ASB9032: Corporate Finance

Unit 2: Capital Budgeting

Professor Aziz Jaafar
Bangor Business School
Bangor University
(email: a.jaafar@bangor.ac.uk)

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Outline
• Introduction – What is Capital Budgeting?
• Appraisal Techniques
– Payback Method
– Discounted Cash Flow (DCF) Techniques
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
• Summary

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What is capital budgeting?

• Capital Budgeting involves evaluation of (and decision about)
projects. Which projects should be accepted?
• The aim is to accept a project which maximizes the shareholder
wealth.
• Focus: Benefits (Cash Inflows) & the cost (Cash Outflows).
• Capital Budgeting is based on forecasting.
– Estimate future expected cash flows.
• Evaluate project based on the evaluation method.
• Classification of Projects:
– Mutually Exclusive - accept ONE project only
– Independent - accept ALL projects as long as they meet the
criteria.
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Capital Budgeting Project Categories:

1. Replacement to continue profitable operations

2. Replacement to reduce costs
3. Expansion of existing products or markets
4. Expansion into new products/markets
5. Safety and/or environmental projects
6. Mergers etc.

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Payback Period
The payback period is the amount of time
required for the firm to recover its initial
investment

• If the project’s payback period is less than the

maximum acceptable payback period, accept the
project
• If the project’s payback period is greater than the
maximum acceptable payback period, reject the
project
Management determines maximum acceptable
payback period
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Payback Period
Example: Cash Flows
• Initial Cash Outlay - amount of capital spent to get project going.
• If spend $10 million to build new plant then the Initial Outlay (IO) = $10 million

CF
CF00 == Cash
Cash Flow
Flow time
time 00 == -10
-10 million
million

• Annual Cash Inflows--after-tax CF

• Cash inflows from the project

CF
CFnn == Sales
Sales -- Costs
Costs

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Payback Period
• Number of years needed to recover the initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500

Cumulative CF -6,500 -3,000 +500
Payback = 2 + (3000/3500) = 2.86 years www.charteredbankermba.co.uk
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Payback Period
• Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000

Cumulative CF -9,500 -9,000 -4,400 +5,600
Payback = 3 + (4400/10000) = 3.44 years www.charteredbankermba.co.uk
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Payback Period
• Number of years needed to recover the initial outlay.

P R O J E C T Decision:
Time A B Company sets maximum
0 (10,000.) (10,000.) acceptable payback. If Max
1 3,500 500 PB = 3 years, accept
2 3,500 500 project A and reject project
3 3,500 4,600 B
4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000

Cumulative CF -9,500 -9,000 -4,400 +5,600
Payback 3.44 years www.charteredbankermba.co.uk
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Payback Period
• 1st Drawback: It does not consider the time value of money.
• Which project should you choose?
CF0 CF1 CF2 CF3
A -100,000 90,000 9,000 1,000
B -100,000 1,000 9,000 90,000

• The Discounted payback method can correct this shortcoming of the payback
method. To find the discounted pay back
– Find the PV of each cash flow on the time line.
– Find the payback using the discounted CF and NOT the CF.

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Payback Method
• 2nd Drawback: it does not consider the cash flows beyond the
payback period.
• Which project should you choose?
CF0 CF1 CF2 CF3 CF4
• A -100000 90000 10000 0 0
• B -100000 90000 9000 80000 1000000

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Net Present Value

• Present Value of all costs and benefits of a project.

NPV
NPV == PV
PV of
of Inflows
Inflows -- Initial
Initial Outlay
Outlay
• NPV method computes the present value of all expected future cash flows
using a minimum desired rate of return

CF1 CF2 CF3 CFn

NPV = (1+ k )
+ (1+ k )2
+ +···+ – IO
(1+ k ) 3
(1+ k ) n

• The minimum desired rate of return depends on the risk-the higher the risk,
the higher the rate.
• The required rate of return (also called hurdle rate or discount rate) is the
minimum desired rate of return based on the firm’s cost of capital.

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Net Present Value
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000

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Net Present Value

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4

(10,000) 500 $500 500 4,600 10,000

(1.10)
455 $500
(1.10) 2 $4,600
413
(1.10) 3
3,456 $10,000
(1.10) 4
6,830

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Net Present Value P R O J E C T

Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000

455
413 PV Benefits > PV Costs NPV > $0
3,456 $11,154 > $ 10,000 $1,154 > $0
6,830
$11,154
$1,154 = NPV www.charteredbankermba.co.uk
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Net Present Value

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500

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Net Present Value

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500

3,500 3,500 3,500 3,500
NPV = (1+ .1 ) + (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 – 10,000

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Net Present Value

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500

3,500 3,500 3,500 3,500
NPV = (1+ .1 ) + (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 – 10,000
= 3,500 x PVIFA 4,.10 - 10,000
= 11,095 – 10,000 = $1,095
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Net Present Value

• Project A: $1,095
• Project B: $1,154

• Which project should you choose:

– Independent project? independent, if the cash flows of
one are unaffected by the acceptance of the other.
– Mutually Exclusive Project? mutually exclusive, if the cash
flows of one can be adversely impacted by the acceptance
of the other.

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Pros and Cons Of Using NPV As Decision

Rule
• NPV is the “gold standard” of investment decision
rules
• Key benefits of using NPV as decision rule
– Focuses on cash flows, not accounting earnings
– Makes appropriate adjustment for time value of
money
– Can properly account for risk differences between
projects
• Though best measure, NPV has some drawbacks
– Lacks the intuitive appeal of payback
– Doesn’t capture managerial flexibility (option value)
well
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Internal Rate of Return

• Measures the rate of return that will make the PV of future CF
equal to the initial outlay.

