Capital Budgeting Techniques

Kwaku Duah Berchie

ILGS LGFM – 504 Financial Resources Management
 Chapter 9 Module Summary
 After estimating the relevant cash flows, the financial manager must apply appropriate decision techniques
to assess whether the project creates value for shareholders. Net present value (NPV) and internal rate of
return (IRR) are the generally preferred capital budgeting techniques.
 Both use the cost of capital as the required return needed to compensate shareholders for undertaking
projects with the same risk as that of the firm. The appeal of NPV and IRR stems from the fact that both
indicate whether a proposed investment creates or destroys shareholder value.
 NPV clearly indicates the expected dollar amount of wealth creation from a proposed project, whereas IRR
provides the same accept-or-reject decision as NPV.
 As a consequence of some fundamental differences, NPV and IRR do not necessarily rank projects the
same.
 Although the potential conflicting rankings can be reconciled, NPV is the theoretically preferred approach.
 In practice, however, IRR is preferred because of its intuitive appeal.
 Regardless, the application of NPV and IRR to good estimates of relevant cash flows should enable the
financial manager to recommend projects that are consistent with the firm’s goals of maximizing stock
price.
 Module Objectives
 Understand the role of capital budgeting techniques in the capital budgeting process.
 Capital budgeting techniques are used to analyze and assess project acceptability and ranking.
They are applied to each project’s relevant cash flows to select capital expenditures that are
consistent with the firm’s goal of maximizing owners’ wealth.
 Calculate, interpret, and evaluate the payback period.
 The payback period is the amount of time required for the firm to recover its initial
investment, as calculated from cash inflows. The formula and decision criteria for the payback
period are summarized in Table 9.8. Shorter payback periods are preferred.
 The payback period’s strengths include ease of calculation, simple intuitive appeal, its
consideration of cash flows, its implicit consideration of timing, and its ability to measure risk
exposure.
 Its weaknesses include its lack of linkage to the wealth maximization goal, its failure to
consider time value explicitly, and the fact that it ignores cash flows that occur after the
payback period.
 Module Objectives…

 Calculate, interpret, and evaluate the net present value (NPV).

 Because it gives explicit consideration to the time value of money, NPV is considered a
sophisticated capital budgeting technique.
 In calculating NPV, the rate at which cash flows are discounted is often called the discount rate,
required return, cost of capital, or opportunity cost. By whatever name, this rate represents the
minimum return that must be earned on a project to leave the firm’s market value unchanged.
 Calculate, interpret, and evaluate the internal rate of return (IRR).
 Like NPV, IRR is a sophisticated capital budgeting technique because it explicitly considers the
time value of money.
 IRR can be viewed as the compound annual rate of return that the firm will earn if it invests in a
project and receives the given cash inflows.
 By accepting only those projects with IRRs in excess of the firm’s cost of capital, the firm
should enhance its market value and the wealth of its owners.
 Both NPV and IRR yield the same accept–reject decisions, but they often provide conflicting
ranks.
 Module Objectives…
 Use net present value profiles to compare NPV and IRR techniques.
 A net present value profile is a graph that depicts the projects’ NPVs for various discount rates.
It is useful in comparing projects, especially when NPV and IRR yield conflicting rankings.
 The NPV profile is prepared by developing a number of “discount rate–net present value
"coordinates, often using discount rates of 0 percent, the cost of capital, and the IRR for each
project, and then plotting them on the same set of discount rate–NPV axes.
 Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical
strengths of each approach.
 Conflicting rankings of projects frequently emerge from NPV and IRR, as a result of differences
in the magnitude and timing of each project’s cash flows. The underlying cause is the differing
implicit assumptions of NPV and IRR with regard to the reinvestment of intermediate cash
inflows—cash inflows received prior to termination of a project. NPV assumes reinvestment of
intermediate cash inflows at the more conservative cost of capital, whereas IRR assumes
reinvestment at the project’s IRR.
 On a purely theoretical basis, NPV is preferred over IRR, because NPV assumes the more
conservative reinvestment rate and does not exhibit the mathematical problems that often occur
when IRRs are calculated for nonconventional cash flows. In practice, however, the IRR is more
commonly used because it is consistent with the general preference for rates of return.
 Capital Budgeting Techniques

