BA016IU - Ms.

Ngoc Anh

LECTURE OBJECTIVES

CAPITAL BUDGETING AND Understand the capital budgeting process in evaluating

investment proposal, including:
INVESTMENT CRITERIA
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Net present value
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Payback period
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Discounted payback period (optional – won’t test)

 Internal Rate of Return
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Profitability Index

Identify the pros and cons of these different methods

CAPITAL ASSETS AND CAPITAL STEPS TO CAPITAL BUDGETING

BUDGETING
Capital assets, what are they?
Capital budgeting:  Estimate Cash Flows (inflows and outflows)
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Analysis of potential additions to fixed assets
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 Assess the riskiness of the cash flows
Long-term decisions; involves large expenditures
 Determine the appropriate cost of capital
Very important to firm’s future
 Find NPV/IRR
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 Accept/reject decisions

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BA016IU - Ms. Ngoc Anh

INDEPENDENT vs MUTUALLY EXCLUSIVE NORMAL (CONVENTIONAL) vs NON-NORMAL

vs CONTINGENT PROJECTS (UNCONVENTIONAL) CASH FLOWS
Independent projects: Acceptance/rejection of one  Conventional Cash Flow Project:
project would not influence the decision regarding other One change of signs
projects  Most common: Cost (negative CF) followed by a
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series of positive cash inflows
Mutually exclusive projects: Only one of a number of
projects can be accepted. The acceptance of one
 Unconventional Cash Flow Project:
particular project means the rejection of other projects
 Two or more changes of signs
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Contingent projects: Acceptance of one projects depends  Most common: Cost (negative CF), then string of
on the acceptance of other projects positive CFs, then cost to close project
Eg: nuclear power plant/strip mine
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CONVENTIONAL OR
UNCONVENTIONAL CASH FLOWS?

0 1 2 3 4 5 C UC NET PRESENT VALUE METHOD

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- + + + + +
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- + + + + - Financial Management
- - - + + +
+ + + - - -
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- + + - + -

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BA016IU - Ms. Ngoc Anh

VALUE OF ASSET TODAY CAPITAL BUDGETING

…. is to a company what buying stock or bond

is to individuals:
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= Sum of PVs  An investment decision where each want a
of future CFs return > cost
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NET PRESENT VALUE (NPV) NET PRESENT VALUE OF A PROJECT

Net present value is the difference between an

investment’s market value (in today’s dollars) and its Project’s Cash Flows
(CFt)
cost (also in today’s dollars). NPV measures the amount
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by which the value of the firm will increase if the
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project is accepted.
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NPV = + + ··· + − Initial cost
(1 + r )1 (1 + r)2 (1 + r)N
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NCFt = after-tax cash flow in year t Project’s risk-adjusted

cost of capital
Rp = project risk = risk-adjusted discount rate for that (r)
investment
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BA016IU - Ms. Ngoc Anh

NET PRESENT VALUE (NPV) NET PRESENT VALUE (NPV)

A project requires initial investment of $1,100 and is planned to last NPV Rule:
for 2 years. Revenues and expenses for the first year is $1,000 and
$500, respectively; for the second year $2,000 and $1,000. Assume
that all revenues and expenses are cash-basis & required return = Accept all projects with NPV > 0
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10%. Should the company accept the project?
0 1 2
Reject all projects with NPV < 0

Initial outlay Revenues $2000

For mutually exclusive projects, choose the
Revenues $1000
($1100) Expenses 500 Expenses 1000 project with the highest NPV
Cash flow 500 Cash flow $1000
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– $1100.00
1
$500 x
1.10
+454.55 1
$1000 x
1.102
+826.45

13 +$181.00 NPV 14

MUTUALLY EXCLUSIVE PROJECTS MUTUALLY EXCLUSIVE PROJECTS

(cont)
Which project is accepted?
 Ex: The government is planning to extend the shipping facilities at
Haiphong port.
 Option 1: Building a jetty
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 Option 2: Building a port (deep enough to accommodate a larger
variety of vessels)
 The environmental considerations require that only one of the
options be undertaken.

Year 0 1 2 3
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Jetty (1 million) 0.5 mi 0.7 mi 0.8 mi

Port (3 million) 1.3 mi 1.3 mi 1.3 mi

Assuming a required rate of return of 8% for both projects, which one

15 of these mutually exclusive projects would you recommend? 16

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BA016IU - Ms. Ngoc Anh

PROBLEMS WITH NPV PROBLEMS WITH NPV

COMPARING PROJECTS WITH DIFFERENT LIVES
Company faces capital rationing ( have limited fund When comparing two mutually-exclusive projects
and cannot invest in all positive NPV projects) with different lives, it is necessary to make
comparisons over the same time period.
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How to choose mutually exclusive projects with
different life time?  So, we compare the ANNUAL EQUIVALENT (AE) , or
the annual annuity with the same NPV
Superior heating Medium heating
system system The equivalent annual annuity (AE) approach calculates the
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vs constant annual cash flow generated by a project over its
15 years duration 7 years duration lifespan if it was an annuity. The present value of the constant
$20,000 $9,000 annual cash flows is exactly equal to the project's net present
value (NPV).
17 18

