Topic 9: Capital Budgeting

Learning Objectives

After successful completion of this topic, you should be able to:

 Discuss capital budgeting;
 Calculate and use the major capital budgeting decision criteria, which
are NPV, IRR, MIRR, and payback.
 Explain why NPV is the best criterion and how it overcomes problems
inherent in the other methods

Activating Prior Knowledge

Think- Pair- Share

Capital Budgeting

Look at the two words “Capital Budgeting”. With your partner, breakdown the
meaning of the two words.

Capital means___________________________________________________

Budgeting means________________________________________________

Now, combine the two words and try to come up with your own definition of
capital budgeting:

Capital budgeting means

___________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________

Presentation of Contents

CAPITAL BUDGETING
The process of identifying, evaluating, planning, and financing capital
investment projects of an organization.

Investment Decision – judgment about which assets to acquire to achieve the

company’s stated objectives
Financing Decision – judgment regarding the method of raising capital to
fund an investment

Financial Management Module 1

Characteristics of Capital Investment Decisions
1. Capital investment decisions usually require large commitments of
resources.
2. Most capital investment decisions involve long-term commitments.
3. Capital investment decisions are more difficult to reverse than short term
decisions.
4. Capital investment decisions involve so much risk and uncertainty.

Stages in the Capital Budgeting Process

1. Identification and definition
2. Search for potential investment projects
3. Information gathering – both quantitative and qualitative information
4. Selection – choosing the investment projects after evaluating their
projected costs and benefits
5. Financing
6. Implementation and monitoring

Types of Capital Investment Projects

1. Replacement
2. Improvement
3. Expansion

Capital Investment Factors

1. Net Investment
2. Cost of capital
3. Net returns

Net investment – cost or cash outflows less cash inflows or savings incidental
to the acquisition of the investment projects

Cost or Cash Outflows:

1. The initial cash outlay covering all expenditures on the project up to the
time when it is ready for use or operation:
Ex. Purchase price of the asset
Incidental project-related cost such as freight, insurance, taxes,
handling, installation, test-runs, etc.
2. Working capital requirement to operate the project at the desired level
3. Market value of an existing, currently idle asset, which will be transferred
to or utilized in the operations of the proposed capital investment project.

Savings or Cash Inflows:

1. Trade-in value of old assets (in case of replacement)
2. Proceeds from sale of old asset to be disposed due to the acquisition of
new project (less applicable tax, in case there is gain on sale, or add tax
savings, in case there is loss on sale)
3. Avoidable cost of immediate repairs on old asset to be replaced, net of tax.

Cost of Capital – the cost of using funds; it is also called the hurdle rate of
return the company must pay to its long term creditors and shareholders for
the use of their funds.

Financial Management Module 2

Net Returns
1. Accounting net income
2. Net cash inflows
Economic life – the period of time during which the asset can provide
economic benefits or positive cash inflows
Depreciable life – the period used for accounting and tax purposes over
which the depreciable asset’s cost is systematically and rationally
allocated.
Terminal Value (End-of-life Recovery Value) – net cash proceeds
expected to be realized at the end of the project’s life.

Commonly Used Methods of Evaluating Capital Investment Projects

1. Methods that do not consider the time value of money
a. Payback
b. Bail-out
c. Accounting rate of return
2. Methods that consider the time value of money (discounted cash flow
methods)
a. Net present value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return

METHODS THAT DO NOT CONSIDER TIME VALUE OF MONEY

Payback Method
Payback Period = Net cost of initial investment
Annual net cash inflows
*Payback period is the length of time required by the project to return the
initial cost of investment

Advantages:
1. Payback is simple to compute and easy to understand. There is no need to
compute or consider any interest rate. One just has to answer the question:
“How soon will the investment cost be recovered”?
2. Payback gives information about the project’s liquidity.
3. It is good surrogate for risk. A quick payback period indicates a less risky
project.
Disadvantages:
1. Payback does not consider the time value of money. All cash receive
during the payback period is assumed to be equal value in analyzing the
project.
2. It gives more emphasis on liquidity rather than on profitability of the
project. In other words, more emphasis is given on return of investment
than the return on investment.
3. It ignores the cash flows that may occur after the payback period.

Bail-out Period
Cash recoveries include not only the operating net cash inflows but also the
estimated salvage value or proceeds from sale at the end of each year of the
life of the project.

Financial Management Module 3

Accounting Rate of Return
Also called book value rate of return, financial accounting rate of return,
average return on investment and unadjusted rate of return.

Accounting Rate of Return = Average annual net income

Investment

Advantages:
1. The ARR computation closely parallels accounting concepts of income
measurement and records.
2. It facilitates re-evaluation of projects due to the ready availability of data
from the accounting records.
3. This method considers income over the entire life of the project.
4. It indicates the projects profitability.

Disadvantages:
1. Like the payback and bail-out methods, the ARR method does not consider
the time value of money.
2. With the computation of income and book value based on the historical
cost accounting data the effect of inflation is ignored.

METHODS THAT CONSIDER TIME VALUE OF MONEY

Present Value (PV) of an amount is the value now on some future cash flow.

