Capital Budgeting Techniques

Session 4 and 5

FINANCIAL MANAGEMENT
MBA-MARKETING
2024

Kavitha Ranganathan
 Corporate Finance – Big Picture*

*Aswath Damodaran
Why Managers Need to Know of tools to access Project
Management?
Is Sony Turning Around?
 What is capital budgeting?

Analysis of potential projects.

Long-term decisions; involve large expenditures.

Very important to firm’s future.

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 Classifying projects
6

Replacement Expansion New Products

Projects Projects and Services

Regulatory, Others
Safety, and • R&D
Environmental • M&A
Projects
 Basic Rules of Capital Budgeting Process
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 Step 1: Generate proposals

 Step 2: Estimate the cash flows

 Step 3: Estimate Discount Rates

 We take estimation of WACC as known for this lecture

 Step 4: Evaluate alternatives and select projects

 Evaluation can be based on multiple criteria such as the NPV

rule, IRR , Profitability Index and Payback periods
 Step 5: Review prior decisions
 Independent versus Mutually Exclusive
Projects

 Independent projects are whose cash flows are unrelated to

one another or unaffected; the acceptance of one does not
eliminate the others from further consideration.
 Mutually exclusive projects are projects that compete with
one another, so that the acceptance of one eliminates further
consideration of other projects that serve a similar function.
 Steps in Project Analysis: Capital Rationing
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 Capital rationing is when the amount of expenditure for capital

projects in a given period is limited.

 If the company has so many profitable projects that the initial

expenditures in total would exceed the budget for capital projects

for the period, the company’s management must determine which
of the projects to select.
 Capital rationing may result in the rejection of profitable
projects.
Investment decision (Evaluation) criteria
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Net Present Value (NPV)

Internal Rate of Return (IRR)

Payback Period

Discounted Payback Period

Average Accounting Rate of Return (AAR)

Profitability Index (PI)

I. Payback Period
 Example

Bennett Company is a medium sized metal fabricator that

is currently contemplating two projects: Project A requires
an initial investment of $42,000, project B an initial
investment of $45,000. The relevant operating cash flows
for the two projects are presented in Table 10.1 and
depicted on the time lines in Figure 10.1.
Table 10.1 Capital Expenditure Data
for Bennett Company
Figure 10.1 Bennett Company’s
Projects A and B
 I. Payback Period (cont.)

 Project A, which is an annuity, the payback period is 3.0 years

($42,000 initial investment ÷ $14,000 annual cash inflow).

 Project B generates a mixed stream of cash inflows

 In year 1, the firm will recover $28,000 of its $45,000 initial investment.
 By the end of year 2, $40,000 ($28,000 from year 1 + $12,000 from year 2)
will have been recovered.
 At the end of year 3, $50,000 will have been recovered.
 Only 50% of the year-3 cash inflow of $10,000 is needed to complete the
payback of the initial $45,000.
 The payback period for project B is therefore 2.5 years (2 years + 50% of year 3).
 Pros and Cons of Payback Analysis

 Used by large firms to evaluate small projects

 Its popularity results from its computational simplicity and

intuitive appeal.
 By measuring how quickly the firm recovers its initial investment,

the payback period also gives implicit consideration to the timing

of cash flows.
 Many firms use the payback period as a decision criterion or as a

supplement to other decision techniques.

 Pros and Cons of Payback Analysis

 Not based on discounting cash flows to determine whether they

add to the firm’s value.

 this approach fails to take into account time value of money.
 Failure to recognize cash flows that occur after the payback

period.
Ia. Discounted Payback Period
Ia. Discounted Payback Period
 II. Net Present Value (NPV)

Net present value (NPV) is a sophisticated capital

budgeting technique; found by subtracting a project’s
initial investment from the present value of its cash
inflows discounted at a rate equal to the firm’s cost of
capital.
NPV = Present value of cash inflows – Initial investment
 II. Net Present Value (NPV) (cont.)

Decision criteria:
 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
increase the market value of the firm, and therefore the
wealth of its owners by an amount equal to the NPV.
Figure 10.1 Bennett Company’s
Projects A and B
 The Big Picture:
The Net Present Value of a Project

Project’s Cash Flows

(CFt)

CF1 CF2 CFN

NPV = + + ··· + − Initial cost
(1 + r )1 (1 + r)2 (1 + r)N

Market Project’s
interest debt/equity
Project’s risk-
rates capacity
adjusted
cost of capital
Market Project’s
(r)
risk business
aversion risk
 Rationale for the NPV Method

NPV = PV inflows – Cost

This is net gain in wealth, so accept project if NPV >

0.

