Investment decisions

(Capital Budgeting)

 Is it worth to put money or “capital” into the business or machine?

 Capital budgeting decision can be defined as the firms decision to

invest most effectively in the long term projects in anticipation of
an expected flow of benefits in future.

 When to take investment decision?

 Why investment decisions are important?
 What should be the investment decision criteria?

 Guidelines for Investment decision rule

1
  Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g., acquiring an
accounting system.
◦ RANK all alternatives, and select the best one.

 Single Independent Projects: accepting or rejecting

one project does not affect the decision of the other
projects.
◦ Must exceed a MINIMUM acceptance criteria

Discounted cash Non-Discounted cash flows/Non-

flows/Profitability criteria Profitability criteria

 NPV  Payback period

 IRR  Discounted Payback
 Profitability Index  Accounting rate of
return or Average
Accounting return

2
  How long does it take the project to “pay back” its
initial investment?
 Payback Period = number of years to recover initial
costs
 Minimum Acceptance Criteria:
◦ Set by management based on predetermined standard payback
 Ranking Criteria:
◦ Set by management – highest (one) rank to the project with
shortest payback

 Constant Cash flow

Payback period = Initial investment/ Annual cash
flow
Assume that a project require an outlay of 50000
and yield annual cash flow of 12500 for seven
years. The payback period for the project is?

 Uneven Cash flow

Assume the cash outlay of a project is 20,000 and
generates the cash inflows of 8,000 7,000 4000
and 3000 during the next 4 years. what is the
project payback period?

3
  Disadvantages:
◦ Ignores the time value of money
◦ Ignores cash flows after the payback period
◦ Biased against long-term projects
◦ Requires an arbitrary acceptance criteria
◦ A project accepted based on the payback criteria may not
have a positive NPV
 Advantages:
◦ Easy to understand
◦ Biased toward liquidity

- C0 C1 C2 C3 C4
A -4000 3000 1000 2000 1000
B -4000 0 4000 1000 1000

 How long does it take the project to “pay back” its initial
investment, taking the time value of money into account?
 Decision rule: Accept the project if it pays back on a
discounted basis within the specified time set by management .
 Ranking Criteria:
◦ Set by management – highest (one) rank to the project with
shortest discounted payback
 By the time you have discounted the cash flows, you might as
well calculate the NPV.

4
  Also known as return on investment, uses accounting
information as revealed by financial statement to measure
the profitability of an investment.

 Minimum Acceptance Criteria: Accept those projects whose

ARR is higher than Minimum Acceptance Criteria set by
management

 Ranking Criteria: Rank number one to the project with

highest ARR

 Example: A project will cost 40000. Its stream of EBDIT during first
year through five year is expected to be 10000, 12000, 14000,
16000, and 20000. Assume a 50% tax and depreciation on straight
line basis. Compute ARR.

Period 1 2 3 4 5 Average
EBDIT 10000 12000 14000 16000 20000 14400
(-)Dep 8000 8000 8000 8000 8000 8000
EBIT 2000 4000 6000 8000 12000 6400
(-) Tax 1000 2000 3000 4000 6000 3200
EBIT(1-T) 1000 2000 3000 4000 6000 3200
BV of Investment
Beginning 40000 32000 24000 16000 8000
Ending 32000 24000 16000 8000 -
Average 36000 28000 20000 12000 4000 20000

5
  Disadvantages:
◦ Ignores the time value of money
◦ Uses an arbitrary benchmark cutoff rate
◦ Based on book values, not cash flows and market
values
 Advantages:
◦ The accounting information is usually available
◦ Easy to calculate

10

 Accepting positive NPV projects benefits

shareholders.
NPV uses cash flows
NPV uses all the cash flows of the project
NPV discounts the cash flows properly

11

6
  Net Present Value (NPV) =
Total PV of future CF’s - Initial Investment
 Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
 Minimum Acceptance Criteria: Accept if NPV > 0
 Reject if NPV < 0
 Indifferent if NPV =0
 Ranking Criteria: Choose the highest NPV

12

 Ex. Project X costs $2500 now and is expected to

generate cash flow of $900, $800, $700, $600 &
$500 in next five years respectively. If the
discount rate is 10%, find NPV?