 The three most popular capital budgeting techniques:

 payback period,
 net present value, and
 internal rate of return
 The Payback Period
 The payback period is the amount of time required for the firm to recover its
initial investment in a project, as calculated from cash inflows
 The Decision Criteria
 When the payback period is used to make accept–reject decisions, the decision
criteria are as follows:
 If the payback period is less than the maximum acceptable payback period,
accept the project.
 If the payback period is greater than the maximum acceptable payback period,
reject the project.
 The Payback Period

LBS Ltd uses the payback period as its sole

investment appraisal method. LBS invests ¢
30,000 to replace its computers and this
investment returns ¢ 9,000 annually for the five
years. From the information above evaluate the
investment using the payback. Assume that ¢
9,000 accrues evenly throughout the year.
 The Payback Period

Solution
Year Yearly cash flow cumulative net cash flow
¢ ¢
0 (30,000) (30,000)
1 9,000 (21,000)
2 9,000 (12,000)
3 9,000 (3,000)
4 9,000 6,000
5 9,000 15,000

Therefore 3years = 27,000

then 3000/9000 x 12 = 4
Payback period = 3 years 4months
 The Payback Period

Time period required to recover the cost of the

investment from the annual cash inflow produced by
the investment.

Amount invested
Expected annual net cash inflow
 The Payback Period

The length of time taken to repay the initial capital cost

Requires information on the revenue the investment generates

E.g. A machine costs ¢600,000
It produces items that sell at ¢ 5 each and produces 60,000 units per year
Payback period will be ?????
 The Payback Period

 2 Years Computed as;

 600,000 / 300,000 = 2
The Payback Period
The Payback Period
 The Decision Criteria

 When the payback period is used to make accept–reject decisions, the

decision criteria are as follows:
 If the payback period is less than the maximum acceptable payback
period, accept the project.
 If the payback period is greater than the maximum acceptable payback
period, reject the project.
 The Decision Criteria

Casey Co. is considering an investment of ¢130,000 in new equipment. The new

equipment is expected to last 10 years. It will have zero salvage value at the end of
its useful life. The straight-line method of depreciation is used for accounting
purposes. The expected annual revenues and costs of the new product that will be
produced from the investment are:

Sales ¢200,000
Cost of goods sold ¢145,000
Depreciation expense 13,000
Selling & Admin expense22,000 180,000
Income before income tax ¢20,000
Income tax expense 7,000
Net Income ¢13,000
 The Decision Criteria

Expected annual net cash inflow =

Net income ¢13,000
Depreciation expense13,000
¢26,000

130,000 / 26,000 = 5 years

 Net Present Value (NPV)
 The net present value (NPV) is found by subtracting a project’s initial
investment (CF0) from the present value of its cash inflows (CFt) discounted at a
rate equal to the firm’s cost of capital (k).
 NPV = Present value of cash inflows - Initial investment

NPV is today’s value of the difference between cash inflows and

outflows projected at future dates, attributable to capital
investments or long-term projects

When NPV is used, both inflows and outflows are measured in terms of present currency. Because
we are dealing only with investments that have conventional cash flow patterns, the initial
investment is automatically stated in terms of today’s currency.
If it were not, the present value of a project would be found by subtracting the present value of
outflows from the present value of inflows.
 The Decision Criteria

 When NPV is used to make accept–reject decisions, the decision criteria are as follows:
 If the NPV is greater than $0, accept the project.
 If the NPV is less than $0, reject the project.
 If the NPV is greater than $0, the firm will earn a return greater than its cost of capital.
Such action should enhance the market value of the firm and therefore the wealth of its
owners.
 Sample Project Data

 You are looking at a new project and have estimated the following cash
flows, net income and book value data:
 Year 0: CF = -165,000
 Year 1: CF = 63,120 NI = 13,620
 Year 2: CF = 70,800 NI = 3,300
 Year 3: CF = 91,080 NI = 29,100
 Average book value = $72,000
 Your required return for assets of this risk is 12%.
 Computing NPV for the Project

n
CFt
 Using the formula: NPV  
t 0 (1  R ) t

NPV = -165,000/(1.12)0 + 63,120/(1.12)1 + 70,800/(1.12)2 + 91,080/(1.12)3 = 12,627.41

Ca p ita l Bud g e ting Pro je c t NPV

Re q uire d Re turn = 12%
Ye a r CF Fo rm ula Disc CFs
0 (165,000.00) =(- 165000)/ (1.12)^0 = (165,000.00)
1 63,120.00 =(63120)/ (1.12)^1 = 56,357.14
2 70,800.00 =(70800)/ (1.12)^2 = 56,441.33
3 91,080.00 =(91080)/ (1.12)^3 = 64,828.94
12,627.41
 Calculating NPVs with Excel

