BBC406 Fundamentals of

Finance
Week 8 Capital Budgeting

Learning Objectives
At the end of this chapter, you should be able to:
Understand the importance of capital budgeting
decision making and explain inputs used in
capital budgeting
Use the accounting rate of return and payback
period methods to make capital investment
decisions
Understand the time value of money and
compute the present and future values
Use the net present value (NPV) and internal rate
of return (IRR) methods to make capital
investment decisions

Learning Objectives (cont.)

Understand the advantages and disadvantages of
various capital budgeting methods
Understand the risks in capital budgeting

What is Capital Budgeting?

Capital Budgeting is a decision that involves broad
strategic aspects of the company, in which managers
analysing alternative long-term investments
Examples of capital budgeting decisions:
Launch a new plant or plant
expansion
Purchase new machinery
Equipment replacement
Equipment selection

What is Capital Budgeting?

(cont.)
Nature of a capital budgeting decision:
a) Outlays of large amounts of resources
b) Non-reversible
c) Strategic and risky

Capital Budgeting Evaluation

Process
There are five steps:
a)

Identify potential capital investments

b)

Forecast future net cash flow

c)

Analyse potential investment

d)

Choose among alternative investments when the resources are not

sufficient to fund all profitable projects

e)

Perform post-audits after making capital investment

Capital Budgeting
Evaluation Process
(cont.)

There are two main types of

capital budgeting decisions:

Screening
Decisions

Preference
Decisions

Pertain to whether
or not some
proposed
investment is
acceptable; these
decisions come first.

Attempt to rank
acceptable
alternatives from
the most to least
appealing.

Three key things

Three keys things to remember about capital
budgeting decisions include:
1. Typically a go or no-go decision on a
product, service, facility, or activity of the
firm.
2. Requires sound estimates of the timing
and amount of cash flow for the proposal.
3. The capital budgeting model has a
predetermined accept or reject criterion.

Capital Budgeting Decisions

a. Accounting
rate of return

b. Payback
period

Methods used to evaluate

capital expenditure decisions

c. Net present
value

d. Internal rate
of return

Capital Budgeting
Decisions (cont.)
Mattel is evaluating a proposal to invest in a new childrens
MP3 product that would require an up-front investment of
$1,000,000. The products estimated life cycle is five years,
Mattel estimates the new products income over the next five
years as follows:

Should Mattel invest in this project?

Accounting Rate of
Return

Average
Annual
Net Income

$126,000
Average Annual
Net Income

Initial
Investme
nt

Accounting
Rate of
Return

$1,000,00
0

12.6%

Accounting Rate of
Return (cont.)

Decision rule:
Accept the project if its ARR is greater than
the companys target rate of return;
otherwise, reject it.

Accounting Rate of
Return (cont.)
Cons

Pros

Simple
Intuitive

The time value of money is

ignored.

The accounting rate of

return is based on net
income instead of cash
flow.

Alternative accounting

methods may have an

impact on reported net
income.

Typical Cash Outflows

The initial investment
Additional amount of working capital
Repairs and maintenance
Additional operating costs

Typical Cash Inflows

(cont.)
Incremental revenues
Reduction in costs
Salvage value
Release of working capital

Capital Expenditure Decisions

Mattel is evaluating a proposal to invest in a new childrens
MP3 product that would require an up-front investment of
$1,000,000. The products estimated life cycle is five years,
Mattel estimates the new products income over
the next five years as follows:

Cash Flow vs. Accounting Net Income

Non-cash
expense

Net Income
$126,000

Depreciatio
n
$200,000

After-Tax
Cash Flow

Net Cash
Flow
$326,000

$1,000,000 5 years = $200,000 per year

Payback Period
The payback period is the length of time it takes for
an investment project to recoup its own initial cost
out of the cash receipts that it generates.
The basic premise of this method is that the more
quickly the cost of an investment can be recovered,
the more desirable is the investment.
Decision rule: Accept the project if its payback period
is shorter than the companys target payback period.

Payback Period (cont.)

Equal Annual Cash Flow
Initial
Investme
nt

Annual
Net Cash
Flow

Payback
Period

Net Income +
Depreciation
$1,000,0
00

$326,000

$126,000 +
$200,000

3.07
years

Payback Period (cont.)

