Capital Budgeting
Professor Thomson
Fin 3013
Capital Budgeting
• Should you . . .
– Build a new factory
– Upgrade your current factory
– Start a marketing campaign
– Install in a new computer system
• How do we determine if these are good
investments?
2
Review: Goal of Financial Manager
• The goal of the Financial Manager is to
maximize the current stock price
• So we should ask, “Will undertaking this
investment increase the current share
price?”
• Another way to ask this is, “Does the
increase in my Cash Flows due to this
project, more than compensate for the
costs of this project?”
3
Cash Flow Timing
• The cash flows (revenues) from a project
flow over time (I.e. in the future), while
the investment cost is today.
• This discounted cash flows have to cover
the cost of the project to ensure that the
marginal benefits exceed the marginal
cost of investing in the project.
4
The Capital Budgeting Decision
Process
The capital budgeting process involves three
basic steps:
1. Generating long-term investment proposals;
2. Reviewing, analyzing, and selecting from the
alternative proposals, and
3. Implementing and monitoring the proposals
that have been selected.
5
Managers should focus on the investment
decision. After suitable projects have been
identified, a following decision is how to to pay
for it (the financing decision).
A Capital Budgeting Process
Should:
Focus on cash flow;
Account for the time value of money;
Account for risk;
Rank competing projects appropriately, and
6
Lead to investment decisions that maximize
shareholders’ wealth.
Capital Budgeting Decision
Techniques
Accounting rate of return (ARR): focuses on project’s impact on
accounting profits (Not covered in this course)
Payback period: most commonly used
Net present value (NPV): best technique
theoretically; difficult to calculate realistically
Internal rate of return (IRR): widely used with
strong intuitive appeal
Profitability index (PI): related to NPV
7
Accounting Rate Of Return (ARR)
Can be computed from available accounting data
ARR 
Average pr ofits afte r taxes
Average in vestment
• Need only profits after taxes and depreciation
• Average profits after taxes are estimated by
subtracting average annual depreciation from the
average annual operating cash inflows.
Average profits = Average annual
operating cash inflows
after taxes
8
Average annual
depreciation
ARR uses accounting numbers, not cash flows; no
time value of money.
Payback Period
The payback period is the amount of time required
for the firm to recover its initial investment.
• If the project’s payback period is less than the
maximum acceptable payback period, accept
the project.
• If the project’s payback period is greater than
the maximum acceptable payback period,
reject the project.
9
Management determines maximum acceptable
payback period. It’s not clear how this relates to
wealth maximization
Global Wireless
• Global Wireless is a worldwide provider of
wireless telephony devices.
• Global Wireless evaluating major expansion of
its wireless network in two different regions:
• Western Europe expansion
• A smaller investment in Southeast U.S. to establish a
toehold
Western Europe ($ millions)
10
Southeast U.S. ($ millions)
Initial outlay
-$250
Initial outlay
-$50
Year 1 inflow
$35
Year 1 inflow
$18
Year 2 inflow
$80
Year 2 inflow
$22
Year 3 inflow
$130
Year 3 inflow
$25
Year 4 inflow
$160
Year 4 inflow
$30
Year 5 inflow
$175
Year 5 inflow
$32
Computing payback
Time
0
1
2
3
4
5
11
CF
-250
35
80
130
160
175
Cumulative CF
-250
-215
-135
-5
155
330
The project pays back during the 4th year. We
prorate the remaining CF to be recovered to the
cash generated that year to compute the fraction
of a year.
Prorating the final year’s CF
fraction 
CF remaining
CF that year