PV of P1 or PV Factor (PVF) = 1 where: i = discount rate

(1+i)n n = number of periods

PV of future cash flows = Future cash flows x PVF

Future Value (FV) of an amount available at a specified future time based on

a single investment (or deposit now)
FV of P1 or FV Factor = (1+i)n
FV of Present Cash Flows = Present cash flows x FVF

Annuities – a series of equal payments at equal intervals of time

 Ordinary Annuity (Annuity in Arrears) – cash flows occur at the end of the
periods involved.
 Annuity Due (Annuity in advance) – cash flows occur at the beginning of
the periods involved.

Net Present Value

1. Present value of cash inflows
 Present value of cash outflows
Net Present Value

2. Present value of cash inflows

 Present value of cost of investment
Net Present Value

Financial Management Module 4

 3. Present value of cash inflows
 Cost of investment
Net Present Value

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate as the reinvestment rate
4. Easy to apply.

Disadvantages
1. It requires predetermination of the cost of capital or the discount rate to be
used.
2. The net present values of different competing projects may not be
comparable because of different magnitudes or sizes of the projects.

Profitability Index

Profitability Index = Total present value of cash inflows

Total present value of cash outflows

If the cost of investment is the only cash outflow:

Profitability Index = Total present value of cash inflows

Cost of investment

Net Present Value Index = Net present value

Investment

Internal Rate of Return

 The rate of return which equates the present value (PV) of cash inflows to
PV of cash outflows.
It is the rate of return where NPV = 0.

When the cash flows are uniform, the IRR can be determined as follows:
1. Determine the present value factor (PVF) for the internal rate of return
(IRR) with the use of the following formula:

PVF for IRR = Net cost of investment

Net cash inflows
2. Using the present value annuity table, find on line n (economic life) the
PVF obtained in step 1. The corresponding rate is the IRR.

When the cash flows are not uniform, the IRR is determined using trial-and-
error method.

Advantage:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computes the true return of the project

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Disadvantages:
1. Assumes that IRR is the reinvestment rate.
2. When project includes negative earnings during their economic life,
different rates of return may result.

Payback Reciprocal
A reasonable estimate of the internal rate of return,

Provided that the following conditions are met:

1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of the
project.
Payback reciprocal = Net cash inflows
Investment
Or

Payback reciprocal = 1_____

Payback period

Discounted Payback or Break-even Time

The period required for the discounted cumulative cash inflows on a project to
equal the discounted cumulative cash outflows (usually the initial cost).

Application

Answer the following questions:

1. How are project classifications used in the capital budgeting process?
2. What are three potential flaws with the regular payback method? Does the
discounted payback method correct all three flaws? Explain.
3. Why is the NPV of a relatively long-term project (one for which a high
percentage of its cash flows occurs in the distant future) more sensitive to
changes in the WACC than that of a short-term project?
4. What is a mutually exclusive project? How should managers rank
mutually exclusive projects?
5. If two mutually exclusive projects were being compared, would a high
cost of capital favor the longer-term or the shorter-term project? Why? If
the cost of capital declined, would that lead firms to invest more in
longer-term projects or shorter-term projects? Would a decline (or an
increase) in the WACC cause changes in the IRR ranking of mutually
exclusive projects?
6. Discuss the following statement: If a firm has only independent projects, a
constant WACC, and projects with normal cash flows, the NPV and IRR
methods will always lead to identical capital budgeting decisions. What
does this imply about the choice between IRR and NPV? If each of the
assumptions were changed (one by one), how would your answer change?
7. Why might it be rational for a small firm that does not have access to the

Financial Management Module 6

 capital markets to use the payback method rather than the NPV method?
8. Project X is very risky and has an NPV of $3 million. Project Y is very
safe and has an NPV of $2.5 million. They are mutually exclusive, and
project risk has been properly considered in the NPV analyses. Which
project should be chosen? Explain.
9. What reinvestment rate assumptions are built into the NPV, IRR, and
MIRR methods? Give an explanation (other than “because the text says
so”) for your answer.
10. A firm has a $100 million capital budget. It is considering two projects,
each costing $100 million. Project A has an IRR of 20%; has an NPV of
$9 million; and will be terminated after 1 year at a profit of $20 million,
resulting in an immediate increase in EPS. Project B, which cannot be
postponed, has an IRR of 30% and an NPV of $50 million. However, the
firm’s short-run EPS will be reduced if it accepts Project B because no
revenues will be generated for several years.
a. Should the short-run effects on EPS influence the choice between the
two projects?
b. How might situations like this influence a firm’s decision to use
payback?

Feedback

A firm with a 14% WACC is evaluating two projects for this year’s capital
budget. After-tax cash flows, including depreciation, are as follows:

a. Calculate NPV, IRR, MIRR, payback, and discounted payback for each
project.
b. Assuming the projects are independent, which one(s) would you
recommend?
c. If the projects are mutually exclusive, which would you recommend?
d. Notice that the projects have the same cash flow timing pattern. Why is
there a conflict between NPV and IRR?

Financial Management Module 7