Fabricio Chala, CFA, FRM

Capital Budgeting S4
Capital Budgeting
❖  Allocation of funds to long-lived capital projects

❖  Long-term investment in tangible assets (to achieve growth) and

Working Capital (WC) investments (to sustain level of operations)

❖  Examples: To replace old machinery or not?, evaluate a new

business line, expand a plant or not?, etc.
Basic Principles of Capital Budgeting
Cash flows Timing

Incremental After tax

Do not take into account financing cost

Investment Decision Criteria
❖  There are many different criteria valid for making investment
decisions

❖  Understanding their pros and cons is very important to make a

well informed decision
Book Rate of Return

Book rate of return = Book income / Book assets

ADVANTAGES:

❖  Easy to calculate

❖  Shareholders will pay attention to book measures of profitability as

they don’t have direct access to cash flows
Book Rate of Return
DISADVANTAGES:
❖  Not based on cash flows

❖  Income is a distorted measure:

❖  Some outflows are considered expenses, while others are put on

the balance sheet and then depreciated

❖  Income includes some non-cash concepts (depreciation,

amortization, etc.)
Payback Period Rule
❖  It is the length of time it takes to recover the initial investment from
future cash flows

Payback rule: Accept a project if its payback period is

less than a specified cutoff period

❖  Example: Calculate the payback period of Project X if cost of the project is

USD 2,000:
0 1 2 3 4

500 1,000 1,500 2,100

Payback Period
Example: Would you invest on Project A or Project B, based on a 3
years payback rule?

Project A Project B
Year Cash Flows Cash Flows
0 –£100 –£100
1 £50 £25
2 £60 £35
3 £5 £45
4 £-30 £130
Payback Period
ADVANTAGES:
❖  Easy to calculate

❖  Easy to understand

❖  Useful when expected cash flows are stable

Payback Period
DISADVANTAGES:
❖  Ignores the time value of money

❖  Ignores the cash flows beyond the payback period

Discounted Payback Period
❖  It is the length of time it takes to recover the initial investment from
discounted future cash flows

❖  Length of time for Project to reach a NPV = 0

Example: Calculate the payback period of Project A and B. Use a 10%

opportunity cost
Project A Project B
Year Cash Flows Cash Flows
0 –£100 –£100
1 £50 £25
2 £60 £35
3 £5 £45
4 £-30 £130
Payback Period

Is the payback period method consistent with

shareholder wealth maximization? Why or
why not?
Net Present Value (NPV)
❖  Present value of all incremental cash flows less the initial
investment
IMPORTANT
N
CFt
NPV = ∑
Inflows come with a positive sign whereas
outflows (investments) come with a negative
t
t=0 (1+ r)
❖  NPV is the estimate of the value added (or destroyed) of an
investment

❖  It depends on: (i) Projected CF; (ii) CF timing (t) and; (iii)
Opportunity cost of capital (r)

❖  Opportunity Cost: Expected return of second best option with a

similar risk profile
Net Present Value (NPV)
❖  Some people thing of this formula as:
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❖  This is just a special case of the previous one, as this one assumes
that investments are only made in year 0. However, is it the case
of a mine?
Net Present Value (NPV) Rule

NPV > 0 Invest (Project adds value)

NPV = 0 Indifferent

NPV < 0 Do not invest (Project destroys value)

Net Present Value (NPV) Rule
❖  What does this imply for the return of the project vs. the
opportunity cost?

NPV > 0

NPV = 0

NPV < 0
Net Present Value (NPV)
Example: Project X has the following expected cash flows: Inflows of US$ 1K,
2K, 3K and 4K over the first four years; and outflows of US$ 0.5K, 1K, 2K
and 1.9K, respectively. If the opportunity cost of capital is 10% and the
Capital Project requires an initial investment of US$ 3.5K, would you invest
in Project X?

REMEMBER
K in finance means 1,000
Net Present Value (NPV)
Example: Project X has the following expected cash flows: Inflows of US$ 1K,
2K, 3K and 4K over the first four years; and outflows of US$ 0.5K, 1K, 2K
and 1.9K, respectively. If the opportunity cost of capital is 10% and the
Capital Project requires an initial investment of US$ 3.5K, would you invest
in Project X?

Period Inflows Outflows Investment Total

0 -3,500 -3,500
1 1,000 -500 500
2 2,000 -1,000 1,000
3 3,000 -1,500 1,500
4 4,000 -1,900 2,100

r 10%
NPV 342.29
Net Present Value (NPV)
ADVANTAGES:
❖  Easy to undestand.

❖  Considers the time value of money.

❖  Considers all Project cash flows.

