Week 4: Lecture

1
Capital Budgeting
Capital budgeting decisions: what fixed assets
should we buy?
Firms will frequently face broader issues like
whether or not they should launch a new product
or enter a new market.
Decisions such as these will determine the nature
of a firms operations and products for years to
come, primarily because fixed asset investments
are generally long-lived and not easily reversed
once they are made.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 2
Capital Budgeting
The most fundamental decision that a business
must make concerns its product line.
What services they will offer or what will they sell?
In what markets will they compete?
What new products will they introduce?

The answer to any of these questions will require

that the firm commit its scare and valuable capital
to certain types of assets.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 3
Good Decision Criteria
Any firm possesses a huge number of possible
investments.
Each of these possible investments is an option
available to the firm.
Some of these options are valuable and some are
not. The essence of successful financial
management, is learning to identify which are
which.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 4
Good Decision Criteria
We need to ask ourselves the following questions
when evaluating decision criteria:
Does the decision rule adjust for the time value
of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on
whether we are creating value for the firm?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 5
Net Present Value
The difference between the market value of a
project and its cost is the NPV.
How much value is created from undertaking an
investment?
The first step is to estimate the expected future
cash flows
The second step is to estimate the required
return for projects of this risk level
The third step is to find the present value of the
cash flows and subtract the initial investment
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 6
Net Present Value
An investment is worth undertaking if it creates
value for its owners; that is an investment that is
worth more in the marketplace than it costs to
acquire it.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 7
Net Present Value
Example
Suppose you buy a run-down house for $95 000
and spend another $25 000 on painters, plumbers,
and so on to get it fixed up. Your total investment
is $120 000. when the work is completed, you place
the house back on the market and find that its
worth $130 000.
The net result is that you have created $10 000 in
value.
With this example, it turned out after the fact
that $10 000 in value was created. Things thus
worked out nicely.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 8
Net Present Value
Example contd
The real challenge, of course, was to somehow
identify ahead of time whether or not investing the
necessary $120 000 was a good idea in the first
place this is what capital budgeting is all about.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 9
NPV Decision Rule
In other words, NPV is a measure of how much
value is created or added today by undertaking an
investment.
Given our goal of creating value : If the NPV is
positive, accept the project
A positive NPV means that the project is expected
to add value to the firm and will therefore increase
the wealth of the owners
Since our goal is to increase owner wealth, NPV is a
direct measure of how well this project will meet
our goal.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 10
NPV Decision Rule
Investment decisions are greatly simplified when
there is a market for assets similar to the
investment we are considering.
Capital budgeting becomes much more difficult
when we can not observe the market price for at
least roughly comparable investments.
The reason is that we are then faced with the
problem of estimating the value of an investment
using indirect market information.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 11
Project Example Information
You are looking at a new project and you have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000
Your required return for assets of this risk is 12%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 12
Computing NPV for the Project
Using the formula:

minus (-) Initial Outlay (IO)

where
t - the time of the cash flow
i - the discount rate (the rate of return that could be
earned on an investment in the financial markets with
similar risk.); the opportunity cost of capital
Rt - the net cash flow (the amount of cash, inflow minus
outflow) at time t.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 13
Computing NPV for the Project
Using the formuls:

minus (-) Initial Outlay (IO)

