CFA Level I

Corporate Finance
Capital Budgeting
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Contents
1. Introduction
2. The Capital Budgeting Process
3. Basic Principles of Capital Budgeting
4. Investment Decision Criteria

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1. Introduction
Capital budgeting is the process that companies use for
decision making on long-term projects
Capital budgeting
helps decide the future of many corporations
can be adapted for many other corporate decision such as
investment in working capital, leasing, mergers and
acquisitions

Valuation principles used in capital budgeting are used in

security valuation
Corporate budgeting decisions are consistent with
management goal of maximizing shareholder value
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2. The Capital Budgeting Process

The process is as follows:
1. Generating Ideas
2. Analyzing Individual Proposals
3. Planning and Capital Budgeting
4. Monitoring and Post Audit

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Project Categories
Replacement projects
Expansion projects
New products and services
Mandatory projects

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3. Basic Principles of Capital

Budgeting
1. Decisions are based on cash flows
2. Timing of cash flows is crucial
3. Cash flows are based on opportunity costs
4. Cash flows are analyzed on an after-tax basis
5. Financing costs are ignored

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Key Concepts
Sunk cost (not included in investment appraisal)

Incremental cash flows

Externality (positive /negative)

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Key Concepts (Cont)

Conventional versus non-conventional cash flows

Independent versus mutually exclusive projects

Project Sequencing

Unlimited funds versus capital rationing

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4. Investment Decision Criteria

Analysts use several important criteria to evaluate capital
investments. Some known metrics are the following:

Net present value ( NPV)

Internal rate of return (IRR)
Payback and discounted payback period
Profitability index (PI)
Average accounting rate of return (AAR)

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4.1 Net Present Value

Net present value is the present value of the future after
tax cash flows minus the investment outlay

For independent projects: positive NPV accept

negative NPV reject

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Example
Cost of Capital = 10%
Expected Net After
Tax Cash Flows
Year
Proje Proje
(t)
ct A
ct B
0
$1,00 $1,00
0
0
1
500
100
2
400
300
3
300 Compute
400
Requirement:
NPV for Project A and
100
600
B 4
Answer:
NPV for A = 78.82; NPV for B = 49.18
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NPV Using Calculator

Key
strokes

Display

[CF][2nd ]
[CLR
WORK]

CF0= 0

1000 []
[ENTER]

CF0 =
-1000

[] 500
[ENTER]

C01= 500

[]

F01= 1

[] 400
[ENTER]

C02= 400

[]

F02= 1

[] 300
[ENTER]

C03= 300

[]

F03= 1

[] 100
[ENTER]

C04= 100

[]

F04= 1

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4.2 Internal Rate of Return

IRR measures the return for a given project

IRR is the discount rate that makes the present value of the future
cash flows equal to the investment outlay; we can also say that
IRR is the discount rate which makes NPV equal to 0.

IRR Decision Rule

If IRR > the required rate of return, accept the project
If IRR < the required rate of return, reject the project
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Example
Cost of Capital = 10%
Expected Net After
Tax Cash Flows
Year
Proje Proje
(t)
ct A
ct B
0
$1,00 $1,00
0
0
1
500
100
2
400
300
3
300 Compute
400
Requirement:
IRR for Project A and
100
600
B 4

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IRR Using Calculator

Key
strokes

Display

[CF][2nd ]
[CLR
WORK]

CF0 = 0

1000 []
[ENTER]

CF0 =
-1000

[] 500
[ENTER]

C01 = 500

[]

F01 = 1

[] 400
[ENTER]

C02 = 400

[]

F02 = 1

[] 300
[ENTER]

C03 = 300

[]
1
Compute
IRRF03
for=Project
B (cash flows on previous
[] 100
C04 = 100
slide)
[ENTER]
[]

IRR of B =
11.79%
F04 = 1

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4.3 Payback Period

The payback period is the number of years it
takes to recover the initial cost of the investment
Advantages:
Easy to calculate
Easy to explain
Indicator of project liquidity
Drawbacks:
Does not consider cash flows after payback
period
Does not consider time value of money
Does not consider risk of a project
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4.4 Discounted Payback Period

Discounted payback method uses the present value of
the estimated cash flows; it gives the number of years to
recover the initial investment in present value terms

Drawbacks:
Does not consider any cash flow beyond payback
period
Poor measure of profitability
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Example
Y 0 1 2 3 4
e
ar
P - 3 3 3 3
Compute the payback period and discounted payback period
ro 8 4 4 4 4
assuming
je 0 0 a
0 rate
0 of
0 10%.
ct 0
C

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4.5 Average Accounting Rate of

Return

The average accounting rate of return (AAR) can be defined

as:
AAR = Average net income/ average book value

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4.6 Profitability Index

Profitability index (PI) is the present value of a
projects future cash flows divided by the initial
investment
PI = PV of future cash flows/Initial investment
PI = 1+ (NPV/Initial investment)

