Dr.

Ridha ESGHAIER
Principles of Corporate
Finance

CHAPTER 2: DISCOUNTED
CASH FLOW APPLICATIONS
(Capital Budgeting)

Spring 2018 11-1

 Dr. Ridha ESGHAIER

Course Plan

A. Capital budgeting Definition.

B. Investments Classification.
C. Criteria of Investment Choice.
1. Regular Payback Period
2. Discounted Payback Period
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)

11-2
 A. What is capital
budgeting?
Capital budgeting is the process of
identifying and analyzing projects, and
deciding which ones to include in the
capital budget.
Is the process by which the firm decides
which long-term investments to make.
It is a Long-term decision that involves
large expenditures, and thus, is very
important to firm’s future.

Dr. Ridha ESGHAIER 11-3

Definition of an
Investment
The use of resources today for the
purpose of increasing productivity or
income in the future
Represents for a company a
commitment of capital, under various
forms, in the hope to maintain or to
improve its economic situation.
Dr. Ridha ESGHAIER
11-4
 Dr. Ridha ESGHAIER

B. Classification of investments
According to their degree of homogeneity

Capital Budgeting projects are classified as:

Mutually exclusive investments.

Independent investments.
Contingent investments.

11-5
 Dr. Ridha ESGHAIER

Mutually exclusive investments

Mutually exclusive investments serve the same
purpose and compete with each other. If one
investment is undertaken, others will have to be
excluded.
The cash flows of one can be adversely impacted
by the acceptance of the other
For example, A company may, either use a more
labor intensive, semi automatic machine, or employ a
more capital intensive, highly automatic machine for
production. Choosing the semi-automatic machine
precludes the acceptance of the highly automatic
machine.
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 Dr. Ridha ESGHAIER

Independent investments
Independent investments serve different purposes
and do not compete with each other.
The cash flows of one are unaffected by the
acceptance of the other.
For example, a heavy engineering company may be
considering expansion of its plant capacity to
manufacture additional excavators and addition of new
production facilities to manufacture a new product light
commercial vehicles. Depending on their profitability and
availability of funds, the company can undertake both
investments.
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 Dr. Ridha ESGHAIER

Contingent investments
Contingent investments are dependent projects; the
choice of one investment necessitates undertaking one or
more other investment.
For example, if a company decides to build a factory in
a remote, backward area, it may have to invest in
houses, roads, hospitals, and many more for employees
to attract the work force. Thus, building of factory also
requires investment in facilities for employees. The total
expenditure will be treated as one single investment.

11-8
 Dr. Ridha ESGHAIER

The capital budgeting Process

1. Estimate project Cash Flows (inflows

and outflows).
2. Compute the appropriate criteria of
investment choice.
3. Decide whether to retain or not the
project.

11-9
 C. Criteria of investment
choice: the Financial techniques

- Timeless criteria (Traditional technique)

1. The Regular Payback period

- Time adjusted Criteria (DCF techniques)

2. The Discounted Payback period
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)

Dr. Ridha ESGHAIER

11-10
 Dr. Ridha ESGHAIER

1- The Regular 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.
Decision Rule:
- If independent projects: Accept the projects with Payback Period shorter
than the target one.
- If mutually exclusive: Accept the one with the shortest Payback period
(< target PB period) 11-11
Application 1: Dr. Ridha ESGHAIER

Calculate the Regular Payback Periods of these two investment Projects.

Which projet to choose if the investors want to recover their initial
investment at maximum after 2 years?

Year (t) Expected Cash Flows ($)

Project L Project S
0 (100) (100)
1 10 70
2 60 50
3 80 20

0 1 2 3
Project L
-100 10 60 80
0 1 2 3
Project S
-100 70 50 20
11-12
 Calculating regular payback
Project L’s Payback
Calculation 0 1 2 3

CFt -100 10 60 80
Cumulative -100 -90 -30 +50

Payback = n – (Cum CF(n) / CF(n+1) )

n refers to the number of years prior to full recovery
Payback (L) =

Payback (L) =
Payback (S) =
Dr. Ridha ESGHAIER
11-13
 Dr. Ridha ESGHAIER

Calculating payback
The Linear interpolation System
Project L’s Payback
Calculation
0 1 2 3

