FINANCE

FIN2704/FIN2704X

Lecture 8: Capital Budgeting 1

Example: Capital Budgeting Decision

J A a c C a a c US$2 b

I a E A a, Oc b 22, 2007

Newly-established Jurong Aromatics Corporation Pte Ltd (JAC) said it

a b a US$2 b c ca a S a

Jurong Island next year.

When completed in 2011, the complex will produce around 1.5 million

tonnes of aromatics, comprising 800,000 tonnes of paraxylene,

200,000 tonnes of orthoxylene, 450,000 tonnes of benzene, and 2.5

million tonnes of oil products. The plant would provide raw materials

to textile and plastics manufacturers.

What type of analysis did Jurong Aromatics management follow in

de each hi deci i b ild he la ? T da lec e

introduces this 1


Example: Capital Budgeting Decision

ExxonMobil completes acquisition of Jurong Aromatics Corporation's

I a a August 28, 2017

EXXONMOBIL has completed its acquisition of Jurong Aromatics Corporation's

Jurong Island plant, one of the largest aromatic facilities in the world. The deal, for

an undisclosed sum, was first announced in May this year..

The facility has an ethylene production capacity of 1.9 million tonnes each year. It

will boost ExxonMobil's Singapore aromatics production to over 3.5 million tonnes

each year, including 1.8 million tonnes of paraxylene, and add 65,000 barrels a day

of transportation fuels capacity.

E M bil ac i ii a al a eflec i f i ca i al b dge i g ac i i ie .

2


Example: Capital Budgeting Decision

Campana to build $20m data centre corridor in Southeast Asia

DataCenter News, October 4, 2018

Singapore-based Campana Group are welcoming a US$20 million investment following a

B Ja a M &C , ba a H b S

Freehills acting to advise the transaction.

According to Herbert Smith Freehills, this investment into Campana will go towards the

construction of the largest high-speed data center corridor connecting Singapore and

Myanmar, with prebuilt connections for Thailand.

"This is typical of the increasing investment we're seeing in data and tech infrastructure in

Asia, and in Southeast Asia in particular," says Herbert Smith Freehills Asia head of

TMT Mark Robinson.

"The new network will utilize submarine cables and land connections to meet the demand

from Myanmar's rapid growth in online activity.".

As per the Jurong Aromatics example, this reflects a thoroughly considered capital

budgeting decision.
3


Capital Budgeting

Recall that current expenditures are short-term in nature and are

completely expensed in the year incurred.

Capital expenditures are expenditures on fixed assets that will be used for

production over a period of years. As such, in accounting terms these

expenditures are capitalized and then depreciated over a period of years.

Capital budgeting refers to the process of deciding how to allocate the

ca c ca a c ( a , ab , a ca a ) a

investment alternatives. It considers whether a project is worth

undertaking (i.e., worth its capital expenditures).

The over-riding rule of capital budgeting is to accept all projects for

which the cost is less than, or equal to, the benefit:

Accept if: C B

Reject if: Cost > Benefit 4



Learning Objectives

Be able to compute payback and discounted payback

and understand their shortcomings

Be able to compute average accounting return and

understand its shortcomings

Be able to compute the internal rate of return (IRR) &

Modified IRR and understand the strengths and

weaknesses

Be able to compute the net present value (NPV) and

understand why it is the best decision criterion

Lecture Outline

bestcriteria

1. Net Present Value (NPV)

2. The Payback Rule

3. The Discounted Payback

4. Average Accounting Return

5. The Internal Rate of Return (IRR) &

Modified IRR (MIRR)

6. The Profitability Index

7. The Practice of Capital Budgeting

What Are Good Decision Criteria?

Since value must take into account what cash flow is

received, when it is received and the likelihood associated

with receiving those cash flows, we need to ask ourselves

the following questions when evaluating decision criteria:

1. Does the decision rule adjust for the time value of

money?

2. Does the decision rule adjust for risk?

3. Does the decision rule provide information on

whether we are creating value for the firm?

Capital Budgeting Example A:

You are looking at a new project and you have

estimated the following cash flows:

Year 0: CF0 = -165,000

Year 1: CF1 = 63,120; NI = 13,620

Year 2: CF2 = 70,800; NI = 3,300

Year 3: CF3 = 91,080; NI = 29,100

Average Book Value = 72,000

Your required return for assets of this risk is 12%.

The NPV Decision Making Recipe

1. Estimate the expected future cash flows:

• Amount and timing (Use a time-line)

2. Estimate the required return for projects of this risk level

• May have to use CAPM

3. Find the present value of the cash flows and subtract the initial

investment.

