BASICS OF CAPITAL BUDGETING
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CAPITAL BUDGETING
▪ Capital – refers to long-term assets used in
production
▪ Budget – a plan that outlines projected
expenditures during some future period
▪ Capital Budget – a summary of planned
investments in long-term assets
▪ Capital Budgeting – whole process of analyzing
projects and deciding which ones to include in the
capital budget; Its rationale:
• Analysis of potential additions to fixed assets
• Long-term decisions involves large expenditures
• Very important to a firm’s future
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MAIN CLASSIFICATION
OF PROJECTS
• Independent Projects – if the cash flows of
one project are unaffected by the acceptance of
the other project
• Mutually Exclusive Projects – if the cash
flows of one project can be adversely impacted
by the acceptance of the other project
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CAPITAL BUDGETING
TECHNIQUES & PRACTICE
▪ An Overview of Capital Budgeting
▪ Payback Period: Regular and Discounted
▪ Net Present Value (NPV)
▪ Profitability Index (Benefit-Cost Ratio)
▪ Internal Rate of Return (IRR)
▪ Modified Internal Rate of Return (MIRR)
▪ NPV Profiles
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TYPES OF PROJECTS
FOR CAPITAL BUDGETING
▪ Replacement Projects
• Needed to Continue Current Operations
• Cost Reduction
▪ Expansion Projects
• Existing Products or Markets
• New Products or Markets
• Safety and/or Environmental Projects
• Other Projects: office buildings, executive aircraft, etc
• Mergers
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PROJECT CASH FLOWS
▪ Cash Flows - represent the benefits generated
from accepting a capital-budgeting proposal
▪ Types of Cash Flow Stream:
• Normal Cash Flow Stream – One change of signs:
Cost (negative CF) followed by a series of positive cash
inflows.
• Non-Normal Cash Flow Stream – Two or more changes
of signs. Most common: Cost (negative CF), then string
of positive CFs, then cost to close project.
Ex: Nuclear power plant, strip mine, etc.
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STEPS TO CAPITAL BUDGETING
1. Estimate Cash Flows (CFs: inflows & outflows)
2. Assess Riskiness of CFs
3. Determine the Appropriate Cost of Capital
4. Find Net Present Value (NPV) and/or Internal
Rate of Return (IRR)
5. Accept if NPV > 0 and/or IRR > Weighted
Average Cost of capital (WACC)
PAYBACK PERIOD
▪ The number of years required to recover a project’s cost,
or “How long does it take to get our money back?”
▪ Calculated by adding project’s cash inflows to its cost
until the cumulative cash flow for the project turns
positive.
▪ Decision Criteria:
• Accept, if payback period < maximum acceptable
payback period
• Reject, if payback period > maximum acceptable
payback period

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CALCULATING PAYBACK CALCULATING PAYBACK

SEATWORK : 0 1 2 2.4 3
Project A
0 1 2 3
Project A CFt -100 10 60 100 80
CFt -100 10 60 80 Cumulative -100 -90 -30 0 50
Cumulative -100 -90 -30 50 PaybackA == 2 + 30 / 80 = 2.375 years
PaybackA ?
0 1 1.6 2 3
0 1 2 3 Project B
Project B
CFt -100 70 100 50 20
CFt -100 70 50 20
Cumulative -100 -30 0 20 40
Cumulative -100 -30 20 40
PaybackB == 1 + 30 / 50 = 1.6 years
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REGULAR PAYBACK PERIOD DISCOUNTED PAYBACK PERIOD

▪ Advantages: ▪ The number of years it takes to recapture a project’s
• Uses free cash flows initial outlay from the discounted net cash flows
▪ Decision Criteria:
• Provides an indication of a project’s risk and
liquidity • Accept, if discounted payback < maximum
acceptable discounted payback period
• Benefits the capital-constrained firm • Reject, if discounted payback > maximum
• Easy to calculate and understand acceptable discounted payback period
0 1 2 2.7 3
▪ Disadvantages: 10%
• Ignores the time value of money CFt -100 10 60 80
• Ignores CFs occurring after the payback period PV of CFt -100 9.09 49.59 60.11
• Selection of the maximum acceptable payback Cumulative -100 - 90.91 - 41.32 18.79
period is arbitrary Disc. PaybackL== 2 + 41.32 / 60.11 = 2.7 years

