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The Basics of Capital Budgeting:

Evaluating Cash Flows
Should we
build this
plant?

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13 - 2

What is capital budgeting?

Analysis of potential additions to fixed

assets.
Long-term decisions; involve large
expenditures.
Very important to firms future.
Investment is made in present times

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13 - 3

Evaluate expenditure decisions

benefit of which may accrue for more
than one year
Irreversible
Effect for longer period
Lot of funds are required
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13 - 4

What is the difference between

independent and mutually exclusive
projects?
Projects are:
independent, if the cash flows of
one are unaffected by the
acceptance of the other.
mutually exclusive, if the cash flows
of one can be adversely impacted by
the acceptance of the other.
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13 - 5

An Example of Mutually Exclusive

Projects

BRIDGE vs. BOAT to get

products across a river.
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13 - 6

Normal Cash Flow Project:

Cost (negative CF) followed by a
series of positive cash inflows.
One change of signs.
Nonnormal Cash Flow Project:
Two or more changes of signs.
Most common: Cost (negative
CF), then string of positive CFs,
then again negative CF
.
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13 - 7

Inflow (+) or Outflow (-) in Year

0

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NN

NN

NN
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13 - 8

What is the payback period?

The number of years required to

recover a projects cost,
or how long does it take to get the
businesss money back?

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13 - 9

Payback for Project L

(Long: Most CFs in out years)
0

CFt
-100
Cumulative -100
PaybackL

= 2

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10
-90
+

30/80

2.4

60 100
-30
0

3
80
50

= 2.375 years

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13 - 10

Project S (Short: CFs come quickly)

0
CFt

-100

Cumulative -100
PaybackS

1.6 2

70 100 50

20

-30

40

0 20

= 1 + 30/50 = 1.6 years

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13 - 11

Strengths of Payback:
1. Provides an indication of a
projects risk and liquidity.
2. Easy to calculate and understand.
Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
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13 - 12

Discounted Payback: Uses discounted

rather than raw CFs.
0

10%

10

60

80

CFt

-100

PVCFt

-100

9.09

49.59

60.11

Cumulative -100

-90.91

-41.32

18.79

Discounted
= 2
payback

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+ 41.32/60.11 = 2.7 yrs

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13 - 13

Average rate of Return

ARR=
Average annual profits after taxes and depreciation
__________________________________________
Average Investment
Note: Average Investment=
( Original Investment + Salvage Value)/2

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13 - 14

NPV
Cost often is CF0
n

CFt
NPV
CF0 .
t
t 1 1 k

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13 - 15

Whats Project Ls NPV?

Project L:
0

10%

-100.00

10

60

80

9.09
49.59
60.11
18.79 = NPVL
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13 - 16

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. Adds most value.
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13 - 17

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 ; NPV > 0.
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13 - 18

Internal Rate of Return: IRR

0

CF0
Cost

CF1

CF2
Inflows

3
CF3

IRR is the discount rate that forces

PV inflows = cost or PV of Cash
Outflows
This is the same as forcing NPV = 0.
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13 - 19

NPV: Enter k, solve for NPV.

CFt
NPV.

t
t 0 1 k
n

IRR: Enter NPV = 0, solve for IRR.

CFt
0.

t
t 0 1 IRR
n

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13 - 20

IRR Acceptance Criteria

If IRR > k, accept project.

If IRR < k, reject project.

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13 - 21

Profitability Index or Benefit Cost Ratio

PI=
Present Value of Cash Inflows
___________________________
Present Value of Cash Outflows
PI>1------Accept
PI<1------Reject
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13 - 22

NOTE
Pay Back/IRR/NPV/PI
= Cash Flow After Tax Before Dep
ARR= Cash Flow after tax and after
Depreciation

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