Chapter 13 - Capital Budgeting Techniques

CHAPTER 6 What is capital budgeting?
The Basics of Capital Budgeting

 Also known as investment appraisal,
is the process in which a business
Should we determines whether projects such as
build this
plant? building a new plant or investing in a
long-term venture are worth
pursuing.
13.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 13.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Importance of Capital Project Evaluation:

Budgeting Alternative Methods
 Avoid forecast error • Payback Period (PBP)

 Helps firm to plan its financing • Accounting Rate of Return (ARR)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
Payback Period (PBP) Payback Period (PBP)
Payback period = investment – salvage value
0 1 2 3 4 5
net annual cash flow
–40 K 10 K 12 K 15 K 10 K 7K
Note: formula used when cash flows are constant for the given period
 The number of years required to recover

a project’s cost, or “How long does it take When two or more projects are considered, the
rule for making a selection is as follows:
to get our money back?”
 Calculated by adding project’s cash Decision Rule: Choose the project with the
inflows to its cost until the cumulative shorter payback period. The shorter the
cash flow for the project turns positive. payback period, the less risky the project, and
the greater the liquidity.
Proposed Project Data Payback Solution (#1)

Julie Miller is evaluating a new project 0 1 2 3 (a) 4 5
for her firm, Basket Wonders (BW).
–40 K (-b) 10 K 12 K 15 K 10 K (d) 7 K
She has determined that the after-tax
10 K 22 K 37 K(c) 47 K 54 K
cash flows for the project will be
$10,000; $12,000; $15,000; $10,000; Cumulative
Inflows PBP =a+(b–c)/d
and $7,000, respectively, for each of
= 3 + (40 – 37) / 10
the Years 1 through 5. The initial
= 3 + (3) / 10
cash outlay will be $40,000.
= 3.3 Years
Payback Solution (#2) PBP Acceptance Criterion
0 1 2 3 4 5 The management of Basket Wonders

has set a maximum PBP of 3.5
–40 K 10 K 12 K 15 K 10 K 7K
years for projects of this type.
–40 K –30 K –18 K –3 K 7K 14 K
Should this project be accepted?
PBP = 3 + ( 3K ) / 10K
= 3.3 Years Yes! The firm will receive back the
Cumulative
Cash Flows initial cash outlay in less than 3.5
Note: Take absolute value of last
negative cumulative cash flow value.
years. [3.3 Years < 3.5 Year Max.]
PBP Strengths ACCOUNTING (SIMPLE)

and Weaknesses RATE OF RETURN
Strengths: Weaknesses: measures profitability from the
• Easy to use and • Does not account conventional accounting standpoint
understand for TVM by relating the required investment
• Can be used as a • Does not consider to the future annual net income.
measure of cash flows beyond
liquidity the PBP ARR = average annual profit
• Cutoff period is investment
subjective
ACCOUNTING (SIMPLE)
RATE OF RETURN Net Present Value (NPV)
Decision Rule: Under the ARR method, choose the
project with the higher rate of return NPV is the present value of an
Advantages:
investment project’s net cash
flows minus the project’s initial
 The method is easily understood and simple
to compute, and recognizes profitability factor cash outflow.
Disadvantages:
 1. It fails to recognize the time value of money CF1 CF2 CFn
NPV = + +...+ - ICO
(1+i)1 (1+i)2 (1+i)n
 2. It uses accounting data instead of cash flow
data
Rationale for the NPV method NPV Strengths

and Weaknesses
NPV = PV of inflows – Cost
Strengths: Weaknesses:
= Net gain in wealth
• Accounts for TVM. • It requires detailed
• Considers all long-term forecasts
 accept if the project’s NPV > 0 of incremental cash
cash flows.
flow data.
NPV Solution NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
Basket Wonders has determined that the
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
appropriate discount rate (i) for this $ 7,000(PVIF13%,5) – $40,000
project is 13%.
NPV = $10,000(0.885) + $12,000(0.783) +
NPV = $10,000 +$12,000 +$15,000 + $15,000(0.693) + $10,000(0.613) +
(1.13)1 (1.13)2 (1.13)3 $ 7,000(0.543) – $40,000
$10,000 $7,000 NPV = $8,850 + $9,396 + $10,395 +
+ $6,130 + $3,801 – $40,000
(1.13)4 (1.13)5 - $40,000
= - $1,428
NPV Acceptance Criterion Profitability Index (PI)