Net Present Value (NPV)
DISADVANTAGES:
❖  The result is a monetary amount, not a return

❖  It doesn’t reflect cualitative factors involved in the decisión making

(e.g Environmental or social considerations)

❖  It is “static”
Internal Rate of Return (IRR)
❖  It is the implied rate of return of a Project (geometric average
return)

❖  It is also the rate of return that results in NPV = 0

IMPORTANT
N
CFt
NPV = 0 = ∑
Inflows come with a positive sign whereas
outflows (investments) come with a negative
t
t=0 (1+ r)
IMPORTANT
This is a special case when the project only
N
CFt requires an investment in year 0
NPV = 0 = ∑ t
− Investment
t=1 (1+ r)
Internal Rate of Return (IRR)
Example: Project X has the following expected cash flows: Inflows of US$ 1K,
2K, 3K and 4K over the first four years; and outflows of US$ 0.5K, 1K, 2K
and 1.9K, respectively. If the opportunity cost of capital is 10% and the
Capital Project requires an initial investment of US$ 3.5K, would you invest
in Project X?
USE THE IRR
Internal Rate of Return (IRR)
Example: Project X has the following expected cash flows: Inflows of US$ 1K,
2K, 3K and 4K over the first four years; and outflows of US$ 0.5K, 1K, 2K
and 1.9K, respectively. If the opportunity cost of capital is 10% and the
Capital Project requires an initial investment of US$ 3.5K, would you invest
in Project X?
500 1,000 1,000 2,100
0 = −3,500+ 1
+ 2
+ 3
+ 4
(1+ IRR) (1+ IRR) (1+ IRR) (1+ IRR)

r NPV r NPV
10% 342.29 13.1% 44.09
11% 242.20 13.2% 35.04
12% 145.88 13.3% 26.03
13.4% 17.05
IRR = 13.59101%
13% 53.17
14% -36.11 13.5% 8.11
15% -122.12 13.6% -0.80
16% -205.00 13.7% -9.68
13.8% -18.52
13.9% -27.33
Internal Rate of Return (IRR)
WHAT’S PLOTTED?
The NPVs of the same project (y-axis) as we change the opportunity cost (x-axis)

THE IRR IS THE OPPORTUNITY COST

THAT MAKES THE NPV=0

NPV

Opportunity Cost of Capital

500 1,000 1,000 2,100

0 = −3,500+ 1
+ 2
+ 3
+ 4
(1+ IRR) (1+ IRR) (1+ IRR) (1+ IRR)
Internal Rate of Return (IRR) Rule

IRR > r Invest (Project adds value)

IRR = r Indifferent

IRR < r Do not invest (Project destroys value)

r = Discount rate
Internal Rate of Return (IRR)
ADVANTAGES:
❖  Easy to communicate

❖  Easy to understand

❖  Considers the time value of money

❖  Considers all projects cash flows

Internal Rate of Return (IRR)
DISADVANTAGES:
❖  Assume all CFs are reinvested at the IRR
❖  Yields equal results for lending and borrowing projects:

Proyect T0 T1 IRR NPV 10%

A -1,000 +1,500

B +1,000 -1,500

❖  Multiple IRRs can be calculated for cash flows in which there are
more than one change of signs
Internal Rate of Return (IRR)
Multiple IRRs: There can be as many internal rates of return for a project as there are changes
in the sign of the cash flows. Examples?

NPV

Opportunity Cost of Capital

0 1 2 3 4

-252 1431 -3,035 2,850 -1,000

Internal Rate of Return (IRR)
DISADVANTAGES:
❖  There can be misleading results when dealing with:

1.  Mutually exclusive projects of a different scale (size)

2.  Projects with a different curve of NPVs

❖  Comparisons can get complex when the discount rate is not a

constant, but rather a curve (different for each term)
Contrasting NPV with IRR
Comparing projects with different size:

Proyect T0 T1 T2 IRR NPV 10%

A -100 +80 +80

B -80 +65 +65

Contrasting NPV with IRR
Mutually exclusive projects:

Proyect T0 T1 IRR NPV 10%

A -10,000 +20,000

B -20,000 +35,000
Contrasting NPV with IRR
Comparing projects with different size:

16,000
14,000
12,000
10,000
8,000
NPV A
6,000
NPV B
4,000
2,000
0
5% 15% 25% 35% 45% 55% 65% 75% 85% 95%
-2,000
-4,000
Contrasting NPV with IRR
Comparing projects with different useful lifes:

Proyect T0 T1 T2 IRR NPV 10%

A -100 +180 0

B -100 +100 +100

Contrasting NPV with IRR
Comparing projects with different useful life:

60.00

50.00

40.00

30.00 NPV A

20.00 NPV B

10.00

-
10%
13%
16%
19%
22%
25%
28%
31%
34%
37%
40%
1%
4%
7%

-10.00
Examples
❖  Two alternative projects presents the following cash
flows:

Proyect Investment Year 1 Year 2 Year 3 …

A -1,500 1,000 1,200 1,440 0
B -2,000 500 500 500 500

❖  What would you suggest to the company regarding

both projects, if the discount rate is 17%?
❖  Would your answer change if the discount rate
changed to 10%?
 Examples
❖  What would you suggest to the company regarding
both projects, if the discount rate is 17%?
❖  Would your answer change if the discount rate
changed to 10%? 60,000

50,000

40,000
VPN (10%) IRR VPN (17%)
30,000 VPN A
1,483 57% 1,130
VPN B
3,000 25% 941 20,000

10,000

0
1% 3% 5% 7% 9% 11% 13% 15% 17% 19% 21% 23% 25% 27% 29%
-10,000