CFt

NPV = CF0

t =1 (1 + r )t

NPV Rule: Accept the project If NPV > 0

Net Present Value

It should be clear then that the difference between the

intrinsic value of a project and its cost is the NPV.

How much value is created from undertaking an investment?

If PV(Cash Inflows) > PV(Cash Outflows), this means that

taking on the project will the Value of the firm

Thus 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 g al i i c ea e e eal h, NPV is a

direct measure of how well this project will meet our goal.

10


Timeline for Example A

T=0 12% 1 2 3

-165,000 63,120 70,800 91,080

C B

Value of the Project

11


Computing NPV for Example A

Draw a time-line and using the formulas:

T=0 12% 1 2 3

-165,000 63,120 70,800 91,080

PVIF12%,1

56,357.14

PVIF12%,2

56,441.32

PVIF12%,3

64,828.94

12,627.40

NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3

165,000 = 12,627.40 o accept 12



Using TI BA II Plus Calculator:

Press <CF> & Use < > and < > to enter the following values:

CF0: 165000 <+/-> <ENTER> CF0 = -165000

< > C01: 63120 <ENTER> CF1 = 63120

< > F01: 1 Freq. of receiving 63120 is 1.

< > C02: 70800 <ENTER> CF2 = 70800

< > F02: 1 Freq. of receiving 70800 is 1.

< > C03: 91080 <ENTER> CF3 = 91080

Press <NPV> to display the current discount rate (I)

12 <ENTER> I = 12 : Enter discount rate 12%

< > NPV: 0 to reach the NPV function.

<CPT> NPV: 12,627.41 NPV = 12,627.41

13


Evaluating NPV as a Capital Budgeting

Decision Criteria

Does the NPV rule account for the time value of

money? Yes

Does the NPV rule account for the risk of the cash

flows? Yes discounting atrequiredreturn

Does the NPV rule provide an indication about the

increase in value? Yescalculatesexactvalueto ti m

Should we consider the NPV rule for our primary

decision criteria? Yes 14



Payback Period

Payback period is the # of years to recover initial costs

How long does it take to get the initial cost back in a

nominal sense?

The Payback Decision Recipe

1. Estimate the cash flows

2. Add the future cash flows to the initial cost until the

initial investment has been recovered

Payback Period Decision Rule: Accept if the payback period

is less than some preset limit (determined arbitrarily)

15


Computing Payback For Example A

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 remaining cashflow

foryear3
initialcost

31080

To be more exact, 2 and = 2 . 34 years

91080

Do we accept or reject the project? Reject

16


Evaluating Payback as a Decision Criteria:

Does the payback rule account for the time value

of money? NO

Does the payback rule account for the risk of the

cash flows? Maybe

Does the payback rule provide an indication

about the increase in value? NO

Should we consider the payback rule for our

primary decision criteria? NO

17


Payback

Advantages Disadvantages

Quick and easy to calculate Ignores the time value of

money

Easy to understand

Requires an arbitrary cutoff

Adjusts for uncertainty of

point possibilityofcorruption and

later cash flows manipulationduetosubjectivity

Ignores cash flows beyond the

Biased towards liquidity

cutoff date latterbreakeven
f

projectsthatpaybackfaster

arepreferred

extremelylarge Biased against long-term

rejectsprojects projects, such as research and

with HPV

high

negative development, and new projects

18


Discounted Payback Period

Compute the present value of each cash flow

and then determine how long it takes to

payback on a discounted basis

Compare to a specified required period

Discounted Payback Rule: Accept the project

if it pays back on a discounted basis within

the specified time (again arbitrarily selected)

19


Computing Discounted Payback: Example A

Assume we will accept the project if it pays back

on a discounted basis in 2 years.

