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Capital Budgeting: The Basics

Recall the objective of a firm
Maximization of the market value of shareholders equity
The theory of how to do this was provided in the earlier chapters.
Compute the net present value of the projects expected cash flows,
and undertake only those with positive NPV
The Nature of Project Analysis
Basic unit of analysis is the individual investment project
Most investment projects require capital expenditure whether it be for new
products, cost reduction or replacement of existing assets. These
expenditures are supposed to increase shareholders equity.

Decision Criteria
Pay back Period:
Number of years needed to recover the initial outlay.
Net Present Value Rule
To analyze the project we need a plan. To materialize the plan we need to
gather information on timing and magnitude of costs and benefits. Then
apply NPV rule.

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What is a NPV rule?

A projects net present value is the amount by which the project is
expected to increase the wealth of the firms current shareholders.

To use the rule we find the present value of all future cash flows, and
subtract the initial investment to obtain the net present value (NPV).
As a criterion :

Invest in proposed projects with positive NPV

Consider a project :

Suppose you are investing $ 1000 in a project that is expected to

generate a cash flow of $450, $350, $250, $150 and $50 for next five
years. Should you invest in the project?

To calculate the projects NPV we need to specify the capitalization rate (k)
to use to discount the cash flows. This is called the projects cost of capital.
Assume a capitalization rate, K ( discount rate) = 10%. The following
tables show the computation of NPV

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Illustration
To show the affect of the discount rate, three tables are shown based
on different rates

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Internal Rate of Return

NPV of a Project
Discout

11.04%

Year
0
1
2
3
4
5

Flow
PV
Cum_PV
-1000
-1000
-1000
450
405
-595
350
284
-311
250
183
-128
150
99
-30
50
30
0
NPV

Indifferent

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Profitability Index:
Benefits/ cost
Both in present value terms.
If Benefits/Cost > 1, Accept the project.
This decision will have the same result, as NPV
Common Error
It is a common mistake to start the investment in year 1 rather than
year 0 (when this was not intended)
Now is time 0
Like a child, a project is not one-year old until a year has passed
Summary
In the first scenario, the discount rate was assumed to be 10%, and the
resulting NPV was $20
In the second scenario it was assumed to be 15%, and the NPV was -$69
In the third scenario, the discount rate that resulted in a zero NPV was
found. Whenever the discount rate associated with zero NPV is called
internal rate of return (IRR).

(But there is a complication with IRR. Sometimes it may

result with multiple rates.)
We can show the relation in the graph as follows:

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Incremental Cash Flows

Only the incremental cash flows should form part of an investment
decision
Evaluate the projected cash flows, by (category and) timing, both with
and without the project, and find the difference.
This difference is a collection of timed cash flows, and this is what
affects the wealth of the shareholders.
Illustration_1: Cannibalism

If a proposed project will generate $10,000 in revenue, but will

causes another product line to lose $3,000 in revenues. Then the
incremental cash flow is only $7,000.

Illustration_2: Prior Expenses

Suppose, R&D expenses are $10,000 to-date for your project, and you
plan to spend another $20,000, making $30,000 in all.

The $10,000 is a sunk cost. The decision whether to undertake the

project will not change this expenditure. Only the $20,000 is an
incremental cost, and the $10,000 should be excluded.

Sunk Costs: A sunk cost has no impact on future cash flows: it is irrelevant
to shareholders

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Illustration_3: Underutilized Resources

A project uses an existing (non-cancelable) leased warehouse with a

remaining life of 20 years, and total annual rent of $100,000. The
warehouse is projected to remain 50% utilized, unless your project is
undertaken. The lease prohibits sub-leasing. The current project is
making a loss. Your project will use 25% of the warehouse.

What should the project be charged?

(Think carefully and decide which alternative be chosen for project analysis.)

Proposed Solution 1
The original project currently using the warehouse is making a loss:
Charge the full $100,000 /year so the company can
recover the very real warehousing costs.
Proposed Solution 2
Half the warehouse is available:
The project should be charged the full $50,000 /year if it
needs to use it. A portion of the warehousing costs will not
be charged-out otherwise.
Proposed Solution 3
The project should be charged for its share of the used space:
Charge $33,333 /year.
Proposed Solution 4
The project is going to use only 25% of the space.
Charge $25,000 /year.

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Proposed Solution 5
The charge should be proportioned according to revenues generated
by each project--that is fair, isnt it?
The old projects revenues = $9,000,000, and the new
project has projected revenues = $1,000,000, so the
charge is 10%, or $10,000/year.
Proposed Solution 6
There is a suitable new (smaller) warehouse available on the market
for $27,000 /year.
Charge the project the market rate of the space,
$27,000.
Proposed Solution 7
The original lease was entered into when warehouse space was cheap,
but now space is twice what it was:
The market value of the leased warehouse is now
$200,000, and the project should take its proper share of
that amount.
Proposed Solution 8
This is a new project, so give it a sporting chance:
The project should be charged nothing.

Solution:
The project should be charged nothing
Reason is:

The warehouse expenditure will occur whether

the project is done or not. It is therefore not an
incremental cash flow

With different facts (alternative usage or lease re-negotiation) the

answer would be different