Capital Budgeting

Prof. Arnab Bhattacharya

MBA (Term III) Corporate Finance
 Capital Budgeting

 Process of accepting or rejecting long-term

investment projects
 Objective is to maximize shareholder wealth

 Types of capital budgeting projects

 Independent projects ~ acceptance or rejection of a
project does not affect cash flows of other projects
 Mutually exclusive projects ~ If a project is accepted, it
implies rejection of all other projects
 Capital Budgeting Techniques

 Estimation of project cash flows

 Initial fixed investments
 Cash inflows and outflows during economic life of
project
 Salvage value from sale of assets at the end of
economic life of project
 Estimate discount rate for project
 Opportunity cost of capital
 Return on a financial asset of comparable risk
 Capital Budgeting Techniques

 Compute present value of project cash flows

 Accept or reject project, based on appropriate
capital budgeting decision rule
 Undertake project risk analysis
 Project Cash Flow Estimation

 Consider cash flows, not accounting income

 Consider post tax cash flows
 Only post-tax incremental cash flows are considered
 Cash flows are considered when incurred, irrespective
of timing of accounting accruals
 Always consider only incremental cash flows
 (Cash flows with project) – (Cash flows without project)

 Ignore sunk cost

 Sunk costs are not relevant costs (not incremental costs)
 Costs incurred irrespective of acceptance or rejection of project
 Project Cash Flow Estimation

 Consider opportunity costs

 Needs to be included as part of project cash flows

 Consider only incremental allocated costs

 Relevant, only if incremental in nature

 Net working capital

 Initial investment and increases in NWC are part of
project cash outflows
 Closing balance of NWC at the end of project life may
be part of project cash inflows, if there is salvage value
 Project Cash Flow Estimation

 Side effects (externalities)

 Side effects are part of incremental project cash flows
 Can be positive (synergy) or negative (cannibalization)

 Consider salvage value

 Residual value of asset at the end of project life
 Consider capital gain taxes payable on difference
between asset selling price and its book value
 Capital Budgeting Techniques

 Payback period (PB)

 Discounted payback period (DPB)
 Accounting rate of return (ARR)
 Net present value (NPV)
 Internal rate of return (IRR)
 Modified internal rate of return (MIRR)
 Profitability index (PI)
 Payback Period

 Time required to recover initial investment

 Decision rule ~ Accept project, if :
 Payback period < Cut-off payback period

 Advantage
 Easy to understand and compute
 Favours selection of projects with faster recovery of
initial investment
 Payback Period

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 Disadvantage
 Ignores time value of money
 Ignores cash flows beyond payback period
 Arbitrary cut-off period for project selection
 Discounted Payback Period

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 Payback period computed on the basis of

discounted net cash flows
 Decision rule ~ Accept project, if :
 Discounted PB < Cut-off discounted PB

 Better than payback period, as time value of

money is taken into consideration
 Other drawbacks of payback period also exists for
discounted payback period
 Accounting Rate of Return

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 ARR = Avg. Net Accounting Income / Avg. Book

Value of Investment
 Decision rule ~ Accept project, if :
 ARR > Target rate of return

 Disadvantage
 Uses book value of investment instead of its market
value
 Uses accounting income instead of net cash flows
 Arbitrary cut-off rate of return
 Net Present Value

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 Net Present Value (NPV) of a project

 Equals present value of all future net cash flows
 NPV = ∑ PV (NCFt) = ∑{NCFt / (1 + r)t}
 Focuses only on incremental cash flows of project
 Cash flows to be discounted at appropriate discount rate

 Decision rule ~ Accept project, if NPV is positive

 Advantage
 Best method for capital budgeting decision making
 Value additive ~ NPV(A + B) = NPV(A) + NPV(B)
 Reinvestment assumed at project discount rate
 Internal Rate of Return

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 IRR is the discount rate at which project NPV = 0

 Decision rule ~ Accept project, if :
 IRR > Required rate of return

 Advantages
 Summary indicator of profitability of project
 IRR value internal / intrinsic to project cash flows only
 Internal Rate of Return

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 Disadvantages
 Ignores scale of project
 Problematic for selection of mutually exclusive projects

 Problem of multiple IRRs

 In case of multiple sign changes in project net cash flows

 Decision rule changes based on nature of project

 Investment type: Accept if IRR > Project cost of capital
 Financing type: Accept if IRR < Project cost of capital

 Reinvestment assumption
 Project cash flows assumed to be reinvested at IRR
 Modified Internal Rate of Return

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 Modified IRR (MIRR) method

 Helps to overcome problems of multiple IRRs
 Uses project cost of capital to discount few project cash
flows so that IRR is uniquely determined
 Only one sign change in the project cash flows
 Modified Internal Rate of Return

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 Modified IRR (MIRR) method

 Initial investment = I(0), Project life = T
 Future value of project interim net cash flows = FV(T)
 FV(T) = CF1*(1 + k)(T – 1) + CF2*(1 + k)(T – 2) + … + CFT
 Assumes reinvestment rate = cost of capital of project = k