discount

1. Compute the PV for each cash flow: cashflows

12%

-165,000 63,120 70,800 91,080

56,357 PVIF12%,1

PVIF12%,2

56,441

PVIF12%,3

64,829

20


Computing Discounted Payback: Example A

2. Determine the payback period using

discounted cash flows

Year 1: -165,000 + 56,357 = -108,643

Year 2: -108,643 + 56,441 = -52,202

Year 3: - 52,202 + 64,829 = 12,627 project pays back

in year 3

2 52,202 = 2.81 years

64,829

Do we accept or reject the project? Reject

21


Evaluating Discounted Payback Decision Criteria

Does the discounted payback rule account for

the time value of money? Yes

Does the discounted payback rule account for

the risk of the cash flows? Yes

Does the discounted payback rule provide an

indication about the increase in value? NO

Should we consider the discounted payback

rule for our primary decision criteria? NO

22


Discounted Payback

Advantages Disadvantages

Includes time value of May reject positive NPV

money investments if ittakestoolong

Requires an arbitrary cutoff

Easy to understand

point

Does not accept negative

Ignores cash flows beyond

estimated NPV investments

the cutoff point

Biased towards liquidity 1 Biased against long-term

ifNPVnegative projects, such as R&D and

nodiscounted

paybackperiod

willneverbreak new products

even 23


Payback Period Example – Serious Deficiencies

Cash Flows A B

Initial Outlay -$10,000 -$10,000

1 $5,000 $5,000

2 $4,000 $5,000

3 $4,000 0

4 $4,000 0

5 $4,000 0

If the desired payback period is 2 years, which project do

you invest in? rejectIteventhoughhigherNPVbecausediscountedpayback 24



Average Accounting Return

There are many different definitions for average accounting return

The one used in the book is:

ROA

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

Average Accounting Return Decision Rule:

Accept the project if the AAR is greater than a

preset rate (determined arbitrarily).

25


Computing AAR 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? Reject

26


Evaluating AAR as a Decision Criteria Test

Does the AAR rule account for the time value of

money? NO

Does the AAR rule account for the risk of the cash

flows? NO

Does the AAR rule provide an indication about the

increase in value? Maybe

Should we consider the AAR rule for our primary

decision rule? NO

27


Average Accounting Return

Advantages Disadvantages

Easy to calculate Not a true rate of return;

Needed information time value of money is

will usually be ignored

available Uses an arbitrary

benchmark cutoff rate

Based on accounting net

income and book values,

not cash flows and

intrinsic/market values

28


Internal Rate of Return

Definition: IRR is the return that makes the NPV = 0

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

General IRR Rule: Accept the project if the IRR is

greater than the required return

29


Computing IRR for Example A

Solve for unknown discount rate:

T=0 IRR? 1 2 3

-165,000 63,120 70,800 91,080

NPV = 0
30


The Internal Rate of Return (IRR)

The IRR is the discount rate that makes the NPV

equal to zero:

63,120

NPV = 165,000 +
(1 + IRR )

$70,800 $91,080

+ +
(1 + IRR ) 2
(1 + IRR ) 3

NPV = 0

31


Using the TI BA II Plus Financial Calculator

165 000 <+/-> <CFj> useIRR insteadofMPV

IRR Lcp1

63 120 <CFj>

Required Return

70 800 <CFj>

91 080 <CFj>

Do not enter <I/YR>!!!

Press <Gold> <IRR> 16.13 > 12%

Do we accept or reject the project? Accept

If you do not have a financial calculator, then this

becomes a trial and error process

32


NPV Profile for Example A

70,000

60,000

50,000 IRR = 16.13%

40,000

30,000
NPV

20,000

NPV 12,627.41 whendiscount

10,000 rate_lb 131

MPV_O
OT

-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

-20,000

Discount Rate
33


Evaluating IRR as a Decision Criteria

Does the IRR rule account for the time value of

money? Yes

Does the IRR rule account for the risk of the

cash flows? yes

Does the IRR rule provide an indication about

the increase in value? Yes

Should we consider the IRR rule for our

primary decision criteria? Yes

34


Advantages of IRR

Knowing a return is intuitively appealing

rateofreturnismoreintuitiveandeasytocompare

It is a simple way to communicate the value of a

c a

estimation details

If the IRR is high enough, you may not need to

estimate a required return, which is often a

difficult task

35


Example A: Summary of Capital

Budgeting Decisions

Summary
Net Present Value Accept

Payback Period Reject

Discounted Payback Period Reject

Average Accounting Return Reject

Internal Rate of Return Accept

36
NPV vs. IRR
NPV and IRR will generally give us the same
decision.
Exceptions:
Mutually exclusive projects
Initial investments are substantially different
Timing of cash flows is substantially different
Non-conventional cash flows cash flow signs change
more than once
conventional CF cashflowsignchangesonce
37
The Difference Between Independent And
Mutually Exclusive Projects:
Projects are:
optionofdoingboth
1. Independent, if the cash flows of one are
unaffected by the acceptance of the other.
havetochooseone
2. Mutually exclusive, if the cash flows of one
can be adversely impacted by the acceptance of
the other (usually due to limitation of available
funds)
38
IRR and Non-Conventional Cash Flows
W a c ca c a
than once, there can be more than one IRR
When you solve for IRR you are solving for the
root of an equation and when you cross the x-
axis more than once, there will be more than
one return that solves the equation
If you have more than one IRR, which one do
you use to make your decision?