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DISCOUNTED PAYBACK PERIOD NET PRESENT VALUE (NPV)
▪ Advantages: ▪ The present value of an investment’s annual
free cash flows less the investment’s initial cash
• Uses discounted cash flows rather than raw cash
outlay:
flows
NPV = PV benefits – IO (initial outlay) or
• Considers time value of money
PVcost (outlay on other years)
▪ Disadvantages: ▪ Sum of the PVs of all cash inflows and outflows
• Cash flows incurred after the discounted payback of a project:
period are ignored NPV = FCF1 + FCF2 + ….. + FCFn - IO
• Limited by the arbitrary assignment of a maximum (1 + k)1 (1 + k)2 (1 + k)n
acceptable discounted payback period or n
CFt
NPV =  − IO
t =0 ( 1 + k )t
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CALCULATING FOR CALCULATING FOR

PROJECT A’s NPV PROJECT A’s NPV
SEATWORK : Year CFt PV of CFt
Calculate for Project A’s NPV. Assume a 0 -100 -$100
discount rate (k) of 10%. 1 10 9.09
2 60 49.59
Year CFt 3 80 60.11
0 -100 NPVA = $18.79
1 10
2 60
For comparison purposes, given: NPVB = $19.98
3 80
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SOLVING FOR NPV:

Financial Calculator Solution RATIONALE FOR NPV METHOD
▪ Concept of NPV = PV of Inflows – Cost
• Enter CFs into the calculator’s CFLO register. = Net gain in stock values
– CF0 = -100 ▪ Decision Criteria :
– CF1 = 10 • Accept, If NPV > 0.0 and Reject, if NPV < 0.0
– CF2 = 60 • Based on Project Classification:
– CF3 = 80 o If projects are independent, accept both projects
with NPV > 0.
o If projects are mutually exclusive, accept projects
• Enter I/YR = 10, press NPV button to get with the highest positive NPV since it is those that
NPVA = $18.78 add the most value.
▪ In this example, you would accept B if mutually
exclusive (NPVB > NPVA), and you would accept both if
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 NET PRESENT VALUE (NPV) PROFITABILITY INDEX
▪ Advantages: ▪ Profitability Index (PI) or Benefit-Cost Ratio – the ratio
• Deals with free cash flows and not accounting of the present value of free cash flows or future net
profits benefits to the initial outlay
• Sensitive to the true timing of benefits resulting from
the project FCF1 + FCF2 + ….. + FCFn
• Recognizes the time value of money, which compares PI = (1 + k)1 (1 + k)2 (1 + k)n___
the benefits and cost of the project IO
• Projects accepted if with a positive NPV, which
increases and is consistent with maximizing ▪ Decision Criterion :
shareholders’ value • Accept, if PI > 1.0
▪ Disadvantage: • Reject, if PI < 1.0
• Needs a detailed, long-term forecasts of the free cash
flows accruing from the project’s acceptance
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PROFITABILITY INDEX PROFITABILITY INDEX

▪ What is the Profitability Index (PI) or Benefit-Cost Ratio if the ▪ What is the Profitability Index (PI) or Benefit-Cost Ratio if the
firm has the ff. free cashflow data and discount rate = 10%: firm has the ff. free cashflow data and discount rate = 10%:
Year FCFt Year FCFt
0 -100 0 -100
1 10
1 10
2 60
2 60
3 80
3 80
FCF1 + FCF2 + ….. + FCFn
FCF1 + FCF2 + ….. + FCFn PI = (1 + k)1 (1 + k)2 (1 + k)n___
PI = (1 + k)1 (1 + k)2 (1 + k)n___ IO
IO = 9.09 + 49.59 + 60.11 = 1.1879
100
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PROFITABILITY INDEX INTERNAL RATE OF RETURN (IRR)

▪ Advantages: ▪ IRR is the rate of return that the project earns
• Uses free cash flows ▪ It is the discount rate that equates the PV of the
• Recognizes time value of money project’s cash inflows with the project’s initial
• Consistent with the firm’s goal of shareholder wealth cash outlay, assuming NPV = 0:
maximization FCF1 + FCF2 + ….. + FCFn
IO = (1 + IRR)1 (1 + IRR)2 (1 + IRR)n
▪ Disadvantage:
n
FCFt
• Requires detailed long-term forecasts of a project’s or IO = 
t = 0 ( 1 + IRR )
cash flows t

