Capital Budgeting

For 9.220

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Outline
 Introduction
 Net Present Value (NPV)
 Payback Period Rule (PP)
 Discounted Payback Period Rule
 Average Accounting Return (AAR)
 Internal Rate of Return Rule (IRR)
 Profitability Index Rule (PI)
 Special Situations
 Mutually Exclusive, Differing Scales
 Capital Rationing
 Summary and Conclusions

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 Recall the Flows of funds and decisions
important to the financial manager

Investment Financing
Decision Decision

Reinvestment Refinancing
Real Assets Financial Financial
Manager Markets

Returns from Investment Returns to Security Holders

Capital Budgeting is used to make the Investment Decision 3
Introduction
 Capital Budgeting is the process of determining which real
investment projects should be accepted and given an
allocation of funds from the firm.
 To evaluate capital budgeting processes, their consistency
with the goal of shareholder wealth maximization is of
utmost importance.

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 Capital Budgeting
Mutually Exclusive versus Independent Project
 Mutually Exclusive Projects: only ONE of several potential
projects can be chosen, e.g. acquiring an accounting system.


RANK all alternatives and select the best one.

 Independent Projects: accepting or rejecting one project

does not affect the decision of the other projects.


Must exceed a MINIMUM acceptance criteria.

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 The Net Present Value (NPV) Rule
 Net Present Value (NPV) =
Total PV of future CF’s - Initial Investment

 Estimating NPV:

1. Estimate future cash flows: how much? and when?
 2. Estimate discount rate

 3. Estimate initial costs

 Minimum Acceptance Criteria:

Accept if: NPV > 0

 Ranking Criteria: Choose the highest NPV

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 NPV - An Example
 Assume you have the following information on
Project X:
Initial outlay -$1,100 Required return = 10%
Annual cash revenues and expenses are as follows:
Year Revenues Expenses
1 $1,000 $500
2 2,000 1,300
3 2,200 2,700
4 2,600 1,400

 Draw a time line and compute the NPV of project X.

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 The Time Line & NPV of Project X
0 1 2 3 4

Initial outlay Revenues $1,000 Revenues $2,000 Revenues $2,200 Revenues $2,600
($1,100) Expenses 500 Expenses 1,300 Expenses 2,700 Expenses 1,400
Cash flow $500 Cash flow $700 Cash flow (500) Cash flow $1,200

– $1,100.00 1
$500 x
1.10
+454.54 1
$700 x
1.10 2
+578.51 1
- $500 x
1.10 3
-375.66 1
$1,200 x
1.10 4
+819.62
+$377.02 NPV

NPV = -C0 + PV0(Future CFs)

= -C0 + C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + C4/(1+r)4
= ______ + ______ + ______ + _______ + _______
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= $377.02 > 0
 NPV in your HP 10B Calculator
First, clear previous data, and check that your calculator is set to 1 P/YR:
CLEAR ALL
The display should show: 1 P_Yr
Yellow INPUT Input data (based on above NPV example)

Display should show:

Key in CF0 1,100 +/- CFj
CF 0
Display should show:
Key in CF1 500 CFj CF 1

Display should show:

Key in CF2 700 CFj CF 2

Display should show:

Key in CF3 500 +/- CFj CF 3

1,200 CFj Display should show:

Key in CF4
CF 4

Key in r 10 I/YR
NPV
Display should show:
Compute NPV 377.01659723
Yellow PRC 9
NPV: Strengths and Weaknesses
 Strengths

Resulting number is easy to interpret: shows how wealth
will change if the project is accepted.

Acceptance criteria is consistent with shareholder wealth
maximization.
 Relatively straightforward to calculate
 Weaknesses

An improper NPV analysis may lead to the wrong choices
of projects when the firm has capital rationing – this will be
discussed later.

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 The Payback Period Rule
 How long does it take the project to “pay back” its
initial investment?

 Payback Period = # of years to recover costs of

project

 Minimum Acceptance Criteria: set by management

 Ranking Criteria: set by management

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Discounted Payback - An Example

Initial outlay -$1,000

r = 10%
PV of
Year Cash flow Cash flow
1 $ 200$ 182
2 400331
3 700526
4 300205

Accumulated
Year discounted cash flow
1 $ 182
2 513
3 1,039
4 1,244

Discounted payback period is just under 3 years

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Average Accounting Return (AAR)
 Also known as Accounting Rate of Return (ARR)

 Method: using accounting data on profits and book

value of the investment


AAR = Average Net Income / Average Book
Value

 If AAR > some target book rate of return, then

accept the project
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Average Accounting Return (AAR)
 You want to invest in a machine that produces squash balls.
 The machine costs $90,000.

