Basics of Capital Budgeting

Capital Budgeting
process of decision making with respect to
investments made in fixed assets - that is, should
a proposed project be accepted or rejected.
The following criteria are used for deciding whether to
accept or reject projects:
1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
3. Modified Internal Rate of Return (MIRR)
4. Regular Payback
5. Discounted Payback

Payback Period
the length of time required for an investments net
revenues to cover its cost.
A. Even Returns
Example: A firms has an initial cash outlay of $100,000 and
has an even annual cash return of $25,000. What is its
payback period?
0

-$100,000

$25,000

$25,000

$25,000

$25,000

$25,000

6
$25,000

PP =

Investments
Annual Cash Return

$100,000
$25,000

= 4 years

A. Uneven Returns
Example: A firms maximum desired payback period is 3yrs.,
and an investment proposal requires an initial cash outlay of
$100,000 and yields the following set of annual cash flows,
what is the payback period? should the project be accepted?
Year

Free Cash Flow

$40,000

30,000

30,000

20,000

+ > 70,000
+ > 100,000

PP = 3 Years
if PP is < the maximum acceptable PP, ACCEPT the project.
if PP is > the maximum acceptable PP, REJECT the project.

A. Uneven Returns
Example: A firms maximum desired payback period is 3yrs.,
and an investment proposal requires an initial cash outlay of
$100,000 and yields the following set of annual cash flows,
what is the payback period? Should the project be
accepted?
Year

Free Cash Flow

$40,000

30,000

3
4

20,000
20,000

+ > 70,000
+ > 90,000
+ > 10,000 / 20,000 = 0.5

PP = 3 + 0.5 = 3.5 Years

Problem 12 -4 : Payback

PP =

Investments

Annual Cash Return

$52,125

$12,000

4.34 years

Project
Problem
12A:-7Payback calculation:

2,000
Cumulative CF:
4,000

0
|
-6,000

1
|
2,000
+

-6,000

2,000
+

-4,000

Regular PaybackA = 3 years.

Payback calculation:
0
1
2
|
|
|
-18,000
5,600
5,600
+
+
Cumulative CF:
10,000

-18,000 -12,400

2
|

3
|
2,000

4
|

2,000

+
-2,000

3
|
5,600
+

4
|
5,600

-6,800 -1,200

Regular PaybackB = 3 + $1,200/$5,600 = 3.21 years.

2,000

5
|
5,600
4,400

5
|

Discounted Payback Period

the length of time required for an investments
cash flows, discounted at the investments cost of
capital to cover its cost.
Ex. Initial outlay = $10,000; interest = 17%
YR

ACR

6,000

PViF
X

0.855

PF-ACR

Cumulative

5,130

5,130
+

4,000

0.731

2,924

>

8,054

>

9,926

10,000
9,926
74

3,000

0.624

1,872

2,000

0.534

1,068

1,000

0.456

456
11,450

74 / 1,068 = .07
DPP = 3.07 years

Net Present Value (NPV)

equal to the present value of future net cash
flows, discounted at the cost of capital.

NPV
Total PV of ACF
Investment
NPV

11,450
- 10,000
1,450

NPV >= 0 ;
ACCEPT
NPV < 0 ; REJECT

Discounted Payback Period - even ACR (annuities)

Ex. A company plans to invest in a project with an initial
cash outlay of $10,000 with expected annual cash
flow/return of $4,000 for 3 yrs. discounted at 15% per
annum.
YR

ACR

PViF
15%

4,000

X 0.870

PV ACR

Cumulativ
e

3,480

3,480

4,000

X 0.756

3,024

6,504

4,000

X 0.658

2,632

9,136

REJECT investment
is not recovered

NPV

PVIFA

Total PV of ACF
Investment
NPV

9,136
- 10,000
( 864 )

NPV < 0 ; REJECT

4,000 X 2.283 = 9,132

Investment
NPV

- 10,000
( 868 )

NPV < 0 ; REJECT

Net Present Value (NPV)

Ex. Initial outlay = $40,000; interest = 12%
YR

ACR

15,000

0.893

13,395

14,000

0.797

11,158

13,000

0.712

9,256

12,000

0.636

7,632

11,000

0.567

6,237
47,678
- 40,000

PViF

Initial Outlay
NPV

PF-ACR

7,678

NPV >0 ; ACCEPT

Internal Rate of Return

discount rate that forces a projects NPV to equal
zero.
if IRR >= cost of capital ;
ACCEPT
if IRR < cost of capital ;
REJECT
if Even Cash Returns
1.Compute for PP. (Investment / Annual Cash Flow)
2.Locate the PP in the PViFA table considering
economic life of investment as n years.