The management of Basket Wonders PI is the ratio of the present value of
has determined that the required a project’s future net cash flows to
rate is 13% for projects of this type. the project’s initial cash outflow.
Should this project be accepted? Method #1:
CF1 CF2 CFn
PI = + +...+ ICO
No! The NPV is negative. This means (1+k)1 (1+k)2 (1+k)n
that the project is reducing shareholder << OR >>
wealth. [Reject as NPV < 0 ] Method #2:
PI = 1 + [ NPV / ICO ]
PI Strengths
and Weaknesses PI Acceptance Criterion
PI = $38,572 / $40,000
Strengths: Weaknesses:
= .9643 (Method #1, previous slide)
• Same as NPV • Same as NPV
• Allows • Provides only Should this project be accepted?
comparison of relative profitability
different scale No! The PI is less than 1.00. This
• Potential Ranking
projects means that the project is not profitable.
Problems
[Reject as PI < 1.00 ]
IRR Strengths
Internal Rate of Return (IRR) and Weaknesses
IRR is the discount rate that equates the
present value of the future net cash flows Strengths: Weaknesses:
from an investment project with the project’s
initial cash outflow. • Accounts for • It is difficult to
TVM compute, especially
In other words, at IRR, I=PV, or NPV=0
• Considers all when the cash
 The present value of future cash flows is computed using the so-
called cost of capital (or minimum required rate of return) as the cash flows inflows are not
discount rate. given
CF1 CF2 CFn • Less
+ +...+ subjectivity
ICO = (1 + IRR)1 (1 + IRR)2 (1 + IRR)n
IRR Solution IRR Solution (Try 10%)
$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$40,000 = $10,000 + $12,000 + $15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
(1+IRR)1 (1+IRR)2 $ 7,000(PVIF10%,5)
$15,000 $10,000 $7,000 $40,000 = $10,000(0.909) + $12,000(0.826) +
+ + $15,000(0.751) + $10,000(0.683) +
(1+IRR)3 (1+IRR)4 (1+IRR)5
$ 7,000(0.621)
Find the interest rate (IRR) that causes the $40,000 = $9,090 + $9,912 + $11,265 +
discounted cash flows to equal $40,000. $6,830 + $4,347
= $41,444 [Rate is too low!!]
IRR Solution (Try 15%) IRR Solution (Interpolate)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + 0.10 $41,444

X $1,444
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) + 0.05 IRR $40,000 $4,603
$ 7,000(PVIF15%,5)
0.15 $36,841
$40,000 = $10,000(0.870) + $12,000(0.756) +
$15,000(0.658) + $10,000(0.572) +
$ 7,000(0.497) X $1,444
0.05 = $4,603
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
IRR Solution (Interpolate) IRR Solution (Interpolate)
0.10 $41,444 0.10 $41,444

X $1,444 X $1,444
0.05 IRR $40,000 $4,603 0.05 IRR $40,000 $4,603
0.15 $36,841 0.15 $36,841
X $1,444 X = ($1,444)(0.05) X = 0.0157