Investment decision rule for PI is:

Invest if : PI > 1.0
Do not invest if: PI < 1.0
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4.7 NPV Profile

The NPV profile shows a projects NPV graphed as a function of
various discount rates. The NPV is graphed on the y-axis and
discount rates on the x-axis respectively. Create the NPV profile for
Project X.
Year

Proje
ct X

40
0

1
6
0

16 1
0 6
0

1
6
0

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Crossover
Draw the NPV profiles for Projects X and Y. Discuss the
significance of the cross over point.
Ye 0
ar

Pr oj 40
ec 0
tX

16
0

16
0

16
0

16
0

Pr oj 40
ec 0
tY

80
0

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Example
The initial investment on a project is 200. The after-tax cash flows from this project
are 80 annually for four years. Improvements on the project equipment increase the
cost by 30 and the after-tax cash flows by 10. What is the impact on the NPV
profile?
A. Vertical intercept shifts up and horizontal intercept shifts left
B. Vertical intercept shifts up and horizontal intercept shifts right
C. Vertical intercept shifts down and horizontal intercept shifts right

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4.8 Ranking Conflicts between NPV and

IRR
Project A

No conflict between NPV and IRR decision rules

Conventional
Cash Flows

Project A

Project B

Conventional
Cash Flows

Conventional
Cash Flows

Project C

O
R

Project D

A and B are independent

No conflict between NPV and IRR
decision rules
A and B are mutually exclusive
Possible conflict between NPV and IRR
decision rules
Reasons: 1) Different cash flow patterns
and
2) Different scale
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Ranking Conflict Due to Differing Cash Flow

Patterns
Y 0 1 2 3 4 NI
e
P R
a
V R
r
P - 1 1 1 1
rWhich
4 6 project
6 6 6 do you select according to the NPV rule using a rate
o of
0 0
0 0 0
10%?
j 0
Which project do you select according to the IRR rule?
e
cShow the NPV profile for both projects.
t
X
P - 0 0 0 8
r 4
0
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o 0
0

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Ranking Conflict Due to Differing Project Scale

Y 0 1 2 3 4 NI
e
P R
a
V R
r
P - 1 1 1 1
rWhich
2 0 project
0 0 0 do you select according to the NPV rule using a rate
o of
0 0
0 0 0
10%?
j 0
Which project do you select according to the IRR rule?
e
cShow the NPV profile for both projects.
t
C
P - 3 3 3 3
r 8 4 4 4 4
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o 0 0 0 0 0

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Example
For the projects shown below what discount rate would result in the same NPV? The
required rate of return is 10%.
A. A rate between 0% and 10%
B. A rate between 10% and 25%
C. A rate between 25% and 35%
Y
e
a
r
P
r
o
j
e
c
t
C
P

0 1 2 3 4 N I
P R
V R
- 1 1 1 1 1 3
2 0 0 0 0 1 5
0 0 0 0 0 7 %
0

3 3 3 3 2 2

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4.9 The Multiple IRR Problem and No IRR

Problem
Show the NPV profile for this project? Hint:
use these rates: 0%, 50%, 100%, 150%,
200%, 250%
Time
2
0
1
Cash
Flow

1,0
200 00

1,2
00

Show the NPV profile for this project? Hint:

use these rates: 0%, 50%, 100%, 150%,
200%, 250%
Time
2
0
1

Cash
Flow

100 250
300
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Comparison between NPV and IRR

NPV
Advantages:
Direct measure of expected
increase in value of firm
Theoretically the best method
Disadvantage:
Does not consider project size

IRR
Advantages
Shows the return on each dollar
invested
Allows us to compare return with
the required rate
Disadvantage:
Incorrectly assumes that
money is reinvested at IRR
rate
Might conflict with NPV analysis
Possibility of multiple IRRs or no
IRR for a project
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4.10 Popularity and Usage of The Capital

Budgeting Methods
See Table 13 in the curriculum; this gives an indication of
the popularity of various capital budgeting techniques in
different parts of the world
NPV and IRR more likely to be used at larger firms and
where management has MBA degrees
Payback method is also quite popular, especially at
private companies

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Relationship between NPV and Stock

Price
NPV is a direct measure of the expected change in firm
value from undertaking a capital project
NPV is the criterion most related to stock prices
A positive NPV project should cause a proportionate
increase in a companys stock value

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Example
A company is undertaking a project with a NPV of $500 million.
The company currently has 100 million shares outstanding and
each share has a price of $50. What is the likely impact of the
project on the stock price?

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Summary
Capital budgeting process
NPV calculation and NPV rule
IRR calculation and IRR rule
Issues with IRR
NPV profile
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Conclusion
Read summary
Review learning objectives
Practice problems: good but not enough
Practice questions from other sources

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