3.Interpolate if necessary.

Internal Rate of Return

if Uneven Cash Returns
1.Compute for tentative PP.
(Investment / Total Annual Cash Flow/# of yrs.)
2 & 3. as even ACR.

Ex. Compute for the IRR of an investment of $100,000

with annual cash net income of 20,000. The projects
economic life is 10 yrs. and cost of capital is 12%.
STEP 1:

PP =

Investments

Annual Cash Return

$100,000

= 5 years

$20,000

STEP 2:
Locate the PP= 5 in the PViFA table considering economic life of investment as
10 yrs.

Between 15% & 16%

STEP 3:
15%

5.019

0.019

5.000

.001021
0.019
=0.1510215
15% + .186 X 0.01 = 0.15 +
5
15.10%
.008978
0.019
=0.1510215
16% - .186 X 0.01 = 0.16 4
15.10%

(
(

)
)

16%

4.833

0.167

1%

.186

15.10% IRR > 12% cost of capital ;

ACCEPT

Ex. Determine the IRR of a $7,000 project with free cash

flow of 1,000 for 10 yrs. given a cost of capital is 5%.
STEP 1:
PP =

Investments
Annual Cash Return

$7,000

= 7 years

$1,000

STEP 2:
Between 7% & 8%

STEP 3:
7%

7.024

0.024

.000764
0.024
= 7.08%
7% + .314 X 0.01 = 0.07 +
3

0.290

8%

7.000

8%

6.710

1%

.314

)
(
- 0.290 X 0.01 = 0.08 - .009235 =
)
( .314
6

7.08%

7.08% IRR > 5% cost of capital ; ACCEPT

IRR: if Uneven Cash Returns

Ex. An investment of $60,000 is expected to earn the
following cash flows: yr1 - $20,000; yr2 - $25,000; yr3 $30,000. The prevailing interest rate on capital is 10%.
Find the IRR of the project.
STEP 1:

Investments
tentativeP
=
P
Annual Cash Return

$60,000

= 2.4

$75,000 / 3

STEP 2:
Locate the PP= 2.4 in the PViFA table considering economic life of investment as
3 yrs.
Between 12% & 13 %
STEP 3:
12%

2.402

0.002

2.40
13%

2.361

1%

.041

.039

.000487
0.002
= 12.05%
12% + . 041 X 0.01 = 0.12 +
8

)
(
13% - .039 X 0.01 = 0.13 - .009512 = 12.05%
)
( . 041
1

12.05% IRR > 10% cost of capital ; ACCEPT

IRR: seatwork
An investment of $40,000 is expected to earn the
following cash flows: yr1 - $15,000; yr2 - $14,000; yr3 $13,000; yr4 - $12,000; yr5 - $11,000. The prevailing
interest rate on capital is 12%. Find the IRR of the project.
Investments
solution: tentativeP =
P
Annual Cash Return

$40,000
$65,000 / 5

= 3.077

Locate the PP= 3.077 in the PViFA table considering economic life of investment
as 5 yrs.
Between 18% & 19 %
18%

3.127

0.05

3.077
19%

3.058

1%

.069

.019

.0072463
0.05
= 18.72%
. 069 X 0.01 = 0.12 +
7

)
(
19% - .019 X 0.01 = 0.13 -.00275362 = 18.72%
)
( . 069
18% +

18.72% IRR > 12% cost of capital ; ACCEPT

Modified Internal Rate of Return (MIRR)

discount rate at which the present value of a
projects cost is equal t the present value of its
terminal value.
Terminal Value (TV)

sum of the future values of the ACR/cash inflows,

compounded at the firms cost of capital.
Steps:
1. Determine the present value of the projects free cash
outflows. ( Usually the investment is already in PV).
2.Determine the TV of the project - total FV of cash
inflows/returns.
3.TV / Initial Outlay = answer, locate at the FVIF table;
between ? where n = economic life.
4.Interpolate if necessary.

Ex. UNEVEN ACR

A project with an initial outlay of $6,000 with a 3 year life and a cost of
capital of 10% has the following cash flows associated with it:
YR

ACR

FViF
10%

2,000

X 1.210

2,420

3,000

X 1.100

3,300

4,000

same

4,000
9,720

FV

TV
0
-$6,000

TV / IO =

9,720
6,000

1
$2,000

= 1.620

2
$3,000

3
$4,000

locate FViF, n = 3 yrs, between 17% and 18%.

