15-10-2022

Capital Budgeting Techniques

Corporate Finance S2
Prof. Jijo Lukose P.J.; IIM Kozhikode

Investment Decision
 A capital expenditure is an outlay of funds by the firm that is
expected to produce benefits over a period greater than one year.
 Capital budgeting is the process of evaluating and selecting long-
term investments.
 Key Points
1. Capital budgeting decisions are critical in defining a company’s
business
2. Very large investments frequently consist of smaller investment
decisions that define a business strategy
3. Successful investment decisions lead to the development of
managerial expertise and capabilities that influence the firm’s
choice of future investments.

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HUL to set up new manufacturing arm, move to

help co avail lower 15% tax : 25 Feb 2020, 12:47 AM IST
 In the first phase—the company that sells
popular brands such as Dove shampoo, Lux soap,
and Kissan jams—will invest ₹500 crore to ₹800
crore

HUL-GSK merger complete, FMCG giant buys

Horlicks brand for ₹3,045 crore: 02 Apr 2020, 10:13 AM IST
 Hindustan Unilever Ltd (HUL) has completed the merger of
GlaxoSmithKline Consumer Healthcare Limited (GSKCH) with itself,
over a year after the Rs31,700 crore mega-deal was first announced. The
company has additionally paid Rs3,045 crore to acquire the Horlicks
brand for India from GSK

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Capital Investments and Cash Transfers

 Every possible method for evaluating projects impacts the
flow of cash about the company as follows.
Cash

Investment Investment
opportunity Firm Shareholder opportunities
(real asset) (financial assets)

Invest Alternative: Shareholders invest

pay dividend for themselves
to shareholders

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Agenda
 Net Present Value Method
 The Payback Period Method
 The Discounted Payback Period Method
 The Internal Rate of Return
 Problems with the IRR Approach
 The Profitability Index

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CFO Decision Tools

Survey Data on CFO Use of Investment Evaluation Techniques

NPV, 75%

IRR, 76%

Payback, 57%

Book rate of
return, 20%

Profitability
Index, 12%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of
Financial Economics 61 (2001), pp. 187-243.
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NPV Rule
 The net present value (NPV) is the difference between the
present value of cash inflows and the cash outflows. NPV
estimates the amount of wealth that the project creates.
 Minimum Acceptance Criteria: Accept if NPV > 0
 Ranking Criteria: Choose the highest NPV
 Why NPV Rule?
 Time value of money.
 It consider CFs, not accounting income
 It consider the risk associated with the project
 Value Additivity (NPV(A + B) = NPV(A) + NPV(B) )
 Wealth Maximization: The value of the firm rises by the NPV of the
project
 Calculating NPV with Spreadsheets (NPV function)
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The Payback Period Method

 The Payback period for an investment opportunity is the
number of years needed to recover the initial cash outlay
required to make the investment.
 Decision Criteria: Accept the project if the payback period is
less than a prespecified maximum number of years.
 Ignores the time value of money & cash flows after the payback period
 Biased against long-term projects
 Requires an arbitrary acceptance criteria
 A project accepted based on the payback criteria may not have a positive
NPV
 Discounted Payback Period
 Discounted payback period approach is similar except that it uses
discounted cash flows to calculate the payback period.

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Payback Vs NPV
 Examine the three projects and note the mistake we
would make if we insisted on only taking projects with a
payback period of 2 years or less.

Payback
Project C C C C NPV@ 10%
Period ∗
A −2000 500 500 5000 3 2624
B −2000 500 1800 0 2  58
C −2000 1800 500 0 2 50

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The Internal Rate of Return

 The internal rate of return (IRR) of an investment is
analogous to the yield to maturity (YTM) on a bond.
Specifically, the IRR is the discount rate that results in a zero
NPV for the project.
 Minimum Acceptance Criteria: Accept if the IRR >required return
 Ranking Criteria: Select alternative with the highest IRR
 Reinvestment assumption:
 All future cash flows are assumed to be reinvested at the IRR
 Advantages:
Easy to understand and communicate
 Calculating IRR with Spreadsheets
 You first enter your range of cash flows, beginning with the initial cash
flow.
 Use function IRR
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IRR: Example
Consider the following project:
$50 $100 $150
0 1 2 3
-$200 0  200 
$50

$100

$150
(1  IRR) (1  IRR) 2 (1  IRR) 3 IRR =19.44%
If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept.
For a typical project NPV is +ve for discount rate below IRR and –ve for above IRR
0% $100.00
$150.00
4% $73.88
8% $51.11 $100.00 IRR = 19.44%
12% $31.13
16% $13.52 $50.00
20% ($2.08) NPV
24% ($15.97) $0.00
28% ($28.38) -1% 9% 19% 29% 39%
32% ($39.51) ($50.00)
36% ($49.54)
($100.00)
40% ($58.60)
44% ($66.82) Discount rate
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Pitfall 1 - Lending or Borrowing?

 No difference between (-100,130 : Investing) and (100, -130:
Financing)
 With some cash flows (as noted below) the NPV of the project
increases as the discount rate increases.
 This is contrary to the normal relationship between NPV and
discount rates.