CFt -100 10 60 80
Cumulative -100 -90 -30 +50

The project’s cost is recovered between year 2 and year 3

After 2 years Cum CFs = -30
PB=? Cum CFs = 0
After 3 years Cum CFs = 50
PB − 2 0 − ( −30) 30 PB = 2 + (3 − 2) ×
30
= 2.375 years
= = then,
3− 2 50 − ( −30) 80 80 11-14
 Dr. Ridha ESGHAIER

Strengths and weaknesses of the

Regular Payback Period
Strengths
Provides an indication of a project’s risk
and liquidity.
Easy to calculate and understand.
Weaknesses
Ignores the time value of money.
Ignores CFs occurring after the payback
period.
11-15
 2- The Discounted Payback period
the Discounted payback period represents the moment at which the
investment amount I0 is recovered by the future cash flows discounted at
the Required Rate of return by the investor (RRR).
► It uses discounted cash flows rather than raw CFs
Application 2: Calculate the discounted payback period of project L knowing
that the Required Rate of Return by the investor RRR = 10% (discount rate)
PV CF1=
PV CF2= 0 10% 1 2 3
PV CF3=
CFt -100 10 60 80
PV of CFt
Cumulative
Payback = n – (Cum CF(n) / CF(n+1) )

Disc Payback (L) =

11-16
Dr. Ridha ESGHAIER
 Dr. Ridha ESGHAIER

2- The Net Present Value

(NPV) Criterion
The Net present value is a calculation that compares the amount
invested today (I0 or –CF0) to the present value of the future
cash receipts from the investment.
In other words, the amount invested is compared to the future
cash amounts after they are discounted by a specified Required
Rate of Return (RRR or r ) demanded by the investor.
NPV is the Sum of the PVs of all cash inflows and outflows of a
project:
CF 1 CF 2 CF n
NPV = CF 0 + + + ... +
(1 + r) 1 (1 + r) 2 (1 + r) n
CF 1 CF 2 CF n
NPV = − I 0 + + + ... +
(1 + r) 1 (1 + r) 2 (1 + r) n
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 Dr. Ridha ESGHAIER

The Net Present Value (NPV)

r% is the Required Rate of Return (RRR) by the investor

NPV Calculation 0 r%
1 2 … n

CF0 CF1 CF2 … CFn

CF1/(1+r)1

Sum of PV of CF0 n CF2/(1+r)2

…
CFn/(1+r)n
CF1 CF2 CFn
NPV = CF0 + + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) n

CF1 CF2 CFn

NPV = CF0 + + + ... +
(1 + r ) (1 + r )
1 2
(1 + r ) n
11-18
 Application 3: What is the NPV of each Project if
the required rate of return by the investor is
10%? (Discount rate =10%) Dr. Ridha ESGHAIER

Years 0 1 2 3
CFs Project L $-100 $10 $60 $80
CFs Project K $-100 $30 $40 $50

0 1 2 3
Project L’s NPV 10%
-100 10 60 80
Calculation
10/(1.1)1
Sum of PV of CF0-3
60/(1.1)2
80/(1.1)3

NPV= 18.79
CF1 CF2 CF3
NPV = CF0 + + +
(1 + r )1 (1 + r ) 2 (1 + r )3
NPV (L) =

NPV (K) =
11-19
 Dr. Ridha ESGHAIER

Rationale for the

NPV method
NPV = PV of future inflows – investment Cost
= Net gain in wealth
If projects are independent:
accept if the project NPV>0
reject if the project NPV<0.
If projects are mutually exclusive, accept
projects with the highest positive NPV, those
that add the most value.
In application 3, accept L since NPVL>0 and
reject K since NPVK <0.
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 Dr. Ridha ESGHAIER

Strengths and weaknesses of NPV

Strengths
All the CFs are taken into account.
The timing of CFs is considered.
The required rate of return on the project is
considered (Through the discounting rate).
Weaknesses
Is very sensitive to the choice of the discounting rate.
Does not allow to compare projects with different
economic lives and different sizes.

