CAPITAL BUDGETING

The process of planning expenditures on assets (long-

term investments, primarily plant and equipment),
whose cash flows are expected to extend beyond one
year
Involves making long-term decisions, and involves
large expenditures
Extremely important to a firms future
SOME PROJECTS THAT CAN BE DECIDED
THROUGH CAPITAL BUDGETING
Replacement Decisions
Maintenance (replace damaged equipment)
Cost Reduction Decisions (replace serviceable but obsolete equipment to
lower costs)
Expansion of existing projects or markets (Jollibee Cebu Branch 1,2,3)
Expansion into new products or markets (Jollibee expand for the first
time to US, Singapore)
Safety (DNV/mining companies) and/or environmental projects
(Nestle Vietnams water purification system [ISO]) = (mandatory
investments)
Mergers
Others (Office buildings, parking lots, executive aircrafts)
 PROJECTS CAN BE:
Independent
Projects with cash flows that are not affected by the
acceptance or non-acceptance of other projects.
You can pick as many projects as you wish.
Mutually Exclusive
A set of projects where only one can be accepted.
Mutually Inclusive
A set of projects where when you accept the primary project,
you have to accept all other secondary projects connected
with the primary project.
STEPS IN CAPITAL BUDGETING:
1. Estimate the projects cash flows
2. Assess riskiness of the projects cash flows
3. Determine r (WACC) for the project
4. Find payback period, discounted payback
period, NPV, IRR, and MIRR
5. Decide whether to accept or reject the
project
 PAYBACK PERIOD
A breakeven analysis
Refers to the number of years or length of time required to recover a
projects cost.
How long does it take to get your money back?
You must add the projects cash inflows to its cost until the cumulative
cash flows of the project turns positive
Uses Nominal Cash Flows
Two possible scenarios:
When annual cash inflows are equal
When annual cash inflows are unequal
 COMPUTING PAYBACK PERIOD, WHEN ANNUAL CASH
INFLOWS ARE EQUAL

A project costs P200,000. The expected returns of the project

amount to P40,000 annually. What is the payback period?
Answer: P200,000/P40,000 = 5 years
COMPUTING PAYBACK PERIOD, WHEN ANNUAL
CASH INFLOWS ARE UNEQUAL

0 1 2 3
Project L
CFt -100 10 60 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years
0 1 2 3
Project S
CFt -100 70 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

PAYBACK PERIOD ACCEPT OR REJECT?
Independent: If you have two projects whose payback
period is less than or equal to the projects life; or, if you
have two projects which fit your firms acceptable criteria,
then you ACCEPT BOTH PROJECTS.
Mutually Exclusive: If you have two projects whose payback
period is less than or equal to the projects life; or, if you
have two projects which fit your firms acceptable criteria,
ACCEPT THE PROJECT WITH THE SHORTER PAYBACK
PERIOD, because in mutually exclusive projects, you cannot
undertake both projects at the same time.
ADVANTAGES/STRENGTHS OF PAYBACK PERIOD
Indicates a projects risk and liquidity
Risk: Cash flows expected in the distant future are generally riskier than
near-term cash flows
Liquidity: The shorter the payback period, ceteris paribus, the greater the
projects liquidity
Serves as a screening tool
Identifies investments that recoup cash investments quickly.
Identifies products that recoup initial investment quickly.
Easy to calculate and understand

DISADVANTAGES/WEAKNESSES OF PAYBACK
PERIOD
Ignores the time value of money
Ignores cash flows occurring after payback period. Therefore, in
mutually exclusive projects, it is possible that you might choose
the project with the faster payback period but with lower total
returns.
 DISCOUNTED PAYBACK PERIOD
The length of time (number of years) required for the
present value of an investments cash flows (discounted
at the investments cost of capital) to recover a projects
cost.
Discounts the cash inflows and outflows, and compute
the same way as you compute payback period.
Uses Discounted Cash Flows
DISCOUNTED PAYBACK PERIOD
Uses discounted cash flows rather than raw CFs.