C0 C1 C2 C3 IRR NPV @ 10%

1,000 -3,600 4,320 -1,728 0.20 -0.68
NPV

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Pitfall 2 - Multiple Rates of Return

 Certain cash flows can generate NPV=0 at two different discount
rates. Consider a project (-100, 230, -132); IRR =10% and 20%
 Consider the following project that generates NPV=0 at both (-
50%) and 15.2%.
C0 C1 C2 C3 C4 C5 C6
-1000 800 150 150 150 150 -150
NPV
1000

500 IRR=15.2%

0 Discount
Rate
-500
Which one
IRR=-50%
should we use?
-1000
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Pitfall 2 - Multiple Rates of Return

 There are also cases in which no IRR exists : It is possible to
have no IRR and a positive NPV
C0 C1 C2
CFs 1000 -3000 2500
10.0% 308 50.0% 74
20.0% 197 100.0% 63
30.0% 132 500.0% 95
40.0% 95 1000.0% 68

 Modified IRR: Combine CFs until only one change in sign

remains
 Or combine the future values of the CFs as of the termination
date of the project.

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Problems with the IRR Approach

Pattern No of IRR Criterion NPV Criterion

IRRs
First CF is –ve 1 Accept if IRR>r
All remaining Reject if IRR<r
CFs are +ve
First CF is +ve 1 Accept if IRR<r Accept if
All remaining Reject if IRR>r NPV>0
CFs are -ve Reject if NPV<0

Some CFs are May be

+ve and Some more No valid IRR
CFs are -ve than 1

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Mutually Exclusive Investment Projects

 Independent projects : cash flows are unrelated to (or
independent of) one another; the acceptance of one does not
eliminate the others from further consideration.
 Mutually exclusive projects: compete with one another, so that
the acceptance of one eliminates from further consideration
all other projects that serve a similar function.
Evaluating Mutually Exclusive Investment Opportunities
Following are two situations where firm is faced with mutually exclusive
projects:
1. Substitutes – When a firm is analyzing two or more alternative
investments, and each performs the same function.
2. Firm Constraints – Firm faces constraints such as limited
managerial time or limited financial capital that limit its ability to
invest in every positive NPV project.

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Mutually Exclusive Projects

 Scale
 IRR sometimes ignores the magnitude of the project. Would you rather
make 100% or 50% on your investments?
 What if the 100% return is on a Rs.1 investment while the 50% return is on a
Rs.1,000 investment?

Project 𝐶 𝐶 𝐼𝑅𝑅 𝑁𝑃𝑉@10%

𝐸 −10,000 +20,000 100 +8,182
𝐹 −20,000 +35,000 75 +11,818
 Timing
Time 0 1 2 3IRR NPV @7% NPV @15%
Project A -10000 10000 1000 1000 16% 1035.65 ₹ 109.40
Project B -10000 1000 1000 12000 13% 1603.69 ₹ -484.02

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Calculating the Crossover Rate

 Compute the IRR for either project “A-B” or “B-A”

$3,000.00
$2,000.00 10.55% = IRR

$1,000.00
A-B
NPV

$0.00
0% 5% 10% 15% 20% B-A
($1,000.00)
($2,000.00)
($3,000.00)
Discount rate

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Pitfall 4-More than One Opportunity Cost of

Capital
 Term structure assumption
 We assume that discount rates are stable during the
term of the project
 This assumption implies that all funds are reinvested
at the IRR
 This is a false assumption

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Profitability Index
 The profitability index (PI) is a cost-benefit ratio equal
to the present value of an investment’s future cash flows
divided by its initial cost.

Decision Criteria:
 If PI is greater than one, the NPV will be positive, and the
investment should be accepted
 When PI is less than one, which indicates a bad investment,
NPV will be negative, and the project should be rejected.

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The Profitability Index (PI)

 Disadvantages:
 Problems with mutually exclusive investments
 Advantages:
 May be useful when available investment funds are limited
 Easy to understand and communicate
 Correct decision when evaluating independent projects

Project 𝐶 𝐶 𝐶 𝑁𝑃𝑉@10% 𝑃𝐼
𝐴 −10 +30 +5 21 3.1
𝐵 −5 +5 +20 16 4.2
𝐶 −5 +5 +15 12 3.4

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When resources are limited

 Capital Rationing - Limit set on the amount of funds
available for investment.
 Soft Rationing - Limits on available funds imposed by
management.
 Hard Rationing - Limits on available funds imposed by the
unavailability of funds in the capital market.
 When resources are limited, the profitability index (PI)
provides a tool for selecting among various project
combinations and alternatives
 The highest weighted average PI can indicate which projects to select
 Highest NPV

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Book Rate of Return (Accounting Rate of

Return)
 Average income divided by average book value over project
life.
Average book income
Book rate of return =
Average book assets
 Also called accounting rate of return.
 Managers rarely use this.
 Disadvantages:
 Ignores the time value of money
 Uses an arbitrary benchmark cutoff rate set by management.
 Based on book values, not cash flows and market values

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Summary – Discounted Cash Flow

 Net present value
 Difference between market value and cost
 Accept the project if the NPV is positive
 Preferred decision criterion
 Internal rate of return
 Discount rate that makes NPV = 0
 Take the project if the IRR is greater than the required return
 Same decision as NPV with conventional cash flows
 IRR is unreliable with non-conventional cash flows or mutually
exclusive projects
 Profitability Index
 Benefit-cost ratio
 Take investment if PI > 1
 Cannot be used to rank mutually exclusive projects
 May be used to rank projects in the presence of capital rationing

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