PROBLEMS WITH NPV PROBLEMS WITH NPV

COMPARING PROJECTS WITH DIFFERENT LIVES COMPARING PROJECTS WITH DIFFERENT LIVES
Machine A costs $3,000 and then $1,000 per annum Step 1. Calculate the NPV for each project
for the next four years

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Machine B costs $6,000 and then $1,200 for the next
eight years.
The required rate of return for both projects is 10
per cent. If either of the machines wears out, the Step 2. Convert the NPVs for each project into an Annual
company would have to replace with a new one. Equivalent annuity
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Which is the better project the company should choose? Note:

Assume that the two projects bring the same benefits (profits)
19 20
to the company.

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BA016IU - Ms. Ngoc Anh

PROBLEMS WITH NPV A DECISION TREE FOR EVALUATION OF

COMPARING PROJECTS WITH DIFFERENT LIVES COMPETING PROJECTS – ON A CONTINUING CYCLE
CLASS EXERCISE
Select all projects
Yes with NPV >0
Are projects
P&G must decide which of the two machines it should use to independent ?
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produce its new line of products – new generation of Mutually exclusive
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shampoo called Maxxhairr No
Machine A costs $100,000, has a useful life of 4 years, and Do projects have
generates after-tax cash flows of $40,000 per year equal lives ?
No Yes
Select project with
Machine B costs $65,000, has a useful life of 3 years, and highest NPV annual Select projects with
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generates after-tax cash flows of $35,000 per year equivalent the highest +NPV

Assume that the discount rate is 10% per year. Which

machine P&G should buy ?
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PAYBACK PERIOD
The payback period is the amount of time required for
the firm to recover its initial investment
PAYBACK METHOD
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– If the project’s payback period is less than the
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maximum acceptable payback period, accept the

project
– If the project’s payback period is greater than the
maximum acceptable payback period, reject the
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project

Management determines maximum acceptable

payback period (cut-off point) 24

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BA016IU - Ms. Ngoc Anh

PAYBACK ILLUSTRATION PAYBACK ILLUSTRATION

Initial investment = –$1,000

Example:
Year Cash flow
1 $200 Project CF0 CF1 CF2 CF3 Payback NPV (at 10%)
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2 400
3 600 A -2,000 +1,000 +1,000 +10,000 2 $7,249
B -2,000 +1,000 +1,000 0 2 -264
Accumulated C -2,000 0 +2,000 0 2 -347
Year Cash flow
1 $200
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2 600 What do you think about these 3 projects ?
3 1200

Payback period = 22/3 years

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PAYBACK – PROS AND CONS

Advantages of payback method:

 Extremely simple
 Helps prevent cash flow problems DISCOUNTED PAYBACK METHOD
Since cash is recovered as quickly as possible
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 Useful when technology changes rapidly

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Cost of machinery is recovered before new model comes out

Disadvantages of payback method:

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 Ignores the time value of money

 Ignores cash flows after the payback period
 Arbitrary acceptance criteria
 A project is accepted based on the payback criteria may
not have a positive NPV 27

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BA016IU - Ms. Ngoc Anh

DISCOUNTED PAYBACK (optional – ORDINARY AND DISCOUNTED PAYBACK

won’t test) (optional – won’t test)
 How long does it take the project to “pay back” its initial
Initial investment = –$300
investment taking the time value of money into account?
R = 12.5%
Cash Flow Accumulated Cash Flows
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Accumulated Year Undiscounted Discounted Undiscounted Discounted
Initial investment = —$1,000 Year discounted cash flows
R = 10% 1 $ 100 $ 89 $ 100 $89
PV of 1 $182
2 100 79 200 168
Year Cash flow Cash flows 2 513
3 100 70 300 238
1 $200 $182 3 1,039
4 1,244 4 100 62 400 300
2 400 331 5 100 55 500 355
Discounted payback period is just under three
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3 700 526
years
4 300 205
•Ordinary payback?
•Discounted payback?

