Capital Budgeting Decision

Investment Valuation Criteria

Capital Budgeting Decision

What is capital budgeting?

NPV rule for making investment decisions

Other alternative investment criteria

Payback period (traditional and discounted)

Internal rate of return

Profitability index and capital rationing

Deciding on projects with different lives

Investment criteria in corporate practice

What is capital budgeting?

Capital budgeting deals with the analysis of

potential additions to firms fixed assets

These are long-term decisions that generally

involve large expenditures and are typically

quite difficult to reverse

Capital budgeting is very important for a

firms future
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Capital budgeting process

Accounting,
finance,
engineering

Idea
development

Collection of
data

Project
analysis

Decision
making

Results

Reevaluation

What is a project?

Any of the following decisions would qualify as

projects:

Major strategic decisions to enter a new area of

business or new markets
Acquisitions of other firms
Decisions on new ventures with existing business or
markets
Decisions that may change the way existing ventures
and projects are run
Decisions on how best to deliver a service that is
necessary for the business to run smoothly
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Types of projects

Independent projects
Mutually exclusive projects
Expansion projects

Replacement projects

Existing products / markets

New products / markets
Maintenance of business
Cost reduction

Research & development projects

Other projects (safety / environmental projects)
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NPV rule illustrated a reminder

Assume you have the following information on

Project X:

Initial outlay -$1,100

Required return = 10%
Annual cash revenues and expenses are as follows:
Year
1
2

Revenues
$1,000
2,000

Expenses
$500
1,000

Draw a time line and compute the NPV of project X

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NPV rule concluded

0
Initial outlay
($1,100)

Revenues $1,000
Expenses
500

Revenues $2,000
Expenses 1,000

Cash flow

Cash flow $1,000

$500

$1,100.00
$500 x
+454.55

1.10
$1,000 x

+826.45

1
1.102

+$181.00 NPV
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Foundations of the NPV rule

Why does NPV work? And what does work mean?

A firm is created when security holders supply the

funds to acquire assets that will be used to produce
and sell goods and services
The market value of the firm is based on the free
cash flows it is expected to generate
Thus, good projects are those which increase firm
value good projects are those projects that have
positive NPVs

Moral:
INVEST ONLY IN PROJECTS WITH POSITIVE NPVs
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Why do we like NPV that much?

NPV

uses

cash

flows,

NPV uses all the cash flows generated by the

and
accounting artificial constructs

not

other

project during its life

NPV discounts the cash flows properly, since

it takes into account TVM
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Payback Period

Payback Period (PB): The length of time it takes

to recover the original costs (of the project) from
expected cash flows.
Rationale: The sooner investment costs are
recovered, the better.
Process: Simply add up the expected cash flows
until they equal (or exceed) the original investment.
The number of years it take to do this is the
payback period.
Note: no discounting of cash flows is required

Payback Period
Number of years before
full recovery of
original investment

PB =

Uncovered cost at start

of full-recovery year
Total cash flow during
full-recovery year

Example: Find the payback period for a project which has the
following cash flows
Full-recovery year

Cash Flow
Cumulative
Net CF

-3,000

1,500

1,200

800

300

-3,000

-1,500

-300

500

800

PB =

PB

2 + 300/800 = 2.375 years

Payback Period

Decision Rules:
PP = payback period
MDPP = maximum desired payback period
Independent Projects:
PP MDPP - Accept
PP > MDPP - Reject
Mutually Exclusive Projects:
Select the project with the fastest payback,
assuming PP MDPP.

Pitfalls in using the payback period

Which project would you choose from the

followings, given a 2 years payback?
Project

C0

C1

C2

C3

Payback
period

500 5000

-2,000

500

-2,000

500

1800

-2,000 1800

500

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Pitfalls in using the payback period

Project

C0

C1

C2

C3

500 5000

Payback
period

NPV @
10%

+2,624

-2,000

500

-2,000

500

1800

-58

-2,000 1800

500

+50

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Pitfalls in using the payback period

By using payback period:

You may select projects that are not acceptable

under NPV rule look at project B
You wont consider the timing of cash flows within
the payback period compare project B and
project C

You wont consider the payments after the payback

period compare project A and project C
You cant compare projects that have no initial
investment
Arbitrary standard for payback period
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Use of payback period

PB is often used when making relatively

small decisions

PB ensures liquidity
Nevertheless, as a decision grows in
importance, the NPV becomes the order of
the day
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Discounted Payback Period

Similar to Payback Period Method

Expected future cash flows are discounted by
the projects cost of capital
Thus the discounted payback period is
defined as the number of years required to
recover the investment from discounted net
cash flows.

Discounted Payback Period

Number of years before
full recovery of
original investment

DPB =

Uncovered cost at start

of full-recovery year
Total discounted cash flow during
full-recovery year

Example: Find the discounted payback period for a project which has
the following cash flows
Full-recovery year

-3,000
Cash Flow
Cumulative
-3,000
Net Discounted CF

r =10%

PB

1,500

1,200

800

300

-1,636

-645

-44

161

DPB = 3 + 44/161 = 3.273 years

Discounted payback period

Although recognizes TVM, it has the same

problems as the traditional payback period
Is suitable to be used in case of investments
made in risky markets.