NPV = 63,120/(1.12) + 70,800/(1.12)2 +

91,080/(1.12)3 165,000 = $12,627.42
Do we accept or reject the project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 14
Decision Criteria Test NPV
Does the NPV rule account for the time value of
money?
Does the NPV rule account for the risk of the cash
flows?
Does the NPV rule provide an indication about the
increase in value?
Should we consider the NPV rule for our primary
decision criteria?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 15
Payback Period
Payback is the length of time it takes to recover our
initial investment or get our money back.
Computation
Estimate the cash flows
Subtract the future cash flows from the initial
cost until the initial investment has been
recovered
Decision Rule Accept if the payback period is
less than some preset limit
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 16
Project Example Information
You are looking at a new project and you have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000
Your required return for assets of this risk is 12%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 17
Computing Payback for the Project
Assume we will accept the project if it pays back within
two years
Year 1: 165,000 63,120 = $101,880 still to recover
Year 2: 101,880 70,800 = $31,080 still to recover
Year 3: 31,080 91,080 = -$60,000 project pays back in
year 3
Do we accept or reject the project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 18
Decision Criteria Test
Payback
Does the payback rule account for the time value of
money?
Does the payback rule account for the risk of the cash
flows?
Does the payback rule provide an indication about the
increase in value?
Should we consider the payback rule for our primary
decision criteria?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 19
Advantages and Disadvantages of
Payback
Advantages
Easy to understand
Adjusts for uncertainty of later cash flows
Biased towards liquidity (it is biased toward
liquidity) . Favor investments that frees up cash
for other uses more quickly.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 20
Advantages and Disadvantages of
Payback
Disadvantages
Ignores the time value of money (no discounting
involved)
Requires an arbitrary cutoff point. We dont have
a objective basis for choosing a particular
number.
Ignores cash flows beyond the cutoff date

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 21
Advantages and Disadvantages of
Payback
Disadvantages
Biased against long-term projects, such as
research and development, and new projects
(The NPV of the shorter term investment is
actually negative, meaning that it diminishes the
value of the shareholders equity and the opposite
is true for longer term investment).

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 22
Accounting Rate of Return (ARR)
There are many different definitions for average
accounting return
The one we will use is:
Average net income/average book value
Note that the average book value depends on
how the asset is depreciated.
Need to have a target cutoff rate
Decision Rule: Accept the project if the AAR is
greater than a preset rate
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 23
Project Example Information
You are looking at a new project and you have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000
Your required return for assets of this risk is 12%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 24
Computing ARR for the Project
Assume we require an average accounting return of
25%
Average Net Income:
(13,620 + 3,300 + 29,100) / 3 = $15,340
AAR = 15,340 / 72,000 = .213 = 21.3%
Do we accept or reject the project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 25
Decision Criteria Test ARR
Does the AAR rule account for the time value of
money?
Does the AAR rule account for the risk of the cash
flows?
Does the AAR rule provide an indication about the
increase in value?
Should we consider the AAR rule for our primary
decision criteria?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 26
Advantages and Disadvantages of ARR

Advantages
Easy to calculate
Needed information will usually be available

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 27
Advantages and Disadvantages of ARR
Disadvantages
Not a true rate of return; time value of money is
ignored. When we average figures that occur at
different times, we are treating the near future
and the more distant future the same way.
Uses an arbitrary benchmark cutoff rate. There
is no agreed upon way to specify the target ARR.
Based on accounting net income and book
values, not cash flows and market values. As a
result it does not tell us what the effect on share
price will be from taking an investment.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 28
Internal Rate of Return (IRR)
This is the most important alternative to NPV
It is often used in practice and is intuitively
appealing
It is based entirely on the estimated cash flows and
is independent of interest rates found elsewhere
Definition: IRR is the discount rate that makes the
NPV of an investment zero.
Decision Rule: Accept the project if the IRR is
greater than the required return
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 29
Project Example Information
You are looking at a new project and you have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000
Your required return for assets of this risk is 12%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 30
 Computing IRR for the Project
If you do not have a financial calculator, then this
becomes a trial and error process (interpolation)

= Initial Cost (thereby

. making NPV = 0)

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 31
 Computing IRR for the Project
If you do not have a financial calculator, then this
becomes a trial and error process (interpolation)
=Initial Cost (thereby
making NPV = 0)

Try 15% as a 1st pass at the cost of debt

NPV = 63,120/(1.15)+70,800/(1.15)2 + 91,080/(1.15)3 =168308.51
Try 16% as a 2nd pass at the cost of debt
NPV = 63,120/(1.16)+70,800/(1.16)2 + 91,080/(1.16)3 =165380.83
Try 17% as a 3rd pass at the cost of debt
NPV = 63,120/(1.17)+70,800/(1.17)2 + 91,080/(1.17)3 =162536.75

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 32
Computing IRR for the Project
So we take the interpolation between 16% and 17%
as:
Difference of lower discount rate value and initial
cost 165380.83 165 000 = 380.83
Difference of lower and higher discount rate value
165380.83 162536.75= 2844.08
Take ratio of difference 380.83/2844.08 = 0.13
Lower rate ratio 16% +0.13 = 16.13%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 33
Computing IRR for the Project