0.05 = $4,603 $4,603
IRR = 0.10 + 0.0157 = 0.1157 or 11.57%
Project Evaluation
Evaluation Summary
We will start with the cash
Basket Wonders Independent Project flows of the project and also
calculate the cumulative
Method Project Comparison Decision cash flow values.
PBP 3.3 3.5 Accept We can use Excel functions / approaches to calculate each of
the following methods from the above cash flows.
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
CAPITAL BUDGETING TECHNIQUES
Examples
Examples
2. Payback Period. Data relating to three investment
1.Premiere Company plans to acquire equipment costing P
609,804. Depreciation on the new equipment would be
projects are given below.
P120,000 each year, for 5 years . The annual cash inflows
before income taxes from this equipment has been A B C
estimated at P220,000. The income tax rate is 25% and Investment $30,000 $20,000 $50,000
the cost of capital is 16%. Useful life 10 years 4 years 20 years
Compute: Annual cash $6,207 $7,725 $9,341
a. Accounting Rate of Return savings
b. Payback Period
c. Net Present Value Rank the projects according to their attractiveness using
d. Profitability Index the payback period. Show all your solutions to prove
e. Internal Rate of Return your answer.
CAPITAL BUDGETING TECHNIQUES CAPITAL BUDGETING TECHNIQUES

Examples Examples
4. NPV. Luzon Company has been offered a contract to provide a key
3. ARR. Consider the following investment of XYZ
replacement part for its ice making machine. The contract would expire in
manufacturing company: eight years. The projected cash flow that result from the contract are given
below:
Initial investment $6,500 Cost of new equipment - $ 300,000
Estimated life 20 years Working capital needed - $ 100,000
Cash inflows per year $1,000 Net annual cash flows - $ 85,000
Salvage value of equipment in 8 years $ 50,000
What is the accounting rate of return assuming that The company’s required rate of return is 16%. The working capital would
the investment will depreciate on straight-line be released for use elsewhere at the end of the project.
basis? Required: Determine whether the contract should be accepted using the
net present value.
Examples
Examples
6. XYZ, Inc., is considering two investment proposals, labeled Project A
5. IRR. Calculate the internal rate of return on the following and Project B, with the characteristics shown in the table.
project. The project will not change the firm’s market risk. If PROJECT A
the firm’s cost of capital is 12%, should management PERIOD COST PROFIT AFTER TAX NET CASH FLOW
0 $9,000 ----- ------
accept the project? 1 $1,000 $5,000
2 1,000 4,000
Year: Cash Flows 3 1,000 3,000
PROJECT B
0 P 751,137 PERIOD COST PROFIT AFTER TAX NET CASH FLOW
1 400,000 0 $12,000 ----- ------
2 300,000 1 $1,000 $5,000
3 200,000 2 1,000 5,000
4 100,000 3 4,000 8,000
For each project, compute it’s a) average rate of return, b) payback period and
its c) net present value, using a discount rate of 15%. Tell whether you are going
to accept or reject the project as per technique, and explain why.
7. An investment in a machinery will cost P60,000, with

a useful life of 5 years and no salvage value. Its 8. The following are cash flow data for an investment that
expected annual cash flows from operations, net of is being evaluated by ABC Company:
income taxes are as follows: (10 pts)
Year 1 = P 15,000 YEAR CASH FLOWS

Year 2 = 18,000 0 -114,200
Year 3 = 20,000 1 40,000
Year 4 = 21,000 2 40,000
Year 5 = 19,000 3 40,000
4 40,000
What is the payback period of the investment?
Cost of capital is 12%. Compute for Profitability Index.

Chapter 13 - Capital Budgeting Techniques

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Chapter 13 - Capital Budgeting Techniques

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CHAPTER 6 What is capital budgeting?

The Basics of Capital Budgeting

Importance of Capital Project Evaluation:

 Avoid forecast error • Payback Period (PBP)

 The number of years required to recover

Proposed Project Data Payback Solution (#1)

0 1 2 3 4 5 The management of Basket Wonders

PBP Strengths ACCOUNTING (SIMPLE)

Rationale for the NPV method NPV Strengths

NPV Acceptance Criterion Profitability Index (PI)

IRR Solution (Try 15%) IRR Solution (Interpolate)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + 0.10 $41,444

0.10 $41,444 0.10 $41,444

X $1,444 X = ($1,444)(0.05) X = 0.0157

CAPITAL BUDGETING TECHNIQUES CAPITAL BUDGETING TECHNIQUES

7. An investment in a machinery will cost P60,000, with

Year 1 = P 15,000 YEAR CASH FLOWS

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