Chapter 7

CAPITAL BUDGETING
Definition

 process of making long-term investment

decisions that maximizes the wealth of the
shareholders.
 Three Parts:
 Estimating Cash Flows (Most tedious)
 Estimating discount rate (Cost of Capital, base rate
computed once a year)
 Applying decision rules (Topic of this chapter)
Some Assumptions

 Projects belong in the same risk class.

 Project lives are identical.
 Project sizes are roughly identical.
 Project decisions are not affected by the project
financing decisions. All projects are financed
according to the company’s target capital
structure.

 We will relax the assumptions as we move along

Decision Criteria

 Payback Period
 Time value adjusted payback period
 Internal Rate of Return
 Modified Internal Rate of Return
 Net Present Value
 Profitability Index
Payback Period

 How long does it take to recover investment

 Steps
 Compute cumulative cash flows
 Identify the payback year (the year CCF changes to
positive)
 In what fraction in the payback year the investment
is fully recovered
 (Payback year -1) + (last negative CCF/CF in PBY)
Payback Year-Example

 Incremental Cumulative
 Year Cash Flows Cash Flow
 Project A Project A
 0 (Taka 10,000) (Taka 10,000)
 1 1,000 (9,000)
 2 2,000 (7,000)
 3 3,000 (4,000)
 4 Payback Year 5,000 1,000
 5 6,000
 6 6,000
 (Payback year -1) + (last negative CCF/CF in PBY)
 = 3+4000/5000 = 3.8 years
Time Value Adjusted Payback
Period
 After factoring in time value of money(@15%), how long does it take to recover initial investment.
 Incremental Pv of Cash Flows Cumulative Pv of
 Year Cash Flows Cash Flow (CPV) Project A
Project A Project A
 0 (Taka 10,000) (Taka 10,000) (10,000)
 1 1,000 869.57 ( 9,130.43)
 2 2,000 1,512.29 ( 7,618.14)
 3 3,000 1,972.55 ( 5,645.59)
 4 5,000 2,858.77 ( 2,786.82)
 5 Payback Year 6,000 2,983.06 196.24
 6 6,000 2,593.97
 Adjusted Payback Period = (Adjusted payback year -1) + (Last negative CPV/PV in PBY)
 = 4 + (2786.82/2983.06 = 4.93
Net Present Value

 Residual Value after All Capital Suppliers are

Satisfied. Present Value of inflows minus
present value of outflows at a given discount
rate
 NPV on Financial Calculator.
NPV with no risk assumption
 Cost of Capital 15%
 Cash Flows: Cfo = -25,000, CO1 = 12,000, CO2 = 10,000, CO3 = 15,000.
 Present Value of Inflows: 27,859

 Keep in mind, flows are certain. You can mortgage the inflows for 27,859 at 15%.
 Invest 25,000 leaving 2859 in the bag (yours NPV).
 Your interest on the loan in first year: 4,179.
 When your first inflow occurs, pay the interest and pay (12000-4179) in loan
repayment. Remaining Balance: 20,038
 Your interest on loan in second year: 3006
 When your second inflow occurs, pay the interest and pay (10000-3006) in loan
repayment. Remaining Balance: 13044
 Your interest on loan in third year: 1957
 When your third inflow occurs, pay the interest and pay (15000-1957) in loan
repayment. Last payment pays off the loan.
 You increased your wealth by 2859 today.
NPV Profiles

 NPV Profile.xlsx
 NPV Profile1.xlsx
 Scale difference
 NPV Profile1-Scale Difference.xlsx
Internal Rate of Return
(IRR)
 It is that rate that makes present value of
inflows equal to the present value of
outflows, NPV = 0, it is the geometric rate of
return.
 Solve by interpolation.
 Solve by using Financial Calculators.
 You must have both inflows and outflows.
 Some projects may not have IRR
 Some projects may have multiple IRR
IRR- Financial Calculator
Example
Be sure to clear your calculator first. [2nd CF, 2nd
Clr work Clr work]
 Incremental C fo = - 10,000
 Year Cash Flows CO1 = 1,000
Project A FO1 = 1
 0 (Taka 10,000) CO2 = 2,000
 1 1,000 FO2 = 1
 2 2,000 -
 3 3,000 -
 4 5,000 CO6 = 6,000
 5 6,000 FO6 = 1
 6 6,000 IRR [CPT] 22.35%
IRR: Some problems

 Normal projects have a unique IRR, Non

normal projects may have no IRR or multiple
IRRs.
 Small projects tend to have high IRRs even
though they are not very valuable.
 When we have multiple IRRs, it is difficult to
tell which one we should use as the right
measure of annual return.
 IRR computation assumes that all interim
flows will also earn IRR.
 Crossover rate