▪ If IRR > Weighted Cost of Capital (WACC), the project’s

rate of return is greater than its costs. Then, there is
some return left over to boost stockholders’ returns.
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 CALCULATING FOR
PROJECT’s IRR vs. BOND’s YTM THE PROJECTS’ IRR
▪ IRR and YTM refer to the same thing. SEATWORK :
Calculate for Project A’s IRR. Assume a discount rate
▪ Think of a bond as a project. The YTM on the (k) of 10%.
bond would be the IRR of the “bond” project. Year CFt PV of CFt
▪ Example: 0 -100 -$100
Suppose a 10-year bond with a 9% annual coupon
1 10 9.09
sells for $1,134.20 2 60 49.59
• Solving for IRR = YTM = 7.08%, which is the annual 3 80 60.11
return for this project / bond NPVA = $18.79

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IRR CALCULATION IRR’s DECISION CRITERIA

n
FCFt
▪ Using the formula: IO =  ▪ Where k is the required rate of return or
t =0 ( 1 + IRR ) t
the opportunity cost of capital :
100 = ___10____ + ___60____ + ___80____
(1 + IRR) (1 + IRR)2 (1 + IRR)3 • Accept, If IRR > k
IRR = 18.13% • Reject, If IRR < k

▪ Solving for IRR with a financial calculator: ▪ Based on Project Classification:

• Enter CFs in CFLO register • If projects are independent, accept both
• Enter n = 3 projects, as both IRR > k
• Press IRR:
• If projects are mutually exclusive, accept
o IRRA = 18.13%
Project B because IRRB > IRRA.

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INTERNAL RATE OF RETURN NPV PROFILES

▪ Advantages: • A graphical representation of project’s NPVs at
• Uses free cash flows different costs of capital:
• Recognizes time value of money
• Is, in general, consistent with firm’s goal of k NPVA NPVB
shareholder wealth maximization 0 $50 $40
• Disadvantages: 5 33 29
• Requires detailed long-term forecasts of a project’s 10 19 20
cash flows 15 7 12
• Possibility of multiple IRRs 20 (4) 5
• Assumes cash flows over the life of the project can be
reinvested at the IRR

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 DRAWING NPV PROFILES FINDING THE CROSSOVER POINT
1. Find cash flow differences between the
NPV 60 projects for each year.
($)
50 . 2. Enter these differences in CFLO register, then
press IRR. Crossover Rate = 8.68%, rounded
40 . to 8.7%.
. Crossover Point = 8.7%
30 . 3. Can subtract B from A or vice versa, but better
20 . IRRA = 18.1% to have first CF negative.
.. B 4. If profiles don’t cross, then one project
10 IRRB = 23.6%
A . .
dominates the other.
0 . Discount Rate (%)
5 10 15 20 23.6
-10
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REASONS WHY NPV PROFILES CROSS
• Size (Scale) Differences – the smaller project
frees up funds at t = 0 for investment. The
higher the opportunity cost, the more valuable
these funds, so high k favors small projects.
• Timing Differences – the project with faster
payback provides more CF in early years for
reinvestment. If k is high, early CF especially
good, NPVB > NPVA.
COMPARING NPV & IRR METHODS
▪ If projects are independent, the two methods
always lead to the same accept/reject decisions.
▪ If projects are mutually exclusive:
• If k > crossover point, the two methods lead
to the same decision and there is no conflict.
• If k < crossover point, the two methods lead
to different accept/reject decisions.

