Learning Objectives

• Discuss capital budgeting.

• Calculate and use the major capital budgeting

decision criteria, which are NPV, IRR, MIRR,
and payback.

• Explain why NPV is the best criterion and

how it overcomes problems inherent in the
other methods.
 Topics:
• An Overview of Capital Budgeting
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Multiple Internal Rates of Return
• Reinvestment Rate Assumptions
 What is Capital Budgeting?
• Capital
- refers to long-term assets used in production

• Budget
- is a plan that outlines projected expenditures during some future period.

• Capital Budget
- is a summary of planned investments in long-term assets

• Capital Budgeting
- the whole process of analyzing projects and deciding which ones to include in
the capital budget.
- the process of planning expenditures on assets with cash flows that are
expected to extend beyond 1 year.
 Overview
Analyzing capital expenditure proposals is not costless. Benefits can be gained,
but analysis does have a cost. For certain types of projects, an extremely detailed
analysis may be warranted, while for other projects, simpler procedures are
adequate. Accordingly, firms generally categorize projects and then analyze them in
each category somewhat differently:

• Replacement: needed to continue current operations.

• Replacement: cost reduction.
• Expansion of existing products or markets.
• Expansion into new products or markets.
• Safety and/or environmental projects.
• Other projects.
• Mergers.
Net Present Value

Net Present Value

tu rn
Internal Rate of Re

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 Net Present Value
Recall that free cash flow represents the net amount of cash that is available
for all investors after taking into account the necessary investments in fixed
assets (capital expenditures) and net operating working capital.

Similarly, the value of a project is equal to its net present value (NPV),
which is simply the present value of the project’s free cash flows discounted at
the cost of capital. The NPV tells us how much a project contributes to
shareholder wealth; the larger the NPV, the more value the project adds—and
added value means a higher stock price.
 Net Present Value
Net Present Value (NPV) is:

“Present Value of all cash inflows – Present Value of all cash outflows”

Example: Pay Slip

Net Salary = Gross Salary – Deductions

Similarly, The Present Value of all cash inflows is the Gross Present Value
and if you deduct cash outflows it becomes your Net Present Value.

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 Criteria of
NPV
If NPV > 0 (NPV is + then ACCEPT the Project)

If NPV < 0 (NPV is – then REJECT the Project)

If NPV = 0 (Accept the Project, considering other non

tangible benefits)

The greater the NPV, the

better the prospects.
 How do we compute the NPV?

Where:
FV is the Future Value
k is the discounted rate
n is the time of the cash flow
Solution:
Step 1: Calculate the PV value of year 1, year 2, year 3, year 4, and year 5.
Step 2: Sum up the PV of all years.
Step3: NPV = Present value of all cash inflows – Present value of all cash
outflow.
Step 4: If NPV is positive, accept the project, if not reject the project.
Example 1: Calculating NPV

A sum of $ 400,000 dollars invested today in an IT project may give a series of below
cash inflows in the future:

$ 70,000 in year 1
$ 120,000 in year 2
$ 140,000 in year 3
$ 140,000 in year 4
$ 40,000 in year 5

If Opportunity cost of capital is 8% per annum, then should we accept or reject the
project?
Example1: Calculating NPV

Cash Inflow of all Present Values is: $ 408,959.50

Present value of Cash outflow is: $400,000

Net Present Value = PV of Cash inflows – PV of Cash Outflows

($408959.50 – $400000) = $8959.50 dollars.

Since NPV is positive, (i.e., $8959.50, This project can be ACCEPTED)

Example2: Calculating NPV
Same example: Calculating NPV however with Discount rate or Opportunity cost of capital at 15%
A sum of $ 400,000 dollars invested today in an IT project may give a series of below cash inflows in future:

$ 70,000 in year 1
$ 120,000 in year 2
$ 140,000 in year 3
$ 140,000 in year 4
$ 40,000 in year 5

If Opportunity cost of capital is 15% per annum, then should we accept or reject the project?

