International Center For
Environmental Finance.
Environmental Finance Policy
Presentation #?:
Capital Budgeting Decisions
CAPITAL BUDGETING
 Capital Budgeting is used to describe how
managers plan projects that have long-term
implications such as the purchase of new
equipment and the introduction of new products
or services.
 Managers have many potential projects that can
be funded, hence, they must carefully select those
projects that promise the greatest future return.
Typical Capital Budgeting Decisions
1. Cost reduction decisions. Should new equipment
be purchased to reduce costs?
2. Expansion decisions. Should a new plant,
warehouse, or other facility be acquired or built to
increase capacity and sales?
3. Equipment selection decisions. Which of several
available machines would be the most cost
effective purchase?
4. Lease or buy decisions. Should new equipment be
leased or purchased ?
5. Equipment replacement decisions. Should old
equipment be replaced now or later?
Discounted Cash Flow
 There are two approaches to making capital
budgeting decisions by means of discounted cash
flow.
1. The net present value
2. The internal rate of return
The Net Present Value Method
 Net present value is the difference between an
investment’s market value and its cost.
 In other words, net present value is a measure of
how much value is created or added today by
undertaking an investment, which will determine
whether or not the project is an acceptable
investment.
The Net Present Value Method
Example 1
Moscow City Vodokanal is considering the
purchase of a machine that will bring cash
revenues of $20,000 per year. Cash costs
(including taxes) will be $14,000 per year. The life
of the machine is 8 years and its salvage cost will
be $2,000. The project cost $30,000 to launch. We
will use 15% discount rate.
 Should the machine be purchased?
 If there are 1,000 shares of stock outstanding,
what will be the effect on price per share for
taking this investment?
The Net Present Value Method
 It may appear that the answer is obvious, since we
pay only $30,00 for revenue of 8x($20,000$14,000)+$2,000=$50,000
 However, it is not that obvious.
To see if this investment is acceptable we have to
perform Net Present Value Analysis
The Net Present Value Method
 We need to calculate the present value of the
future cash flows at 15 percent.
 The net cash inflow will be $20,000 cash income
less $14,000 in costs per year for eight years.
 We have an eight-year annuity of
$20,000-$14,000=$6,000 per year, along with a
single lump-sum inflow of $2,000 in eight years.
The Net Present Value Method
Time
(years)
1
2
3
4
5
6
7
8
Inflow
$20
$20
$20
$20
$20
$20
$20
$20
Outflow
-14
-14
-14
-14
-14
-14
-14
-14
$6
$6
$6
$6
$6
$6
$6
$6
Initial cost
0
($30)
Net inflow
Salvage
Net cash
flow
2
($30)
$6
$6
$6
$6
$6
$6
$6
$8
The Net Present Value Method
Present Value = $6,000x[1-(1/1.158)/0.15+
+(2,000/1.158)=($6,000 x 4.4873)+
+(2,000/3.0590)=$26,924+654=
=$27,578
When we compare this to the $30,000 estimated
cost ,we se that the NPV is:
NPV=-$30,000 + 27,578 = -$2,422
Therefore, this is not a good investment
The Net Present Value Method
 Now, lets answer the question regarding how this
investment affect the value of our stock.
 It will decrease the total value of our stock by
$2,422. With 1,000 shares outstanding, we
should expect a loss of value of
$2,422/1,000 = $2,42 per share
The Net Present Value Method
Summary:
If the Net Present
Value Is …
Then the Project Is…
Positive
Acceptable, since it promises
a return grater than the
required rate of return
Zero
Acceptable, since it promises
a return equal the required
rate of return
Negative
Not acceptable, since it
promises a return less than
the required rate of return
The Net Present Value Method
Example 2
Now let us consider an example that has different cash
inflows in different periods.
 Suppose we are asked to decide whether or not a new
consumer service product should be launched.
 Based on projected sales and costs, we expect that the
CF over the 5 year life of the project will be $2,000 in
the first two years, $4,000 in the next two, and $5,000
in the last year.
 It will cost $10,000 to begin operation and we use 10%
discount rate.
WHAT SHOULD WE DO?
The Net Present Value Method
 Given the cash flows and discount rate, we can
calculate the total value of the product by
discounting the cash flows back to the present.
Present Value = ($2,000/1.1) + (2,000/1.12) +
+ (4,000/1.13) + (4,000/1.14) + (5,000/1.15)=
= $1,818 + 1,653 + 3,005 + 2,732 + 3,105 =
= $12,313
NPV = $12,313 – 10,000 - $2,313
Importance of Cash Flows
 Although, the accounting net income figure is
useful for many things, it is not used in
discounted cash flow analysis.