13

7
 Total PV of Future Cash Flows
PI 
Initial Investent
 Minimum Acceptance Criteria:
◦ Accept if PI > 1
◦ Reject if PI < 1
◦ Indifferent if PI = 1

 Ranking Criteria:
◦ Select alternative with highest PI

14

 Disadvantages:
◦ Problems with mutually exclusive investments

 Advantages:
◦ May be useful when available investment funds are limited
◦ Easy to understand and communicate
◦ Correct decision when evaluating independent projects

15

8
  Ex. The initial cash outlay of a project is 100000
and can generate cash flow of 40000, 30000,
50000, and 20000 in year1 to year 4. Assume at
10% rate of discount. Find PI of this project?

16

 IRR: the discount rate that sets NPV to zero

 Minimum Acceptance Criteria:
◦ Accept if the IRR > the required return, +ve NPV
◦ Reject if the IRR < the required return, -ve NPV
◦ Accept if the IRR = the required return, 0 NPV

 Ranking Criteria:
◦ Select alternative with the highest IRR
 Reinvestment assumption:
◦ All future cash flows are assumed to be reinvested at the
IRR

 NPV gives you answer in dollar return, whereas IRR

gives you answer in percentage return but both will
give same accept/reject decision

17

9
  Disadvantages:
◦ Does not distinguish between investing and
borrowing
◦ IRR may not exist, or there may be multiple IRRs
◦ Problems with mutually exclusive investments

 Advantages:
◦ Easy to understand and communicate

18

Consider the following project:

$50 $100 $150

0 1 2 3
-$200
The internal rate of return for this project is 19.44%
$50 $100 $150
NPV  0  200   
(1 IRR) (1 IRR) 2 (1 IRR) 3

19

10
 If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
0% $100.00 $150.00
4% $73.88
8% $51.11 $100.00
12% $31.13
16% $13.52 $50.00 IRR = 19.44%
20% ($2.08) NPV
24% ($15.97) $0.00
28% ($28.38) -1% 9% 19% 29% 39%
32% ($39.51) ($50.00)
36% ($49.54)
40% ($58.60) ($100.00)
44% ($66.82) Discount rate

20

NPV and IRR will generally give the same decision.

Exceptions:
 Are We Borrowing or Lending (Conventional cash flow)
 Multiple IRRs (Non-conventional cash flows – cash
flow signs change more than once): Modified IRR
 The Scale Problem
 The Timing Problem

21

11
 There are two IRRs for this project:
$200 $800
Which one should
we use?
0 1 2 3
-$200 - $800

22

 Calculate the present value of all cash outflows

using the borrowing rate.
 Calculate the future value of all cash inflows using
the investing rate.
 Find the rate of return that equates these values.
 Benefits: single answer and specific rates for
borrowing and reinvestment.

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12
 Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment, while
the 50% return is on a $1,000 investment?

24

$10,000 $1,000 $1,000

Project A
0 1 2 3
-$10,000

$1,000 $1,000 $12,000

Project B
0 1 2 3
-$10,000

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13
 $5,000.00 Project A
$4,000.00 Project B
$3,000.00
$2,000.00
10.55% = crossover rate
$1,000.00
NPV

$0.00
($1,000.00) 0% 10% 20% 30% 40%

($2,000.00)
($3,000.00)
($4,000.00)
12.94% = IRRB 16.04% = IRRA
($5,000.00)

Discount rate

26

Compute the Incremental IRR for either project “A-B” or “B-A”

0 ($10,000) ($10,000) $0 $0
11 $10,000 $1,000 $9,000 ($9,000.00)

2 $1,000 $1,000 $0 $0

3 $1,000 $12,000 ($11,000.00) $11,000

$3,000.00
$2,000.00
10.55% = IRR
$1,000.00
NPV

A-B
$0.00
B-A
($1,000.00) 0% 5% 10% 15% 20%
($2,000.00)
($3,000.00)
Discount rate

27

14
  NPV and IRR will generally give the same decision.
 Exceptions:
◦ Non-conventional cash flows – cash flow signs change
more than once
◦ Mutually exclusive projects
 Initial investments are substantially different
 Timing of cash flows is substantially different

28

 Varies by industry:
◦ Some firms may use payback, while others choose an
alternative approach.

