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Capital Budgeting Techniques

2007 Thomson/South-Western
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What is Capital Budgeting?
The process of planning and evaluating
expenditures on assets whose cash flows are
expected to extend beyond one year
Analysis of potential additions to fixed assets
Long-term decisions; involve large expenditures
Very important to firms future

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Generating Ideas for Capital Projects
A firms growth and its ability to remain
competitive depend on a constant flow of
ideas for new products, ways to make
existing products better, and ways to produce
output at a lower cost.
Procedures must be established for
evaluating the worth of such projects.
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Project Classifications
Replacement Decisions: whether to purchase capital
assets to take the place of existing assets to maintain or
improve existing operations
Expansion Decisions: whether to purchase capital
projects and add them to existing assets to increase
existing operations
Independent Projects: Projects whose cash flows
are not affected by decisions made about other projects
Mutually Exclusive Projects: A set of projects where
the acceptance of one project means the others cannot
be accepted
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Determine the cost, or purchase price, of the asset.
Estimate the cash flows expected from the project.
Assess the riskiness of cash flows.
Compute the present value of the expected cash flows to
obtain as estimate of the assets value to the firm.
Compare the present value of the future expected cash
flows with the initial investment.

Similarities between Capital Budgeting
and Asset Valuation
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1, 5 00
1, 2 00
80 0
30 0
40 0
90 0
1, 3 00
1, 5 00
^
N et C as h F lo w s , C F
t
r e d p A Ex ct e fte -T ax
Y ea r ( T ) P r o jec t S P r o jec t L
0 $ ( 3,00 0 ) $ ( 3,00 0 )
1
2
3
4
Net Cash Flows for
Project S and Project L
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The length of time before the original cost of an
investment is recovered from the expected cash
flows or . . .
How long it takes to get our money back.
|
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+
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= =
year recovery - full
during flow cash Total
year recovery - full of
start at cost d Unrecovere
investment original
of recovery full
before years of Number
PB Payback
What is the Payback Period?
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Payback Period for Project S
=
Payback
S
2 + 300/800 = 2.375 years
Net
Cash Flow

Cumulative
Net CF
1,500

-1,500
800

500
1,200

-300
-3,000

-3,000
300

800
PB
S

0 1 2 3 4
10
=
Payback
L
3 + 400/1,500 = 3.3 years
Net
Cash Flow

Cumulative
Net CF
400

- 2,600
1,300

- 400
900

- 1,700
- 3,000

- 3,000
1,500

1,100
PB
L

0 1 2 3 4
Payback Period for Project L
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Strengths of Payback:
Provides an indication of a
projects risk and liquidity
Easy to calculate and understand

Weaknesses of Payback:
Ignores TVM
Ignores CFs occurring after the
payback period

Strengths and Weaknesses
of Payback:
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Cost is CF
0
and is generally negative.


NPV =
t=0
n

CF
t
1+r
( )
t
CF
0
.
^
^
Net Present Value:
Sum of the PVs of Inflows and Outflows
^


NPV =
CFt
(1+r)
t
t=0
n

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What is Project Ss NPV?
r = 10%
1,500 800 1,200 (3,000)

1,363.64

991.74

601.05

204.90

161.33
300
0 1 2 3 4
NPV
S
=

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What is Project Ls NPV?
r = 10%
400 1300 900 (3,000)

363.64

743.80

976.71

1024.52

108.67
1500
0 1 2 3 4
NPV
L
=

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Rationale for the NPV method:
NPV = PV inflows - Cost
= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually exclusive projects
on basis of higher NPV.
Which adds most value?

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Using NPV method,
which project(s) should be accepted?
If Projects S and L are mutually
exclusive, accept S because NPVS >
NPVL.

