Capital budgeting (Lecture 8)

Expenditures
• Capital expenditure: expenditures on xed assets that can be used for production over a period of
years. These terms are capitalise and depreciated over a period of years.
• Current expenditures: short term in nature and are completely expensed in the year incurred
Capital budgeting
• Process of deciding how to allocate the rm’s scarce resources to its various alternatives and
whether the project is worth undertaking
• NPV and IRR is the Accepted methods
• Accept if cost <=Bene t
• Reject if cost > Bene t

1. Net present value

• Value of cash ow: Amount, timing and risk
• Net present value: The di erence between the intrinsic value of a project and its cost. A positive NPV
men’s that the project add values to the rm and will increase the wealth of its owner, hence accept
positive values
• When NPV = 0, we will be indi erent

2. Payback and discounted payback

Payback period is the number of years taken to recover the initial costs. Accept if the payback period
is less than some preset limit
• Disadvantages
◦ ignores the time value of money
◦Requires an arbitrary cuto point
◦Ignores the cash ows beyond the cuto date
◦Biased against the long term projects such as R&D and new projects, biased towards liquidity

Discounted payback period compute the value of each cash ow and determine how long it takes to
payback on a discounted basis
• Steps
◦compute PV of each cash ow
◦Determine the payback period using discounted cash ows
• Disadvantages (in addition to previously mentioned above)
◦May reject positive NPV investments
• Advantages
◦Takes into account time value of money

3. Average accounting returns Dependsonhowitis

depreciated

• Average income/ average book value

• Accept the project if AAR is greater than a preset rate
• Disadvantages
◦not a true rate of return, time value of money is ignored
◦Uses an arbitrary benchmark cuto rate
◦Based on accounting net income and book values, not cash ows and intrinsic values

4. Internal rate of return

• IRR is the rate that makes NPV=0 and its the most important alternative to NPV
• Accept if the project IRR is greater than the required return
• NPV and IRR generally gies the same decision except
 ◦mutually exclusive projects (cash ow of one can be adversely impacted the acceptance of
another. If you choose one you can’t choose the other)
‣ initial investments are substantially di erent
‣ Timing of cash ow is substantially di erent
‣ NPV should be used to choose between mutually exclusive projects
◦non convention cash ow
‣ cash ow signs change more than once
‣ There can be more than one IRR

MIRR is the discount rate which causes the PV of the projects terminal value to be equals to the PV of
its costs
• Assumes the cash ows are reinvested at WACC, weighted average cost of capital
• Steps
◦ nd FV of all cash in ows and add up
◦Find PV of all cash out ows and add up
◦Calculator
‣ N
‣ FV
‣ PV
‣ Compute I/Y
• Avoids problem of multiple IRR, but since it requires the WACC assumption, it may not be the true
rate of return of the project
•

5. Pro tability index

Measures the bene t per unit cost, based on the time value of money
• Total PV of future CF/ Initial cost
• Accept if PV > 1
• Eg. A pro tability index of 1.1 implies that for every $1 of investment, we create $0.1 in value
• Disadvantages
◦ May lead to incorrect decisions in comparisons of mutually exclusive projects