5
 0 . 0313
1160
So, the payback period for this project is
4.0313 years.
12
Calculating Payback Periods for
Global Wireless Projects
• Management selects a 2.75 years payback period.
• Western Europe project has initial outflow of -$250
million,
• But cash inflows over first 3 years only $245 million.
• Global Wireless would reject Western Europe project.
• Southeast U.S. project: initial outflow of -$50
million
• Cash inflows over first 2 years cumulate to $40
million.
• Project recovers initial outflow after 2.40 years.
• Total inflow in year 3 is $25 million. We estimate that
the projects generates $10 million in year 3 in 0.40
years ($10 million  $25 million).
13
• Global Wireless would accept the project.
Pros and Cons of Payback Method
Advantages of payback method:
• Computational simplicity
• Easy to understand
• Focus on cash flow
Disadvantages of payback method:
14
• Does not directly account for time value of money
• Does not account properly for risk
• Cutoff period is arbitrary (gives no value to CF’s
that occur after the payback cutoff)
• Does not link to value-maximization
Discounted Payback Period
• Discounted payback accounts for time value.
• Apply discount rate to cash flows during
payback period (say 3 years).
• Still ignores cash flows after payback period
• Global Wireless uses an 18% discount rate.
PV Factors
(18%)
Western Europe
project ($million)
Southeast U.S.
project
($million)
PV Year 1 inflow
0.8475
$29.7
$15.2
PV Year 2 inflow
0.7182
$57.4
$15.8
PV Year 3 inflow
0.6086
$79.1
$15.2
Cumulative PV
--
$166.2
$46.2
Accept / reject
--
Reject
Reject
Item
15
NPV: Net Present Value
• The theoretically correct investment criteria is:
If NPV > 0, then invest
NPV = PV of Cash Flows – Investment Cost
If the NPV > 0 then the current stock price of the
firm should increase if we undertake the project
(and vice versa)
NPV measure the wealth increase from
implementing the project
The marginal cost is the investment costs and the
marginal benefits are the discounted cash flows
16
Using NPV
• To use the NPV criterion we
need to know:
1. The investment cost
2. The incremental Cash Flows due to
the project (these are often the cash
flows of the project).
3. The appropriate discount rate to apply
to the Cash Flows which reflect the risk
of the project
17
Net Present Value
NPV  CF 0 
CF 1
(1  r )

CF 2
(1  r )
2

CF 3
(1  r )
3
 ... 
CF N
(1  r )
N
A key input in NPV analysis is the discount rate.
r represents the minimum return that the project
must earn to satisfy investors.
r varies with the risk of the project which is often
related to the risk of the firm.
18
Calculating NPVs for Global
Wireless Projects
• Assuming Global Wireless uses 18% discount rate,
NPVs are:
Western Europe project: NPV = $75.3 million
NPV W estern
Europe
 $ 75 . 3   250 
35

(1 . 18 )
80
(1 . 18 )
2

130
(1 . 18 )
3

160
(1 . 18 )
4

175
(1 . 18 )
5
Southeast U.S. project: NPV = $25.7 million
NPV Southeast
U .S .
 $ 25 . 7   50 
18
(1 . 18 )

22
(1 . 18 )
2

25
(1 . 18 )
3

30
(1 . 18 )
4

32
(1 . 18 )
5
Should Global Wireless invest in one project or both?
19
Computing the NPV on the HP10BII
• Set calculator to correct P/YR
• Enter the CF’s.
• Usually the time period 0 cash flow will be
negative
• Enter the discount rate as I/YR
• Press the
20
Demonstration
P/YR=1
t
0
1
2
3
4
5
CF
-250
35
80
130
160
175
Type 18, press I/YR
Press  NPV = 75.26
21
Pros and Cons of Using NPV as
Decision Rule
NPV is the “gold standard” of investment decision
rules.
Key benefits of using NPV as decision rule:
• Focuses on cash flows, not accounting earnings
• Makes appropriate adjustment for time value of money
• Can properly account for risk differences between
projects
Though best measure, NPV has some drawbacks:
• Lacks the intuitive appeal of payback, and
• Doesn’t capture managerial flexibility (option value) well.
22
NPV Profile
• As we increase the discount rate, the NPV
will fall.
• We give a special name for the discount
rate that causes NPV to exactly equal zero
• The Internal Rate or Return (IRR) is the
discount rate that cause the NPV to equal
zero
• It is the return that money invested in the
project earns
23
NPV Profile for Global Wireless
250
200
NPV
150
100
IRR
50
0
-50
5%
10%
15%
20%
25%
Discount Rate
24
30%
35%
40%
Internal Rate of Return
Internal rate of return (IRR) is the discount rate that
results in a zero NPV for the project:
NPV  0  CF 0 
CF 1
(1  r )

CF 2
(1  r )
2

CF 3
(1  r )
3
 .... 
CF N
(1  r )
N
• IRR found by computer/calculator or manually by
trial and error.
The IRR decision rule is:
• If IRR is greater than the cost of capital, accept
the project.
25
• If IRR is less than the cost of capital, reject the
project.
Calculating IRRs for Global
Wireless Projects
Global Wireless will accept all projects with at least
18% IRR.
Western Europe project: IRR (rWE) = 27.8%
0   250 
35
(1  rW E )

80
(1  rW E )
2

130
(1  rW E )
3

160
(1  rW E )
4

175
(1  rW E )
Southeast U.S. project: IRR (rSE) = 36.7%
0   50 
26
18
(1  rSE )

