Capital budgeting

Capital budgeting describes decisions where expenditures and

receipts for a particular undertaking will continue over a
period of time.

These decisions usually involve outflows of funds in the early

periods while the inflows start somewhat later and continue
for a significant number of periods.
 Types of capital budgeting
decisions
• Expansion of facilities
• New or improved products
• Replacement
• Lease or buy
• Make or buy
 Methods of capital project
evaluation
• Payback period

• Accounting rate of return

• Net present value (NPV)

• Internal rate of return (IRR)

 The rate of return a
company must earn on
its assets to justify the
using and acquiring of
funds

Discount
rate / cost The rate at which cash

of capital:
flows are discounted

Also called the minimum

required rate of return,
the hurdle rate or the
cutoff rate
 Time value for money
Time value of money: a dollar today is worth
more than a dollar tomorrow because today’s
dollar will earn interest and increase in value.

To put cash flows originating at different times

on an equal basis, we must apply an interest
rate to each of the flows so that they are
expressed in terms of the same point in time.
 The number of years required to
recover a project’s cost,

Payback or how long does it take to get

period the business’s money back?

is the period of time required for

the cumulative expected cash
flows from an investment project
to equal the initial cash outflow.
 Example
• Julie Miller is evaluating a new project for
her firm, Basket Wonders (BW). She has
determined that the after-tax cash flows for
the project will be $10,000; $12,000;
$15,000; $10,000; and $7,000, respectively,
for each of the Years 1 through 5. The
initial cash outlay will be $40,000.
 0 1 2 3 (a) 4 5

-40 K (-b) 10 K 12 K 15 K 10 K (d) 7K

10 K 22 K 37 K (c) 47 K 54 K

Cumulative
Inflows PBP = a + ( b - c ) / d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years
 another solution

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K
-40 K -30 K -18 K -3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K
Cumulative = 3.3 Years
Cash Flows Note: Take absolute value of last negative
cumulative cash flow value.
 PBP Acceptance Criterion
The management of Basket Wonders has
set a maximum PBP of 3.5 years for
projects of this type.
Should this project be accepted?
 PBP Strengths
and Weaknesses
Strengths: Weaknesses:
– Easy to use and – Does not account
understand for TVM
– Can be used as a – Does not consider
measure of cash flows beyond
liquidity the PBP
– Easier to forecast – Cutoff period is
ST than LT flows subjective
 Internal rate of return (IRR)
The internal rate of return of a project is the discount rate that causes NPV
to equal zero

- It is an interest rate that equates the present value of the cash flows with
the present value of the cash outflows

- -
The IRR for the previous example is
approximately 19.8 percent.

IRR can be obtained by:

– Trial and error with interpolation
– Calculation using a business calculator
– Calculation using a spreadsheet program
If the IRR is larger than the cost of capital it
signals acceptance.
(IRR > k)

If the IRR is less than the cost of capital the

proposed project should be rejected.
(IRR < k)
 example

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the

discounted cash flows to equal $40,000 (you
may need several trials)
 Try 10%

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +

$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
 Try 15%

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +

$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
 interpolate

.10 $41,444 $1,444

X
.05 IRR $40,000
$4,603
.15 $36,841
=
X $1,444
.05 : x = 0.0157
$4,603
IRR = .10 + .0157 = .1157 or 11.57%
 IRR acceptance criteria

The management of Basket Wonders has

determined that the hurdle rate is 13% for
projects of this type.
Should this project be accepted?

No! The firm will receive 11.57% for each

dollar invested in this project at a cost of
13%. [ IRR < Hurdle Rate ]
 IRR strength and weaknesses

Strengths: Weaknesses:
– Accounts for – Assumes all cash
TVM flows reinvested at
– Considers all the IRR
cash flows – Difficulties with
– Less project rankings and
subjectivity Multiple IRRs
 Net present value

NPV is the present value of an

investment project’s net cash flows
minus the project’s initial cash
outflow.

CF1 CF2 CFn

NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k)n
 example

A firm has determined that the appropriate

discount rate (k) for this project is 13%.

NPV = $10,000 +$12,000 +$15,000 +

(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)
 example
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $
7,000(PVIF13%,5) - $40,000

NPV = $10,000(.885) + $12,000(.783) +

$15,000(.693) + $10,000(.613) + $
7,000(.543) - $40,000

NPV = $8,850 + $9,396 + $10,395 +

$6,130 + $3,801 - $40,000
= - $1,428
 Acceptance criteria

The management has determined that the

required rate is 13% for projects of this
type.
Should this project be accepted?

No! The NPV is negative. This means that the

project is reducing shareholder wealth. [Reject
as NPV < 0 ]
 NPV > 0 IRR >
For single k
projects IRR
and NPV NPV = 0 IRR =
will give the k
same results
NPV < 0 IRR <
k
If multiple projects are being considered, IRR and NPV will
give the same results if the projects are independent.

Projects can be implemented simultaneously.

Available funds are not limited.

One project will not affect the cash flow of another.

IRR and NPV methods may yield different results
if mutually exclusive projects are analyzed.