 The most frequently used technique for large

corporations is either IRR or NPV.

29

15
 Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150

30

Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053

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16
 Payback Period:
Project A Project B
Time CF Cum. CF CF Cum.CF
0 -200 -200 -150
-150
1 200 0 50 -100
2 800 800 100
0
3 -800 0 150 150

Payback period for project B = 2 years.

Payback period for project A = 1 or 3 years?

32

Discount rate NPV for A NPV for B

-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52

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17
 NPV
$400

$300
IRR 1(A) IRR (B) IRR 2(A)
$200

$100

$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100)

($200)
Project A
Discount rates
Cross-over Rate Project B

34

Maxwell software in corporation has the following

mutually exclusive projects.

Year Project A Project B

0 -20000 -24000
1 13200 14100
2 8300 9800
3 3200 7600

Suppose the company payback period cutoff is 2

year. Which of these two projects should be chosen?

Suppose the company uses the NPV rule to rank

these two project, which project should we choose
and if the appropriate discount rate is 15%?

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18
 Compute the internal rate of return for the
cash flows of the following two projects.
Year Project A Project B
0 -$5700 -$3450
1 $2750 $1380
2 $2800 $1800
3 $1600 $1200

36

Suppose the following two independent investment

opportunities are available to relax incorporation
and the appropriate discount rate is 8.5 %

Year Project Alpha Project Beta

0 -2100 -3700
1 1200 800
2 1100 2300
3 900 2900

Compute the profitability index for each of the two

projects.
Which project should the company accept based on
the profitability index rule?

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19
 Consider the following cash flows on two mutually exclusive projects
for the Bahamas recreation Corporation. Both projects required and
annual return of 14%.
Year Deepwater fishing New Submarine ride
0 -$850000 -$1650000
1 $320000 $810000
2 $470000 $750000
3 $410000 $690000
As a financial analyst for BRC you are asked the following question:
a. If your decision rule is to accept the project with the greater IRR,
which project should you choose?
b. Because you are fully aware of the IRR rules scale problem, you
calculate the incremental IRR for the cash flows. Based on your
computation, which project should you choose?
c. To be prudent, you compute the NPV for both projects. Which
project should you choose? Is it consistent with the increment the
IRR rule?

38

Consider the following cash flows of two mutually exclusive projects

for Tokyo rubber company. Assume discount rate for both projects is
8%.
Year Deepwater fishing New Submarine ride
0 -$1700000 -$750000
1 $1100000 $375000
2 $900000 $600000
3 $750000 $390000

a. Based on the payback period which project should be taken?

b. Based on the NPV, which project should be taken?
c. Based on IRR, which project should be taken?
d. Based on this analysis, is incremental IRR analysis necessary? If yes
please conduct the analysis.

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20
  Consider the case when the firm does not have enough capital
to fund all positive NPV projects. This is the case of capital
rationing.
 In the case of limited funds, we cannot rank projects according
to their NPVs. Instead we should rank them according to the
ratio of present value to initial investment. This is the PI rule.
 “Bang for the buck”
 Indivisibilities, different project durations may reduce the
effectiveness of the PI rule.
 Nevertheless, while not perfect, the profitability index goes a
long way toward handling capital rationing.

40

 Consider the following example. If there is no capital

constraint, all projects will be accepted. If the company has
limited funds of ₹50,000, it should accept project M and N.
Why?

41

21
 Cash Flow Analysis

42

 Cash flows matter—not accounting earnings.

 Sunk costs do not matter.
 Incremental cash flows matter.
 Opportunity costs matter.
 Side effects like cannibalism and erosion matter.
 Taxes matter: we want incremental after-tax cash
flows.
 Inflation matters.