Chart Title
$8,000.00

$6,000.00

$4,000.00 C
NPV

$2,000.00 D

$0.00
9%

23%
11%

15%

19%

25%
27%

33%
13%

21%

29%
31%
7%

17%

($2,000.00)
Finding Crossover Rate

 Define the Difference between the Two Cash

Flows.
 Compute the Differences Accordingly
 Determine the IRR of the Differences. The
NPVs cross over at this rate
Modified Internal Rate of
Return (MIRR)
 Definition: Assuming a reinvestment rate, it is
that rate that makes the present value of
outflows equal to the present value of the
accumulated future value of all inflows.
 Find the Future Value of (only) inflows
 You can find the PV and convert it FV (Value 2)
 Find the Present Value of Outflows (Value 1). If
the Project has just the Initial Outlay as the only
outflow, Initial Outflow is Value 1
 Compute the implied interest rate using Value 1
as PV, Value 2 as FV, n for the time frame. The
implied interest rate is MIRR
 MIRR

 With different reinvestment rate

 Reinvestment Rate 18%, Cost of Capital 15%
 Year 0 Year 1 Year 2 Year 3
 Cash Flow (45000) 20000 28000 25000
 Future Value of Inflows (@ 18) = 85888
 MIRR = 24.04%
 Reinvestment Rate 25%, Cost of Capital 15%
 Year 0 Year 1 Year 2 Year 3

 Cash Flow(45000) 28000 20000 18000

 Future Value of Inflows (@ 25) = 86750
 MIRR = 24.46%
Profitability Index

 PI = Present Value of Inflows/Initial Outlay

If you know the NPV and initial outlay is the
only outflow, then
 PI = (NPV + IO)/IO
Decision Rules for Ranking
Projects
 Accept/Reject Rules for Independent Projects
 Payback or Adjusted Payback Period
 Quicker Payback better, Rank higher
 Should be less than company’s required maximum payback
 IRR/MIRR
 Must be greater than discount rate. The higher rate, the
better rank
 NPV
 Must be Positive. The higher the NPV the better rank.
 IRR and NPV criteria will not conflict with unlimited
resources
 Profitability Index
 Must be greater than 1. Higher PI ranks higher
Decision Rules for Mutually
Exclusive Situation. Can Choose
only One
 IRR/MIRR: Choose the Best, Reject others.
Must be higher than the company’s discount
rate.
 NPV: Choose Project with Highest NPV,
Reject Others. NPV must be positive
 PI : Choose the Project with Greatest PI Value,
Reject Others. PI must be greater than 1
Projects with Unequal Lives
Mutually Exclusive
 Replacement Chain
 Keep renewing the projects until both Projects end
in The Same Year
 Find the NPV on a common life basis. Project with
Higher NPV is The better Value Creator
 Equivalent Annual Annuity (EAA)/Annual Net
Present Value (ANPV)
 First find Regular one Cycle NPV
 Second, Divide Above by Appropriate PVIFA. This
is Equivalent Annual Annuity or ANPV.
 Assumption: Unlimited Renewal
Example:
 Year CF(X) CF(Y)
 0 (6,000) (8,500)
 1 2,500 4,000
 2 3,000 4,000
 3 4,600 3,000
 4 2,000
 5 2,000
 6 1,000
 Project(X) Project(Y)
 IRR 27,76% 28.34%
 NPV Taka 1,331.69 Taka 2,310.15
 PI 1.22 1.27
Common Life (Replacement Chain)

 Year CF(X) CF(Y)

 0 (6,000) (8,500)
 1 2,500 4,000
 2 3,000 4,000
 3 4,600 -6,000 3,000
 4 2,500 2,000
 5 3,000 2,000
 6 4,600 1,000
 Project(X) Project(Y)
 IRR 27.76% 28.34%
 NPV Taka 2,184.84 Taka 2,310.15
Equivalent Annual Annuity

 EAA = NPV (Based on one cycle)/PVIFAi,n

 Project(X) Project (Y)

NPV 1331.69 2310.15
PVIFA 2.2459 3.6847
EAA 592.95 626.95
WACC VS Risk-Adjusted Discount
Rate
 Return ** Risk-

Adjusted Discount Rate

 *

* * *

* WACC

*
* *

Risk
Risk-Adjustment in Capital
Budgeting
 Risk Adjusted Discount Rate

RADR

 Risk
 Use judgment to add 3 to 4 % to previous level of
required return
Risk Adjustment Using Certainty
Equivalents
 Certainty Equivalents are between 0 and 1.
 Exchanges Risky Cash Flows for Risk-Free
Flows. A risky Cash Flow of Taka 2,00,000
may be exchanged for a risk-free Flow of Taka
1,60,000. This implies Certainty Equivalent
Factor of .8
 Discount the Risk-free flows at risk-free rate
Risk Adjustment Using Certainty
Equivalents:Example:Problem 11-
Page 132
 Use the following cash flows and certainty equivalent coefficients to evaluate the
worthiness of the project.
 Year Cash Flow Certain Equivalent
 Coefficients
 0 (2,00,000) 1
 1 60,000 .95
 2 75,000 .85
 3 80,000 .75
 4 75,000 .70
 5 78,000 .70

 Use a risk-free rate of 11 percent and a risk-adjusted discount rate of 25 percent.
 Compute the IRR and apply the RADR decision rule. Should the project be accepted?
 Compute the certainty equivalent net present value. Should the project be selected on a certainty
equivalent basis?