39
Another Example – Non-Conventional Cash
Flows
Suppose an investment will cost $90,000 initially
and will generate the following cash flows:
Year 1: 132,000 ifcashflowsare
nonconventional
CANNOTUSEIRR
Year 2: 100,000
Year 3: -150,000 (Decommissioning costs)
The required return is 15%.
Should we accept or reject the project?

40
 NPV Profile
$4,000.00

$2,000.00

$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NPV

($4,000.00)

($6,000.00)

($8,000.00)
IRR = 10.11% and 42.66%

($10,000.00)
Discount Rate 41
Summary of Decision Rules
The NPV is positive at a required return of 15%,
so you should Accept
If you use the financial calculator*, some models
would give 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

42
IRR and Mutually Exclusive Projects
Mutually exclusive projects
I c , ca c
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

43
Example With Mutually Exclusive Projects
Period Project A Project B
The required
0 -500 -400 return for both
projects is 10%.
1 325 325

2 325 200
Which project
IRR 19.43% 22.17% should you accept
higherIRR and why?
NPV 64.05 60.74 A higherNPVasbothhave
IRR 101
higherNPV

44
 NPV Profiles wilIbe indifferentif

$160.00 ifunssoner rate

IRR for A = 19.43% is highar pi gc
$140.00 option withhighor
$120.00 IRR for B = 22.17% MPV

$100.00
Crossover Point = 11.8%
$80.00
NPV

A
$60.00
B
$40.00
$20.00
$0.00
($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
Discount Rate
45
Reasons Why NPV Profiles Cross
Size (scale) differences: at discount rate = 0, the
NPV of smaller project B is less than (hence
largerproject
below the) larger project A (on the y-axis). usuallyhigher MPV
y intercept
probof
higher NPV
Timing differences: the project with faster havinghigher
smallerproject
payback provides more CF in early years for can havelarger
rateofreturn
reinvestment. It is less sensitive to changes in
discount rate. If r is high, early CF is especially
good, NPVB > NPVA.

46
Reinvestment Rate Assumptions
NPV a CF a a c a
weighted average cost of capital (WACC), the
opportunity cost of capital. assumesCFcanbecompounded
at IRR whichisunrealisticas itcanbe vhigh
IRR method assumes CFs are reinvested at IRR.
Assuming CFs are reinvested at the opportunity cost of
capital is more realistic, so 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. 47
Since Managers Tend to Prefer The IRR To
The NPV Method, Is There A Better IRR
Measure?
Yes, Modified IRR (MIRR). There are a number of different MIRR
methods. Your text reviews (i) the discounting approach, (ii) the
reinvestment approach and (iii) the combination approach.
We will focus on the combination approach. Under this method, the
MIRR c a a ca PV a c a a
(TV) to equal the PV of its costs. TV is found by compounding positive
project inflows at WACC to the date of maturity. PV of costs is found by
discounting negative project cash flows to time zero using WACC.
MIRR assumes cash flows are reinvested at the WACC.
*Recall ha WACC i a fi m e all i e e a e, efe ed a Weighed A e age
Cost of Capital 48
 compoundall positiveCFto

Calculating MIRR lastperiod

addup compoundedCF
determineimplieddiscountrate

10%
0 1 2 3

-100.0 10.0 60.0 10% 80.0

66.0
10%
12.1
MIRR = 16.5%
-100.0 158.1
$158.1
$100 = TV inflows
(1 + MIRR)3
PV outflows
MIRR = 16.5%
49
Why Use MIRR vs. IRR?
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.
resolves BUT stilluseNPVtormutually
reinvestment rateproblem exclusive cashflows
compoundCFatintendednetum
nonconventionalof
multipleIRRbutonlyon MIRR

50
Another IRR Example:
Project P has the following cash flows: Find Project
P NPV a IRR.

0 10% 1 2
-800 5,000 -5,000

NPV = -$386.78.
IRR = ?

