© 2010 Financial Management

Prepared by: Amyn Wahid

 Capital Budgeting: the process of
planning for purchases of long-term
assets.
■ example:
Suppose our firm must decide whether to purchase a new
plastic molding machine for $125,000.
How do we decide?
■ Will the machine be profitable?
■ Will our firm earn a high rate of return

on the investment?
Decision-making Criteria in
Capital Budgeting

How do we decide
if a capital
investment
project should
be accepted or
rejected?
4
 Project Evaluation:
Alternative Methods

–Payback Period (PBP)

–Net Present Value (NPV)
–Internal Rate of Return (IRR)
–Profitability Index (PI)
 Decision-making Criteria in
Capital Budgeting
■ The Ideal Evaluation Method should:

a) include all cash flows that occur

during the life of the project,
b) consider the time value of money,
c) incorporate the required rate of
return on the project.
 Independent Project

◆ For this project, assume that it is

independent of any other potential
projects that Basket Wonders may
undertake.
■ Independent -- A project whose acceptance (or
rejection) does not prevent the acceptance of
other projects under consideration.
 Other Project Relationships

◆ Dependent -- A project whose

acceptance depends on the
acceptance of one or more other
projects.
■ Mutually Exclusive -- A project whose
acceptance precludes the acceptance of
one or more alternative projects.
 Proposed
Proposed Project
Project Data
Data

Cesc fabregas is evaluating a new project for his

firm, Arsenal fc. He has determined that the after-
tax cash flows for the project will be $10,000;
$12,000; $15,000; $10,000; and $7,000,
respectively, for each of the Years 1 through 5.
The initial cash outlay will be $40,000.
 Payback Period (PBP)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

PBP is the period of time required for the

cumulative expected cash flows from an
investment project to equal the initial cash
outflow.
(The number of years needed to recover the
initial cash outlay).
 Payback
Payback Solution
Solution (#1)
(#1)

0 1 2 3 (a) 4 5

-40 K (-b) 10 K 12 K 15 K 10 K (d) 7K

10 K 22 K 37 K (c) 47 K 54 K

Cumulative
PBP =a+(b-c)/d
Inflows
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years
 Payback
Payback Solution
Solution (#2)
(#2)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K
-40 K -30 K -18 K -3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K
Cumulative = 3.3 Years
Cash Flows Note: Take absolute value of last negative
cumulative cash flow value.
 PBP
PBP Acceptance
Acceptance Criterion
Criterion
The management of Basket Wonders has set a maximum
PBP of 3.5 years for projects of this type.

Should this project be accepted?

Yes! The firm will receive back the initial cash

outlay in less than 3.5 years.
[3.3 Years < 3.5 Year Max.]
 Drawbacks of Payback Period:

■ Firm cutoffs are subjective.

■ Does not consider time value of money.
■ Does not consider any required rate of
return.
■ Does not consider all of the project’s
cash flows.
 Other Methods

1) Net Present Value (NPV)

2) Profitability Index (PI)
3) Internal Rate of Return (IRR)

Each of these decision-making criteria:

■ Examines all net cash flows,
■ Considers the time value of money, and
■ Considers the required rate of return.
 Net Present Value

• NPV = the total PV of the annual net

cash flows - the initial cash outlay.

Σ
ACFt
NPV = - ICO
(1 + k) t
t=1

Refer to the nest slide

 Net
Net Present
Present Value
Value (NPV)
(NPV)

NPV is the present value of an

investment project’s net cash
flows minus the project’s initial
cash outflow.
CF1 CF2 CFn
NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k)n
 Net Present Value

• Decision Rule:

• If NPV is positive, ACCEPT.

• If NPV is negative, REJECT.
 NPV
NPV Solution
Solution
Basket Wonders has determined that the appropriate
discount rate (k) for this project is 13%.

NPV = $10,000 +$12,000 +$15,000 +

(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
+ - $40,000
(1.13) 4
(1.13) 5

= $-1424.423
 NPV
NPV Solution
Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $
7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428 (due to rounding)
 NPV
NPV Acceptance
Acceptance Criterion
Criterion

The management of Basket Wonders has

determined that the required rate is 13%
for projects of this type.

Should this project be accepted?