 NPV function: =NPV(rate,CF01:CFnn)

 First parameter = required return entered as a decimal (5% = .05)
 Second parameter = range of cash flows beginning with year 1
 After computing NPV, subtract the initial investment (CF0)

Re q uire d Re turn = 12%

Ye a r CF Fo rm ula Disc CFs
0 (165,000.00) =(- 165000)/ (1.12)^0 = (165,000.00)
1 63,120.00 =(63120)/ (1.12)^1 = 56,357.14
2 70,800.00 =(70800)/ (1.12)^2 = 56,441.33
3 91,080.00 =(91080)/ (1.12)^3 = 64,828.94
12,627.41

EXCEL =NPV(D2,B5:B7) 177,627.41

NPV + CF0 12,627.41
 Calculating NPVs with Discount Factor table

Using the d isc o unt fa c to r ta b le @ 12%

Ye a r Ca shflo w Disc o unt Fa c to r Pre se nt Va lue
0 (165,000.00) 1 (165,000.00)
1 63,120.00 0.8929 56,359.85
2 70,800.00 0.7972 56,441.76
3 91,080.00 0.7118 64,830.74

= NPV(F6,F7:F9) 177,632.35

NPV + CF0 12,632.35

 Calculating NPVs with Excel

Using the d isc o unt fa c to r ta b le @ 12%

Ye a r Ca shflo w Disc o unt Fa c to r Pre se nt Va lue
0 -165000 1 =D5*E5
1 63120 0.8929 =D6*E6
2 70800 0.7972 =D7*E7
3 91080 0.7118 =D8*E8

= NPV(F6,F7:F9) =SUM(F6:F8)

NPV + CF0 =F10+F5

 Internal Rate of Return (IRR)
 The internal rate of return (IRR) is the discount rate that equates the NPV of an
investment opportunity with $0 (because the present value of cash inflows equals the initial
investment). It is the compound annual rate of return that the firm will earn if it invests in
the project and receives the give cash inflows.
 Mathematically, the IRR is the value of k in the NPV equation that causes NPV to equal $0.
 Internal Rate of Return (IRR)

 Mutually exclusive projects

 If you choose one, you can’t choose the other
 Example: You could have chosen to attend graduate school at either Legon or
ILGS, but not both
 Internal Rate of Return (IRR)

 The Decision Criteria

 When IRR is used to make accept–reject decisions, the decision criteria are as
follows:
 If the IRR is greater than the cost of capital, accept the project.
 If the IRR is less than the cost of capital, reject the project.
 Interest yield of the potential investment
 The interest rate that will cause the present value of the proposed capital
expenditure to equal the present value of the expected annual cash inflows.
 Internal Rate of Return (IRR)

 A project’s IRR is the return it generates on the investment of its cash outflows
 For example, if a project has the following cash flows

0 1 2 3
-5,000 1,000 2,000 3,000

The “price” of receiving

the inflows

The IRR is the interest rate at which the present value of the three inflows
equals the $5,000 outflow
 0 1 2 3
Beginning -$10,000 -$6,979 -$3,656
project balance

Return on -$1,000 -$697 -$365

invested capital

Payment -$10,000 +$4,021 +$4,021 +$4,021

received

Ending project -$10,000 -$6,979 -$3,656 0

balance
The firm earns a 10% rate of return on funds that remain internally invested in
the project. Since the return is internal to the project, we call it internal rate of
return.
 STEP 1.Compute the internal rate of return factor using this formula:

Capital Investment
Annual Cash Inflows

130,000 / 26,000 =5
 Internal Rate of Return Method

 STEP 2. Use the factor and the present value of an annuity of 1 table to find the internal
rate of return.
 Locate the discount factor that is closest to 5.0 on the line for 10 periods.

PRESENT VALUE OF AN ANNUITY OF 1

(N) 6% 7% 8% 9% 10% 12% 14% 15%
Periods
10 7.360 7.024 6.710 6.418 6.145 5.650 5.216 5.019
Internal Rate of Return – Uneven Cash Flows

 If cash inflows are unequal, trial and error solution will result if present value
tables not are used.
 Use business calculators and electronic spreadsheets
 Recap - How do we calculate IRR?