Choose between mutually exclusive projects on basis

of higher positive NPV. Adds most value.

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Using the NPV measure, which Project
should be accepted?

If Projects A and B are mutually exclusive, accept A

because NPVA > NPVB.

If A & B are independent, accept both; NPV > 0.

NPV is dependent on cost of capital.

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 III. Profitability Index

For a project that has an initial cash outflow followed by cash

inflows, the profitability index (PI) is simply equal to the
present value of cash inflows divided by the initial cash outflow:

When companies evaluate investment opportunities using the PI,

the decision rule they follow is to invest in the project when the
index is greater than 1.0.
 III. Profitability Index (cont.)

We can refer back to Figure 10.2, which shows the present

value of cash inflows for projects A and B, to calculate the
PI for each of Bennett’s investment options:

PIA = $53,071 ÷ $42,000 = 1.26

PIB = $55,924 ÷ $45,000 = 1.24

 IV. Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a sophisticated capital

budgeting technique
 the discount rate that equates the NPV of an investment

opportunity to 0 (because the present value of cash inflows

equals the initial investment)
 Internal rate of return (IRR) calculates a rate of return

which is offered by the project irrespective of the required

(market) rate of return
Calculation of IRRs for Bennett Company’s Capital Expenditure
Alternatives
Figure 10.3 Calculation of IRRs for Bennett Company’s Capital
Expenditure Alternatives
Understanding Internal Rate of Return
2500
2000
1500
IRR=35%
1000
NPV (,000s)

500
0
-500
-1000
-1500
-2000
Discount rate (%)
 Rationale for the IRR Method

If IRR > r, then the project’s rate of return is greater

than its cost. The extra return over the cost of capital
is to boost stockholders’ ROI.

Example:

r= 10%, IRR = 15%.

This project adds extra return to shareholders.

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 Internal Rate of Return (IRR)

Decision criteria:

 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.

These criteria guarantee that the firm will earn at least its
required rate of return or the cost of capital.
 Decisions on Projects A and B per IRR

If A and B are independent, accept both: IRRA > r

and IRRB > r.

If A and B are mutually exclusive, accept B because

IRRB > IRRA.

IRR is NOT dependent on the cost of capital.

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 Don’t confuse IRR and
Opportunity Cost of Capital

 IRR and opportunity cost of capital

 IRR is that rate at which NPV = 0

 Which depends solely on the amount and timing of cash flows
 Opportunity cost of capital is a standard of profitability that is

used to calculate how much is the project worth

 It is the expected rate of return offered by other assets in the
market with the same risk as the project being evaluated.
Comparison of NPV and IRR Methods

and inherent Conflicts

 Conventional and nonconventional CFs
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Today 1 2 3 4 5
| | | | | |
| | | | | |

–CF +CF +CF +CF +CF +CF

–CF –CF +CF +CF +CF +CF

–CF +CF +CF +CF +CF

Today 1 2 3 4 5
| | | | | |
| | | | | |

–CF +CF +CF +CF +CF –CF

–CF +CF –CF +CF +CF +CF

–CF –CF +CF +CF +CF –CF

 Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN

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 Pitfall 1 - Multiple Rates of Return

 Certain cash flows can generate NPV= 0 at two different discount rates.

 Hemsley ore company proposing to develop a new mine strip in western

India. The mine involves an initial investment of $30 billion and is

expected to produce a cash inflow of $10 billion a year for next nine years.
At the end of the time, the company will incur 65 billion clean-up costs
(remove its offshore oil platforms).
Pr oject C0 C1 C9 C10 IRR = +3.50% and 19.54
A  30  10 ... 10  65 NPV = 2.53 billion
 Multiple Rates of Return

 Certain cash flows can generate NPV=0 at two different discount rates.
 The following cash flow generates NPV=0 at both (3.5%) and 19.54%.

NPV
100

IRR=19.54
50
%

0 Discount
Rate

-50 IRR=3.5%

-100
 Which IRR would you consider?