 FV(T) = I(0)*(1 + MIRR)T

 Modified IRR = [FV(T) / I(0)]^(1/T) – 1
 Modified Internal Rate of Return

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 Modified IRR (MIRR) method

 Compute MIRR for the project below
 Assume cost of capital = 10%

Time Period Project Net Cash Flow

0 (150)
1 25
2 100
3 (50)
4 250
5 185
 Modified Internal Rate of Return

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 Modified IRR (MIRR) method

 Calculate MIRR for the project below
 MIRR = (272.2 / 150)(1/5) – 1 = 12.66%

Time Period Project Net Cash Flow FV of Interim NCF @ 10%

0 (150)
1 25 36.6
2 100 133.1
3 (50) (60.5)
4 80 88.0
5 75 75.0
Total 272.2
 NPV vs IRR : Cross Over Rate

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 Assume L and S are mutually exclusive projects

 If discount rate > cross over rate, both NPV rule and
IRR rule chooses project S over project L
 NPV vs IRR : Cross Over Rate

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 Assume L and S are mutually exclusive projects

 If discount rate < cross over rate, NPV rule chooses
project L over project S (in conflict with IRR rule)
 Incremental IRR Analysis

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 Why does IRR Analysis contradict NPV Analysis?

 Investment type project
 IRR captures rate of return from investment
 We expect IRR (profit) to be higher than cost of capital

 Financing type project

 IRR captures cost of financing investment
 We expect IRR (cost) to be lower than expected return
 Incremental IRR Analysis

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 Compute incremental project cash flows (S – L)

 Calculate NPV (S – L); accept if NPV is positive
 Calculate IRR (S – L); accept if IRR > cost of capital
 Assumes investment type project

 Incremental IRR analysis always consistent with

NPV analysis
 Profitability Index

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 Profitability Index
 Ratio of present value of future expected cash flows
after initial investment divided by initial investment
 PI = ∑ PV (CFt) / Initial Investment

 Decision rule
 Independent projects ~ Accept, if PI > 1
 Mutually exclusive projects
 PI suffers from scale problem (similar to IRR analysis)
 Accept, if PI of incremental cash flows > 1
 Capital Rationing

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 Capital rationing
 Limited capital for funding all NPV positive projects

 Selection of best feasible projects

 Constrained optimization techniques
 Linear programming

 Rank projects as per profitability index

 May not always give the best feasible option
 Mutually Exclusive Projects

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 Mutually exclusive projects may differ in

 Size of investment ~ PI method may be used
 Cash flow pattern ~ NPV method may be used
 Life of project ~ Equivalent annuity method or
replacement chain method may be used
 Equivalent Annual Costs (EAC) Method

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 Mutually exclusive projects with unequal lives

 Equivalent annual / annuity cost method
 Computes costs on a per-year basis
 Annuities of mutually exclusive projects are compared

 Decision rule
 Project with lower equivalent annual cost is accepted
 Project with higher equivalent annual revenue accepted
 Equivalent Annual Costs (EAC) Method

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 Mutually exclusive projects with unequal lives

 Cash outflows of machines A and B with unequal lives
 Appropriate discount rate = 10%

Cash Outflows of Machines Year 0 Year 1 Year 2 Year 3 Year 4

Machine A 500 120 120 120
Machine B 600 100 100 100 100

 Which machine should you choose?

 Equivalent Annual Costs (EAC) Method

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 Mutually exclusive projects with unequal lives

 Cash outflows of machines A and B with unequal lives
 Appropriate discount rate = 10%

Cash Outflows of Machines Year 0 Year 1 Year 2 Year 3 Year 4

Machine A 500 120 120 120
Equivalent Annual Cost 0 X X X

 NPV (500, 120, 120, 120) = NPV (0, X, X, X)

 {X/10%}*[1 – 1/(1 + 10%)3] = 798.42
 2.4869*X = 798.42
 X = 321.06
 Equivalent Annual Costs (EAC) Method

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 Mutually exclusive projects with unequal lives

 Cash outflows of machines A and B with unequal lives
 Appropriate discount rate = 10%

Cash Outflows of Machines Year 0 Year 1 Year 2 Year 3 Year 4

Machine B 600 100 100 100 100
Equivalent Annual Cost 0 Y Y Y Y

 NPV (600, 100, 100, 100,100) = NPV (0, Y, Y, Y,Y)

 {Y/10%}*[1 – 1/(1 + 10%)4] = 798.42
 3.1699*Y = 916.99
 Y = 289.28
 Equivalent Annual Costs (EAC) Method

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 Mutually exclusive projects with unequal lives

 Cash outflows of machines A and B with unequal lives
 Appropriate discount rate = 10%

Cash Outflows of Machines Year 0 Year 1 Year 2 Year 3 Year 4

Machine A 500 120 120 120
Machine B 600 100 100 100 100

 Choose machine B (lower equivalent annual cost)

Cash Outflows of Machines Equivalent Annual Cost
Machine A 321.06
Machine B 289.28
 Inflation and Capital Budgeting

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 NPV is same if consistency is maintained

 Nominal discount rate used for discounting nominal
cash flows
 Real discount rate used for discounting real cash flows
Thank you 