11-21
 Dr. Ridha ESGHAIER

Choice of the discounting rate

There are several possibilities when choosing
the appropriate discount rate. The discount rate
used to evaluate a project should reflect : The
cost of the capital used to finance the project,
The opportunity cost of that capital and The
risk of the project to the business.
This discounting rate is simply the
Required Rate of Return (RRR) by the
investor to accept to finance the new
project.
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 Dr. Ridha ESGHAIER

5- Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) of an
investment project (rate of return offered by an
investment project) is the discount rate that
makes the investment amount (I0 or –CF0) equal
to the sum of the future cash flows discounted
at that rate (the Present Value of the future CFs).
Equivalently, it is the rate that makes the NPV
equal zero :
CF1 CF2 CFn
NPV = CF0 + + + ... + =0
(1 + IRR) (1 + IRR)
1 2
(1 + IRR)n

CF1 CF2 CFn

− CF0 = + + ... +
(1 + IRR) (1 + IRR)
1 2
(1 + IRR)n
I0 11-23
 Dr. Ridha ESGHAIER

The IRR Criterion

IRR Calculation 0 IRR
1 2 … n

CF0 CF1 CF2 … CFn

CF1/(1+IRR)1

CF2/(1+IRR)2
ΣPV of CF1-n = -CF0

…
CFn/(1+IRR)n

NPV = 0
CF1 CF2 CFn
NPV = CF0 + + + ... + =0
(1 + IRR) (1 + IRR)
1 2
(1 + IRR)n

CF1 CF2 CFn

− CF0 = + + ... +
(1 + IRR) (1 + IRR)
1 2
(1 + IRR)n 11-24
 Dr. Ridha ESGHAIER

Understanding the IRR..

Application 4:

Consider the following investment project:

Investment of $1,500 today at an annual interest rate of
5% as follows:
$400 are invested for 1 year
$500 are invested for 2 years
$600 are invested for 3 years
All investments are made today (at the same time) and
the total investment amont I0 = $1,500

11-25
 We can represent this project as follows:

investment CF1 CF2 CF3

0 1 2 3
10%

x(1+5%)1
$400 420
x(1+5%)2
$500 551.25
x(1+5%)3
$600 694.575

∑=I0=$1,500

Dr. Ridha ESGHAIER 11-26

 Since the discounting is the reverse of the compounding
we can also represent this project as follows:

investment CF1 CF2 CF3

0 1 2 3
10%

x(1+5%)-1
$400 420
x(1+5%)-2
$500 551.25
x(1+5%)-3
$600 694.575

∑=I0=$1,500
420 551.25 694.575
Which means that: 1,500 = + +
(1 + 5%)1 (1 + 5%) 2 (1 + 5%) 3
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Dr. Ridha ESGHAIER
 Dr. Ridha ESGHAIER

Assume that the annual rate of return of this

project (r%) is unkown,

and that we know :

- the initial investment amount (I0)
- The expected cash flows at the end of
each year (CF1, CF2 and CF3)
The annual rate of return of this project will be the
discount rate r solving the following equality :
420 551.25 694.575
1,500 = + +
(1 + r) (1 + r)
1 2
(1 + r)3
CF1 CF2 CF3
I0 = + +
(1 + r) (1 + r) (1 + r)3
1 2

11-28
 IRR approximation
CF1 CF2 CFn
NPV = CF0 + + + ... + =0
(1 + IRR) (1 + IRR)
1 2
(1 + IRR)n

1- Guess the value of r and calculate the NPV of the project at that value.
2- If NPV is close to zero then IRR is equal to r.
3- If NPV is greater than 0 then increase r and jump to step 5.
4- If NPV is smaller than 0 then decrease r and jump to step 5.
5- Recalculate NPV using the new value of r and go back to step 2.

Lets call:
ra: the lower discount rate chosen at which NPVa > 0
rb: the higher discount rate chosen at which NPVb < 0

NPVa
IRR = ra + (rb − ra )
NPVa + NPVb

Dr. Ridha ESGHAIER 11-29

 Dr. Ridha ESGHAIER

Application 5: What is the IRR of each Project?

Years 0 1 2 3
CFs Project L $-100 $10 $60 $80
Cfs Project K $-100 $30 $40 $50

0 1 2 3
Project L’s IRR IRR
-100 10 60 80
Calculation
10/(1+IRR)1
Sum of PV of CF1-3 60/(1+IRR)2
= 100
80/(1+IRR)3

NPV= 0
- The NPV at a rate of 10% is :
10 60 80
NPV10% (L) = − 100 + + + = $18.79 > 0
(1 + 10%) (1 + 10%)
1 2
(1 + 10%) 3

► At a rate of 10% NPV (L) is >0, it is then necessary to choose a higher discount
rate to obtain an NPV equal to zero.
11-30
 - Let’s try with 18% :
10 60 80
at 18% NPV (L) = − 100 + + + = 0.26 > 0
(1 + 18%) 1
(1 + 18%) 2
(1 + 18%) 3

