Chapter 16

Capital Budgeting
Benninga et al. (2012) and Nguyen (BFN3174)
What is Capital Budgeting?
Two big questions:
Yes-No: Should you invest money today
in a project that gives future payoffs?
Ranking: How to compare mutually-
exclusive projects? If you have several
alternative investments, only one of which
you can choose, which should you undertake?
Benninga et al. (2012) and Nguyen (BFN3174)
Capital Budgeting
Two groups of project for decision making
process:
Independent projectwhich cash flows are
unrelated to one another. A decision to
accept one project will not affect the
decision to accept another.
Mutually exclusive projectsdecision to
choose only one project from the many
projects evaluated.
Accept one project and reject the others
Benninga et al. (2012) and Nguyen (BFN3174)
Other Issues
Sunk costsHow should we account for costs
incurred in the past?
The cost of foregone opportunities
Salvage values and terminal values
Incorporating taxes into the valuation decision
Benninga et al. (2012) and Nguyen (BFN3174)
NPV and IRR
The three basic capital budgeting tools
Note: We usually prefer NPV to IRR and
Payback Period
Benninga et al. (2012) and Nguyen (BFN3174)
Yes-No and NPV
NPV rule: A project is worthwhile if the NPV > 0
According to the NPV rule:
If NPV > 0, project is worthwhile
If NPV < 0, project should not be undertaken

1 2
0
1 2
... 0?
1 1 1
N
N
CF CF CF
NPV CF
r r r

Benninga et al. (2012) and Nguyen (BFN3174)
Technical Notes
CF
0
is usually negative (the project cost)
CF
1
, CF
2
, are usually positive (future payoffs of
project)
CF
1
, CF
2
, are expected or anticipated cash
flows
r is a discount rate appropriate to the projects risk
Benninga et al. (2012) and Nguyen (BFN3174)
Example 1
Project A: Buying an expensive machinery that
produces a better product at a lower cost.
Cost of the purchase: $1,000
Annual generated cash flow: $500
Project duration: 5 years
Project B:
Cost of the purchase: $800
Annual generated cash flow: $420
Project duration: 5 years
Discount rate: 12%
Benninga et al. (2012) and Nguyen (BFN3174)
Benninga et al. (2012) and Nguyen (BFN3174)
Yes-No and IRR
IRR rule: A project is worthwhile if the IRR >
discount rate
According to the IRR rule:
If IRR > r, then the project is worthwhile
If IRR < r, project should not be undertaken