 The machine will ‘die’ after 3 years (assume straight line depreciation,
the annual depreciation is $30,000).

 You estimate for the life of the project:

Year 1 Year 2Year 3

Sales 140160 200
Expenses 120100 90
EBD 2060 110

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Calculating Projected NI

Year 1 Year 2 Year 3

Sales 140 160 200
Expenses 120 100 90
E.B.D.
Depreciation
E.B.T.
Taxes (40%)
NI:

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We calculate:
(i) Average NI =  6 18  48  60  20
3 3
(ii) Average book value (BV) of the investment (machine):

time-0 time-1 time-2 time-3

BV of investment: 90 60 30 0

=> Average BV = (divide by 4 - not 3)

(iii) The Average Accounting Return:

90  60  30  0  45
AAR = = 44.44% 4
Conclusion: If target AAR < 44.44% => accept
If target AAR > 44.44% => reject
20
45

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 The Internal Rate of Return (IRR) Rule

 IRR: the discount rate that sets the NPV to zero

 Minimum Acceptance Criteria:

Accept if: IRR > required return

 Ranking Criteria: Select alternative with the highest IRR

 Reinvestment assumption: the IRR calculation assumes that all future

cash flows are reinvested at the IRR

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 Internal Rate of Return - An Example

Initial outlay = -$2,200

Year Cash flow
1 800
2 900
3 500
4 1,600

Find the IRR such that NPV = 0

______ _______ ______ _______

800 900 500 1,600

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 IRR in your HP 10B Calculator
First, clear previous data, and check that your calculator is set to 1 P/YR:
CLEAR ALL
The display should show: 1 P_Yr
Yellow INPUT Input data (based on above NPV example)

Display should show:

Key in CF0 2,200 +/- CFj
CF 0
Display should show:
Key in CF1 800 CFj CF 1

Display should show:

Key in CF2 900 CFj CF 2

Display should show:

Key in CF3 500 CFj CF 3

Key in CF4 1,600 CFj Display should show:

CF 4
IRR/YR
Display should show:
Compute IRR 23.29565668%
Yellow CST

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 Internal Rate of Return and the NPV Profile

The NPV Profile

Discount rates NPV

0% $1,600.00
5% 1,126.47
10% 739.55
15% 419.74
20% 152.62
25% -72.64


IRR is between 20% and 25% -- about 23.30%

If required rate of return (r) is lower than IRR => accept the project (e.g. r = 15%)

If required rate of return (r) is higher than IRR => reject the project (e.g. r = 25%)

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 The Net Present Value Profile

Net present
value
Year
1,600.00
Cash flow
0 – $2,200
1 800
1,126.47
2 900
3 500
4 1,600
739.55

419.74

159.62

0 Discount
– 72.64 2% 6% 10 14% 18% 22% rate
%

IRR=23.30%

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IRR: Strengths and Weaknesses
 Strengths
 IRR number is easy to interpret: shows the
return the project generates.
 Acceptance criteria is generally consistent with
shareholder wealth maximization.
 Weaknesses
 Does not distinguish between investing and
financing scenarios
 IRR may not exist or there may be multiple IRR
 Problems with mutually exclusive investments
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 IRR for Investment and Financing Projects

Initial outlay = $4,000

Year Cash flow
1 -1,200
2 -800
3 -3,500

Find the IRR such that NPV = 0

_______ _______ _______

-1,200 -800 -3,500

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 Internal Rate of Return and the NPV Profile for a Financing Project

The NPV Profile of a Financing Project:

Discount rates NPV

0%-$1,500.00
5% -891.91
10% -381.67
15% 50.2
20% 418.98


IRR is between 10% and 15% -- about 14.37%

For a Financing Project, the required rate of return is the cost of financing, thus

If required rate of return (r) is lower than IRR => reject the project (e.g. r = 10%)

If required rate of return (r) is higher than IRR => accept the project (e.g. r = 15%)
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 The NPV Profile for a Financing Project

$2,000.00

$1,500.00

$1,000.00

$500.00
NPV ($)