Definition:
The IRR is that discount rate at which
NPV = 0
• If IRR > minimum desired rate of return,
then NPV > 0 and accept the project.
• If IRR < minimum desired rate of return,
then NPV < 0 and reject the project.

• IRR is similar to the Yield To Maturity (YTM). It is the

same concept but the term YTM is used only for bonds.

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Internal Rate of Return

• Measures the rate of return that will make the PV of future CF
equal to the initial outlay.

Or, the IRR is the discount rate at which NPV =

0

6,000
N
P
Project B
V

Project
ProjectAA
3,000
NPV = $0 IRRA » 15%

IRRB » 14%
0 Cost of Capital
5% 10% 15% www.charteredbankermba.co.uk
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Internal Rate of Return

• Determine the mathematical solution for IRR
CF1 CF2 CFn
0 = NPV = + +···+ – IO
(1+ IRR ) (1+ IRR ) 2
(1+ IRR ) n

CF1 CF2 CFn

IO = + +···+
(1+ IRR ) (1+ IRR ) 2
(1+ IRR )n

Outflow = PV of Inflows
Solve for Discount Rates

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Internal Rate of Return

6,000
N Project B
For Project B P
Cannot solve for IRR V
directly, use Trial &
3,000
Error

IRRB » 14%
0 Cost of Capital
5% 10% 15% 20%

10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

(1+ IRR ) (1+ IRR ) (1+ IRR ) (1+ IRR )
TRY 14%
? 500
10,000 = + 500 2 + 4,600 3+ 10,0004
(1+ .14 ) (1+ .14) (1+ .14 ) (1+ .14 )
?
10,000 = 9,849 www.charteredbankermba.co.uk
PV of Inflows too low, try lower rate
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Internal Rate of Return

For Project B 6,000
N Project B
P
use Trial & Error V

3,000

IRRB » 14%
0 Cost of Capital
5% 10% 15% 20%

10,000 = 500 + 500 2 + 4,600 3 + 10,000 4

(1+ IRR ) (1+ IRR ) (1+ IRR ) (1+ IRR )
TRY 13%
? 500
10,000 = + 500 2 + 4,600 3+ 10,0004
(1+ .13 ) (1+ .13) (1+ .13 ) (1+ .13 )
?
10,000 = 10,155 13% < IRR < 14%
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Internal Rate of Return

Decision Rule for Internal Rate of Return

Independent Projects
Accept Projects with
IRR ³ required rate

Mutually Exclusive Projects

Accept project with highest
IRR ³ required rate

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Internal Rate of Return

• Advantages
– Properly adjusts for time value of money
– Uses cash flows rather than earnings
– Accounts for all cash flows
– Project IRR is a number with intuitive appeal
• Three key problems encountered in using IRR:
– Lending versus borrowing?
– Multiple IRRs
– No real solutions

IRR and NPV rankings do not always agree

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Profitability Index
Similar to Net Present Value

PI = PV of Inflows
Initial Outlay

Instead of Subtracting the Initial Outlay from the PV

of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.

CF1 CF2 CF3 CFn

(1+ k )
+ (1+ k )2
+ +···+
(1+ k )3 (1+ k )n
PI =
IO
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Profitability Index
Profitability Index for Project B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4 P R O J E C T
PI =
10,000 Time A B
0 (10,000.) (10,000.)
11,154
PI = = 1.1154 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
Profitability Index for Project A 4 3,500 10,000
1 1
3,500(.10 .10(1+.10) )
4

PI =
10,000
11,095
PI = = 1.1095
10,000
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Decision Rules
Profitability Index
• Independent Projects
– Accept Project if PI ³ 1
• Mutually Exclusive Projects
– Accept Highest PI ³ 1 Project

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Comparison of Methods
Project A Project B Choose
Payback < 3 years < 4 years A
NPV $1,095 $1,154 B
IRR 14.96% 13.50% A
PI 1.1095 1.1154 B
 Time Value of Money
• Payback - Does not adjust for timing
differences
• NPV, IRR and PI take into account the
time value of money
 Relevant Cash Flows?
• NPV, IRR and PI use all Cash Flows
• Payback method ignores Cash Flows that
occur after the Payback Period.

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Comparison of Methods
• NPV & PI indicated accept Project B while IRR indicated that Project A should
be accepted. Why?
• Sometimes there is a conflict between the decisions based on NPV and IRR
methods.
• The conflict arises if there is difference in the timing of CFs or sizes of the
projects (or both).
• The cause of the conflict is the underlying reinvestment rate assumption.
• Reinvestment Rate Assumptions
– NPV assumes cash flows are reinvested at the required rate, k.
– IRR assumes cash flows are reinvested at IRR.
• Reinvestment Rate of k more realistic as most projects earn approximately k
(due to competition)
• Another problem with IRR is that if the sign of the cash flow changes more
than once, there is a possibility of multiple IRR.
• NPV is the Best Method for project evaluation as it is consistent with the goal
of a firm, i.e. shareholders’ wealth max. www.charteredbankermba.co.uk
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Summary:
A Capital Budgeting Process Should:
Account for the time value of money

Account for risk

Focus on cash flow

Rank competing projects appropriately

Lead to investment decisions that maximize

shareholders’ wealth
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Thank you

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