► At 18%, the NPV (L) is still >0, Let’s try with 19% :
10 60 80
at 19% NPV (L) = − 100 + + + = − 1.75 < 0
(1 + 19%) 1
(1 + 19%) 2
(1 + 19%) 3

at 18% NPV (L) = 0.26 > 0

IRR L ? NPV (L) = 0

at 19% NPV (L) = - 1.75 < 0

IRR L − 18% 0 − 0.26

= = 0.1293
19% − 18% − 1.75 − 0.26
IRR L = 18% + (19% − 18%) × 0.1293 = 18.13%

IRRL = 18.13%

Dr. Ridha ESGHAIER 11-31

Project K’s IRR Calculation Dr. Ridha ESGHAIER
- The NPV at a rate of 10% is :
30 40 50
NPV10% (K) = − 100 + + + = $ − 2.10 < 0
(1 + 10%)1 (1 + 10%) 2 (1 + 10%) 3
► At a rate of 10% NPV (K) is <0, it is then necessary to choose a lower
discount rate to obtain an NPV equal to zero.
- Let’s try with 9% :
30 40 50
at 9% NPV (K) = − 100 + + + = -0.20 < 0
(1 + 9%) 1 (1 + 9%) 2
(1 + 9%) 3

► At 9%, the NPV (K) is still <0, Let’s try with 8% :

30 40 50
at 8% NPV (K) = − 100 + + + = 1.76 > 0
(1 + 8%) 1
(1 + 8%) 2
(1 + 8%) 3

at 8% NPV (K) = 1.76 > 0

NPV (K) = 0 IRR K − 8% 0 − 1.76
IRR K ? = = 0.89
9% − 8% − 0.20 − 1.76
at 9% NPV (K) = - 0.20 < 0

IRR K = 8% + (9% − 8%) × 0.89 = 8.89%

IRRK = 8.89% 11-32

 Rationale for the IRR method
If IRR ≥ RRR, the project’s return exceeds the
minimum required return (RRR) by the investors.
Investors will accept to finance the project
If IRR < RRR, the project’s return is lower than
the minimum required return (RRR) on it by the
investors. They will refuse to finance it.
- If IRR ≥ RRR, accept project.
(when the NPV ≥ 0, the IRR ≥ RRR).
- If IRR < RRR, reject project.
(when the NPV < 0, the IRR < RRR).
In Application 6:
Accept project L, because IRRL > RRR (10%). its
NPV10% is positive
Reject project K since IRRK < RRR (10%). Its NPV10%
is negative 11-33
Dr. Ridha ESGHAIER
Dr. Ridha ESGHAIER

11-34
 Dr. Ridha ESGHAIER

Application 6:
Consider the following investment:
Investment amount : $9,000
CF1= $2,400
CF2= $2,900
CF3= $3,500
CF4= $4,000
If the investor demands 17% as a
minimum return (RRR), will he accept to
finance this project?

11-35
 Dr. Ridha ESGHAIER

Solution 6:
2 ways to answer the question:

Calculate the NPV at 17% discount rate

If NPV17% < 0, refuse the project
If NPV17% ≥ 0, accept the project
Calculate the IRR of the project
If IRR < 17%, refuse the project
If IRR ≥ 17%, accept the project

11-36
Dr. Ridha ESGHAIER
2400 2900 3500 4000
► NPV (17%) = − 9000 + + + + = $ − 510.33 < 0
(1.17) 1 (1.17) 2 (1.17) 3 (1.17) 4

NPV17% < 0, refuse the project

Since at 17%, the NPV is negative, the IRR must be lower than 17%

► - To compute the IRR we should use a discount rate lower than 17% that
provides a positive NPV. Let’s try with 15% discount rate…
2400 2900 3500 4000
NPV (15%) = − 9000 + 1
+ 2
+ 3
+ 4
= $ − 131.9 still < 0
(1.15) (1.15) (1.15) (1.15)
- It is then necessary to choose a lower discount rate to obtain a positive
NPV. Let’s try with 14%...
2400 2900 3500 4000
NPV (14%) = − 9000 + + + + = $67.44 > 0
(1.14) 1 (1.14) 2 (1.14) 3 (1.14) 4
At 15%, NPV= -131.9 IRR − 14% 0 − 67.44
IRR? , NPV=0 = = 0.3383
15% − 14% − 131.9 − 67.44
At 14%, NPV= 67,44
IRR = 14% + (1% × 0.3383) ≈ 14.34%
IRR < 17%, refuse the project 11-37
 Application 7 : Dr. Ridha ESGHAIER