51
Multiple IRRs donothaveto
multipleIRRs
calculate

NPV NPV Profile

IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
52
Why Are There Multiple IRRs?
At very low discount rates, the PV of CF2 is large
discountrate negativeNpv
& negative, so NPV < 0. low
At very high discount rates, the PV of both CF1
and CF2 are low, so CF0 dominates and again NPV
< 0. highdiscountrates negativeHPV
In between, the discount rate hits CF2 harder than
CF1, so NPV > 0.
Result: 2 IRRs.
53
When to Use the MIRR Instead of the IRR?
Accept Project P?
When there are non-normal CFs and more than
one IRR, use MIRR
PV of outflows @ 10% = -$4,932.2314.
TV of inflows @ 10% = $5,500.
terminal
MIRR = 5.6%. value

Do not accept Project P

NPV = -$386.78 < 0.
MIRR = 5.6% < 10%. 54
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 use NPV
IRR is unreliable in the following situations
Non-conventional cash flows
Mutually exclusive projects
Use MIRR if you really want to use IRR
55
Profitability Index
Measures the benefit per unit cost, based on
the time value of money numerator
denominator
NPV
also know as a benefit/cost ratio

“benefits”
To tal P V of future C F ’ s
PI =
Initial Investm ent “costs”

Profitability Index Decision Rule:

Accept if PI > 1
56
 usedin capitalscarcitysituations
Profitability Index
Measures the benefit per unit cost, based on the
time value of money
A profitability index of 1.1 implies that for every
$1 of investment, we create an additional $0.10
in value
This measure can be very useful in situations
where we have limited capital (1 period capital
rationing)
Select alternative with highest PI 57
Profitability Index
Advantages Disadvantages
Closely related to NPV, May lead to incorrect
generally leading to decisions in comparisons
identical decisions of mutually exclusive
Easy to understand and investments
Project 1 Projects
communicate a o 3OM Cfo 8m
5150M
NPV 6m mpv
May be useful when P1 1.2 P1 1.16

available investment funds A hashigherpI butP2has

higherHPV i should
choose

are limited P2butPImethodmakes

youchooseP1
58
Quick Review
What decision rule should be the primary decision
method?
When is the IRR rule unreliable?
Consider the following Perma Filter example. The
required return is 12% and required payback is 5 years.
What is the payback period?
What is the discounted payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
59
Example: Perma-Filter Co.
Summary of Cash Flows
Cash Flow
Initial Investment -$3,985,000

OCF in years 1 to 5 $806,000

OCF in years 6 to 10 $926,000

Net Salvage Value $245,000

60
 Timeline for Perma-Filter Project

t = 0 12% 1 5 6 9 10
… …

-3,985K 806K 926K 1,171K

926K + 245K

61
Payback Period
Cash Flows Accumulated
Initial Outlay -$3,985,000 -$3,985,000
1 806,000 -3,179,000
2 806,000 -2,373,000
3 806,000 -1,567,000
4 806,000 -761,000
5 806,000 $45,000
761,000
P ayback P eriod = 4 = 4 . 94 years
806 ,000 62
Discounted Payback Period
Discounted CFj Accumulated
Initial Outlay ($3,985,000) -$3,985,000
1 719,643 -3,265,357
2 642,538 -2,622,819
3 573,695 -2,049,124
4 512,228 -1,536,896
5 457,346 -1,079,550
6 469,140 -610,410
7 418,875 -191,535
8 373,996 182,461

191,535
Discounted Payback Period = 7 = 7 .51 years
373,996 63
Using TI BA II Plus Calculator:
Press <CF> & Use < > and < > to enter the following values:
CF0: 3985000 <+/-><ENTER> CF0 = - 3985000
< > C01: 806000 <ENTER>
< > F01: 5 <ENTER> 806,000 is received from t = 1 to 5.
< > C02: 926000 <ENTER>
< > F02: 4 <ENTER> 926,000 is received from t = 6 to 9.
< > C03: 1171000 <ENTER> CF10 = 1171000 (=926000+245000)
Press <NPV> to display the current discount rate (I)
12 <ENTER> I = 12 : Enter discount rate 12%
< > NPV: 0 to reach the NPV function.
<CPT> NPV: 893,416.82 NPV = 893,416.82
Press <IRR> & <CPT> IRR: 16.97 IRR = 16.97%
64
Comprehensive Problem 1
An investment project has the following cash flows:
CF0 = -1,000,000; CF1 to CF8 = 200,000 annually.
If the required rate of return is 12%, what decision
should be made using NPV?
How would the IRR decision rule be used for this
project, and what decision would be reached?
How are the above two decisions related?

65
Comprehensive Problem 2
Consider an investment that costs $100,000 and has a
cash inflow of $25,000 every year for 5 years. The
required return is 9% and required payback is 4 years.
What is the payback period? 4years
What is the discounted payback period? doesnot
payback
What is the NPV?
What is the IRR?
Should we accept the project? reject

66