CHAPTER 8

BASICS OF CAPITAL BUDGETING

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CHAPTER OBJECTIVES

q Understand the variety of techniques to

evaluate a project and make decisions

q Distinguish different kinds of projects

q Explain why Net Present Value is the right one

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 CHAPTER OUTLINE

6.1. Overview of projects ;

6.2. Cash flows of a project ;

6.3. Criterion for making project decisions.

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 6.1. Overview of projects
KINDS OF PROJECT ?

Ø Based on the purpose of a project:

+ Replacement: maintenance of business
+ Replacement: cost reduction
+ Expansion of existing products or markets
+ Expansion into new products or markets
+ Others

Ø Based on relation of projects:

+ Independent projects
+ Mutually exclusive projects. 174
 6.1. Overview of projects
STEPS IN CAPITAL BUDGETING

1. Estimate cash flow of the project ;

2. Estimate cost of capital ;

3. Determining the appropriate cost of capital at

which cash flows are discounted ;

4.Selecting and calculating criteria for decision

making ;

5. Making decision: accept or reject the project. 175

 6.2. Cashflow of a project

PROJECT CASH FLOW PROFILE

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 6.2. Cashflow of a project

METHODS FOR ESTIMATING CASH FLOWS

Ø Direct method for estimating cash flows:

Net cash flows (NCF) = Cash inflows – cash
outflows

Ø Indirect method for estimating cash flows:

NCF = Net income + Depreciation – Investment
+/- Changes in net working capital

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 6.2. Cashflow of a project
EXAMPLE 1

The cash inflows and outflows of project A are shown

as below: (Unit: billion VNĐ)
Year 0 1 2 3 4
Cash inflows 0 15 40 45 50
Cash outflows 35 20 15 18 20

Please making the net cash flows table of project A:

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 6.3. CRITERION FOR MAKING PROJECT
DECISIONS

6.3.1. Net Present Value (NPV) ;

6.3.2. Internal Rate of Return (IRR) ;

6.3.3 Payback period & discounted payback

period.

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 6.3. Making project decisions
6.3.1NET PRESENT VALUE (NPV)

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6.3.1.NET PRESENT VALUE (NPV)
Ø NCFt (Net Cash Flow) = Bt –Ct

Ø Bt : Cash Inflows

Ø Ct : Cash Outflows

Ø r : discount rate (using WACC)

Ø n: project’s length of life (number of years)

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 6.3.1. NPV

NPV – 1 PROJECT DECISIONS

NPV < 0 NPV ≥ 0

REJECT THE PROJECT ACCEPT THE PROJECT

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 6.3.1. NPV
NPV – GROUP PROJECTS DECISIONS
GROUP PROJECTS DECISION RULES
Independent projects Accept projects that have NPV ≥ 0.
Reject projects that have NPV < 0.
Mutually exclusive Accept an alternative project that
projects generates the largest NPV (NPVmax
(All projects have the ≥ 0)
same length of life and
discount rate)
Budget constraints Choose that subset of the available
(Do not have enough projects which maximizes NPV.
capital to perform all
projects)
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 6.3.1. NPV
EXAMPLE 2
The NCF of A and B projects are shown as below (Unit:
million VND):
Year 0 1
NCF of project A -2,000 2,210
NCF of project B -3,000 3,300

The market required rate of return is 8%/ year. Please make

your projects decisions in following cases:
a) A and B are independent projects

b) A and B are mutually exclusive projects

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 EXAMPLE 3 6.3.1. NPV

There are 3 projects (A, B and C) of RT company:

Project Capital expenditure NPV
(million VND) (million VND)
A 2,000 400
B 2,000 350
C 3,000 360

The company has a fixed budget for capital expenditures of

5,000 million VND. Which projects should the company
choose ?

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 6.3.2. IRR
INTERNAL RATE OF RETURN (IRR)

ØInternal rate of return (IRR) is the discount

rate forces the PV of a project’s inflows to equal
the PV of its costs.

Ø r* = IRR

Ø IRR implies the rate of return of a project.

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 6.3.2. IRR
IRR – 1 PROJECT DECISIONS
IRR < MARR IRR ≥ MARR

REJECT THE PROJECT ACCEPT THE PROJECT

MARR (Minimum Acceptable Rate of Return): required

rate of return 187
 6.3.2. IRR
EXAMPLE 4
The NCF of project A is shown as below:
Year 0 1 2 3
NCF (million VND) -2,000 500 1,000 1,500

What is the internal rate of return of the project A?

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 6.3.3. PP
PAYBACK PERIOD
ØPayback period – the length of time required
for the net revenues of an investment to recover
the cost of the investment.
Ø The longer the payback period, the higher the
risk a company is incurring.

ØPayback Period (PP) vs Discounted Payback

Period (DPP)
Payback Period Discounted Payback Period
Ignores the time value of Consider the time value of
money money
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 6.3.3. PP
EXAMPLE 5

The NCF of A and B projects are shown as below :

Năm 0 1 2 3 4
NCF of A ($) -1,000 500 500 300 100
NCF of B ($) -1,000 100 300 400 600

The discount rate is 10%.

a) Please compute the Payback Period (PP) and
Discounted Payback Period (DPP) of 2 projects:
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 6.3.3. PP

DECISION RULE – PP & DPP

Ø Criterion for a worth project :
+ Accept a project: DPP ≤ n
+ Reject a project: DPP > n
(n: project’s length of life (number of years)
ØMoreover, under the viewpoint of
expected payback period from project
investors:
+ Accept a project: PP (or DPP) of the
project ≤ expected PP (or DPP) from
project investors 191
 6.3.3. PP
EXAMPLE 5 (continued)
b) The required rate of return is 10%. Which
projects should be chosen ? Why ?

c) The project investors wish that the

payback period of a project is only 3 years.
Which projects should be chosen ? Why ?

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