When annual cash flows are unequal, the payback period must be
computed on a year by year basis by subtracting the net cash flow
from the unpaid investment balance each year.

The payback period is somewhere between 3 and 4

years:
3 + 110,000 / 375,000 = 3.29 years

Example: Payback Period

Payback period of a new machine
Lets say that the owner of Perfect Images Salon
is considering the purchase of a new tanning bed.
It costs $10,000 and is likely to bring in after-tax
cash inflows of $4,000 in the first year, $4,500 in
the second year, $10,000 in the 3 rd year, and
$8,000 in the 4th year.
The firm has a policy of buying equipment only if
the payback period is 2 years or less.
Calculate the payback period of the tanning bed
and state whether the owner would buy it or not.

Example 1 Answer

Payback Period Method

Cons

Pros

1.
1. Fails
Fails to
to consider
consider the
the
time
time value
value of
of money.
money.
2.
2. Does
Does not
not consider
consider aa
projects
projects cash
cash flows
flows
beyond
beyond the
the payback
payback
period.
period.

1.
1. Provides
Provides aa simple
simple and
and
intuitive
intuitive tool
tool for
for roughly
roughly
screening
screening investments.
investments.
2.
2. For
For some
some firms,
firms, itit may
may
be
be essential
essential that
that an
an
investment
investment recoup
recoup its
its
initial
initial cash
cash outflows
outflows as
as
quickly
quickly as
as possible.
possible.

Time Value of Money

One ringgit received today is
worth more than one ringgit
received a year from now
because the dollar can be
invested to earn interest.

For example RM1,000 today,

invested at 10%, will be worth
RM1,100 in one year.

Discounted Cash Flow

Methods
Now lets look at capital budgeting methods
that consider the time value of cash flows:
Net Present
Value (NPV)

Internal Rate
of Return (IRR)

Net Present Value (NPV)

Net present value analysis emphasizes on

discounted cash flows.
The reason is that accounting net income is
based on accruals that ignore the timing of
cash flows into and out of an organization.

Net Present Value (NPV) (cont.)

Choose a discount rate k the
minimum required rate of return.

Calculate the present

value of annual net cash flows CFt.

NPV

n
CFn
CFt
CF1
CF2
CF

= 0 (1 k )1 (1 k )2
(1 k ) n t 0 (1 k )t

Net Present Value (NPV)

(cont.)
Decision Rule under NPV

Net Present Value (NPV)

(cont.)
Lets return to Mattels MP3 proposal. Recall that the up-front
investment is $1,000,000, and the products estimated life is 5
years. Mattels required rate of return, or hurdle rate,
is 12%. Mattel estimates the new products income
over the next five years as follows:

Net Present Value (NPV)

(cont.)
Equal Annual Cash Flow

Since the NPV is positive, we know the rate of return

is greater than the 12 percent discount rate.

Net Present Value (NPV)

(cont.)
Equal Annual Cash Flow

The present value of an annuity of $1

for 12%, 5 years is the sum of the present
value of $1 factors for 12%, 5 years.

Example: NPV
NPV, discount rate 10%
Lets say that the owner of Perfect Images Salon
is considering the purchase of a new tanning bed.
It costs $10,000 and is likely to bring in after-tax
cash inflows of $4,000 in the first year, $4,500 in
the second year, $10,000 in the 3 rd year, and
$8,000 in the 4th year.
Using the cash flows for the tanning bed given in
above, calculate its NPV and indicate whether the
investment should be undertaken or not.

Mutually Exclusive versus

Independent Projects
NPV approach useful for independent as well as mutually
exclusive projects.
A choice between mutually exclusive projects arises when:
1.There is a need for only one project, and both projects can
fulfill that need.
2.There is a scarce resource that both projects need, and by
using it in one project, it is not available for the second.
NPV rule considers whether or not discounted cash inflows
outweigh the cash outflows emanating from a project.
Higher positive NPVs would be preferred to lower or negative
NPVs.
Decision is clear-cut.