 The reason is that accounting net income is based
on accrual concepts that ignore the timing of cash
flows into and out of an organization.
 The timing of cash flows is important, since a
dollar received today is more valuable than a
dollar received in the future.
 Therefore, instead of determining accounting net
income, the manager must concentrate on
identifying the specific cash flows associated with
an investment project.
Cash Outflows
 Most projects will have an immediate cash outflow
in the form of an initial investment in equipment
or other assets.
 In addition, some projects require expansion of
the working capital.
 Also, many projects require periodic repairs and
maintenance and additional periodic costs – these
should be treated as cash outflows.
Cash Outflows




Cash Outflows:
Initial investment
Increased working capital needs
Repairs and maintenance
Incremental operating costs
Cash Inflows
 Any sound project will normally either increase
revenues or reduce costs. And the amount
involved should be treated as a cash inflow.
 Cash inflows are also frequently realized from
salvage of equipment when the project is
terminated.
 Also, upon termination of a project, any working
capital that was tied up to the project can be
released to for use elsewhere and should be trayed
as cash inflow.
Cash Inflows




Cash Inflows:
Incremental revenues
Reduction in costs.
Salvage value
Release of working capital
Choosing a Discount Rate
 To use the net present value method, we must
choose some rate of return for discounting cash
flows to their present value.
 The firm’s cost of capital is usually regarded as
the most appropriate choice for the discount rate.
 The cost of capital is the average rate of return the
company must pay to its long term creditors for
the use of their funds.
Extended Example of the NPV Method
Example 3
 GorVodokanal has an opportunity to offer new
service to an industrial client, but has to purchase
supplies and equipment from a chemical
manufacturer in order to provide that service.
 The contract between all 3 parties is for 5 years
with an option for renew.
 GorVodokanal is responsible for all costs of
promotion and distribution of its new service.
 After careful study, GorVodokanal has estimated
that the following costs and revenues would be
associated with the new service:
Extended Example of the NPV Method
Cost of equipment needed
$60,000
Working capital needed
100,000
Overhaul of the equipment in four years
Salvage value of the equipment in five years
5,000
10,000
Annual revenue and costs:
Sales revenues
200,000
Cost of goods sold
125,000
Out of pocket operating costs (for salaries,
advertising, and other direct costs)
35,000
Extended Example of the NPV Method
 At the end of the five-year period, the working
capital would be released for investment elsewhere
if contract will not be renewed.
 GorVodokanal’s discount rate and cost of capital
is 20%.
 Would you recommend that GorVodokanal
undertakes this project?
Extended Example of the NPV Method
Sales revenue
Less cost of goods sold
Less out-of-pocket costs for salaries,
advertising, etc.
Annual net cash inflows
$200,000
125,000
35,000
$40,000
Extended Example of the NPV Method
Amount of
Cash
Flows
Present
Value of
Cash Flows
20%
Factor
Item
Year(s)
Purchase of equipment
Now
($60,000)
1
($60,000)
Working capital needed
Now
-100,000
1
-100,000
-5,000
0.482*
-2,410
40,000
2.991^
119,640
Overhaul of equipment
Annual net cash inflows
from sales of the product
Line
4
1-5
Salvage value of the
equipment
5
10,000
0.402*
4,020
Working capital released
5
100,000
0.402*
40,200
Net present value
$1,450
Extended Example of the NPV Method
 *From Present Value and ^Present Value of an
Annuity Tables
 Notice how working capital is handled in this
exhibit. It is counted as a cash outflow at the
beginning of the project and as a cash inflow when
it is released at the end of the project.
Discounted Cash Flows –The
Internal Rate of Return
Method
The Internal Rate of Return Method
 The internal rate of return (IRR) method can be
defined as the interest yield promised by an
investment project over its useful life.
 The IRR is computed by finding the discount rate
that equates the present value of a project’s cash
outflows with the present value of its cash inflows.
 In other words, the IRR is that discount rate that
will cause the NPV of a project to be equal zero.
The Internal Rate of Return Method
Example 4
 GorVodokanal is considering the purchase of
automatic water purification machine. At present,
water is purified in a small labor intensive
machine.
 The new machine would cost 16,950 and will have
a useful life of 10 years.