No! The NPV is negative. This means that the project

is reducing shareholder wealth.
[Reject as NPV < 0 ]
 Net
Net Present
Present Value
Value Profile
Profile
$000s Sum of CF’s Plot NPV for each
15 Thre discount rate.
e
Net Present Value

of th
e se p
10 oints
are
easy
now
!
5 IRR (discussed later)
NPV@13%
0
-4
0 3 6 9 12 15 Discussed
Discount Rate (%) Later
 NPV Example
■ Suppose Small Wonders is considering a capital
investment that costs $276,400 and provides annual
net cash flows of $83,000 for four years and $116,000
at the end of the fifth year. The firm’s required rate
of return is 15%.

83,000 83,000 83,000 83,000 116,000

(276,400)

0 1 2 3 4 5
You should get NPV = $18,235.71
 Profitability Index

Σ
ACFt
NPV = t - IO
(1 + k)
t=1
 Profitability Index

Σ
ACFt
NPV = t - IO
(1 + k)
t=1

Σ
ACFt
PI = IO
(1 + k) t
t=1
 Profitability
Profitability Index
Index (PI)
(PI)
PI is the ratio of the present value of a
project’s future net cash flows to the
project’s initial cash outflow.

CF1 CF2 CFn

PI = + +...+ ICO
(1+k)1 (1+k)2 (1+k)n
<< OR >>

PI = 1 + [ NPV / ICO ]
 Profitability Index

• Decision Rule:

• If PI is greater than or equal to

1, ACCEPT.
• If PI is less than 1, REJECT.
 PI
PI Acceptance
Acceptance Criterion
Criterion
PI = $38,572 / $40,000
= 0.9643

Should this project be accepted?

No! The PI is less than 1.00. This means

that the project is not profitable.
[Reject as PI < 1.00 ]
 PI Example

■ Suppose we are required to find PI for

Small Wonders . Recall that the firm’s
required rate of return is 15%.

83,000 83,000 83,000 83,000 116,000

(276,400)

0 1 2 3 4 5
You should get PI = 1.066
 Internal Rate of Return (IRR)

IRR: the return on the firm’s invested capital.

IRR is simply the rate of return that the firm earns

on its capital budgeting projects.It is the discount
rate that equates the present value of the future
net cash flows from an investment project with
the project’s initial cash outflow.
 Internal Rate of Return (IRR)

Σ
ACFt
NPV = - IO
(1 + k) t
t=1
 Internal Rate of Return (IRR)

Σ
ACFt
NPV = - IO
(1 + k) t
t=1

n
ACFt
IRR:
Σ
t=1
(1 + IRR) t = IO
 Internal Rate of Return (IRR)

CF1 CF2 CFn

ICO = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n

■ IRR is the rate of return that makes the PV of

the cash flows equal to the initial outlay.
■ This looks very similar to our Yield to Maturity
formula for bonds. In fact, YTM is the IRR of a
bond.
 IRR
IRR Solution
Solution

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the discounted cash
flows to equal $40,000
 IRR
IRR Solution
Solution (Try
(Try 10%)
10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +

$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
 IRR
IRR Solution
Solution (Try
(Try 15%)
15%)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
 IRR
IRR Solution
Solution (Interpolate)
(Interpolate)
.10 $41,444
.05 X IRR $40,000 $1,444 $4,603
.15 $36,841

X $1,444
=
.05 $4,603
 IRR
IRR Solution
Solution (Interpolate)
(Interpolate)
.10 $41,444
.05 X IRR $40,000 $1,444 $4,603
.15 $36,841

($1,444)(0.05)
X= X = .0157
$4,603

IRR = .10 + .0157 = .1157 or 11.57%

 IRR
IRR Acceptance
Acceptance Criterion
Criterion
The management of Basket Wonders has
determined that the hurdle rate is 13% for
projects of this type.

Should this project be accepted?

No! The firm will receive 11.57% for each dollar
invested in this project at a cost of 13%.
[ IRR < Hurdle Rate ]
 IRR Example
■ Looking again at same Small Wonders
problem for IRR.

83,000 83,000 83,000 83,000 116,000

(276,400)

0 1 2 3 4 5

You should get IRR = 17.63%

 IRR
• Decision Rule:

• If IRR is greater than or equal to

the required rate of return,
ACCEPT.
• If IRR is less than the required
rate of return, REJECT.
 IRR
■ IRR is a good decision-making tool as
long as cash flows are conventional.
(- + + + + +)
■ Problem: If there are multiple sign
changes in the cash flow stream, we
could get multiple IRRs. (- + + - + +)
(500) 200 100 (200) 400 300

0 1 2 3 4 5
 Evaluation Summary

Basket Wonders Independent Project

Method Project Comparison Decision
PBP 3.3yrs 3.5yrs Accept
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
 Summary Problem:

