CHAPTER 10

The Basics of Capital Budgeting

Business Studies Department, BUKC 1

What is capital budgeting?
• Analysis of potential additions to fixed assets.
• Long-term decisions; involve large
expenditures.
• Very important to firm’s future.
Capital Budgeting Concepts
 Capital Budgeting involves evaluation of (and decision
about) projects. Which projects should be accepted?
 Here, our goal is to accept a project which maximizes the
shareholder wealth. Benefits are worth more than the cost.
 The 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 profitable projects.
Steps to capital budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find:
i. Payback Period
ii. Discounted Payback Period
iii. NPV
iv. IRR
v. PI
vi. MIRR
Difference between independent and
mutually exclusive projects
• Independent projects – if the cash flows of one
are unaffected by the acceptance of the other.
• Mutually exclusive projects – if the cash flows
of one can be adversely impacted by the
acceptance of the other.
What is the difference between normal
and non-normal cash flow streams?
• Normal cash flow stream – Cost (negative CF)
followed by a series of positive cash inflows.
One change of signs.
• Non-normal cash flow stream – Two or more
changes of signs. Most common: Cost
(negative CF), then string of positive CFs, then
cost to close project. Nuclear power plant, strip
mine, etc.
Capital budgeting techniques
1. Payback Period (PP)
2. Discounted Payback (DPP)
3. NPV (Net Present Value)
4. IRR (Internal Rate of Return)
5. Profitability Index (PI)
6. MIRR (Modified Internal Rate of Return)
What is the payback period?
• The number of years required to recover a
project’s cost, or “How long does it take to
get our money back?”
• Calculated by adding project’s cash inflows
to its cost until the cumulative cash flow for
the project turns positive.
Calculating payback
Year project S YearProject L
0 ($ 1,000) 0 ($1,000)
1 500 1 100
2 400 2 300
3 300 3 400
4 100 4 600
Calculating payback Project S
Year project S
0 ($ 1,000)
1 500 - 1000
2 400 - 500 1
3 300 - 100 1
4 100 (100/300) = 0.33
2.33
years
Calculating payback
Year Project L Year project L
0 ($1,000) 0 - $1,000
1 -900 1
1 100
2 -600
2 300 1
3 400 3 - 200
1
4 600
4 (200/600)
0.33years
3.33
Calculating payback
Project S
Project L
• Payback Period 2.33 3.33

Decision: PBP with fewer years is better, i.e.

Invest in Project S
Strengths and weaknesses of payback
Calculating Discounted Payback

WACC is 10% & PV = FV/ (1+i)n

Year Project S PV @ WACC
0 ($ 1,000) ($ 1000)
1 500 454.55
2 400 330.58
3 300 225.39
4 100 68.30
Calculating Discounted Payback

Year project S PV @ WACC Disc. Payback

0 ($ 1,000) ($ 1000) -1000
1 500 454.55 -545.45 1
2 400 330.58 -214.87
1
3 300 225.39 (214.87/ 225.39)
0.95
4 100 68.30
2.95
Calculating Discounted Payback
Year project L PVs @ 10%
0 ($ 1,000) - $1,000
1 100 90.90 -909.1 1
2 300 247.93 -661.17 1

3 400 300.52 -360.65 1

4 600 409.80 (-360.65/409.8) 0.88
3.88
Calculating Discounted Payback “S & L”
Project S Project
L
• Payback Period 2.33 3.33
• Discounted Payback 2.95 3.88

Decision: Invest in Project S based on PBP & DPBP (shown

above)
 3. Net Present Value (NPV)
• Sum of the PVs of all cash inflows
and outflows of a project:

NPV = PVs of Cash inflows - PVs of Cash outflows

NPV = CF1 + CF2 + CF3 +···+ CFn – IO

(1+ k ) (1+ k )2 (1+ k )3 (1+ k )n
Rationale for the NPV method
NPV = PV of inflows – Cost
= Net gain in wealth
• If projects are independent, accept if the project
NPV > 0.
• If projects are mutually exclusive, accept
projects with the highest positive NPV, those
that add the most value.
Calculating NPV of Project S
Calculating NPV of Project L
Year project L @ 10%
0 ($ 1,000) - $1,000
1 100 90.90
2 300 247.93
3 400 300.52
4 600 409.80
1049.15
NPV 49.15
 Decision: NPV
Project S Project L
• NPV 78.82 49.15