22
(1  rSE )
2

25
(1  rSE )
3

30
(1  rSE )
4

32
(1  rSE )
5
5
Demonstration: Compute IRR
P/YR=1
t
0
1
2
3
4
5
CF
-250
35
80
130
160
175
Press  IRR/YR = 27.79
27
IRR v. NPV
• IRR and NPV are in some ways, different
ways of saying the same thing
• By inspection of the NPV profile we see
that if the IRR > required rate of return,
the NPV is positive, so either criteria
would say to accept the project as one
that build wealth. (The converse is also
true).
28
Advantages and Disadvantages of IRR
Advantages of IRR:
• Properly adjusts for time value of money
• Uses cash flows rather than earnings
• Accounts for all cash flows
• Project IRR is a number with intuitive appeal
Disadvantages of IRR
• “Mathematical problems”: multiple IRRs, no real solutions
• Scale problem
29
• Timing problem
Multiple IRRs
NPV ($)
IRR
NPV>0
NPV>0
NPV<0
NPV<0
Discount
rate
IRR
When project cash flows have multiple sign changes,
there can be multiple IRRs.
30
With multiple IRRs, which do we compare with the
cost of capital to accept/reject the project?
No Real Solution
Sometimes projects do not have a real IRR solution.
Modify Global Wireless’s Western Europe project to
include a large negative outflow (-$355 million) in
year 6.
• There is no real number that will make NPV=0,
so no real IRR.
Project is a bad idea based on NPV. At r =18%,
project has negative NPV, so reject!
31
Competing projects
• Competing projects are those which
cannot all be chosen, even if all appear
desirable. For example, say you have a
chuck of commercial property and you are
considering
– Shopping mall
– Office building
– Apartments
• You cannot do them all, so can choose
only one of the alternatives
32
Funding or other constraints
• If a firm feels it can only raise a limited
amount of funds, or only has the
managerial or other talent to take on
some of the available projects, the
projects will have to be ranked
• Best solution, choose the set of projects
that will maximize the NPV of the sum of
the projects
• This is called the “knapsack” problem of
management science
33
Conflicts Between NPV and IRR
NPV and IRR do not always agree when ranking
competing projects.
The scale problem: Small scale projects often have
higher IRR’s
Project
IRR
NPV (18%)
Western Europe
27.8%
$75.3 mn
Southeast U.S.
36.7%
$25.7 mn
• Southeast U.S. project has higher IRR, but
doesn’t increase shareholders’ wealth as much as
Western Europe project.
34
NPV Profile for Global Wireless Projects
250
West Europe
200
SE US
NPV
150
100
50
0
-50
5%
35
10%
15%
20%
25%
Discount Rate
30%
35%
40%
Often larger scale projects are
disadvantaged by using IRR
• Example – you have land that could be
developed for parking. The alternatives,
listed by investment cost are:
– Gravel parking lot
– Paved parking lot
– Parking garage
• IRR will tend to favor the one with the
lowest capital cost, that generates some
funds very quickly
36
Long vs. Short Term Projects
NPV
Long-term
project
Short-term
project
IRR = 17%
13% 15%
17%
Discount
rate
IRR = 15%
• The NPV of long-term project is more sensitive to the
discount rate than the NPV of the short-term project is.
37
• Long-term project has higher NPV if the cost of capital is
less than 13%. Short-term project has higher NPV if the
cost of capital is greater than 13%.
Which is a more effective wealth
builder (your alternative rate = 10%)?
• You can lend your brother $100 who will
pay you back $100.06 (i.e. an extra six
cents) tomorrow
• Or lend your sister $100 for a year who
will pay you back $120 after one year
• What is the EAR of each investment?
• P/YR=363 I/YR(PV=100, FV=100.05,
N=1) = 21.90
• Press  EFF% = 24.47
38
Profitability Index
Calculated by dividing the PV of a project’s cash
inflows by the PV of its outflows:
CF 1
PI 
(1  r )

CF 2
(1  r )
2
 ... 
CF N
(1  r )
CF 0
N

NPV  CF 0
CF 0
Decision rule: Accept project with PI > 1.0, equal to NPV > 0
Project
PV of CF (yrs1-5)
Initial Outlay
PI
Western Europe
$325.3 million
$250 million
1.3
Southeast U.S.
$75.7 million
$50 million
1.5
• Both projects’ PI > 1.0, so both acceptable if
independent.
39
Like IRR, PI suffers from the scale problem.
Capital Budgeting
Methods to generate, review, analyze, select, and
implement long-term investment proposals:
Accounting rate of return
Payback Period
Discounted payback period
Net Present Value (NPV)
Internal rate of return (IRR)
Profitability index (PI)
Net Present Value
Compute the present value of a project’s cash
inflows and outflows
Discounting cash flows accounts for the time value of
money.
Choosing the appropriate discount rate accounts for
risk.
NPV  CF 0 
41
CF 1
(1  r )

CF 2
(1  r )
2

CF 3
(1  r )
3
 ... 
Accept projects if NPV > 0.
CF N
(1  r )
N