0 k = 10% 1 2 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Try to Payback
Disc find the discounted
L== 2 payback period
+ 41.32 of Project
/ 60.11 S asyears
= 2.7 well.
 DPBP ACCEPT OR REJECT?
Independent: If you have two projects whose discounted
payback period is less than or equal to the projects life; or,
if you have two projects which fit your firms acceptable
criteria, then you ACCEPT BOTH PROJECTS.
Mutually Exclusive: If you have two projects whose
discounted payback period is less than or equal to the
projects life; or, if you have two projects which fit your firms
acceptable criteria, ACCEPT THE PROJECT WITH THE
SHORTER DISCOUNTED PAYBACK PERIOD, because in
mutually exclusive projects, you cannot undertake both
projects at the same time.
 ADVANTAGES/STRENGTHS OF DISCOUNTED
PAYBACK PERIOD
Indicates a projects risk and liquidity
Risk: Cash flows expected in the distant future are generally riskier than
near-term cash flows (riskiness of cash flows through the cost of capital)
Liquidity: The shorter the payback period, ceteris paribus, the greater the
projects liquidity

Serves as a screening tool

Identifies investments that recoup cash investments quickly.
Identifies products that recoup initial investment quickly.
Easy to calculate and understand
Considers the time value of money
DISADVANTAGES/WEAKNESSES OF DISCOUNTED
PAYBACK PERIOD
Ignores cash flows occurring after discounted payback period. Therefore, in
mutually exclusive projects, it is possible that you might choose the project with
the faster payback period but with lower total returns.
NET PRESENT VALUE METHOD
A method of ranking investment proposals
using the NPV, which is equal to the PV of
future net cash flows, discounted at the cost
of capital.
NPV depends on:
Risk
WACC
Timing of Cash Flows
Amount of Cash Flows
 TO DETERMINE NPV
1. Calculate the present value of cash inflows.
2. Calculate the present value of cash outflows.
3. Subtract the present value of the outflows from the
present value of the inflows

NPV emphasizes cash flows and not accounting net

income.
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 METHOD
Sum of the PVs of all cash inflows and outflows of a project

n
CFt
NPV
t 0 ( 1 r )
t

0 k = 10% 1 2 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11

NPV(L) = -100 + 9.09 + 49.59 + 60.11 = 18.79

Try =
NPV (S) to 19.98
find the Net Present Value of Project S as well.
 NPV ACCEPT OR REJECT?
Independent: Accept Projects with Positive (+) NPV
Mutually Exclusive: Accept the Project with the highest
Positive (+) NPV
 ADVANTAGES/STRENGTHS OF NPV
Gives a direct measure of peso benefit of the project to the shareholders (Tells
whether the investment will increase the firms value or not) = + NPV will add
value to the firm
Considers all cash flows and the time value of money
Considers the risk of future cash flows (through the cost of capital)
Does not suffer from Multiple IRR problems

DISADVANTAGES/WEAKNESSES OF NPV
Expressed in terms of peso, not as a percentage
Very complex analysis, too many variables to forecast
INTERNAL RATE OF RETURN METHOD
A method of ranking investment proposals using the
rate of return on an investment
This is calculated by finding the discount rate that
equates the PV of future cash inflows to the projects
cost
PV(Inflows) = PV(Outflows)
IRR is the rate that forces the PV of cash flows = 0
 INTERNAL RATE OF RETURN
IRR is the rate that forces the PV of cash flows = 0.
Therefore, this is equivalent to forcing the NPV to equal
zero.
n
CFt
0
t 0 ( 1 IRR) t

Two possible scenarios:

When annual cash inflows are equal
When annual cash inflows are unequal
 IRR EQUAL CASH INFLOWS
When solving for the IRR, you have to use the TRIAL AND ERROR
approach if you do not have CALC function.
Assume the following information, with initial investment of
P45,000 and expected cash inflows of P20,000 per year for 5
years, and a WACC of 20%, compute IRR. Will you accept the
project? Why or why not?
Choices: a) 18.75% b) 21.35% c) 26.75% d) 34.25% e) 38.50%

Start with the middle choice. If answer is +, try the higher answer.
If answer is , try the lower answer.
 INTERNAL RATE OF RETURN
Solve the IRR of the following projects:
Year 0 Year 1 Year 2 Year 3
Project A (200) 100 100 100
Project B (300) 160 160 160

If WACC is 25%, which project(s) would you accept if the

projects are independent? Which project(s) would you
accept if the projects are mutually exclusive?
 IRR UNEQUAL CASH INFLOWS
When solving for the IRR, you have to use the TRIAL AND ERROR
approach if you d not have CALC function.
Assume the following information, with initial investment of P45,000 and
WACC of 20%, compute IRR. Will you accept the project or not?
Year (t) Cash inflows PVIF (19%, t) Present Value at 19%
1 28,000 0.840 23,520
2 12,000 0.706 8,472
3 10,000 0.593 5,930
4 10,000 0.499 4,990
5 10,000 0.419 4,190

Choices: a) 17% b) 18% c) 19% d) 21% e) 22%

Start with the middle choice. If answer is +, try the higher answer. If
answer is , try the lower answer.
 COMPUTE THE IRR OF PROJECTS L AND S.