1 2
0
1 2
... 0
1 1 1
N
N
CF CF CF
CF
IRR IRR IRR


Benninga et al. (2012) and Nguyen (BFN3174)
Benninga et al. (2012) and Nguyen (BFN3174)
Basic Yes-No Example
1
2
3
4
5
6
7
8
9
10
11
12
13
A B C
Discount rate 12%
Year
Project cash
flow
0 -1000
1 300
2 400
3 500
4 600
5 100
NPV 380.68 <-- =B5+NPV($B$2,B6:B10)
IRR 26.47% <-- =IRR(B5:B10)
YES-NO WITH NPV AND IRR
This project is worthwhile by both NPV and IRR rules:
NPV > 0
IRR > discount rate of 12%
Benninga et al. (2012) and Nguyen (BFN3174)
Basic Ranking Example
Yes-No: Both projects
are worthwhile
NPV
A
, NPV
B
> 0
IRR
A
, IRR
B
> Discount
rate of 12%
Ranking: If you can
choose only one project,
B is preferred by both
NPV and IRR:
NPV
B
> NPV
A
IRR
B
> IRR
A
1
2
3
4
5
6
7
8
9
10
11
12
13
A B C D
Discount rate 12%
Year Project A Project B
0 -1000 -800
1 200 420
2 400 100
3 600 300
4 300 600
5 100 200
NPV 171.92 363.05 <-- =C5+NPV($B$2,C6:C10)
IRR 19% 29% <-- =IRR(C5:C10)
RANKING TWO PROJECTS WITH NPV AND IRR
Benninga et al. (2012) and Nguyen (BFN3174)
Excels NPV Function
Excels NPV function is really the present value of
future cash flows!
To compute the actual NPV, add in the initial cash flow
as shown below:
Benninga et al. (2012) and Nguyen (BFN3174)
Summing Up
Benninga et al. (2012) and Nguyen (BFN3174)
1
2
3
4
5
6
7
8
9
10
11
12
13
A B C D
Discount rate 6%
Year Project A Project B
0 -500 -500
1 100 250
2 100 250
3 150 200
4 200 100
5 400 50
NPV 266.60 242.84 <-- =C5+NPV(B2,C6:C10)
IRR 19.77% 27.38% <-- =IRR(C5:C10)
NPV AND IRR CAN SOMETIMES GIVE CONFLICTING
RANKINGS
In this example:
Both A and B are worthwhile by both NPV and IRR criteria
If discount rate = 6%
A is preferred to B by NPV rule
B preferred to A by IRR rule
Do IRR and NPV produce the same project
rankings?
Benninga et al. (2012) and Nguyen (BFN3174)
Example 2: Do IRR and NPV produce the
same project rankings?
Benninga et al. (2012) and Nguyen (BFN3174)
Example 2: Do IRR and NPV produce the same
project rankings?
In this example:
Both A and B are worthwhile by both NPV and IRR criteria
If discount rate = 8%
A is preferred to B by NPV rule
B preferred to A by IRR rule
Benninga et al. (2012) and Nguyen (BFN3174)
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
A B C D E F G
Project A
NPV
Project B
NPV
0% 450.00 350.00 <-- =$C$5+NPV(A17,$C$6:$C$10)
2% 382.57 311.53 <-- =$C$5+NPV(A18,$C$6:$C$10)
4% 321.69 275.90
6% 266.60 242.84
8.5128% 204.58 204.58
10% 171.22 183.49
12% 129.85 156.79
14% 92.08 131.84
16% 57.53 108.47
18% 25.86 86.57
20% -3.22 66.00
22% -29.96 46.66
24% -54.61 28.45
26% -77.36 11.28
28% -98.39 -4.93
30% -117.87 -20.25
TABLE OF NPVs AND DISCOUNT RATES
-200
-100
0
100
200
300
400
500
0% 5% 10% 15% 20% 25% 30%
Project A
NPV
Project B
NPV
IRR
A
is always < IRR
B
: By IRR rule, B is always preferred to A
For discount rates < 8.5128%: NPV
A
> NPV
B
(Ranking conflict)
For discount rates > 8.51285: NPV
A
< NPV
B
(No ranking conflict)
Why different rankings given by IRR
and NPV (cont.)
Benninga et al. (2012) and Nguyen (BFN3174)
When IRR and NPV Conflict,
Use NPV
Why?: IRR gives the rate of return
NPV gives the wealth increment

1 2
0
1 2
Cost of
project
Value today of future
project cash flows
Incremental wealth:
How much does the project's
net value add to your wealth?
...
1 1 1
N
N
CF CF CF
NPV CF
r r r