Solution: Calculating NPV

Step 1: Calculate the PV value of year 1, year 2, year 3, year 4, and year 5
Step 2: Sum up the PV of all years
Step3: NPV = Present value of all cash inflows – Present value of all cash outflow.
Step 4: If NPV is positive, Accept the project, if not Reject the project.
Example2: Calculating NPV

N.B: Though we have the same

inflow & outflow of cash as in
the previous example, the NPV
value changed with the change
in the Discount rate of interest.
Therefore, NPV is very much
dependent on the Discount rate
or in other words the opportunity
cost of the capital value.

Cash Inflow of all Present Values is : $ 343591.60

Present value of Cash outflow is : $400,000

Net Present Value = PV of Cash inflows – PV of Cash Outflows

($343591.60 – $400000) = $ -56408.40 dollars
(negative 56408.40 dollars)

Since NPV is Negative, (i.e., - $56408.40, this project should be REJECTED)

 What if there are two projects to choose from?

Before using these NPVs in the decision process, we need to know

whether the two projects are independent or mutually exclusive.
Independent projects are projects whose cash flows are not affected by one
another. If Waltermart was considering a new store in Batangas City and
another in Lipa City, the projects would be independent - and if both had
positive NPVs, Waltermart should accept both.

Mutually exclusive projects, on the other hand, are projects where if

one project is accepted, the other must be rejected. A conveyor belt system to
move goods in a warehouse and a fleet of forklifts used for the same purpose
would be mutually exclusive - accepting one implies rejecting the other.
 What if there are two projects to choose from?
What should be the decision if there are two projects are independent?
In this case, both should be accepted because both have positive NPVs and
thus add value to the firm. However, if they are mutually exclusive, the
project that should be chosen be the one which has higher positive NPV and
thus adds more value than other project.

Here is a summary of the NPV decision rules:

• Independent projects. If NPV exceeds zero, accept the project.
• Mutually exclusive projects. Accept the project with the highest positive
NPV.
• If no project has a positive NPV, reject them all.

Because projects must be either independent or mutually exclusive, one

or the other of these rules applies to every project.
Internal Rate of Return (IRR)
• IRR = % of Return on investment.
• To put it simple: It is the percentage of Return of your investment.
• How do we calculate IRR?
• If you remember from NPV example, we mentioned that the NPV is dependent on
Discounted rate.
• If we increase the discount rate, the NPV value decreases.
• We need to increase /decrease the discount rate to a level where NPV becomes zero.
• The discount rate at which NPV becomes zero is in fact the Internal rate of return.
• In other words, IRR is the opportunity cost at which the NPV becomes Zero.

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IRR
Let’s say at 8%, Discount rate, the NPV is 5000

Discount And
Rate
Let’s say at 12%, Discount rate, the NPV is 0

Net Then 12% is the return, we are getting from the

Present project .
Value
And

This 12% is called the IRR.

Internal Rate of Return (IRR)
Note:
• For Constant rate of Cash inflow for every year, Internal Rate of Return can be calculated with the help
of a formula.
• For Uneven rate of Cash inflows for every year, IRR can be calculated by little trial & error
adjustments.

Accept the project when Internal rate of return > Discount rate or Opportunity cost of capital.

Reject the project when Internal rate of return < Discount rate or Opportunity cost of capital.

May accept the project when Internal rate of return = Discount rate or Opportunity cost of
capital.

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Calculating Internal Rate of Return
Example:

The cost of a project is $1000. It has a time horizon of 5 years and the expected year wise incremental cash flows are:

Year 1 : $200
Year 2 : $300
Year 3 : $300
Year 4 : $400
Year 5 : $500

Compute IRR of the project. If opportunity cost of Capital is 12%, And tell us, should we accept the project?

Solution:
Step 1: Take “K” as 12% and calculate NPV value.
Step 2: If NPV < 0 then Project is NOT financially viable at 12% discount rate.
Step 3: If NPV > 0 then Project is financially viable at 12% however we need to know the actual IRR value, so we
need to increase the K value to and calculate the NPV, continue it till you reach a point where the NPV becomes zero
or close to zero.