0 1 2 3
Project L
CFt -100 10 60 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years
0 1 2 3
Project S
CFt -100 70 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

IF THE WACC OF BOTH PROJECTS IS 20%, WHICH PROJECT(S) WILL YOU ACCEPT
IF THEY ARE INDEPENDENT? WHAT IF THEY ARE MUTUALLY EXCLUSIVE?
 IRR ACCEPT OR REJECT?
Independent: Accept Projects if IRR > or at least = to
WACC, because projects whose IRR > WACC means that
NPV is positive.
Mutually Exclusive: Accept the Project with the higher
IRR, provided that the IRR must be greater than or at
least equal to WACC.
 ADVANTAGES/STRENGTHS OF IRR
IRR measures a projects profitability in the rate of return sense (IRR = WACC implies that
there are just sufficient returns on the project to provide investors with their required rate
of return. IRR > WACC implies that the projects rate of return is more than sufficient to
meet investors rate of return.
It contains information regarding a projects safety margin
It is more appealing because it provides a basis (rate of return) for decision making,
rather than a peso amount like the NPV method.

DISADVANTAGES/WEAKNESSES OF IRR
Reinvestment rate assumption (assume that cash flows are reinvested at the same IRR) is
unrealistic. Using WACC is more realistic because it is what projects earn on average.
Multiple IRR problems
IRR can only rank independent projects properly, if signs do not change. They cannot
properly rank mutually exclusive projects all the time. Sometimes decision rule for IRR can
conflict with NPV, in which case, IRR is erroneous.

Why NPV and IRR may conflict?

1. Assumption of cash flow reinvestment
2. Different lives, sizes, risk factors, timing of cash flows
 NPV PROFILES
A graphical representation of project NPVs at
various different costs of capital.

r NPVL NPVS
0 $50 $40
5 33.0526 29.2949
10 18.7829 19.9850
15 6.6656 11.8271
20 (3.7037) 4.6296
 FINDING THE CROSSOVER POINT MATHEMATICAL WAY
Crossover Rate or Fisher rate is the cost of capital at which the
NPV profiles of 2 projects cross, and thus, at which the projects
NPVs are equal.
Find the crossover rate when the NPV profile is given:

r NPVL NPVS
0 $50 $40
5 33.0526 29.2949
10 18.7829 19.9850
15 6.6656 1.8271
20 (3.7037) 4.6296
 FINDING THE CROSSOVER POINT MATHEMATICAL WAY
Find the crossover rate when the cash flows are given:

Project L Project S Difference

0 -100 -100 0
1 10 70 -60
2 60 50 +10
3 80 20 +60
 FINDING THE CROSSOVER POINT GRAPHICAL WAY
Step 3: Draw a graph, with r or WACC in the X-axis and NPV in the Y-axis

NPV 60
($)
50

40

30

20

10

0
5 10 15 20 23.6
-10
Discount Rate (%)
 FINDING THE CROSSOVER POINT GRAPHICAL WAY
Step 4: Plot the graph. At r = 0, NPV of Project L is 50 and at r = 0, NPV of Project S is
40. At NPV = 0, r of Project L is 18.126% and at NPV = 0, r of Project S is 23.56%

Project L Project S
IRR 18.126% 23.56%

NPV 60 k NPVL NPVS

0 $50 $40
($)
50 . 5
10
33.0526
18.7829
29.2949
19.9850

40 .
15 6.6656 11.8271
20 (3.7037) 4.6296

. Crossover Point = 8.7%

30 .
20 . IRRL = 18.1%

10 .. S IRRS = 23.6%
L . . Discount Rate (%)
0 .
5 10 15 20 23.6
-10
 INTERPRETING THE NPV PROFILE
If r is less than 8.7%, NPV of Project L is greater than NPV of Project S. So, if it is a
mutually exclusive project, we should choose Project L.

If r is greater than 8.7%, NPV of Project S is greater than NPV of Project L. So, if it is a
mutually exclusive project, we should choose Project S.

NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

10 .. S IRRS = 23.6%
L . . Discount Rate (%)
0 .
5 10 15 20 23.6
-10
COMPARING THE NPV AND IRR METHODS
NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

10 .. S IRRS = 23.6%
L . .
0 .
5 10 15 20 23.6
-10
If projects are independent, the two methods always lead to the same accept/reject decisions.
If projects are mutually exclusive
If r > crossover point, the two methods lead to the same decision and there is no conflict.
If r < crossover point, the two methods lead to different accept/reject decisions.
REINVESTMENT RATE ASSUMPTIONS
NPV method assumes CFs are reinvested at r, the opportunity cost of
capital.
IRR method assumes CFs are reinvested at IRR.
Assuming CFs are reinvested at the opportunity cost of capital is more
realistic, because:
If a firm has a reasonably good access to capital markets, it can raise all the
capital it needs at the going rate (WACC).
Since the firm can obtain capital at the going rate (WACC), if it has
investment opportunities with positive NPVs, it should take them on and
finance them at the going rate (WACC).
If the firm uses internally generated cash flows from past projects rather
than external capital, it will save the going rate (WACC).
Thus, NPV method is the best. NPV method should be used to choose
between mutually exclusive projects.
Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is
needed.
In case of conflict between NPV and
IRR, ALWAYS choose NPV!!!
ANOTHER PROBLEM FOR USING IRR
Multiple IRR the situation where a project has 2 or
more IRRs
A non-normal cash flow occurs when a project calls for a large
cash outflow sometime during or at the end of its life.

Project P has cash flows (in 000s):

CF0 = -$800, CF1 = $5,000, and CF2 = -$5,000.
Find Project Ps NPV and IRR.

0 1 2
r = 10%

-800 5,000 -5,000

PROJECT P HAS CASH FLOWS (IN 000S): CF0 = -$800,
CF1 = $5,000, AND CF2 = -$5,000. FIND PROJECT PS
NPV AND IRR.

0 1 2
k = 10%

-800 5,000 -5,000

NPV = -$386.78
IRR = ?
n
CFt
0
t 0 (1 IRR)
t

Try using 25% and try using 400%

MULTIPLE IRRS

A situation
NPV where a NPV
project has Profile
two or more IRRs

IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
You typically encounter Multiple IRR problems when
any of your cash flows change signs more than once.
(Non-normal Cash Flows)
SOME MANAGERS PREFER THE IRR TO THE NPV
METHOD, EVEN THOUGH NPV METHOD IS MORE
RELIABLE. IS THERE A BETTER IRR MEASURE?
 YES!!!
MIRR (Modified Internal Rate of Return) is the discount rate that
causes the PV of a projects terminal value (TV) to equal the PV
of costs. TV is found by compounding inflows at WACC.
MIRR assumes cash flows are reinvested at the WACC.
MIRR correctly assumes reinvestment at opportunity cost =
WACC.
MIRR also avoids the problem of multiple IRRs.
Managers like rate of return comparisons, and MIRR is better for
this than IRR.
 CALCULATING MIRR (NORMAL CFS)

0 r = 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% 12.1
MIRR = 16.5%
-100.0 158.1
$158.1 TV inflows
$100 =
(1 + MIRRL)3
PV outflows
MIRRL = 16.5%
 CALCULATING MIRR (NON-NORMAL CFS)

0 1 2
r = 10%

-1,000 5,000 -1,000

-826.446
PV outflows TV inflows
5,500
-1,826.446
5,500
1,826.446 =
(1 + MIRRA)2
MIRRA = 73.53%
 MIRR
Compute for the MIRR of Projects L and S

Project L Project S
0 -100 -100
1 10 70
2 60 50
3 80 20
If WACC is 10%, which project(s) would you
accept if the projects are independent? What
if they are mutually exclusive?
 MIRR
Compute for the MIRR of Projects A and B

Project A Project B
0 -10,000 -1,000
1 4,000 500
2 7,000 600
3 8,000 900
If WACC is 10%, which project(s) would you
accept if the projects are independent? What
if they are mutually exclusive?
 MIRR ACCEPT OR REJECT?
Independent: Accept Projects if MIRR > or at least = to
WACC
Mutually Exclusive: Accept the Project with the higher
MIRR, provided that the MIRR must be greater than
WACC.
CAN NPV AND MIRR CONFLICT?
Size Life Verdict
Equal Same NPV and MIRR
same conclusion
Equal Different NPV and MIRR
same conclusion
Different Same/Different NPV and MIRR
may conflict

Which should be followed if

NPV and MIRR conflict?
 CONCLUSIONS:
NPV is important in the capital budgeting process as it gives
a DIRECT MEASURE of the peso benefit of the project to the
shareholders. NPV is absolutely the best single measure of
profitability. Hence, in case of conflicts between PBP, DPBP,
NPV, IRR and MIRR, we must choose NPV!