 The new machine would do the job much more
quickly and would result in labor savings of
$3,000 per year
The Internal Rate of Return Method
Initial cost
Life of the project (years)
Annual cost savings
Salvage value
$16,950
10
$3,000
0
The Internal Rate of Return Method
 To compute IRR promised by the new machine, we
must find the discount rate that will cause NPV of
the project to be zero.
 To do that, we need to divide the investment in the
project by the expected net annual cash inflow. This
computation will give us a factor from which the
IRR can be determined.
Factor of the IRR =
Investment
Required
Net annual cash
inflow
=
$16,950
= 5.65
$3,000
The Internal Rate of Return Method
 Thus, from our computations, the discount factor
that will equate a series of $3,000 cash inflows
with a present investment of $16,950 is 5.65.
 Now, we need to find this factor in Present Value
of an Annuity Table to see what rate of return it
represents.
 We should use the 10 period line in Present Value
of an Annuity Table since the cash flows for the
project continue for 10 years.
Present Value of an Annuity Table
4%
5%
6%
8%
10%
12%
14%
1
0.962
0.952
0.943
0.926
0.909
0.893
0.877
2
1.886
1.859
1.833
1.783
1.736
1.69
1.647
3
2.775
2.723
2.673
2.577
2.487
2.402
2.322
4
3.63
3.546
3.465
3.312
3.17
3.037
2.914
5
4.452
4.212
4.212
2.993
3.791
3.605
3.433
6
5.242
5.076
4.917
4.623
4.355
4.111
3.889
7
6.002
5.786
5.582
5.206
4.868
4.564
4.288
8
6.733
6.463
6.21
5.747
5.335
4.968
4.639
9
7.435
7.108
6.802
6.247
5.759
5.323
4.946
10 8.111
7.722
7.36
6.71
6.145
5.650
5.216
11
8.306
7.887
7.139
6.495
5.988
5.453
Period
8.76
The Internal Rate of Return Method
 As we can see from Present Value of Annuity Table
the internal rate of return promised by the water
purification machine project is 12%.
 We can verify this by computing the project’s net
present value using a 12% discount return
The Internal Rate of Return Method
Item
Annual cost savings
Initial investment
Net present value
Amount
of Cash 12%
Year(s) Flows
Factor
1-10
Now
Present
Value of
Cash
Flows
$3,000
5,650*
$16,950
-16,950
1,000
-16,950
$0
The Internal Rate of Return Method
 Once the IRR has been computed, what does the
manager should do with the information?
 The IRR should be compared to the company’s
required rate of return, which is the minimum
rate of return that an investment project must
yield to be acceptable.
 If the IRR is equal or greater than the required
rate of return, then the project is acceptable.
 If the IRR is less than the required rate of return,
then the project is rejected.
The NPV of Return Method
 The NPV method can be used to compare
competing investment projects in two ways.
1.
total-cost approach
2.
incremental-cost approach
The Total Cost Approach
Example 5
 GorVodokanal has one of its pipe networks in poor
condition. This pipe network can be renovated at
an immediate cost of $20,000. Further repairs
and maintenance will be needed five years from
now at a cost of $8,000. In all, this pipe network
will be usable for 10 years if this work is done. At
the end of 10 years, the pipe network will be
scrapped at a salvage value of $6,000. The scrap
value now is $7,000. It will cost $30,000 each year
to operate pipe network, and revenues will total
$40,000 annually
The Total Cost Approach
 Alternative: GorVodokanal can purchase a new
pipe network at a cost of $36,000. The new pipe
network will have a life of 10 years and will
require some repairs at the end of 5 years and will
amount to $3,000. At the end of 10 years, it is
estimated that the scrap value would be $6,000.
It will cost $21,000 each year to operate the pipe
network, and revenues will total $40,000
annually.
 GorVodokanal requires a return of at least 18% on
all investment capital.
The Total Cost Approach
New Pipe
Network
Annual revenues
Annual cash operating costs
Net annual cash inflows
Old Pipe
Network
$40,000
$40,000
21,000
30,000
$19,000
$10,000
The Total Cost Approach
Item
Amount
of Cash
Flows
Year(s)
18%
Factor*
PV of
Cash
Flows
Buy the new pipe
network:
Initial investment
Now
($36,000)
1.000
($36,000)
5
($3,000)
0.437
($1,311)
Net annual cash inflows
1-10
19,000
4.494
85,386
Salvage of the old network
Now
7,000
1.000
7,000
10
6,000
0.191
1,146
Repairs in 5 years
Salvage of the new network
Net present value
$56,221
The Total Cost Approach
Item
Amount
of Cash
Flows
Year(s)
18%
Factor*
PV of
Cash
Flows
Keep the old pipe
network:
Initial repairs
Repairs in five years
Net annual cash inflows
Salvage of the old network
Net present value
Now
($20,000)
1.000
($20,000)
5
($8,000)
0.437
($3,494)
1-10
10,000
4.494
44,940
10
6,000
0.191
1,146
$22,590
The Total Cost Approach
NPV of the New Pipe Network
$56,221
NPV of the Old Pipe Network
$22,590
NPV in favor of buying the New Network
$33,631
The Incremental Cost Approach
 When only two alternatives are being considered,
the incremental cost approach offers a simpler
and more direct decision.