This disparity may occur if:

• The initial costs of the proposals differ.
• The shapes of the cash inflow streams differ
 Profitability index

PI is the ratio of the present value of a

project’s future net cash flows to the
project’s initial cash outflow.
Method #1:
CF1 CF2 CFn
PI = + +...+ ICO
(1+k)1 (1+k)2 (1+k)n
<< OR >>
Method #2:
PI = 1 + [ NPV / ICO ]
 PI acceptance criteria

PI = $38,572 / $40,000
= .9643

Should this project be accepted?

No! The PI is less than 1.00. This means

that the project is not profitable. [Reject as PI <
1.00 ]
 Strengths: Weaknesses:
– Same as NPV – Same as NPV
– Allows – Provides only
comparison of relative profitability
different scale – Potential Ranking
projects Problems
 Challenges due
to:

Mutually
exclusive (i) Scale
differences
projects
(ii) Cash flow
pattern
differences
 Scale differences
Small (S) VS Large (L)

NET CASH FLOWS

END OF YEAR Project S Project L
0 -$100 -$100,000
1 0 0
2 $400 $156,250
 Scale Differences
Calculate the PBP, IRR, NPV@10%, and
PI@10%.
Which project is preferred? Why?
Project IRR NPV PI

S 100% $ 231 3.31

L 25% $29,132 1.29
 Cash flow patterns

Let us compare a decreasing cash-flow (D) project and

an increasing cash-flow (I) project.

NET CASH FLOWS

END OF YEAR Project D Project I
0 -$1,200 -$1,200
1 1,000 100
2 500 600
3 100 1,080
 Cash Flow Pattern
Calculate the IRR, NPV@10%, and
PI@10%.
Which project is preferred?
Project IRR NPV PI

D 23% $198 1.17

I 17% $198 1.17
 600
NPV profiles

Plot NPV for each

project at various
Net Present Value ($)

Project I discount rates.

400

NPV@10%
200

IRR

Project D
0
-200

0 5 10 15 20 25
Discount Rate (%)
 Fisher’s rate of intersection

600
Net Present Value ($)

At k<10%, I is best! Fisher’s Rate of

Intersection
-200 0 200 400

At k>10%, D is best!

0 5 10 15 20 25
Discount Rate ($)
 Sources of financing
• Equity
• New equity
• Retained earnings
• Debt
• Short-term
• Long-term
 Cost of debt
• Cost of debt = r × (1-t)

r = present interest rate charged for the kind of

debt the company would issue
t = tax rate (interest expense is tax deductible)
 Cost of equity capital

k0 = cost of equity capital

D1 = dividend

P0 = current stock price

g = rate at which dividend is expected to grow

f = flotation costs (as % of P0)

EQUITY: Capital Asset Pricing
Model
kj = Rf + β(km – Rf)
kj = required rate of return on stock j
Rf = Risk-free rate
km = Rate of return on the market portfolio
β = market risk premium
The overall cost of capital is the average of the
cost of debt financing and the cost of equity
financing weighted by their proportions in the
total capital structure.

There is a point where the combination of

components (debt, equity) is optimal.
 Capital rationing
• occurs when a constraint (or budget ceiling) is
placed on the total size of capital expenditures
during a particular period.
• the practice of restricting capital expenditures
to a certain amount, perhaps due to limits on
external financing.
• Without capital rationing:A company should
invest in every project whose:
• NPV ≥ 0.
• IRR ≥ k.
With capital rationing:

A company should choose the combination of

projects that will give the highest NPV within
the spending constraint.
 example
• You must determine what investment
opportunities to undertake for your company.
You are limited to a maximum expenditure of
$32,500 only for this capital budgeting period.
 Available projects
Project ICO IRR NPV PI
A $ 500 18% $ 50 1.10
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
E 12,500 26 500 1.04
F 15,000 28 21,000 2.40
G 17,500 19 7,500 1.43
H 25,000 15 6,000 1.24
 Based on IRRs
Project ICO IRR NPV PI
$ 5,000 37% $ 5,500 2.10 F
15,000 28 21,000 2.40 E
12,500 26 500 1.04 C
5,000 25 6,500 2.30 B
Projects C, F, and E have the three largest
IRRs.
The resulting increase in shareholder wealth is
$27,000 with a $32,500 outlay.
 Based on NPVs
Project ICO IRR NPV PI
$15,000 28% $21,000 2.40 F
17,500 19 7,500 1.43 G
5,000 25 6,500 2.30 B
Projects F and G have the two
largest NPVs.
The resulting increase in shareholder wealth is
$28,500 with a $32,500 outlay.
 Based on PIs
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
G 17,500 19 7,500 1.43
Projects F, B, C, and D have the four largest PIs.
The resulting increase in shareholder wealth is $38,000
with a $32,500 outlay.
 Summary of Comparison
Method Projects Accepted Value Added
PI F, B, C, and D $38,000
NPV F and G $28,500
IRR C, F, and E $27,000
PI generates the greatest increase in shareholder
wealth when a limited capital budget exists for a
single period.
 The analyst’s most difficult task
is to enter the best estimates of
cash flows into the analysis.

Future annual benefits and

costs are uncertain.
Analytical
challenges Market forecasts may be biased
upward.

Costs are often underestimated

The analyst should remember:
1. All revenue and costs must be stated in
terms of cash flows.
2. All cash flows should be incremental.
3. Sunk costs do not count.
4. Any effect on other parts of the operation
must be considered.
5. Interest paid on debt is not considered.