 Consider that IRR, which has realistic

“reinvestment” rates.
 Or, in such instances, go with the NPV-rule to select

or reject projects.
Pitfall 2 – Scale and Timing of CFs for
Mutually Exclusive Projects
 NPV Profiles

A graph that plots a

project’s NPV
against different
cost of capital rates
 Note that at 0
cost of capital,
NPV = project’s
undiscounted
CFs.
 What do you notice from the Graph,
NPV Profiles?
 NPV Rankings Depends on the Cost of Capital

 NPV Profiles for both Project L and S decline, as Cost of Capital

increases.
 Project L has higher NPV, when the cost of capital is low
 In contrast, Project S has higher NPV when cost of capital is
greater than 7.2 crossover rate
 Project L’s NPV profile has a steeper slope than that of S,
indicating that a small change in the cost of capital has greater
effect on NPVL than NPVS

 WHY?
Why?
 Evaluating Independent Projects

 If independent projects are being evaluated, then the NPV and IRR

criteria always lead to the same accept/reject decision:

 Assume that Projects L and S are independent

(1) At any cost of capital less than 11.8%, Project L will be acceptable

by both the NPV and IRR, while both methods reject Project L if
the cost of capital is greater than 11.8%.
(2) whenever the cost of capital is less than its IRR, NPV is positive.

(3) Same with Project S.

 NPV and IRR: No conflict for
independent projects.

NPV ($)

IRR > r r > IRR

and NPV > 0 and NPV < 0.
Accept. Reject.

r (%)
IRR
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 Evaluating Mutually Exclusive Projects

 Logic suggests that the NPV method is better,

because it selects the project that adds the most to

shareholder wealth.

But what causes the conflicting recommendations?

Pitfall 2: What causes NPV and IRR Conflicts?

Two basic conditions can cause NPV profiles to cross, and thus
conflicts to arise between NPV and IRR:
(1) when project size (or scale) differences exist, meaning that the
cost of one project is larger than that of the other, or
(2) when timing differences exist, meaning that the timing of cash
flows from the two projects differs such that most of the cash
flows from one project come in the early years while most of the
cash flows from the other project come in the later years, as
occurred with our Projects L and S.
 How useful is it to generate cash flows
sooner rather than later?

 The value of early cash flows depends on the return we can earn on

those cash flows, that is, the rate at which we can reinvest them.
 The NPV method implicitly assumes that the rate at which cash

flows can be reinvested is the cost of capital, whereas the IRR

method assumes that the firm can reinvest at the IRR. These
assumptions are inherent in the mathematics of the discounting
process.
 Which is the better assumption—that cash flows can be reinvested

at the cost of capital, or they can be reinvested at the project’s IRR?

 Summary: Evaluating Investment Alternatives

Which method should be relied upon?

 It depends on which reinvestment assumption is most realistic.
 Most often, the NPV assumption of reinvestment at WACC is
the most realistic because no rational manager would reinvest
cash flows at rates lower than the firm’s cost of capital.
 Projects with high IRRs are not common – to assume that
future cash flows will be reinvested at the IRR rate is probably
mis-leading.
 Solution: NPV vs IRR Conflict

Calculate Incremental Cashflows, and Find the corresponding NPV and

IRR rate.
 Incremental cashflows

 If you want to use the IRR rule, then you need to

check the incremental cashflows
 The IRR on incremental cash flow from G is 15.6%.
 Since it is greater than the cost of capital, undertake
G than F.
 Matter of Fact

Which Methods Do Companies Actually Use?

 JFE (2001) asked Chief Financial Officers (CFOs) what methods
they used to evaluate capital investment projects.
 The most popular approaches by far were IRR and NPV, used by
75.61% and 74.93% respectively of the CFOs responding to the
survey.
 These techniques enjoy wider use in larger firms, with the
payback approach being more common in smaller firms.
 CFO Preferences
Evaluation Technique

Evaluation
Technique

IRR
NPV
Hurdle Rate
Payback
Sensitivity Analysis
P/E multiples
Discounted payback
Real options
Book rate of return
Simulation analysis
Profitability Index
APV

0% 10% 20% 30% 40% 50% 60% 70% 80%

Source: Data from Graham, John R. and Harvey, Campbell R. “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of
Financial Economics 60 (2001), p. 187-243.