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Internal rate of return

IRR tries to find a single number that

summarizes the merits of a project
This number does not depend on the interest
rate that prevails in the capital market
The number is intrinsic to the project and

only depends on the cash flows of the

project and their timing

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Internal Rate of Return (IRR)

Definition:

The discount rate for what the PV of a projects

expected cash flows is equal with the initial cost
(NPV = 0)

CFt
TV
I0

t
n

IRR
1

IRR
t 1

Internal Rate of Return (IRR)

Decision Rules:
Independent Projects:
IRR opportunity cost of capital
- Accept
IRR < opportunity cost of capital - Reject
Mutually Exclusive Projects:
Select the project with the highest IRR,
assuming IRR opportunity cost of capital.

Internal rate of return illustrated

Year
Cash flow

-200

50

100

150

Find r such that NPV = 0

50
100
150
0 200

2
1 r (1 r)
1 r 3

r 19.44% this r is IRR

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NPV profile
100,00

IRR = 19.44%

80,00
60,00

NPV

40,00
20,00
0,00
1

13

17

21

25

29

-20,00
-40,00
-60,00

Discount rate (%)

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Trial and error for IRR

Trial and error

IRR is just under 20%

19.44%

Discount rates

NPV

0%

$100

5%

68

10%

41

15%

18

20%

-2

!!! In order to estimate IRR for the project you analyze, you
can use Excel IRR function by selecting the column/row of the
cash flows (inflows or outflows) the investment generates
including the initial cost.
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Internal Rate of Return (IRR)

Example: What is the IRR of a project with the following
cash flows?
0

-3,000

1,500

1,200

800

300

3000 = 1,500
+ 1,200 +
800
+
300
(1+IRR)
(1+IRR)2 (1+IRR)3 (1+IRR)4
NPV = 0 = -3000 + 1,500
+ 1,200 +
800
(1+IRR)
(1+IRR)2 (1+IRR)3
Answer: IRR= 13.114% (Excel function IRR)

+
300
(1+IRR)4

Pitfalls with the IRR approach

Pitfall 1: IRR assumes funds can be invested

each year at the same rate of return (IRR)
Pitfall 2: Make no distinction
investing or financing projects

between

Pitfall 3: A project can have multiple rates of

return

Pitfall 4: The scale problem

Pitfall 5: The timing problem

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Solution to pitfall 1:
Modified Internal Rate of Return (MIRR)
It is basically the same as the IRR, except it assumes
that the revenue (cash flows) from the project are
reinvested back into the company, and are compounded
by the company's cost of capital, but are not directly
invested back into the project from which they came.

MIRR assumes that the revenue is not invested back

into the same project, but is put back into the general
"money fund" for the company, where it earns interest.
We don't know exactly how much interest it will earn,
so we use the company's cost of capital as a good
guess.

Profitability index
NPV of the investment
Profitabil ity index
Initial cost of the investment

PI Rule for independent projects:

Accept project if PI 0
Reject project if PI < 0

Look at this!
NPV 0

PI 0

IRR discount rate

ACCEPT PROJECT

NPV < 0 PI < 0

IRR < discount rate

REJECT PROJECT

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Problems with PI

Making decisions with PI for mutually exclusive

projects
Cash flows

Project

C0

C1

C2

PV @ 12%

PI

NPV @ 12%

-20

70

10

70.5

2.53

50.5

-10

15

40

45.3

3.53

35.3

Same problems as in the case of scale problem form

IRR decide using NPV
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Capital rationing
Cash flows

Project

C0

C1

C2

PV @ 12%

PI

NPV @ 12%

-20

70

10

70.5

2.53

50.5

-10

15

40

45.3

3.53

35.3

-10

-5

60

43.4

3.34

33.4

Suppose the projects above are independent, but

you have only $25 mil. to invest. Which project(s)
do you choose?

USE PROFITABILITY INDEX

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Capital rationing

Two types of capital rationing:

Soft rationing provisional limits adopted by

Hard rationing the firm is unable to raise the

management as an aid to financial control

money she desires

Profitability index does not work if funds are

also limited beyond the initial time period
and projects are not divisible use linear
programming
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Investment criteria in practice

Capital budgeting
technique

Percentage
always or
almost always
use

Average score
Scale is 4(always) or
0(never)
Overall

Large
firms

Small
firms

Internal rate of return

76

3.09

3.41

2.87

Net present value

75

3.08

3.42

2.83

Payback period

57

2.53

2.25

2.72

Discounted payback period

29

1.56

1.55

1.58

Profitability index

12

0.83

0.75

0.88

Source: Graham & Campbell (2001) Theory and practice of corporate finance

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