 NPV = Net Present Value of the project

 Initial Investment
 Ct=Cash flow at time t
 IRR = Internal Rate of Return
 Calculating IRR…

 Set the NPV = 0

 Plug in your Cash Flows & Initial Investment
 Solve for IRR!
 This is the same equation used for NPV, except you know your interest rate, i.
 Example

0 1 2
-100 60 60

 -100(1+r)^-0 + 60(1+r)^-1 + 60(1+r)^-2 = 0

 Guess r = 14% or 0.14
 Plug in 0.14 in formula
 -100(1.14)^-0 + 60(1.14)^-1 + 60(1.14)^-2 = -1.2
 Since -1.20 ≠ 0, r ≠14%

 Guess r = 12% or 0.12

 Plug in 0.12 in formula
 -100(1.12)^-0 + 60(1.12)^-1 + 60(1.12)^-2 = 1.4
 Since 1.4 ≠ 0, r ≠ 12%
 Example…

0 1 2
-100 60 60

 Guess r = 13% or 0.13

 Plug in 0.13 in formula
 -100(1.13)^-0 + 60(1.13)^-1 + 60(1.13)^-2 = 0.09
 Since 0.09 is almost equal to 0, r = 13%
 Multiple IRRs

 When projects have non-normal cash flows, multiple IRRs may occur
 A non-normal cash flow occurs when a project calls for a large cash outflow
sometime during or at the end of its life
 There is no way to know which IRR is correct
 Sign changes in the Cash Flows

 IRR evaluates a project correctly when there is an initial negative cash flow,
followed by a series of positive ones (-+++).
 If the signs are reversed (+---), that will change the accurateness of the IRR
calculation.
 If there are multiple sign changes in the cash flows (+-+-+) or (-+-+-), your
calculation would result in multiple IRRs, also making the project very difficult to
evaluate.
 Investment Classification

Simple Investment Non-simple Investment

 Def: Initial cash flows are  Def: Initial cash flows are
negative, and only one negative, but more than
sign change occurs in the one sign changes in the
net cash flows series. remaining cash flow
 Example: -$100, $250, series.
$300 (-, +, +)  Example: -$100, $300, -
$120 (-, +, -)
 ROR: A unique ROR
 ROR: A possibility of
multiple RORs
Period Project A Project B Project C
(N)
0 -$1,000 -$1,000 +$1,000
1 -500 3,900 -450
2 800 -5,030 -450
3 1,500 2,145 -450

4 2,000

Project A is a simple investment.

Project B is a non-simple investment.
Project C is a simple borrowing.
 Multiple Rates of Return Problem

$2,300

-$1,000 -$1,320

• Find the rate(s) of return:

$2,300 $1,320
PW (i )  $1,000  
1 i (1  i ) 2
0
 1
Let x  . Then,
1 i
$2,300 $1,320
PW (i )  $1,000  
(1  i ) (1  i ) 2
 $1,000  $2,300 x  $1,320 x 2
0
Solving for x yields,
x  10 / 11 or x  10 / 12
Solving for i yields
i  10% or 20%
PV Plot for a Non-simple Investment with Multiple Rates of
Return
 Project Balance Calculation
i* =20%
n=0 n=1 n=2

Beg. Balance -$1,000 +$1,100

Interest -$200 +$220
Payment -$1,000 +$2,300 -$1,320

Ending Balance -$1,000 +$1,100 $0

Cash borrowed (released) from the project is assumed to earn the same
interest rate through external investment as money that remains internally
invested.
 Investment Appraisal

Absolutely vital
 Key considerations for firms in considering use: to also
remember this for
evaluation!
 Ease of use/degree of simplicity required

 Degree of accuracy required

 Extent to which future cash flows can be measured accurately

 Extent to which future interest rate movements can be factored in

and predicted
 Necessity of factoring in effects of inflation
 Comparing Methods
Payback Accounting Net present Internal rate
period rate of return value of return
Basisof Cash Accrual Cash flows Cash flows
measurement flows income Profitability Profitability
Measure Number Percent Dollar Percent
expressed as of years Amount
Easy to Easy to Considerstime Considerstime
Understand Understand value of money value of money
Strengths Allows Allows Accommodates Allows
comparison comparison different risk comparisons
acrossprojects acrossprojects levelsover of dissimilar
a project'slife projects
Doesn't Doesn't Difficult to Doesn't reflect
consider time consider time compare varying risk
value of money value of money dissimilar levelsover the
Limitations projects project'slife
Doesn't Doesn't give
consider cash annual rates
flowsafter over the life
payback period of a project
End Here