Chapter

Capital
Budgetin
g
Technique
s
 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
Decision that involve large expenditures
Very important to firms future
 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.
 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
 Similarities between
Capital Budgeting and
Asset Valuation
Uses same steps as in general asset valua
1. Determine the cost, or purchase price, of the asset.
2. Estimate the cash flows expected from the project.
3. Assess the riskiness of cash flows. [Note that we
will explicitly address the risk issue in the next
chapter. For now, risk is taken as given.]
4. Compute the present value of the expected cash
flows to obtain as estimate of the assets value to
the firm.
5. Compare the present value of the future expected
cash flows with the initial investment.
 Net Cash Flows for
Project S and Project
L
Expected After-Tax
^
Net Cash Flows, CF t
Year (T) Project S Project L
0a $(3,000) $(3,000)
1 1,500 400
2 1,200 900
3 800 1,300
4 300 1,500
 What is the Payback
Period?
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.

Unre cov ered cost at start

Number of years before
Payback PB full recovery of
original investment
of full - recovery year
Total cash flow during
full - recovery year
 Payback Period for
Project S

0 1 2 PBS 3 4

Net
Cash Flow -3,000 1,500 1,200 800 300
Cumulative
Net CF
-3,000 -1,500 -300 500 800

PaybackS = 2 + 300/800 = 2.375 years

 Payback Period for
Project L
0 1 2 3 PB 4
L

Net
Cash Flow - 3,000 400 900 1,300 1,500
Cumulative
Net CF
- 3,000 - 2,600 - 1,700 - 400 1,100

PaybackL = 3 + 400/1,500 = 3.3 years

 Strengths and
Weaknesses
of Payback:
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
 Discounted Payback
Period
To correct for the fact that the traditional
payback method does not consider the time
value of money, we can compute the
discounted payback period (DPB).
Discounted payback period (DPB): The
length of time it takes for a projects discounted
cash flows to repay the cost of the investment.
Discounted Payback (DPB) Decision Rule:
A project is acceptable if DPB < Project's life.
 Net Present Value: Sum of
the PVs of Inflows and
Outflows
NPV = PV inflows - Cost
= Net gain in wealth.

Rule: Accept project if NPV > 0.

Choose between mutually exclusive projects

on basis of higher NPV: Which project adds
the most value?
 Using NPV method, which
project(s) should be
accepted?
If Projects S and L are mutually exclusive
accept S because NPVS > NPVL

If Projects S & L are independent accept

both since NPV > 0.
 Internal Rate of
Return: IRR
0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

IRR is the discount rate that forces PV inflows

to equal the cost.

IRR forces NPV = 0.

 What is Project Ss IRR?
0 IRR = ? 1 2 3 4

(3,000) 1,500 1,200 800 300

Sum of
PVs
for CF1-4 = 3,000

Enter CFs in CF register, then

NPVS = 0 press IRR: IRRS = 13.1%
 What is Project Ls IRR?
0 1 2 3 4
IRR = ?

(3,000) 400 900 1300 1500

Sum of
PVs
for CF1-4 = 3,000

Enter CFs in CF register, then

NPVL = 0 press IRR: IRRL = 11.4%
 How is a Projects IRR
Related to a Bonds YTM?

They are the same thing.

A bonds YTM is the IRR if you invest in the bond.
0 1 2 10
IRR = ?

-1134.20 90 90 1090

IRR = 7.08% (use TVM or CF register)

 Rationale for the IRR
Method
If IRR (projects rate of return) > the firms
required rate of return, k, then some return
is left over to boost stockholders returns.

Example: k = 10%,
IRR = 15%. The project is profitable.
 IRR acceptance
criteria:
If IRR > k (= the firms required rate of
return), accept project.

If IRR < k (= the firms required rate of

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

If S and L are mutually exclusive, accept S

because IRRS > IRRL .
 Construct NPV
Profiles
Enter CFs in your calculator and find NPVL and
NPVS at several discount rates (k):
k NPVL NPVS
0 1,100 800
5 554 455
10 109 161
15 (259) ( 91)
20 (566) (309)
 NPV Profiles for Project S
and Project L
k NPV NPV L S
0 1,100 800
1,200 5 554 455
Project L
1,000 10 109 161
800 Crossover 15 (259) ( 91)
600 Point = 8.1%
20 (566) (309)
400
Project S
200 IRRS = 13.1%
0
(200) 0 2 4 6 8 10 12 14 16 18 20
(400)
IRRL = 11.4%
(600)
(800)
 NPV and IRR always lead to the
same accept/reject decision for
independent projects:
NPV ($)
IRR > k IRR < k
and NPV > 0 and NPV < 0.
Accept. Reject.

k (%)
IRR
 Mutually Exclusive
Projects
k< 8.1: NPVL> NPVS , IRRL < IRRS
CONFLICT
NPV
k> 8.1: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
L
S
IRRs

%
8.1
IRRL
 To Find the Crossover
Rate:
1. Find cash flow differences between the
projects. See data at beginning of the
case (repeated on next slide).
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.
 Net Cash Flows for
Project S and Project L

Expected After-Tax
^
Net Cash Flows, CF t
Year (T) Project S Project L
0a $(3,000) $(3,000)
1 1,500 400
2 1,200 900
3 800 1,300
4 300 1,500
 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 k favors small projects.
2) Timing differences. Project with faster payback
provides more CF in early years for reinvestment.
If k is high, early CF especially good, NPVS> NPVL.
 Reinvestment Rate
Assumptions
NPV assumes reinvest at k.

IRR assumes reinvest at IRR.

Reinvest at opportunity cost, k, is more

realistic, so NPV method is best. NPV
should be used to choose between
mutually exclusive projects.
 Cash Flow Patterns
and Multiple IRRs
If a project has a large cash outflow at the
beginning of its life and then another cash
outflow(or multiple outflows) either some time
during or at the end of its life, then it has an
unconditional cash flow pattern. Projects with
unconventional cash flow patterns present
unique difficulties when the IRR method is used.
Multiple IRRs: The situation in which a project
has two or more IRRs.
 Modified Internal
Rate of Return
(MIRR)
Modified IRR (MIRR): The discount rate at
which the present value of a projects cost is
equal to the present value of its terminal
value, where the terminal value is found as
the sum of the future values of the cash
inflows compounded at the firm's required
rate of return.
Thank You