43

22
  Consider depreciation expense.
◦ You never pay for “depreciation.”
 Much of the work in evaluating a project lies in
taking accounting numbers and generating cash
flows.

44

 Sunk costs are not relevant

◦ Just because “we have come this far” does not
mean that we should continue to throw good
money after bad.
 Opportunity costs do matter. Just because a project
has a positive NPV, that does not mean that it should
also have automatic acceptance. Specifically, if
another project with a higher NPV would have to be
passed up, then we should not proceed.

45

23
  Side effects matter.
◦ Erosion is a “bad” thing. If our new product
causes existing customers to demand less of
our current products, we need to recognize
that.
◦ If, however, synergies result that create
increased demand of existing products, we
also need to recognize that.

46

 Cash Flow from Operations

◦ Recall that:
OCF = EBIT – Taxes + Depreciation
 Net Capital Spending
◦ Do not forget salvage value (after tax, of course).
 Changes in Net Working Capital
◦ Recall that when the project winds down, we enjoy a return of
net working capital.

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 0 1 2 3 4 5 6
Initial investment xxx
Sales
Less: Expense
Less: Depreciation
PBT
Less: Tax
PAT
Add: Depreciation
Operating cash flow
Add: Net Salvage Value ##
Net Working Capital (NWC) adjustments

Net Cash Flow

## Net Salvage value = Salvage value – [Tax * (Salvage value-Book value)]

48

Q: Boomerang, Inc is considering a new three-year expansion

project that requires an initial investment of $1,650,000. The fixed
asset will be depreciated on straight line to zero over three year life,
after which it will be worthless. The project is estimated to generate
$1,240,000 in annual sales, with costs of $485,000. The tax rate is
35% and the required rate of return is 15%. Compute the NPV of
the project.

Q: In the previous problem, suppose the project requires an initial

investment in NWC of $285,000 and the fixed asset will have a
market value of $225,000 at the end of the project. Compute the
new NPV.

49

25
 0 1 2 3

Initial Investment -1,650,000.00

Sales 1,240,000.00 1,240,000.00 1,240,000.00

Less: Costs 485,000.00 485,000.00 485,000.00

Less: Depreciation 550,000.00 550,000.00 550,000.00

PBT 205,000.00 205,000.00 205,000.00

Less: Tax 71,750.00 71,750.00 71,750.00

Add: Depreciation 550,000.00 550,000.00 550,000.00

OCF 683,250.00 683,250.00 683,250.00

Add: Net Salvage Value 0 0 0

Net Annual Cash Flow -1,650,000.00 683,250.00 683,250.00 683,250.00

PV of Cash Flows -1650000.00 610044.64 544682.72 486323.85

NPV -8948.79

50

0 1 2 3
Initial Inv -1,650,000.00
Sales 1,240,000.00 1,240,000.00 1,240,000.00
Less: Costs 485,000.00 485,000.00 485,000.00
Less: Dep 550,000.00 550,000.00 550,000.00
EBIT 205,000.00 205,000.00 205,000.00
Less: Tax 71,750.00 71,750.00 71,750.00
Add: Dep 550,000.00 550,000.00 550,000.00
OCF 683,250.00 683,250.00 683,250.00
Add: Net salvage Value 0 0 146,250.00
Working Capital -285,000.00 285,000.00
Net Annual Cash Flow -1,935,000.00 683,250.00 683,250.00 1,114,500.00
PV of cash flows -1935000.00 610044.64 544682.72 793279.09
NPV 13006.45

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26
 Q.

HP is considering a new project that complements its existing

business. The machine required for the project costs $3.9 million. The
marketing department predicts that sales related to the project will be
$2.35 Million per year for the next four years, after which the market
will cease to exist. The machine will be depreciated down to zero over
its four year economic life using SLM. Cost of goods sold and
operating expenses related to the project are predicted to be 25% of
sales. HP also need to add net working capital of $150,000
immediately. The additional net working capital will be recovered in
full at the end of the projects life. The corporate tax is 35 percent. The
required rate of return for HP is 13%. Should HP proceed with the
project?

