10-1

The Basics of Capital Budgeting

10-2

What is capital budgeting? Analysis of potential additions to

fixed assets. Long-term decisions; involve

large expenditures. Very important to firm’s future.

10-3

Examples:

Expansion Replacement Buy or lease Choice of equipment Capital expenditure

10-4

Problems:

Demand for capital-how much money needed for expenditure

Supply of capital – internal and external

Capital rationing – selection of the projects

10-5

Types of capital

Debt Preference share Equity capital Retained earningsWACC: weighted average cost of

capital

10-6

methods

Pay back method Accounting rate of return Internal rate of return Net present value

10-7

Steps to capital budgeting

1. Estimate CFs (inflows & outflows).2. Assess riskiness of CFs.3. Determine the appropriate cost of

capital.4. Find NPV and/or IRR.5. Accept if NPV > 0 and/or IRR > WACC.

10-8

What is the difference between independent and mutually exclusive projects?

Independent projects – if the cash flows of one are unaffected by the acceptance of the other.

Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.

10-9

What is the difference between normal and nonnormal cash flow streams?

Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs.

Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.

10-10

What is the payback period?

The number of years required to recover a project’s cost, or “How long does it take to get our money back?”

Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.

10-11

Calculating payback

PaybackL = 2 + / = 2.375 years

CFt -100 10 60 100Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

PaybackS = 1 + / = 1.6 years

CFt -100 70 100 20Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50-30

Project S

10-12

Strengths and weaknesses of payback

Strengths Provides an indication of a project’s

risk and liquidity. Easy to calculate and understand.

Weaknesses Ignores the time value of money. Ignores CFs occurring after the

payback period.

10-13

Discounted payback period

Uses discounted cash flows rather than raw CFs.

Disc PaybackL = 2 + / = 2.7 years

CFt -100 10 60 80

Cumulative -100 -90.91 18.79

0 1 2 3

=

2.7

60.11

-41.32

PV of CFt -100 9.09 49.59

41.32 60.11

10%

10-14

Accounting rate of return

= estimated net profits/ capital employed . 100

Average investment =( initial investment + scrap value) / 2

Limitation : does not look at time value of money

10-15

Net Present Value (NPV) Sum of the PVs of all cash inflows and

outflows of a project:

n

0tt

t

) k 1 (CF

NPV

10-16

What is Project L’s NPV?

Year CFt PV of CFt

0 -100 -$100 1 10 9.09 2 60 49.59 3 80 60.11

NPVL = $18.79

NPVS = $19.98

10-17

Rationale for the NPV methodNPV = PV of inflows – Cost

= Net gain in wealth If projects are independent, accept if

the project NPV > 0. If projects are mutually exclusive,

accept projects with the highest positive NPV, those that add the most value.

In this example, would accept S if mutually exclusive (NPVs > NPVL), and would accept both if independent.

10-18

Internal Rate of Return (IRR) IRR is the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:

Normally NPV METHOD and IRR method gives the same result

n

0tt

t

) IRR 1 (CF

0

10-19

How is a project’s IRR similar to a bond’s YTM?

They are the same thing. Think of a bond as a project.

The YTM on the bond would be the IRR of the “bond” project.

EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20. Solve for IRR = YTM = 7.08%, the

annual return for this project/bond.

10-20

Rationale for the IRR method

If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns.

10-21

IRR Acceptance Criteria If IRR > k, accept project. If IRR < k, reject project.

If projects are independent, accept both projects, as both IRR > k = 10%.

If projects are mutually exclusive, accept S, because IRRs > IRRL.

10-22

NPV Profiles A graphical representation of project

NPVs at various different costs of capital.

k NPVL NPVS

0 $50 $40 5 33 2910 19 2015 7 1220 (4) 5

10-23

Comparing the NPV and IRR methods

If projects are independent, the two methods always lead to the same accept/reject decisions.

If projects are mutually exclusive … If k > crossover point, the two

methods lead to the same decision and there is no conflict.

If k < crossover point, the two methods lead to different accept/reject decisions.

10-24

Comparisons :proposals Initial inv Annual cash

flowLife in years

1 60,000 12000 15

2 88,000 22,500 22

3 2150 1,500 3

4 20,500 4500 10

5 4,25,000 2,25000 20

10-25

Pay back methodPay back period =

Initial investment/annual cash flow

1 60,000/12,000 5

2 88,00/22500 3.9

3 21,50/1500 1.4

4 2,5000/4500 4.6

5 4,25000/2,25000 1.9

10-26

Accounting rate proposal

Initial investment

Annual cash flow

Life in years

Annual depreciation

Net profits

Rate of return

1 60,000 12000 15 4000 8000 26.67

2 88,000 22,500 22 4000 18,500 42

3 2150 1500 3 717 783 72.84

4 20,500 4500 10 2050 2450 23.9

5 4,25000

2,25000

20 21,250 203750 95.88

10-27

NPV

proposal

Initial inv

Annual cash low

life Pv(10%)

Pv npvi

1 60,000

12,000 15 7.7688 93225.6

1.55

2 88,000

22,500 22 8.8919 200,067.75

2.27

3 2150 1500 3 2.5918 3887.7 1.81

4 20,500

4500 10 6.3213 28445.8

1.39

5 425,000

2,25000

20 8.6466 1945485

4.56

10-28

DCF

Discounted cash flows or internal rate of return may sometimes give different results

10-29

All methods do not give the same interpretation

methods

payback

accounting

DCF NPV

Proposal rank ranks ranks ranks

1 5 4 4 4

2 3 3 3 2

3 1 2 2 3

4 4 5 5 5

5 2 1 1 1