CHAPTER 11

The Basics of Capital Budgeting

Should we
build this
plant?

11-1
What is capital budgeting?
 Analysis of potential additions to
fixed assets.
 Long-term decisions; involve large
expenditures.
 Very important to firm’s future.

11-2
Steps to capital budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of
capital. (If the new project is as risky as
existing assets in the firm, we can use WACC as
the cost of capital, also called discount rate.
Otherwise we should get the discount rate based
on the riskness of the project.)

11-3
Steps to capital budgeting
4. Find NPV=present value of future
cash inflow-initial cost.
5. Accept if NPV > 0.

(For a normal project, we can also

accept if IRR > WACC.)

11-4
What is the difference between
independent and mutually exclusive
projects?
 Independent projects – if the cash
flows of one are unaffected by the
acceptance of the other.
 Mutually exclusive projects – if the
cash flows of one can be adversely
impacted by the acceptance of the other.
If one project is taken, the other has to be
rejected.

11-5
What is the difference between normal
and non-normal cash flow streams?
 Normal cash flow stream – Cost (negative
CF) followed by a series of positive cash
inflows. One change of signs.
 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. Nuclear power
plant, strip mine, etc.

11-6
We will discuss 3 investment
criteria.
 Payback
 NPV
 IRR

11-7
What is the 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.

11-8
 Calculating payback
0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

11-9
Strengths and weaknesses of
payback
 Strengths
 Provides an indication of a project’s risk and
liquidity.
 Easy to calculate and understand.
 Weaknesses
 Ignores the time value of money.
 Ignores CFs occurring after the payback period.
 Tend to bias in favor of short term projects.

11-10
 Discounted payback period
 Uses discounted cash flows rather than
raw CFs.
0 10% 1 2 2.7 3
CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years

11-11
Net Present Value (NPV)
 Sum of the PVs of all cash inflows and
outflows of a project:

N
CFt
NPV   t
t 0 (1  r )

11-12
What is Project L’s NPV?
Project L Year CFt PV of CFt
0 -100 -$100
1 10 9.09
2 60 49.59
3 80 60.11
NPVL = $18.79
Project S Year CFt PV of CFt
0 -100 -$100
1 70 ?
2 50 ?
3 20 ?
NPVS = $19.98

11-13
Solving for NPV:
Financial calculator solution
 Enter CFs into the calculator’s CFLO
register.
 CF0 = -100
 CF1 = 10
 CF2 = 60
 CF3 = 80

 Enter I/YR = 10, press NPV button to

get NPVL = $18.78.
11-14
Detailed steps
 To clear historical data:
 CF, 2nd ,CE/C

 To get PV:

 CF , 100 , +/-, Enter ,”Co1”, 10, Enter, ↓,↓ ,

“C02”,60 , Enter, ↓, ↓, “C03”,80 , Enter, ↓, ↓,

NPV, “I=”, 10,Enter, ↓, “NPV=”, CPT
 “NPV=18.7828”

 IRR, CPT “18.1257”

11-15
 NPV method
NPV = PV of inflows – PV of all
Cost
= Net gain in wealth
 If projects are independent, accept if
the project NPV > 0.

11-16
NPV
 If projects are mutually exclusive,
accept projects with the highest
positive NPV, those that add the most
value.
 In our example, would accept S if mutually
exclusive (NPVs > NPVL), and would accept
both if independent.

11-17
Internal Rate of Return (IRR)
 IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:
n
CFt
0 t
t 0 ( 1  IRR )

 Solving for IRR with a financial calculator:

 Enter CFs in CFLO register.
 Press IRR; IRRL = 18.13% and IRRS = 23.56%.

11-18
How is a project’s IRR similar to a
bond’s YTM?
 They are the same thing.
 Think of a bond as a project. The
YTM on the bond would be the IRR
of the “bond” project.
 EXAMPLE: Suppose a 10-year bond
with a 9% annual coupon sells for
$1,134.20.
 Solve for IRR = YTM = 7.08%, the
annual return for this project/bond.
11-19
Rationale for the IRR method
 For normal projects: If IRR > WACC,
the project’s rate of return is greater
than its costs. There is some return
left over to boost stockholders’
wealth.

11-20
Comparing the NPV and IRR
methods
 NPV always leads to correct decision.
 IRR rules some times not.
 Payback often biases in favor of quick
projects.

 You do not need to know MIRR.

11-21
Exercises
1. The net present value (NPV) rule can be best stated
as:
A) An investment should be accepted if, and only if, the
NPV is exactly equal to zero.
B) An investment should be rejected if the NPV is
positive and accepted if it is negative.
C)An investment should be accepted if the NPV is
positive and rejected if it is negative.
D)An investment with greater cash inflows than cash
outflows, regardless of when the cash flows occur,
will always have a positive NPV and therefore should
always be accepted.

11-22
3. Net present value __________.

A) is equal to the initial investment in a project

B) is equal to the present value of the project benefits
C) is equal to zero when the discount rate used is
equal to the IRR
D)is simplified by the fact that future cash flows are
easy to estimate
E) requires the firm set an arbitrary cutoff point for
determining whether an investment is acceptable

11-23
4. What is the NPV of the following set of
cash flows if the required return is 15%?

Cf0= -$667.6
Cf1=$500
Cf2=$500
Cf3=$400

 A) The NPV is negative

 B) $ 408.27
 C) $ 950.44
 D) $1,247.90
 E) $4,656.12
11-24
5. A project costs $300 and has cash flows of
$75 for the first three years and $50 in each of
the project's last three years.

What is the payback period of the

project?
A) The project never pays back
B) 3.75 years
C) 4.50 years
D) 5.25 years
E) 5.50 years
11-25
6. Bill plans to open a do-it-yourself dog bathing
center in a storefront. The bathing equipment
will cost $50,000.

Bill expects the after-tax cash inflows to be $15,000

annually for 8 years, after which he plans to scrap
the equipment and retire to the beaches of Jamaica.

Assume the required return is 20%. What is the

project's IRR? Should it be accepted?
A) 15%; yes
B) 15%; no
C) 25%; yes
D)25%; no
E) 20%; indifferent

11-26