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REINVESTMENT RATE ASSUMPTIONS A BETTER IRR MEASURE

• NPV method assumes CFs are reinvested at k,
the opportunity cost of capital.
• IRR method assumes CFs are reinvested at
IRR.
• Assuming CFs are reinvested at the opportunity
cost of capital, which is more realistic, the NPV
method is the best. NPV method should be
used to choose between mutually exclusive
projects.
• Perhaps a hybrid of the IRR that assumes cost
of capital reinvestment is needed.
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Since managers prefer the IRR to the NPV Method, is
there a better IRR measure?
• Yes, Modified InternaI Rate of Return (MIRR). It is the
discount rate that causes the PV of a project’s terminal
value (TV) to equal the PV of costs. TV is found by
compounding inflows at weighted average cost of capital
(WACC).
PV outflows = TV inflows
(1 + MIRR)n
• MIRR assumes cash flows are reinvested at the WACC.
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 MODIFIED INTERNAL
CALCULATING MIRR RATE OF RETURN (MIRR)
0 1 2 3 ▪ Decision Criteria :
10%
• Accept, if MIRR > Required Rate of Return
-100.0 10.0 60.0 80.0 • Reject, if MIRR < Required Rate of Return
k = 10%
66.0
k =10% ▪ Advantages of MIRR:
12.1
• Uses free cash flows
MIRR = 16.5%
-100.0 158.1 • Recognizes Time Value of Money
• Allows reinvestment rate to be directly specified
PV Outflows Terminal Value
(TV) Inflows • Consistent with firm’s goal of shareholder wealth
$158.1 maximization
$100 =
(1 + MIRRA)3 ▪ Disadvantage of MIRR: Requires detailed long-term
cash flow forecasts
MIRRA = 16.5%
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PROJECT’s NPV & IRR MULTIPLE IRRs

Project D has Cash Flows (in 000s): CF0 = -$800, CF1 =
$5,000, and CF2 = -$5,000. Find Project D’s NPV and IRR. NPV Profile
NPV
0 1 2
k = 10%
IRR2 = 400%
-800 5,000 -5,000 450
• Enter CFs into calculator CFLO register 0 k
• Enter I/YR = 10 100 400
• NPV = -$386.78
IRR1 = 25%
• IRR = ERROR, Why? -800
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SOLVING FOR
EXISTENCE OF MUTIPLE IRRs MULTIPLE IRR PROBLEM
▪ Using a calculator:
• At very low discount rates, the PV of CF2 is
Enter CFs as before.
large & negative, so NPV < 0.
Store a “guess” for the IRR (try 10%)
• At very high discount rates, the PV of both CF1 10 ■ STO
and CF2 are low, so CF0 dominates and again ■ IRR = 25% (the lower IRR)
NPV < 0. Now guess a larger IRR (try 200%)
• In between, the discount rate hits CF2, which is 200 ■ STO
higher than CF1, so NPV > 0. ■ IRR = 400% (the higher IRR)
• Result: 2 IRRs.
NOTE: When there are Non-Normal CFs and
more than one IRR, use the MIRR.
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 MIRR vs IRR MIRR vs. IRR
When to use the MIRR instead of the IRR?
• MIRR correctly assumes reinvestment at When to accept Project P?
opportunity cost = WACC. MIRR also avoids the
problem of multiple IRRs. ▪ When there are Non-Normal CFs and more than one IRR,
use MIRR.
• Managers like rate of return comparisons, and • PV of outflows @ 10% = -$4,932.2314.
MIRR is better for this than IRR. • TV of inflows @ 10% = $5,500.
• MIRR = 5.6%.
▪ Do not accept Project P.
• NPV = -$386.78 < 0.
• MIRR = 5.6% < k = 10%.
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RANKING OF RANKING OF
MUTUALLY EXCLUSIVE PROJECTS MUTUALLY EXCLUSIVE PROJECTS
▪ Mutually Exclusive Projects – projects that, if ▪ Size-Disparity Problem occurs when mutually exclusive
undertaken, would serve the same purpose; accepting projects of unequal size are compared:
one will necessarily mean rejecting the others:
Project A k = 10% Project B k = 10%
Choose the Highest: NPV > 0 and PI > 1
0 1 0 1
IRR > required rate of return (kd)
-200 300 -1,500 1,900
▪ 3 General Types of Ranking Problems:
• Size-Disparity Problem NPV = $72.73 NPV = $227.28
PI = 1.36 PI = 1.15
• Time-Disparity Problem IRR = 50% IRR = 27%
• Unequal-Lives Problem