52

0 1 2 3 4
Initial Investment -3,900,000.00
Sales 2,350,000.00 2,350,000.00 2,350,000.00 2,350,000.00
Less: COGS (25% of
sales) 587,500.00 587,500.00 587,500.00 587,500.00
Less: Depreciation 975,000.00 975,000.00 975,000.00 975,000.00
EBT 787,500.00 787,500.00 787,500.00 787,500.00
Less: Tax 275,625.00 275,625.00 275,625.00 275,625.00
Add: Depreciation 975,000.00 975,000.00 975,000.00 975,000.00
OCF 1,486,875.00 1,486,875.00 1,486,875.00 1,486,875.00
Add: Net salvage Value 0.00
Working capital -150,000.00
Release of working capital 150,000.00
Net Annual Cash Flow -4,050,000.00 1,486,875.00 1,486,875.00 1,486,875.00 1,636,875.00
PV of cash flows -4,050,000.00 1315818.584 1164441.225 1030478.96 1003926.092
NPV 464,664.86

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27
 Q.
Rightprice Investors Inc. is considering the purchase of $415,000
computer with an economic life of five years. The computer will be
fully depreciated over five years using SLM. The market value of
the computer will be $50,000 in five years. The computer will
replace five office employees whose combined annual salaries are
$120,000. The machine will also immediately lower the firm’s
required net working capital by $80,000. This amount of NWC will
need to be replaced once the machine is sold. The corporate tax rate
is 34% and the discount rate is 9%. Is it worthwhile to buy the
computer?

54

0 1 2 3 4 5
Investment -415,000.00
Reduction in salary 120,000.00 120,000.00 120,000.00 120,000.00 120,000.00
Less: Additional
Depreciation 83,000.00 83,000.00 83,000.00 83,000.00 83,000.00
Benefits before tax 37,000.00 37,000.00 37,000.00 37,000.00 37,000.00
Tax 12,580.00 12,580.00 12,580.00 12,580.00 12,580.00
After Tax benefits 24,420.00 24,420.00 24,420.00 24,420.00 24,420.00
Add: dep 83,000.00 83,000.00 83,000.00 83,000.00 83,000.00
Cashflows 107,420.00 107,420.00 107,420.00 107,420.00 107,420.00
Reduction in working
capital 80,000.00
Net salvage value 33,000.00
Working capital
required -80,000.00

Net Annual cashflows -335,000.00 107,420.00 107,420.00 107,420.00 107,420.00 60,420.00

PV -335,000.00 98,550.46 90,413.26 82,947.95 76,099.04 39,268.85
NPV 52,279.56

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 Q.
A firm is considering an investment in a new machine with a price
of $15.6mn to replace its existing machine. The current machine has
a book value of $5.4mn and a market value of $4.1mn. The new
machine is expected to have a four-year life, and the old machine
has four years left in which it can be used. If the firm replaces the
old machine with the new machine, it expects to save $6.3mn in
operating costs each year over the next four years. Both machines
will have no salvage value in four years. If the firm purchases the
new machine, it will also need an investment of $250,000 in
working capital. The required rate of return on the investment is
10% and the tax rate is 39%.

What are the NPV and IRR of the decision to replace the old
machine?

56

0 1 2 3 4
Invest (new) -15,600,000.00
Savings before tax 6,300,000.00 6,300,000.00 6,300,000.00 6,300,000.00
Depreciation(New) 3,900,000.00 3,900,000.00 3,900,000.00 3,900,000.00
Depreciation(Old) 1,350,000.00 1,350,000.00 1,350,000.00 1,350,000.00
Incremental Dep 2,550,000.00 2,550,000.00 2,550,000.00 2,550,000.00

Incremental Benefits 3,750,000.00 3,750,000.00 3,750,000.00 3,750,000.00

Tax 1,462,500.00 1,462,500.00 1,462,500.00 1,462,500.00
Benefits after Tax 2,287,500.00 2,287,500.00 2,287,500.00 2,287,500.00
Add: Inc Dep 2,550,000.00 2,550,000.00 2,550,000.00 2,550,000.00
OCF 4,837,500.00 4,837,500.00 4,837,500.00 4,837,500.00