(900) 300 400 400 500 600

0 1 2 3 4 5

Using a required rate of return of 15%, find the

NPV, IRR and PI for the cash flows given above.
NPV = $510,52
IRR = 34.37%
PI = 1.57
 Practice Question

A project has the following after-tax cash inflows for

years 1 through 4 :-
$34,444,$39,877,$25,000 & $52,800

Given that the initial cash outflow is $104,000. discount rate

is 12%, hurdle rate is 13% & the maximum payback period is
3.5 years, calculate the PBP, NPV, PI & IRR and prepare an
evaluation summary.
47
 Potential
Potential Problems
Problems
Under
Under Mutual
Mutual Exclusivity
Exclusivity
Ranking of project proposals may create
contradictory results.

A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
 A.
A. Scale
Scale Differences
Differences
Compare a small (S) and a large (L) project.

NET CASH FLOWS

END OF YEAR Project S Project L
0 -$100 -$100,000
1 0 0
2 $400 $156,250
 Scale
Scale Differences
Differences

Calculate the PBP, IRR, NPV@10%, and

PI@10%.
Which project is preferred? Why?
Project IRR NPV PI

S 100% $ 231 3.31

L 25% $29,132 1.29
 B.
B. Cash
Cash Flow
Flow Pattern
Pattern
Let us compare a decreasing cash-flow (D) project and an
increasing cash-flow (I) project.

NET CASH FLOWS

END OF YEAR Project D Project I
0 -$1,200 -$1,200
1 1,000 100
2 500 600
3 100 1,080
 Cash
Cash Flow
Flow Pattern
Pattern

Calculate the IRR, NPV@10%, and

PI@10%.
Which project is preferred?

Project IRR NPV PI

D 23% $197.45 1.16

I 17% $198.20 1.17

 Examine
Examine NPV
NPV Profiles
Profiles
600

Plot NPV for each

project at various
Net Present Value ($)

discount rates.
400

NPV@10%
200

IRR
0
-200

0 5 10 15 20 25
Discount Rate (%)
 Fisher’s
Fisher’s Rate
Rate of
of Intersection
Intersection
600
Net Present Value ($)

At k<10%, I is best! Fisher’s Rate of

Intersection
-200 0 200 400

At k>10%, D is best!

0 5 10 15 20 25
Discount Rate ($)
 C.
C. Project
Project Life
Life Differences
Differences

Let us compare a long life (X) project and

a short life (Y) project.

NET CASH FLOWS

END OF YEAR Project X Project Y
0 -$1,000 -$1,000
1 0 2,000
2 0 0
3 3,375 0
 Project
Project Life
Life Differences
Differences

Calculate the PBP, IRR, NPV@10%, and PI@10%.

Which project is preferred? Why?
Project IRR NPV PI

X 50% $1,536 2.54

Y 100% $ 818 1.82
 Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for
this capital budgeting period.
 Available Projects for BW
Project ICO IRR NPV PI
A $ 500 18% $ 50 1.10
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
E 12,500 26 500 1.04
F 15,000 28 21,000 2.40
G 17,500 19 7,500 1.43
H 25,000 15 6,000 1.24
 Choosing by NPVs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40
G 17,500 19 7,500 1.43
B 5,000 25 6,500 2.30
Projects F and G have the
two largest NPVs.
The resulting increase in shareholder wealth
is $28,500 with a $32,500 outlay.
 Choosing by PIs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
G 17,500 19 7,500 1.43
Projects F, B, C, and D have the four largest PIs.
The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
 Summary of Comparison
Method Projects Accepted Value Added
PI F, B, C, and D $38,000
NPV F and G $28,500
IRR C, F, and E $27,000

PI generates the greatest increase in

shareholder wealth when a limited capital
budget exists for a single period.
 Multiple
Multiple IRR
IRR Problem
Problem
Let us assume the following cash flow pattern for a
project for Years 0 to 4:
-$100 +$100 +$900 -$1,000

How many potential IRRs could this project have?

Two!! There are as many potential IRRs

as there are sign changes.
 NPV
NPV Profile
Profile --
-- Multiple
Multiple IRRs
IRRs

75 Multiple IRRs at
k = 12.95% and 191.15%
Net Present Value

50
($000s)

25

-100
0 40 80 120 160 200
Discount Rate (%)
 Post-Completion Audit
Post-completion Audit
A formal comparison of the actual costs and
benefits of a project with original estimates.

– Identify any project weaknesses

– Develop a possible set of corrective actions
– Provide appropriate feedback

Result: Making better future decisions!

END OF CHAPTER