 Unlike the total cost approach, it focuses only on
differential costs.
The Incremental Cost Approach
Item
Incremental investment required
to purchase the new pipe network
Repairs in five years avoided
Amount
of Cash
Year(s) Flows
18%
PV of
Factor Cash
*
Flows
Now ($16,000)
1 ($16,000)
5
$5,000
0.437
$2,185
Increased met annual cash
inflows
1-10
$9,000
4.494
$40,000
Salvage of the old network
Now
7,000
1
7,000
Difference in salvage value
in 10 years
10
-0-
NPV in favor of buying the new
Network
-
-033,631
The Ranking of Investment Projects
 When considering investment opportunities,
managers must make two types of decisions:
1. screening, and
2. preference decisions.
 Screening decisions pertain whether or not
proposed investments are acceptable.
 Preference decisions come after screening
decisions and attempt to rank selected projects in
terms of preference.
The Ranking of Investment Projects
Internal rate of Return Method
 When using IRR to rank competitive investment
projects, the preference rule is: The higher the
IRR, the more desirable the project.
 For example, an investment project with an IRR of
18% is preferable to another project that promises
a return of only 15%.
The Ranking of Investment Projects
Net Present Value Method
 If the NPV method is used to rank projects, the
NPV of one project cannot be compared directly to
NPV of another project unless the investments in
the projects are of equal size.
The Ranking of Investment Projects –NPV
Method
Example 6
Investment
A
B
($80,000)
($5,000)
Present value of cash inflows
81,000
6,000
Net present value
$1,000
$1,000
Investment required
The Ranking of Investment Projects –NPV
Method
 Each project has a net present value of $1,000,
but they are not equally desirable.
 The project requiring an investment of only
$5,000 is much more desirable (especially when
funds are limited) than the project requiring
$80.000.
 However, there is a way to compare the two
projects on a valid basis – its called Profitability
Index.
The Ranking of Investment Projects –NPV
Method
 To calculate profitability index we need to divide
the present value of all cash inflows by the
investment required.
 The formula for profitability index is:
Present value of cash inflows
Profitability
=
index
Investment required
The Ranking of Investment Projects –NPV
Method
Investment
A
B
Present value of cash inflows (a)
$81,000
$6,000
Investment required (b)
$80,000
$5,000
Profitability index (a)/(b)
1.01
1.20
Other Approaches to Capital
Budgeting Decisions
1. The Payback Method
2. The Simple Rate of Return
The Payback Method
 The payback method centers on a spam of time
known as the payback period.
 The payback period is the length of time until the
sum of an investment’s cash flows equals its cost.
 The payback period rule is to take a project if its
payback is less than some prespecified number of
years.
 The payback period is a flawed criterion, primarily
because it ignores risk, the time value of money,
and cash flows beyond the cutoff point.
The Payback Method
Example 7
 GorVodokanal needs a new piece of equipment
and considers two machines: machine A and
Machine B.
 Machine A costs $15,000 and will reduce
operating costs by $5,000 per year.
 Machine B costs $12,000 and will also reduce
operating costs by $5,000 per year
Which Machine should be purchased?
The Payback Method
Payback period =
Machine A
Payback period
Machine B
payback period
Investment Required
Net annual cash
inflow
$15,000
=
=
3.0 years
=
2.4 years
$5,000
=
$12,000
$5,000
GorVodokanal should purchase machine B, since it has
a shorter payback period than A.
Evaluation of the Payback Method
 The payback method is not a true measure
of the profitability of an investment.
 Managers should not make investment
decisions based on this method alone.
Instead it should be used as a screening tool
to determine which projects are worth
further consideration.
Evaluation of the Payback Method
 Payback method does not take into account
differences between useful lives between
investments.
 Furthermore, payback method does not
consider the time value of money. A cash
inflow to be received several years in the
future is weighed equally with a cash inflow
received today.