Introduction To Finance

Tutorial 4: Capital
Budgeting
Hilary Term 2023/24
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 RECAP: Functions of Finance
Procurement of Funds Utilization of Funds
(Sources of funds) (Application of Funds)
Objective: To Minimize Costs Objective: To Maximize Returns

Short
Long Term Short Term Long Term
Term
Sources Investments Investments
Sources
Own Loan Fixed Assets and
Funds Current Liabilities Current Assets
Funds E.g. Creditors, Payables, etc E.g. Cash, Receivables, etc. Projects Funds
E.g. Equity E.g. Debt

Capital structure Investment

decisions/ Financing Working Capital Management Decisions Decisions/ Capital
Decisions Budgeting

How should we return value to

shareholders?

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Question 1: NPV
a. Given the annual cashflows below, calculate the NPV of Project A and Project B
(rounded to two decimal places), using a cost of capital of 11%.
b. Which of these projects is worth pursuing?
c. Suppose that you can choose only one of these projects. Which would you choose?
d. Which project should you choose if the cost of capital is 16%?

Cost of Capital = 11%

Cashflow in
Cashflow in € for
Year € for PV Project A PV Project B
Project B
Project A
0 -200 -200 -200 -200
1 80 100 72.07 90.09
2 𝐶𝑎𝑠h 𝑓𝑙𝑜𝑤
80 100 𝑛
64.93 81.16
3 (1+ 0.11) 58.50
80 100 73.12
4 80 52.70
Net present value 48.20 44.37
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Question 1: NPV
a. Given the annual cashflows below, calculate the NPV of Project A and Project B
(rounded to two decimal places), using a cost of capital of 11%.

b. Which of these projects is worth pursuing? Both as both have positive NPV

c. Suppose that you can choose only one of these projects. Which would you choose? A

d. Which project should you choose if the cost of capital is 16%?

Cashflow in
Cashflow in € for
Year € for
Project B Project A Project B
Project A 𝐶𝑎𝑠h 𝑓𝑙𝑜𝑤
0 -200 -200 𝑛 -200.00 -200.00
(1+0.16 )
1 80 100 68.97 86.21
2 80 100 59.45 74.32
3 80 100
51.25 64.07
4 80
44.18
Net present value 23.85 24.59

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Question 2: IRR
What are the internal rates of return of projects A and B (express your answer as
a percentage rounded to 2 decimal places)?
(you will need to use excel IRR function or a financial calculator)

Year Cashflows A (in €) Cashflows B (in €)

0 -200 -200 The IRR, also called the discounted
1 80 100 cash flow (DCF) rate of return or the
2 80 100
3 80 100 ‘yield’ of a project, is the discount
4 80 rate at which NPV is 0.

Formula: Solve for IRR in the following equation:

CF1 CF2 CFn
NPV  CF0    .........  0
1  IRR 1  IRR 2
1  IRR n

IRR Decision Rule

• If IRR(r) > k → Invest (project has a positive NPV)
Excel =IRR(A1:A5) • If IRR(r) < k → Do not invest (NPV < 0)
• If IRR(r) = k → Indifferent (NPV = 0)

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Question 3: Is the project with the higher IRR the better
project?
Project A Project B
IRR 21.86% 23.38%
NPV (11%) 48.20 44.37 It depends.

NPV (16%) 23.85 24.59 Even though project B has the higher IRR, its NPV is
lower than that of project A when the discount rate is
lower and higher when the discount rate is higher.

This example shows that the project with the higher

IRR is not necessarily better.

The IRR of each project is fixed, but as the discount

IRR rate increases, project B becomes relatively more
attractive compared to project A.

This is because B’s cash flows come earlier, so the

present value of these cash flows decreases less
Project B rapidly when the discount rate increases.
Project A

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Question 4: Profitability index
If the cost of capital is 11%, what is the profitability index for each project?

The Profitability index measures the net present

value of a project per dollar (or Euro) invested.

Profitability Index = Project A Project B

NPV (11%) 48.20 44.37
initial 200 200
investment
The profitability indices are as follows:
Project A: $48.20/$200 = 0.2410
Project B: $44.37/$200 = 0.2219

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Question 5: Payback period
What is the payback period of each project?
The payback period is the length of time before you recover your initial investment.
Cashflow
Project A has a payback period of 3 years. Year Project A Project B
0 -200 -200
Project B has a payback period of 2 years. 1 80 100
2 80 100
3 80 100
4 80

Is the project with the lower payback period the better project?
Not necessarily.
Despite its longer payback period, Project A may still be the preferred project, for
example, when the discount rate is 11%. The payback period for each project is fixed
but the NPV changes as the discount rate changes. The project with the shorter
payback period need not have the higher NPV.

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Question 6: Discounted Payback period
What is the discounted payback period for each project, using a discount rate
of 11%?
𝐶𝑎𝑠h 𝑓𝑙𝑜𝑤
𝑛
Cashflow in ( 1+ 0.11)
Cashflow in € for
Year € for PV Project A PV Project B
Project B
Project A
0 -200 -200 -200 -200
1 80 100 72.07 90.09
2 80 100 64.93 81.16
3 80 100 58.50 73.12
4 80 52.70

Project A: 4 years
Project B: 3 years
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Which project should you choose?
Project A Project B
IRR 21.86% 23.38%
NPV $48.20 $44.37
Profitability 0.2410 0.2219
index
Payback period 3 years 2 years
Discounted 4 years 3 years
Payback period

Cost of capital = 11%

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Any Questions?
Thank you for your participation!

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