Consider the following investment:

Investment amount (I0) : $21,000
CF1= $5000
CF2= $5000
CF3= $5000
CF4= $5000
CF5= $5000
CF6= $5000
1. If the investor demands 12% as a minimum return rate
(RRR), calculate the NPV of this project.
2. Calculate the annual rate of return offered by this
investment (IRR).
3. Should we accept the project? 11-38
 Dr. Ridha ESGHAIER
►

11-39
 Application 8 : Dr. Ridha ESGHAIER

A project will generate the following

future cash-flows :
CF1= $11,000
CF2= $17,000
CF3= $19,000
CF4= $10,000

If the investor demands 14% as a minimum

return (RRR) on this project, calculate the
maximum amont I0 he will accept to pay to
finance the project.

11-40
 Solution 8: Dr. Ridha ESGHAIER

CF1 CF2 CFn

We know that: NPV = − I 0 + + + ... +
(1 + r)1 (1 + r)2 (1 + r)n
►The investor will accept to finance the project only if the NPV
computed is at minimum equal to zero. The NPV is equal to
zero when I0 is equal to the sum of the future cash flows
discounted at the required rate of return r (=14% in our example).
► The investor will accept to finance the project only when I0 is at
maximum equal to the sum of the future cash flows discounted at his
required rate of return (RRR or r). If I0 is higher than the sum of the
future cash flows discounted at the RRR, the NPV will be negative, so the
investor will refuse to finance the project.
The maximum investment amount that the investor will accept to pay is:

I0 =

If the Investor knows the future cash flows of the project and the
rate of return he wants to earn, he can calculate the maximum
investment amount that he will accept to pay.
11-41
 NPV, IRR and Discounted Payback
interpretation
Application 9:
Consider the following investment project:
Investment amount (I0) : $1,000
CF1= $100
CF2= $300
CF3= $400
CF4= $675
1. If the investor demands 10% as a minimum return
rate (RRR), will he accept to finance this project?
2. Compute the annual rate of return of this project.
3. Calculate the discounted payback period. Interpret.
11-42
Dr. Ridha ESGHAIER
 Solution 9: Dr. Ridha ESGHAIER

CF1 CF2 CFn

1. We know that: NPV = − I 0 + + + ... +
(1 + RRR)1 (1 + RRR)2 (1 + RRR)n
►The investor will accept to finance the project only if the NPV
computed is at minimum equal to zero.
NPV =

► Since the NPV is positive, the investor will accept to finance the
project. This project will offer an annual rate of return (IRR) higher than
the Required rate of return of 10%.
2. To compute the IRR we should use a discount rate higher than 10% that
provides a negative NPV. Let’s try with 13% discount rate…

11-43
 Dr. Ridha ESGHAIER

3. Discounted payback period

Discount rate RRR=10% (Required Rate of Return by the investor)
PV CF1=
PV CF2=
PV CF3=
PV CF4=
0 10% 1 2 3 4

CFt -1000 100 300 400 675

PV of CFt -1000 91 248 301 461
Cumulative -1000 -909 -661 -360 +101
Payback = n – (Cum CF(n) / CF(n+1) )
Disc Payback =

11-44
 Dr. Ridha ESGHAIER
CF1 CF2 CFn
We know that: NPV = − I 0 + + + ... +
(1 + RRR)1 (1 + RRR)2 (1 + RRR)n
100 300 400 675
NPV = - 1,000 + + + + = $100.4 > 0
(1 + 10%)1 (1 + 10%)2 (1 + 10%)3 (1 + 10%)4
► Since at 10% RRR the NPV is positive, there is a Moment before the
end of the life of the project at which The NPV of the project is equal to
zero (when I0 is equal to the sum of the future cash flows discounted at
the required rate of return RRR)
► This moment is the Discounted payback period which represents the
moment at which the investment amount I0 is exactly recovered by the
future cash flows discounted at the RRR. In other words, the discounted
payback period is the moment at which the investor earns exactly the rate
of return (RRR) he demanded.
► After 3 years, 9 months and 11 days the NPV of the project is equal to
Zero. In other words, this is the length of time required to earn the
demanded rate of return of 10% by the investor. If we reach the end of
the life of he project (end of year 4), the return obtained will be the IRR
(13.55%)
► The Discounted Payback Period is the moment at which
11-45
the NPV of the project is equal to zero.