If independent, then invest in both project because both

are profitable.
If Mutually Exclusive, then invest in Project S because its
more profitable than project L
 Profitability Index
•NPV = PV’s of Cash inflows - PV’s of Cash
outflows
• PI = PV’s of Cash inflows
PV’s of Cash outflows
• PI(s) = 1078.8/ 1000
• PI(s)1.078
• PI(L) = 1049.15/ 1000
• PI(L)1.049
 Project S Project L
• Payback Period 2.33 3.33
• Discounted Payback 2.95 3.88
• NPV 78.82 49.15
• PI 1.078 1.049

Decision: Invest in Project S

NPV Profiles
• A graphical representation of project NPVs at
various different costs of capital.

WACC NPVL NPVS

0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5
 Drawing NPV profiles
NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%
.. S
10
L . .
IRRS = 23.6%
0 . Discount Rate (%)
5 10 15 20 23.6
-10
Reasons why NPV profiles cross
• Size (scale) differences – the smaller project frees
up funds at t = 0 for investment. The higher the
opportunity cost, the more valuable these funds,
so a high WACC favors small projects.
• Timing differences – the project with faster
payback provides more CF in early years for
reinvestment. If WACC is high, early CF
especially good, NPVS > NPVL.
Internal Rate of Return (IRR)

• IRR is the discount rate that forces PV of inflows

equal to cost, and the NPV = 0:

N
CFt
0 t 0 ( 1  IRR ) t
Calculating NPV of Project S
Calculating NPV of Project S @ 15%
• @ 10% NPV 78.8
• @15% NPV -8.33

• 78.8 -8.33

i=IRR= i+ve + NPV +ve ( i )

NPV+ve – NPV -ve
• 10%78.8
• 15%-8.33

i=IRR= i+ve + NPV +ve ( i)

NPV+ve – NPV –ve

IRR= 0.10 + 78.8 (0.05)

(78.8 – (-8.33)
IRR = 0.10 + 78.82 X ( 0.05)
(78.82+8.33)
IRR = 0.1452 x 100

IRR = 14.52%
WACC = 10%
We’ll invest in project S.
IRR is greater than WACC
•IRR is greater than WACC then we invest
•IRR is less than WACC then we don't invest
Calculating IRR of Project L
Calculating IRR of Project L
IRR = 0.10 + 49.15 (0.05)
(49.15+80.15)
IRR = 0.1190 x 100
WACC= 10%
IRR(L) = 11.9%
IRR (S)= 14.52%
How is a project’s IRR similar to a bond’s YTM?

• They are the same thing.

• Think of a bond as a project. The YTM on the
bond would be the IRR of the “bond” project.
• EXAMPLE: Suppose a 10-year bond with a 9%
annual coupon and $1,000 par value sells for
$1,134.20.
• Solve for IRR = YTM = 7.08%, the annual
return for this project/bond.
Rationale for the IRR method
•If IRR > WACC, the project’s return
exceeds its costs and there is some
return left over to boost stockholders’
returns.

If IRR > WACC, accept project.

If IRR < WACC, reject project.
Comparing the NPV and IRR methods

• If projects are independent, the two

methods always lead to the same
accept/reject decisions.
Reinvestment rate assumptions
• NPV method assumes CFs are reinvested at the
WACC.
• IRR method assumes CFs are reinvested at IRR.
• Assuming CFs are reinvested at the opportunity
cost of capital is more realistic, so NPV method
is the best. NPV method should be used to
choose between mutually exclusive projects.
Comparing the NPV and IRR methods
• If projects are independent, the two methods
always lead to the same accept/reject decisions.
• If projects are mutually exclusive …
• If WACC > crossover rate, the methods lead to
the same decision and there is no conflict.
• If WACC < crossover rate, the methods lead to
different accept/reject decisions.
Reference
Chapter 10, From Financial Management, theory and practice by
Brigham and Ehrhardt (13th edition)