Benninga et al. (2012) and Nguyen (BFN3174)
Back to Last Example:
Calculating the Crossover Point
1
2
3
4
5
6
7
8
9
10
11
12
13
A B C D E
Discount rate 6%
Year Project A Project B
Project A -
Project B
0 -500 -500 0 <-- =B5-C5
1 100 250 -150 <-- =B6-C6
2 100 250 -150 <-- =B7-C7
3 150 200 -50 <-- =B8-C8
4 200 100 100 <-- =B9-C9
5 400 50 350 <-- =B10-C10
NPV 266.60 242.84
IRR 19.77% 27.38% 8.5128% <-- =IRR(D5:D10)
CROSSOVER POINT: IRR
A
= IRR
B
compute IRR of differential cash flows
Crossover point is the IRR of the differential cash
flows (column D)
Benninga et al. (2012) and Nguyen (BFN3174)
Ignore Sunk Costs and Consider Only
Marginal Cash Flows
You bought a plot of land and built a house on it. Your intention is to
sell the house immediately, but it turns out that the house is really
badly built and cannot be sold in its current state.
The house and land cost you RM100,000 and friendly local contractor
has offered to make the necessary repairs, which will cost RM20,000.
Your real restate broker estimates that even with these repairs you
will never sell the house for more than RM90,000. What should you
do? There are two approaches to answering this questions:
-Father said: Dont through good money after bad
- Mother said: Dont cry over split milk. Look only at the marginal
cash flows.
Benninga et al. (2012) and Nguyen (BFN3174)
Ignore Sunk Costs and Consider Only
Marginal Cash Flows
Benninga et al. (2012) and Nguyen (BFN3174)
Dont forget the Effects of Taxes
Sally and Daves Condo Investment
Sally and Dave are considering buying a nifty condo as a rental
property.
The condo will cost RM100,000. They plan to buy it with cash.
They can rent the condo out for RM24,000 per year. They will have
to pay property taxes of RM1500 annually and additional
miscellaneous expenses of RM1,000 per year.
All income from the condo has to be reported on their annual tax
return. Their current tax rate is 30% and it will continue for the
foreseeable future.
They can charge RM10000 depreciation against the income from the
condo.
Benninga et al. (2012) and Nguyen (BFN3174)
Dont forget the Effects of Taxes
Sally and Daves Condo Investment
Benninga et al. (2012) and Nguyen (BFN3174)
Two ways to Calculate the Cash Flow
Benninga et al. (2012) and Nguyen (BFN3174)
Is Sally and Daves Condo Investment Profitable?
A Preliminary Calculation
Benninga et al. (2012) and Nguyen (BFN3174)
Is Sally and Daves Condo Investment Profitable?
Incorporating Terminal Value into the Calculation
Benninga et al. (2012) and Nguyen (BFN3174)
Benninga et al. (2012) and Nguyen (BFN3174)
Doing Some Sensitivity analysis
Benninga et al. (2012) and Nguyen (BFN3174)
Building a data table
Benninga et al. (2012) and Nguyen (BFN3174)
Salvage value
Your firm is considering buying a new machine.
The machine cost RM800.
Over the next 8 years (the life of the machine) the machine will
generate annual sales of RM1,000.
The actual cost of the goods sold (COGS) is RM400 per year and other
costs; selling, general, and administrative expenses (SG&A) are RM300
per year.
Depreciation on the machine is straight-line over8 years: RM100 per
year.
At the end of 8 years, the machines salvage value (or terminal value)
is zero.
The firms tax rate is 40%.
The firms discount rate for project of this kind is 15%.
Should the firm buy the machine?
Benninga et al. (2012) and Nguyen (BFN3174)
Capital Budgeting and Salvage Value
Benninga et al. (2012) and Nguyen (BFN3174)
Salvage Value
Suppose the firm can sell the machine for RM300 at the end of year 8.
Book value (an accounting
concept)
Initial cost accumulated
depreciation
Market value The price at which the machine
can be sold
Taxable gain The difference between the
market value and the book value.
Benninga et al. (2012) and Nguyen (BFN3174)
Benninga et al. (2012) and Nguyen (BFN3174)
Benninga et al. (2012) and Nguyen (BFN3174)
Dont forget the Cost of Foregone Opportunities
You have been offered the following project,
which involves buying a widget making machine
for RM300 to make a new product.
Your cash flows have been calculated by your
financial analysts as shown in the spreadsheet
below.
Benninga et al. (2012) and Nguyen (BFN3174)
Dont forget the Cost of Foregone Opportunities
Benninga et al. (2012) and Nguyen (BFN3174)
Dont forget the Cost of Foregone Opportunities
Benninga et al. (2012) and Nguyen (BFN3174)
Accelerated Deprecation
Your company is considering buying a machine for
RM10,000.
If bought, the machine will produce annual cost savings
of RM3,000 for the next 5 years; these cash flows will be
taxed at the companys tax rate of 40%.
The machine will be depreciated over the 5 year period
using the accelerated depreciation percentages allowable
in Malaysia.
At the end of the 6
th
year, the machine will be old; your
estimate of its salvage value at this point is RM4,000 even
though for accounting purposes its book value is RM576.
Benninga et al. (2012) and Nguyen (BFN3174)
Accelerated Deprecation
Benninga et al. (2012) and Nguyen (BFN3174)
Payback Period
It measures how quickly the firm can recover its
initial outlay
According to PP rules:
The shorter the payback, the better it is
Payback Period = Initial outlay
Annual cash flow
Benninga et al. (2012) and Nguyen (BFN3174)
Payback Period (cont.)
A firm is evaluating the two mutually exclusive
projects, Project Alpha and Project Gamma.
Both projects require RM30,000 for the initial
investment. After tax cash flows are as follows:
Project Alpha: RM15,000 (Year 1); RM10,000
(Year 2) and RM5,000 every year for the next 3
years.
Project Gamma: RM10,000 every year for 3
years
Benninga et al. (2012) and Nguyen (BFN3174)
Payback Period (cont.)
If we analyze both projects we can conclude
that:
1. Project Alpha returns are earlier than Project
Gamma. It takes only 2.5 years
2. Project Gamma takes 3 years to recover its
initial outlay
3. Project Alpha gives higher total cash flows
than Project Gamma
Benninga et al. (2012) and Nguyen (BFN3174)
Benninga et al. (2012) and Nguyen (BFN3174)