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DISCOUNTED PAYBACK PROS AND

CONS
Advantages Disadvantages

- Includes time value of -May reject positive NPV

INTERNAL RATE OF RETURN
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money investments

- Easy to understand
- Does not accept
negative estimated NPV
investments
-Biased towards liquidity
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-Arbitrary determination of
acceptable payback period
-Ignores cash flows beyond the cut-
off date
-Biased against long-term and new

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- Used by large companies products

when they are making
relatively minor decisions

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BA016IU - Ms. Ngoc Anh

INTERNAL RATE OF RETURN INTERNAL RATE OF RETURN -

ILLUSTRATION
Internal rate of return (IRR) is the discount rate that
results in a zero NPV for the project Initial investment = –$200

Year Cash flow

CF1 CF2 CF3 CFT
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NPV = 0 = CF0 + + + + .... + 1 $ 50
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2 3
(1 + IRR) (1 + IRR) (1 + IRR) (1 + IRR)T 2 100
3 150
• IRR found by computer/calculator or manually by trial
and error n Find the IRR such that NPV = 0

50 100 150
The IRR decision rule is: 0 = –200 + + +
(1+IRR) 1 (1+IRR) 2 (1+IRR) 3
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– If IRR is greater than the cost of capital, accept the 50 100 150
200 = + +
project (1+IRR) 1 (1+IRR) 2 (1+IRR) 3

– If IRR is less than the cost of capital, reject the project 33

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INTERNAL RATE OF RETURN - THE NPV PAYOFF PROFILE FOR THIS

ILLUSTRATION EXAMPLE
Trial and Error
Discount rates NPV
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0% $100
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5% 68 FinancialManagement
10% 41

15% 18
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20% –2

IRR is just under 20%—about 19.44%

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BA016IU - Ms. Ngoc Anh

PROBLEMS WITH IRR

PROBLEMS WITH IRR
BORROWING OR LENDING?
Three key problems encountered in using IRR:
NPV at 10%
Project 0 1 IRR discount rate
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A -1,000 1,500 50% 363.64
Borrowing or lending ?
B 1,000 -1,500 50% -363.64
Multiple IRRs
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Mutually exclusive projects Both projects have an IRR = 50%, but only project A is
acceptable !
IRR and NPV rankings do not always agree
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PROBLEMS WITH IRR PROBLEMS WITH IRR

MULTIPLE RATES OF RETURNS MULTIPLE RATES OF RETURNS
 Project will have multiple rates of returns in case of What’s the IRR? Find the rate at which
unconventional cash flows (there is more than one negative the computed NPV = 0:
cash flows)
Year Cash flows at 25.00%: NPV = 0
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at 33.33%: NPV = 0
0 –$252
at 42.86%: NPV = 0
1 1431
at 66.67%: NPV = 0
2 –3035
Two questions:
3 2850
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u 1. What’s going on here?

4 –1000 u 2. How many IRRs can there be?

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BA016IU - Ms. Ngoc Anh

PROBLEMS WITH IRR PROBLEMS WITH IRR

MULTIPLE RATES OF RETURNS MUTUALLY EXCLUSIVE PROJECTS
 When the cash flows
 The timing problem
change sign more than
once, there is more NPV > 0
than one IRR.
0 1 2 IRR NPV
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 When you solve for IRR
you are solving for the
root of an equation and
-5,000 8,000 0 60% 2,273
when you cross the x
axis more than once, -5,000 0 9,800 40% 3,099
there will be more than
one return that solves
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NPV <0
the equation.

 If you have more than Despite having a higher IRR, Project A is less valuable
one IRR, you cannot use
any of them to make
than project B !
your decision. 42

PROBLEMS WITH IRR NPV vs. IRR RULES

MUTUALLY EXCLUSIVE PROJECTS
 The scale problem  Usually, NPV and IRR are consistent with each other. If
IRR says accept the project, then NPV will also say
Year 0 1 IRR NPV accept the project.
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Small
project
-1 +1.5 50% 0.43  However, IRR can be in conflict with NPV if
Large Investing or Financing decisions
project
-100 +110 10% 4.76 Projects are mutually exclusive
 Projects differ in scale of investment
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 Cash flows pattern of projects are different

IRR does not take into account project scale (size)
In the above example, we would recommend the “small project”
based on IRR, but recommend the “large project” based on NPV
43 – assume 5% required rate of return
Projects have unconventional cash flows
 If IRR and NPV conflict, use NPV approach
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BA016IU - Ms. Ngoc Anh

PROFITABILITY INDEX

 Why in the first place exists this variation of Net

Present Value ?
PROFITABILITY INDEX METHOD  Capital rationing: Limit set on the amount of funds
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available for investment. Sometimes the amount of
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capital that an organisation can invest in long-term
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projects is limited.

 Solution: Management will obviously wish to select

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those projects that will give the greatest return per
dollar invested (highest profitability index).

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PROFITABILITY INDEX PROFITABILITY INDEX

Profitability Index expresses a project’s benefits

relative to its initial cost
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CF1 CF2 CFT
+ 2
+ ... +
PV of cash flows (1 + r ) (1 + r ) (1 + r ) T
PI = =
Initial investment CF0
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Acceptance criteria: Accept a project with a PI > 1.0

47 48

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BA016IU - Ms. Ngoc Anh

Management PROFITABILITY INDEX

This is a good project

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because the present

value of the inflows
exceeds the outlay.

Each dollar invested

generates $1.1645 in
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value

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