Sale of Old(salvage Value) 4,607,000.00

Working capital -250,000.00
Return of WC 250,000.00
Net Annual Cashflows -11,243,000.00 4,837,500.00 4,837,500.00 4,837,500.00 5,087,500.00
PV -11,243,000.00 4397727.27 3997933.88 3634485.35 3474830.95
NPV 4,261,977.46
IRR 26.40%

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 Risk Analysis

58

 Each allows us to look behind the NPV number to see

how stable our estimates are.
 When working with spreadsheets, try to build your
model so that you can adjust variables in a single cell
and have the NPV calculations update accordingly.

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30
  Stewart Pharmaceuticals Corporation is considering investing
in the development of a drug that cures the common cold.
 A corporate planning group, including representatives from
production, marketing, and engineering, has recommended
that the firm go ahead with the test and development phase.
 This preliminary phase will last one year and cost $1 billion.
Furthermore, the group believes that there is a 60% chance
that tests will prove successful.
 If the initial tests are successful, Stewart Pharmaceuticals can
go ahead with full-scale production. This investment phase
will cost $1.6 billion. Production will occur over the following
4 years.

60

Note that the NPV is

Investment Year 1 Years 2-5 calculated as of date 1, the
date at which the
Revenues $7,000 investment of $1,600
million is made. Later we
bring this number back to
Variable Costs (3,000) date 0. Assume a cost of
capital of 10%.
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $1,800
4
Tax (34%) (612) $1,588
NPV 1  $1,600   t
t 1 (1.10)
Net Profit $1,188
NPV 1  $3,433.75
Cash Flow -$1,600 $1,588

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  Let’s move back to the first stage, where the decision boils down to
the simple question: should we invest?
 The expected payoff evaluated at date 1 is:

Expected Prob. Payoff   Prob. Payoff 

      
payoff sucess given success  failure given failure 
Expected
 .60  $3,433.75  .40  $0  $2,060.25
payoff
The NPV evaluated at date 0 is:

$2,060.25
NPV  $1,000   $872.95
1.10
So, we should test.

62

 We can see that NPV is very sensitive to changes in

revenues. In the Stewart Pharmaceuticals example, a
14% drop in revenue leads to a 61% drop in NPV.

$6,000  $7,000
%Rev   14.29%
$7,000
$1,341.64  $3,433.75
%NPV   60.93%
$3,433.75
For every 1% drop in revenue, we can expect roughly a
4.26% drop in NPV:
60.93%
4.26 
14.29%

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  A variation on sensitivity analysis is scenario analysis.
 For example, the following three scenarios could apply to
Stewart Pharmaceuticals:
1. The next few years each have heavy cold seasons, and sales
exceed expectations, but labor costs skyrocket.
2. The next few years are normal, and sales meet expectations.
3. The next few years each have lighter than normal cold
seasons, so sales fail to meet expectations.
 Other scenarios could apply to FDA approval.
 For each scenario, calculate the NPV.

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 Common tool for analyzing the relationship between

sales volume and profitability
 There are three common break-even measures
◦ Accounting break-even: sales volume at which net income = 0
◦ Cash break-even: sales volume at which operating cash flow
=0
◦ Financial break-even: sales volume at which net present value
=0

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  Another way to examine variability in our forecasts is
break-even analysis.
 In the Stewart Pharmaceuticals example, we could be
concerned with break-even revenue, break-even sales
volume, or break-even price.
 To find either, we start with the break-even operating
cash flow.

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 Once we have calculated the break-even revenue of

$5,358.71 million, we can calculate break-even price.
 The original plan was to generate revenues of $7
billion by selling the cold cure at $10 per dose and
selling 700 million doses per year,
 We can reach break-even revenue with a price of
only:
$5,358.71 million = 700 million × PBE

$5,358.71
PBE = = $7.66 / dose
700

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