Interpolate:
17%

1.602

0.018

1.620
18%

1.643

1%

.041

0.23

0.018
.0043902 = 17.44%
17% + .041 X 0.01 = 0.17 +
4
18% - 0.290 X 0.01 = 0.18 - .05609756 = 17.44%
.041

(
(

)
)

Ex. EVEN ACR

Investment : $12,000
Required Rate of Return: 12%
ACR: P4,000/year
Economic life: 4years

0
-$12,000

1
$4,000

2
$4,000

4,000

FViF
12%
X 1.405

5,620

4,000

X 1.254

5,016

4,000

X 1.120

4,480

4,000

X same

=
TV

4,000
19,116

YR

ACR

3
$4,000

FV

4
$4,000

Solution:
PV/IO = $12,000
TV = $4,000 ( FViFA 4yrs, 12% )
= $4,000 ( 4.779 )

TV = 19.116
TV / IO =

19,116
12,000

= 1.593

locate FViF, n = 4 yrs, between 12% and 13%.

Interpolate:
12%

1.574

0.019

1.593
13%

1.630

1%

.056

0.37

0.019
.0033928 = 12.34%
12% + . 056 X 0.01 = 0.12 +
5
13% - 0.37 X 0.01 = 0.13 - .00660714 = 12.34%
. 056

(
(

)
)

MIRR: seatwork
An investment of $50,000 has an annual cash return of
1st year: $17,000; 2nd year: $22,000; 3rd year: $28,000.
The company has a 15% cost of capital. What is the
MIRR?
YR

ACR

FViF
15%

FV

17,00
0

X 1.322

22,474

22,00
0

X 1.150

25,300

28,00
0

same

28,000
75,774

TV

TV / IO =

75,774

= 1.515

50,000

locate FViF, n = 3 yrs, between 14% and

15%.

Interpolate:
14%

1.482

0.033

0.033
14% + . 039 X 0.01 = 0.14 + .0084615

= 14.85%

0.006

.0015384

= 14.85%

1.515
15%

1.521

1%

.039

)
(
15% - 0.006 X 0.01 = 0.15 )
( . 039

REJECT

Assignment: Chapter VII ( Credit Risk )

Describe the following:
1. Credit Risk
2. Character
3. Capacity
4. Capital
5. Collateral
6. Condition
7. Credit Information
8. General Mercantile Agency
9. Credit Bureaus
10. Bank Credit Department

Interpolate:
18%

3.127

0.05

3.077
19%

3.058

1%

.069

0.19

(
19% (
18% +

0.05
.0072463 = 18.72%
. 069 X 0.01 = 0.18 +
7
0.19
.00275362 = 18.72%
X
0.19
0.01
=
. 069

)
)

Project X - Initial Outlay: $1,000 ; @ 12%

YR

ACR

100

300

400

700

TV / IO =

FViF

FV

1.40 = 140.50
5
1.25 = 376.20
4
= 448
1.12
0
= 700
sam
1,664.70
e

1,664.70

Project Y - Initial Outlay: $1,000 ; @ 12%

YR
1

ACR

FViF

1,000 X

1.40 = 1,405
5
1.25 = 125.4
4
= 56
1.12
0
= 50
sam
1,636.40
e

100

50

50

FV

= 1.6647

1,000

Project X Interpolate:
13%

1.630
1.6647

14%

1.689

1%

.059

(
14% (

0.0347 13% +
0.0243

0.0347
.0032203 = 12.34%
. 059 X 0.01 = 0.13 +
4
0.0243
.00660714 = 12.34%
.059 X 0.01 = 0.14 -

)
)

MIRR: seatwork
What is the MIRR of an investment of $180,000 with an
annual cash return of $38,000 for the next 10 years with a
cost of capital of 14%?
IO = 180,000
TV = 38,000 ( 19.337 )
= 734,806

TV / IO =

734,806

= 4.082

180,000

locate FViF, n = 10 yrs, between 15% and 16%.

Interpolate:
15%

4.046

0.036

0.036
15% + . 365 X 0.01 = 0.15 + .0009863

= 15.10%

0.329

.0090136

= 15.10%

4.082
16%

4.411

1%

.365

(
16% - 0.37
( . 365

)
X 0.01) = 0.16 -

ACCEPT

TV / IO =

1,636.40

= 1.6364

1,000

Project Y Interpolate:
13%

1.630
1.6364

14%

1.689

1%

.059

(
14% (

0.0064 13% +
0.0526

0.0064
.0010847 = 13.11%
X
0.13
+
0.01
=
. 059
5
0.0526
.00411864 = 13.11%
.059 X 0.01 = 0.14 -

)
)