If S & L are independent,
accept both; NPV > 0.
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0 1 2 3
CF
0
CF
1
CF
2
CF
3
Cost Inflows
IRR is the discount rate that forces
PV inflows = cost.
This is the same as forcing NPV = 0.
Internal Rate of Return: IRR
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( )
. NPV
r 1
CF
t
t
n
0 t
=
+

=
( )
0
IRR 1
CF
t
t
n
0 t
=
+

=
NPV: Enter r, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
Calculating IRR
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Enter CFs in CF register, then
press IRR:
NPV
S
=

IRR
S
= 13.1%
0
(3,000)
IRR = ?
0 1 2 3 4
Sum of
PVs
for CF
1-4
= 3,000
1,500 800 1,200




300
What is Project Ss IRR?
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NPV
L
=

Enter CFs in CF register, then
press IRR:
IRR
L
= 11.4%
0
IRR = ?
400 1300 900





1500
0 1 2 3 4
Sum of
PVs
for CF
1-4
= 3,000
(3,000)
What is Project Ls IRR?
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They are the same thing.
A bonds YTM is the IRR
if you invest in the bond.
90 1090 90
0 1 2
10
IRR = ?
-1134.20
IRR = 7.08% (use TVM or CF register)
How is a Projects IRR
Related to a Bonds YTM?
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If IRR (projects rate of return) > the
firms required rate of return, r, then
some return is left over to boost
stockholders returns.

Example: r = 10%,
IRR = 15%. Profitable.
Rationale for the IRR Method
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IRR Acceptance Criteria
If IRR > r, accept project.

If IRR < r, reject project.
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Decisions on Projects S and L per IRR
If S and L are independent, accept
both. IRRs > r = 10%.

If S and L are mutually exclusive,
accept S because IRR
S
> IRR
L
.
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Enter CFs in your calculator and find NPV
L
and
NPV
S
at several discount rates (r):
r
0
5
10
15
20

NPV
L
1,100
554
109
(259)
(566)
NPV
S
800
455
161
( 91)
(309)
Construct NPV Profiles
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k
0
5
10
15
20
NPV
L
1,100
554
109
(259)
(566)
NPV
S
800
455
161
( 91)
(309)
(800)
(600)
(400)
(200)
0
200
400
600
800
1,000
1,200
0 2 4 6 8 10 12 14 16 18 20
IRR
L
= 11.4%
IRR
S
= 13.1%
Crossover
Point = 8.1%
Project L
Project S
NPV Profiles for Project S and Project L
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IRR < r
and NPV < 0.
Reject.
NPV ($)
r (%)
IRR
IRR > r
and NPV > 0
Accept.
NPV and IRR always lead to the same
accept/reject decision for independent projects
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Mutually Exclusive Projects
r < 8.1: NPV
L
> NPV
S
, IRR
L
< IRR
S

CONFLICT
r > 8.1: NPV
S
> NPV
L
, IRR
S
> IRR
L

NO CONFLICT
8.1
NPV
%
IRR
s
IRR
L
S
L
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1. Find cash flow differences between the projects.
See data at beginning of the case.

2. Enter these differences in CF register, then press
IRR. Crossover rate = 8.11, rounded to 8.1%.

3. Can subtract S from L or vice versa.

4. If profiles dont cross, one project dominates the
other.
To Find the Crossover Rate:
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Two Reasons NPV Profiles Cross:
1) Size (scale) differences. Smaller project
frees up funds at t = 0 for investment. The
higher the opportunity cost, the more valuable
these funds, so high r favors small projects.

2) Timing differences. Project with faster
payback provides more CF in early years for
reinvestment. If r is high, early CF especially
good, NPV
S
> NPV
L
.

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Reinvestment Rate Assumptions
NPV assumes reinvest at r.

IRR assumes reinvest at IRR.

Reinvest at opportunity cost, r, is more
realistic, so NPV method is best. NPV should
be used to choose between mutually
exclusive projects.
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Modified Internal Rate of Return
A better indicator of relative profitability
Better for use in capital budgeting


PV of cash outflows =
TV
(1+MIRR)
n
n
n
0 t
t n t
n
0 t
t
t
) MIRR 1 (
) r 1 ( CIF
r) (1
COF
+
+
=
+

=
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The End