IRR is also important as it also measures profitability as a

percentage rate of return and gives information concerning
a projects safety margin. These information are not
revealed by the NPV. Thats why managers prefer to use
IRR. However, problems such as assuming cash flows to be
reinvested at the IRR are unrealistic, and we also encounter
Multiple IRR Problems if cash flows are non-normal.
 CONCLUSIONS:
To counter with problems with IRR, we can use
MIRR as it has all the virtues of the IRR but
incorporates a better reinvestment rate
assumption (reinvest at WACC), and it avoids
multiple rate of return problems as well!

Still, even when MIRR looks infallible, we

must still use NPV in case of conflicts!
 DECISION CRITERIA USED IN PRACTICE
1960 (Primary 1970 (Primary 1980 (Primary 1999 (USES)
Criterion) Criterion) Criterion)
Payback 35% 15% 5% 57%
Discounted Payback NA NA NA 29%
NPV 0% 0% 15% 75%
IRR 20% 60% 65% 76%
Others 45% 25% 15% NA
TOTAL 100% 100% 100%
 POST-AUDIT
A comparison of actual versus expected
results for a given capital project.
Purposes:
To Improve Cash Flow Forecasts
To Improve Operations and bring results in line
with forecasts
 HOMEWORK: ADDITIONAL PROBLEM 1

Project K costs $52,125, its expected net cash inflows are $12,000
per year for 8 years, and its WACC is 12%
Requirements:
What is the projects NPV?
What is the projects IRR?
What is the projects MIRR?
What is the projects payback?
What is the projects discounted payback?
HOMEWORK: ADDITIONAL PROBLEM 2

Project S costs $15,000, and its expected

cash flows would be $4,500 per year for 5
years. Mutually exclusive Project L costs
$37,500, and its expected cash flows would
be $11,100 per year for 5 years. If both
projects have a WACC of 14%, which project
would you recommend? Explain.
HOMEWORK: ADDITIONAL PROBLEM 3
A firm is considering two mutually exclusive
projects, X and Y, with the following cash
flows:
Project X = -1000, 100, 300, 400, 700
Project Y = -1000, 1000, 100, 50, 50
The projects are equally risky and their WACC
is 12%. What is the MIRR of the project that
maximizes shareholder value?
 HOMEWORK: ADDITIONAL PROBLEM 4
K. Kim Inc. must install a new air conditioning unit in its main plant. Kim
must install one or the other of the units; otherwise, the highly profitable
plant would have to shut down. Two units are available, HCC and LCC (for
high and low capital costs, respectively). HCC has a high capital cost but
relatively low operating costs, while LCC has a low capital cost but higher
operating costs because it uses more electricity. The costs of the units
are shown here. Kims WACC is 7%.
HCC = -600k, -50k, -50k, -50k, -50k, -50k
LCC = -100k, -175k, -175k, -175k, -175k, -175k
Requirements:
Which unit would you recommend? Explain.
If Kims controller wanted to know the IRRs of the two projects, what would you tell
him?
If the WACC rose to 15%, would this affect your recommendation? Explain your
answer and the reason this result occurred.
HOMEWORK: ADDITIONAL PROBLEM 5

A project has annual cash flows of $7,500 for

the next 10 years and then $10,000 each year
for the following 10 years. The IRR of this 20-
year project is 10.98%. If the firms WACC is 9%,
what is the projects NPV?
 HOMEWORK: ADDITIONAL PROBLEM 6

Tyrell Corporation is considering a project with the

following cash flows:
Year 0 = ?, Year 1 = 1 million, Year 2 = 1.5 million, Year
3 = 2 million, Year 4 = 2.5 million

The project has a regular payback period of exactly two

years. The projects cost of capital is 12 percent. What
is the projects modified internal rate of return (MIRR)?
 HOMEWORK: ADDITIONAL PROBLEM 7

Project C has the following net cash flows: Year 0 = - 500,

Year 1 = 200, Year 2 = - ?, Year 3 = 300, Year 4 = 500

Project C has a 10 percent cost of capital and a 12

percent modified internal rate of return (MIRR). What is
the projects cash outflow at t = 2?