Step 4: The “K” value at which NPV becomes Zero or “Near Zero” is the actual IRR (Internal Rate of Return)
Calculating Internal Rate of Return

At Discount Rate of 12%, the NPV is 169 (positive)

At Discount Rate of 17.7%, the NPV is 0 (Zero), there fore the IRR is 17.7%

Since IRR > Discount rate, Project can be accepted

 Multiple Internal Rates of
Return
A problem with the IRR is that under certain conditions a project
may have more than one IRR. First, note that a project is said to have
normal cash flows if it has one or more cash outflows (costs)
followed by a series of cash inflows. If, however, a cash outflow
occurs sometime after the inflows have commenced, meaning that the
signs of the cash flows change more than once, the project is said to
have non-normal cash flows.

Normal: - + + + + + or - - + + + + +
Non-normal: - + + + + - or - + + + - + + +
 Example of Multiple Internal Rates of Return
The following cash flows series illustrate the difference between normal and non-
normal pattern of cash flows.

Period 0 1 2 3 4 5
Normal cash flows -25,000 6,000 8,000 9,000. 7,000 13,000
Non-normal cash flows -17,000 16,000 16,000 16,000 16,000 -52,000

The first series is the normal cash-flow pattern, which has one sign change, i.e. it has
initial cash out flow followed by five continuous periods of net cash inflows. It has one IRR,
which is 18.95%.

The second series is non-normal cash-flow pattern, which has two sign changes. It has
cash outflow followed by cash inflows followed by cash outflow. It has two IRRs, 6.77%
and 65.36%. This is the range in which the net present value of the non-normal cash flow
series is positive.

The multiple IRR problem poses a series problem to analysts because the decision is not
obvious. IRR decision rule involves comparison of project IRR with the hurdle rate. If there
are two values for IRR, we do not know which value to compare with hurdle rate.
Reinvestment Rate Assumptions
The NPV calculation is based on the assumption that cash inflows can be reinvested
at the project’s risk-adjusted WACC, whereas the IRR calculation is based on the
assumption that cash flows can be reinvested at the IRR.

The NPV assumes reinvestment at the WACC, while the IRR assumes reinvestment
at the IRR. Which assumption is more reasonable? For most firms, assuming
reinvestment at the WACC is more reasonable for the following reasons:
• If a firm has reasonably good access to the capital markets, it can raise all the
capital it needs at the going rate, for example at 10%.
• Because the firm can obtain capital at the rate of 10%, if it has investment
opportunities with positive NPVs, it should take them on, and it can finance them at a
10% cost.
• If the firm uses internally generated cash flows from past projects rather than external
capital, this will save it the 10% cost of capital. Thus, 10% is the opportunity cost of
the cash flows, and that is the effective return on reinvested funds.
 Reinvestment Rate Assumptions
To illustrate, suppose a project’s IRR is 50%, the firm’s WACC is 10%, and the
firm has adequate access to the capital markets. Thus, the firm can raise the capital it
needs at the 10% rate. Unless the firm is a monopoly, the 50% return would attract
competition, which would make it difficult to find new projects with similar high
returns, which is what the IRR assumes.

Moreover, even if the firm does find such projects, it could take them on with
external capital that costs 10%. The logical conclusion is that the original project’s cash
flows will save the 10% cost of the external capital, and that is the effective return on
those flows.

If a firm does not have good access to external capital and if it has many potential
projects with high IRRs, it might be reasonable to assume that a project’s cash flows
could be reinvested at a rate close to its IRR. However, that situation rarely exists:
Firms with good investment opportunities generally do have good access to debt and
equity markets.
 Reinvestment Rate Assumptions

Our conclusion is that the assumption built into the IRR—that cash
flows can be reinvested at the IRR—is flawed, whereas the assumption
built into the NPV— that cash flows can be reinvested at the WACC—
is generally correct.

Moreover, if the true reinvestment rate is less than the IRR, the true
rate of return on the investment must be less than the calculated IRR;
thus, the IRR is misleading as a measure of a project’s profitability.