$0.00
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
-$500.00

-$1,000.00

-$1,500.00

-$2,000.00

Rate of Return (%) 25

 Multiple Internal Rates of Return

Example 1

Assume you are considering a

project for which the cash flows
are as follows:

Year Cash flows

0 -$900
1 1,200
2 1,300
3 -1,200

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 Multiple IRRs and the NPV Profile - Example 1

$600.00

$400.00

IRR1=-29.35% IRR2=72.25%
$200.00

$0.00
NPV ($)

-60% -40% -20% 0% 20% 40% 60% 80% 100% 120% 140%
-$200.00

-$400.00

-$600.00

-$800.00

-$1,000.00
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Rate of Return (%)
 Multiple IRRs in your HP 10B Calculator
First, clear previous data, and check that your calculator is set to 1 P/YR:
CLEAR ALL
The display should show: 1 P_Yr
Yellow INPUT Input data (based on above NPV example)

Display should show:

Key in CF0 900 +/- CFj
CF 0
Display should show:
Key in CF1 1,200 CFj CF 1

Display should show:

Key in CF2 1,300 CFj CF 2

Display should show:

Key in CF3 1,200 +/- CFj CF 3
IRR/YR
Display should show:
Compute 1st IRR Yellow CST 72.252175%
STO IRR/YR

Compute 2nd IRR 30 +/- Yellow RCL Yellow CST

by guessing it first
Display should show:
-29.352494% 28
No or Multiple IRR Problem – What to do?

 IRR cannot be used in this circumstance, the only

solution is to revert to another method of
analysis. NPV can handle these problems.
 How to recognize when this IRR problem can
occur
 When changes in the signs of cash flows happen more
than once the problem may occur (depending on the
relative sizes of the individual cash flows).
• Examples: +-+ ; -+- ; -+++-; +---+

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 Multiple Internal Rates of Return

Example 2

Assume you are considering a

project for which the cash flows
are as follows:

Year Cash flows

0 -$260
1 250
2 300
3 20
4 -340

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 Multiple IRRs and the NPV Profile - Example 2
$10.00

$0.00
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
-$10.00
IRR2=29.84%
-$20.00 IRR1=11.52%
NPV ($)

-$30.00

-$40.00

-$50.00

-$60.00

-$70.00

-$80.00

Rate of Return (%) 31

 Multiple Internal Rates of Return

Example 3

Assume you are considering a

project for which the cash flows
are as follows:

Year Cash flows

0 $660
1 -650
2 -750
3 -50
4 850

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 Multiple IRRs and the NPV Profile - Example 3
$200.00

$150.00

$100.00
NPV($)

IRR1=8.05%
$50.00 IRR2=33.96%

$0.00
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

-$50.00

Rate of Return (%)

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 The Profitability Index (PI) Rule
 PI =
Total Present Value of future CF’s / Initial
Investment

 Minimum Acceptance Criteria: Accept if PI > 1

 Ranking Criteria: Select alternative with highest PI

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 Profitability Index - An Example

 Consider the following information on Project Y:

Initial outlay -$1,100
Required return = 10%
Annual cash benefits:

Year Cash flows

1 $ 500
2 1,000

 What’s the NPV?

 What’s the Profitability Index (PI)?

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 The NPV of Project Y is equal to:

NPV = (500/1.1) + (1,000/1.12) - 1,100 = ($454.54 + 826.45) - 1,100

= $1,280.99 - 1,100 = $180.99.

 PI = PV Cashflows/Initial Investment =

 This is a good project according to the PI rule.

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 The Profitability Index (PI) Rule
 Disadvantages:
 Problems with mutually exclusive investments (to

be discussed later)
 Advantages:
 May be useful when available investment funds

are limited (to be discussed later).

 Easy to understand and communicate

 Correct decision when evaluating independent

projects

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Special situations
 When projects are independent and the firm has few constraints on
capital, then we check to ensure that projects at least meet a minimum
criteria – if they do, they are accepted.

NPV≥0; IRR≥hurdle rate; PI≥1

 Sometimes a firm will have plenty of funds to invest, but it must

choose between projects that are mutually exclusive. This means that
the acceptance of one project precludes the acceptance of any others.
In this case, we seek to choose the one highest ranked of the
acceptable projects.
 If the firm has capital rationing, then its funds are limited and not all
independent projects may be accepted. In this case, we seek to choose
those projects that best use the firm’s available funds. PI is especially
useful here.