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RANKING OF RANKING OF
MUTUALLY EXCLUSIVE PROJECTS MUTUALLY EXCLUSIVE PROJECTS
▪ Size-Disparity Problem occurs when mutually exclusive ▪ Time-Disparity Problem occurs when mutually exclusive
projects of unequal size are compared. projects of unequal size have differing reinvestment
assumptions made by NPV and IRR.
▪ Decision Criteria: Project A k = 10% Project B k = 10%
• Whenever the size-disparity problem results in 0 1 2 3 0 1 2 3
conflicting rankings between mutually exclusive
projects, the project with the largest NPV will be -1000 100 200 2000 -1000 650 650 650
selected, provided there is no capital rationing.
NPV = $758.83 NPV = $616.45
• When capital rationing exists, the firm should select PI = 1.759 PI = 1.616
the set of projects with the largest NPV. IRR = 35% IRR = 43%

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 RANKING OF RANKING OF
MUTUALLY EXCLUSIVE PROJECTS MUTUALLY EXCLUSIVE PROJECTS
▪ Unequal –Lives Problem occurs when mutually exclusive projects
▪ Time-Disparity Problem occurs when mutually of unequal size have differing project life spans, which is brought
exclusive projects of unequal size have differing about by precluding future profitable projects without ever having
been considered.
reinvestment assumptions made by NPV and IRR.
Project A k = 10% Project B k = 10%
▪ Decision Criteria: 0 1 2 3 0 1 2 3 4 5 6
• One solution is this problem is to use the MIRR
method. It allows you to state the rate at which the -1000 500 500 500 -1000 300 300 300 300 300 300
cash flows over the life of the project will be
reinvested. NPV = $243.43 NPV = $306.58
• The NPV criterion is preferred since it makes the most PI = 1.243 PI = 1.307
IRR = 23.4% IRR = 19.9%
acceptable assumption for wealth-maximization and
its required rate of return is the lowest possible
reinvestment rate.

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RANKING OF
MUTUALLY EXCLUSIVE PROJECTS CAPITAL RATIONING
▪ Unequal –Lives Problem occurs when mutually exclusive ▪ Capital Rationing – exists when a firm places a limit on
projects of unequal size have differing project life spans, the peso/dollar size of the capital budget; it places a
which is brought about by precluding future profitable projects constraint on the number of acceptable projects for
without ever having been considered. investment
CUT-OFF CRITERION UNDER CAPITAL RATIONING
▪ Decision Criteria: Projects
Ranked 35
• One option is to assume that the cash flows of the by IRR (%)30
shorter-lived investment will be reinvested at the required 25
rate of return until termination of the longer-lived asset. 20 Required Rate
Compare their NPVs via replacement chain method. 15 of Return
• Another option is projecting reinvestment opportunities into 10
5
the future. Determine the equivalent annual annuity, which
0 Pesos
is the annuity cash flow that yields the same present value A B C D E F
as the project’s NPV. PHP XXX
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CAPITAL RATIONING EFFECTS OF CAPITAL RATIONING

▪ Rationale for Capital Rationing:
• Market conditions faced by the firm are temporarily
adverse, wherein high costs of funding projects exist
• Shortage of qualified managers to direct the new
projects (ex. highly technical projects)
• Firm’s policy is to use only internally generated funds
• Intangible considerations:
o Fear of debt or wanting to avoid interest payments
at any cost
o Limit the issuance of common stock in order to
maintain a stable dividend policy
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▪ Capital Rationing has a negative effect on the firm since it
runs contrary to the firm’s goal of maximizing shareholders’
wealth. To what degree it is negative depends on the severity
of the capital rationing:
• If minor/short-lived, firm’s share price will not suffer to any great
extent and rationing can be excused
• If decision is to limit drastically the number of acceptable projects
or to use only internally generated funds, then it will have a
significantly negative effect on the firm’s share prices
▪ In the long-run, it lowers share prices as a result of lost
competitive advantage from not upgrading its products and
manufacturing processes or not undertaking new products
and serving new markets
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 ETHICS IN CAPITAL BUDGETING
▪ Although it may not seem obvious, ethics plays a role in
capital budgeting.
▪ Choosing the projects to be funded by a firm entails also
disclosure of all information that not only tell the truth on the
firm’s products, but also make sure that consumers have all
the facts they need to make their buying decision.
▪ Consequences of violating the ethical rules will result to the
most damaging events for the firm:
• Lost opportunity to rectify or control the damage if firm did
not disclose the information first to the public
• Loss of public’s confidence in the firm and its products
• Lawsuits against the firm which can wipe out its profits
and/or even affect the firm’s survival

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