Example: Mutually Exclusive versus

Independent Projects

Revision
Morgan, Inc. is considering an eight-year
project that has an initial after-tax outlay or
after-tax cost of $180,000. The future after-tax
cash inflows from its project for years 1
through 8 are the same at $35,000. Morgan
uses the net present value method and has a
discount rate of 12%. Will Morgan accept the
project?
Calculate the payback period for the project.
Calculate the NPV of the project, assuming that
Morgan has a cost of capital equal to 12%
Calculate the IRR for the project.

Internal Rate of Return (IRR)

The internal rate of return is the true
economic return earned by the asset over
its life. It is computed by finding the
discount rate that makes

NPV =
0
CF1

CFn
CF2
CF0

L
1
2
(1 IRR ) (1 IRR )
(1 IRR) n
n

CFt

t
(1

IRR
)
t 0

Internal Rate of Return (IRR) (cont.)

Decision rule under IRR
Internal
Rate of
Return
Internal
Rate of
Return
Internal
Rate of
Return

>

Required
Rate of
Return

Required
Rate of
Return

<

Required
Rate of
Return

then

Positive
NPV

then

Zero
NPV

then

Negative
NPV

Internal Rate of Return Method

Equal Annual Cash Flow
Find the discount factor:

Investment required

Net annual cash flows= Present value factor

$1,000,000
$326,000

= 3.067

The
The present
present value
value factor
factor (3.067)
(3.067) is
is located
located on
on the
the table
table of
of
present
present value
value of
of annuity.
annuity. Scan
Scan the
the 5-year
5-year row
row and
and locate
locate
the
the value
value 3.067.
3.067. The
The internal
internal rate
rate of
of return
return is
is
somewhere
somewhere between
between 18%
18% and
and 20%.
20%.

Revision
Morgan, Inc. is considering an eight-year
project that has an initial after-tax outlay or
after-tax cost of $180,000. The future after-tax
cash inflows from its project for years 1
through 8 are the same at $35,000. Morgan
uses the net present value method and has a
discount rate of 12%. Will Morgan accept the
project?
Calculate the payback period for the project.
Calculate the NPV of the project, assuming that
Morgan has a cost of capital equal to 12%
Calculate the IRR for the project.

Comparing the NPV and IRR

Methods
Net Present Value

Internal Rate of Return

The required rate of

return is used as the
actual discount rate

The required rate of return

is compared to the internal
rate of return on a project

Any project with a

negative net present
value is rejected

Easier to adjust for risk

To be acceptable, a
projects rate of return
must be greater than the
cost of capital
Assumes that cash flows
are reinvested at the IRR

Profitability Index

Mattel is trying to decide how to prioritize their limited

research and development budget. They are
considering these three independent projects.

How should Mattel prioritize these three projects?

Profitability Index (cont.)

The profitability index (PI) is an additional tool to
help managers compare investment projects
with different sizes.
Profitabili
ty
Index

Present Value
of Future Cash
flows

Initial
Investme
nt

Decision rule:
The higher the PI, the more desirable the project.

Ranking Investment Projects

Based on the profitability index, Project A

should be first, followed by Project B, then C.

Additional Considerations
1. Intangible benefits:
Increased quality
Improved safety
Greater employee loyalty
More favorable social influence
2. Risk issues in capital budgeting
a) Sensitivity analysis
b) How to deal with risky projects

Post-audit of Investment Projects

A post-audit is a follow-up evaluation after the project
has been approved to see how well a projects actual
performance matches the original projections.

A post-audit is important because:

a) Managers are more likely to submit reasonable and
accurate data when they make investment proposals.
b) The company can dynamically assess the projects
and determine whether to continuously support or
terminate existing projects.
c) Managers will improve future investment proposals
and implementation.

Overview of Six Decision Models

Payback period
simple and fast, but economically unsound.
ignores all cash flow after the cutoff date
ignores the time value of money.

Net present value (NPV)

economically sound
properly ranks projects across various sizes, time horizons,
and levels of risk, without exception for all independent
projects.

Overview of Six Decision

Models (continued)
Internal rate of return (IRR)
provides a single measure (return),
has the potential for errors in ranking projects.
can also lead to an incorrect selection when
there are two mutually exclusive projects or
incorrect acceptance or rejection of a project
with more than a single IRR.

Profitability index (PI)

incorporates risk and return,
but the benefits-to-cost ratio is actually just
another way of expressing the NPV.