Do we accept or reject the project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 34
Decision Criteria Test IRR
Does the IRR rule account for the time value of
money?
Does the IRR rule account for the risk of the cash
flows?
Does the IRR rule provide an indication about the
increase in value?
Should we consider the IRR rule for our primary
decision criteria?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 35
Advantages of IRR
Knowing a return is intuitively appealing
It is a simple way to communicate the value of a
project to someone who doesnt know all the
estimation details
If the IRR is high enough, you may not need to
estimate a required return, which is often a
difficult task

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 36
NPV vs IRR
NPV and IRR will generally give us the same
decision
Exceptions
Non-conventional cash flows
Mutually exclusive projects

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 37
Non-conventional cash flows
Non-conventional cash flows - A series of inward
and outward cash flows over time in which there is
more than one change in the cash flow direction.
This contrasts with a conventional cash flow,
where there is only one change in cash flow
direction. In terms of mathematical notation an
unconventional cash flow would appear as -, +, +,
+, -, + or alternatively +, -, -, +, -.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 38
Non-conventional cash flows
An unconventional cash flow is more difficult to
handle in DCF analysis than conventional cash flow
since it may have multiple internal rates of return
(IRR), depending on the number of changes in cash
flow direction.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 39
Mutually exclusive projects
Mutually exclusive projects - Group of capital
budget projects that compete with one another
in such a way that the acceptance of one
automatically excludes all others from further
consideration.
Analysis of competing projects using the Net
Present Value (NPV) and Internal Rate Of
Return (IRR) methods may give decision results
contradictory to each other. From a practical
standpoint, the NPV method generally gives
correct ranking to mutually exclusive projects.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 40
IRR and Mutually Exclusive
Projects
Mutually exclusive projects
If you choose one, you cant choose the other
Example: You can choose to attend graduate
school next year at either Harvard or Stanford,
but not both
Intuitively you would use the following decision
rules:
NPV choose the project with the higher NPV
IRR choose the project with the higher IRR
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 41
Example Nonconventional Cash Flow
Suppose an investment will cost $90,000 initially
and will generate the following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000
The required return is 15%
Do we accept or reject the project?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 42
Summary of Decision Rules
The NPV is positive at a required return of 15%, so
you should Accept
If you use the financial calculator, you would get
an IRR of 10.11% which would tell you to Reject
You need to recognize that there are non-
conventional cash flows and look at the NPV
profile

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 43
Conflicts Between NPV and IRR
NPV directly measures the increase in value to the
firm
Whenever there is a conflict between NPV and
another decision rule, you should always use NPV
IRR is unreliable in the following situations
Non-conventional cash flows
Mutually exclusive projects

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 44
Profitability Index
This is another tool used to evaluate projects and
is also known as benefit-cost ratio.
This index is defined as the present value of the
future cash flows divided by the initial
investments.
So if a project costs $200 and the present value of
the future cash flows is $220, the profitability
index value would be $220/$200 = 1.1

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 45
Profitability Index
A profitability index of 1.1 implies that for every $1
of investment, $1.10 is the value or we create an
additional $0.10 in value (NPV).
This measure can be very useful in situations
where we have limited capital, as we can allocate it
to those projects with the highest Profitability
index.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 46
Profitability Index
Profitability index is very similar to NPV. However,
consider an investment that costs $5 and has a $10
present value and an investment that costs $100
with a $150 present value.
The first of these investment has a NPV of $5 and a
PI of 2
The second has a NPV of $50 and a PI of 1.5
Such there seems to be little reason to rely on the
PI instead of NPV.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 47
Advantages and Disadvantages of
Profitability Index
Advantages
Closely related to NPV, generally leading to
identical decisions
Easy to understand and communicate
May be useful when available investment
funds are limited

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 48
Advantages and Disadvantages of
Profitability Index
Disadvantages
May lead to incorrect decisions in comparisons
of mutually exclusive investments

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 49
Capital Budgeting in Practice
We should consider several investment criteria
when making decisions
NPV and IRR are the most commonly used
primary investment criteria
Payback is a commonly used secondary investment
criteria

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 8, Australia: Wiley. 50
51