IRR ?

c) The project with the biggest IRR may not be the project with the biggest NPV (especially if the initial cost outlays are
different).
┬───────┬
0 1 IRR NPV@r=10%
CF Proj. A -$100 $200
CF Proj. B -$10,000 $15,000

5. Comparing mutually exclusive projects with NPV Profiles:

A) Purpose & Method: Compare two mutually exclusive projects and examine how the NPV changes with r.
• In practice, the appropriate risk adjusted discount rate (r) can be difficult to obtain;

• The NPV profile allows the analyst to compare NPVs at a _________ of discount rates (r).

Method

i) Find NPV of all projects at r = ____

ii) Find ____ of each project.

iii) Find the r where the two projects have the same _______ (breakeven r).

iv) Graph the results of NPV vs r.

B) Examples: Consider two projects; A & B with the following cash flows:
C0 C1 C2 C3
A -1000 400 500 750
B -1000 600 400 600
A-B 0 -200 100 150

a) First, find NPV each at r=0%

n
NPV @r=0% = Σ Ct
t=0
NPVA = -1000+400+500+750 = +
NPVB = -1000+600+400+600 = +
at r=0% prefer which?

b) Second, Find IRR of each project.

A
0=-1000+[400/(1+IRR)]+[500/(1+IRR)2]+[750/(1+IRR)3]
IRR=

B
0=-1000+[600/(1+IRR)]+[400/(1+IRR)2]+[600/(1+IRR)3]
IRR=

c) Find crossover rate of interest (IRR) where both projects have identical NPVs.
CF A- CF B
0 = 0+[-200/(1+r)]+[100/(1+r)2]+[150/(1+r)3]
r (found as IRR) =
8. Problems with the NPV rule
A) Assumes that how a project is financed does not affect the cash flows of the project, and that
accepting a project does not change the optimal capital structure (% Debt, % Equity) of the firm.
B) One cannot compare a 3 year project with a 10 year project via the standard NPV rule without
additional information or assumptions.
C) The NPV rule assumes that the firm knows what r should be. This can be very problematic for new projects or for
international investments.
D) Suffers from a false precision problem because the analysis is reduced to one number without reference to the assumptions
used.
used.