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Using IRR and PI correctly when projects are
mutually exclusive and are of differing scales

 Consider the following Cash flows Cash flows

Year
two mutually of Project A of Project B
exclusive projects.
Assume the
opportunity cost of 0 -$100,000 -$50
capital is 12%

1 +$150,000 +$100

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Incremental Cash Flows: Solving the
Problem with IRR and PI
 As you can see, individual IRRs and PIs are not good for
comparing between two mutually exclusive projects.
 However, we know IRR and PI are good for evaluating
whether one project is acceptable.
 Therefore, consider “one project” that involves switching
from the smaller project to the larger project. If IRR or PI
indicate that this is worthwhile, then we will know which
of the two projects is better.
 Incremental cash flow analysis looks at how the cash flows
change by taking a particular project instead of another
project.

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Using IRR and PI correctly when projects
are mutually exclusive and are of differing
scales
Incremental
Cash flows of Cash flows of Cash flows of A
Year
Project A Project B instead of B
(i.e., A-B)

0 -$100,000 -$50 -$99,950

1 +$150,000 +$100 +$149,900

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Using IRR and PI correctly when projects
are mutually exclusive and are of differing
scales
 IRR and PI analysis of incremental cash flows
tells us which of two projects are better.

 Beware, before accepting the better project, you

should always check to see that the better project
is good on its own (i.e., is it better than “do
nothing”).

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 IRR, NPV, and Mutually Exclusive Projects
200

Year
150
0 1 2 3
100 4
Project A: – $350 50 100 150 200
50 Project B:IRR
B 17.80125
– $250 % 100 75 50
NPV ($)

0
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
-50

-100

IRRA  12.91%
-150

-200
Rate of Return (%)

Project A Project B
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 IRR, NPV, and the Incremental Project
200 Year
0 1 2 3
150 4
Project A: – $350 50 100 150 200
100
Project B: – $250 125 100 75 50

50 (A-B):
NPV ($)

0
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

-50

-100 The Crossover Rate

= IRRA-B = 8.07%

-150
Rate o Return (%)
-200

Project A Project B Incremental (A-B)

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Capital Rationing
 Recall: If the firm has capital rationing, then its funds are
limited and not all independent projects may be accepted. In
this case, we seek to choose those projects that best use the
firm’s available funds. PI is especially useful here.
 Note: capital rationing is a different problem than mutually
exclusive investments because if the capital constraint is
removed, then all projects can be accepted together.
 Analyze the projects on the next page with NPV, IRR, and
PI assuming the opportunity cost of capital is 10% and the
firm is constrained to only invest $50,000 now (and no
constraint is expected in future years).
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Capital Rationing – Example
(All $ numbers are in thousands)

Year Proj. A Proj. B Proj. C Proj. D Proj. E

0 -$50 -$20 -$20 -$20 -$10

1 $60 $24.2 -$10 $25 $12.6

2 $0 $0 $37.862 $0 $0

NPV $4.545 $2.0 $2.2 $2.727 $1.4545

IRR 20% 21% 14.84% 25% 26%

PI 1.0909 1.1 1.11 1.136 1.145

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Capital Rationing Example:
Comparison of Rankings
 NPV rankings (best to worst)

A, D, C, B, E
• A uses up the available capital
• Overall NPV = $4,545.45
 IRR rankings (best to worst)

E, D, B, A, C
• E, D, B use up the available capital
• Overall NPV = NPVE+D+B=$6,181.82
 PI rankings (best to worst)

E, D, C, B, A
• E, D, C use up the available capital
• Overall NPV = NPVE+D+C=$6,381.82
 The PI rankings produce the best set of investments to accept given
the capital rationing constraint.

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Capital Rationing Conclusions
 PI is best for initial ranking of independent
projects under capital rationing.
 Comparing NPV’s of feasible
combinations of projects would also work.
 IRR may be useful if the capital rationing
constraint extends over multiple periods
(see project C).

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Summary and Conclusions
 Discounted Cash Flow (DCF) techniques are the
best of the methods we have presented.
 In some cases, the DCF techniques need to be
modified in order to obtain a correct decision. It
is important to completely understand these cases
and have an appreciation of which technique is
best given the situation.

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