CHAPTER 12
THE CAPITAL BUDGETING
DECISION
Capital Expenditures Decision
 CE usually require initial cash outflows in
hope of future benefits or cash inflows
 Examples: new plant construction,
acquisition of business, purchase of new
machine, etc.
 Projects often last for more than a year
 The longer the time horizon, the greater the
uncertainty
Areas of Uncertainty in CE
Decision





Expected cash flows
Product life
Interest rates
Economic conditions
Technological change
Capital Budgeting
 To see if the CE is economically acceptable
- if it creates or adds value to the firm
 To examine the CE from an investment
perspective
 The basic concept is to determine if it
makes sense to commit to an initial cash
outflows in order to receive future cash
inflows
Example - Project A
Year
Net Cash Flows ($)
0
-10000
1
5000
2
5000
3
2000
Project A cont’
Year
PVIF at
10%
0
Net cash
flows ($)
-10000
Present
Value ($)
-10000
1
5000
0.9091
4546
2
5000
0.8265
4133
3
2000
0.7513
1503
NPV =
182
Project Evaluation
 Discount Rate = Cost of Capital
 Positive NPV indicates that the yield or rate
of return on the project exceeds the cost of
capital (thus add value to the firm)
 Project is financially acceptable when the
PV of the total cash inflows greater than the
PV of the total cash outflows ( +ve NPV)
Example - Project B
Year
Net Cash Flows ($)
0
-10000
1
2000
2
5000
3
5000
Project B cont’
PVIF at
10%
0
Net cash
flows ($)
-10000
Present
Value ($)
-10000
1
2000
0.9091
1818
2
5000
0.8265
4133
3
5000
0.7513
3757
NPV =
-292
Year
Project B cont’
 Both projects A and B require an initial
capital outflow of $10000
 Both of them will generate a total return of
$12000 in the next three years
 However, project A has a positive NPV
while project B has a negative NPV
 Why?
Cash Flows of Project A & B





Project A
Yr 0
Yr 1
Yr 2
Yr 3
-$10,000
$5,000
$5,000
$2,000





Project B
Yr 0
Yr 1
Yr 2
Yr 3
-$10,000
$2,000
$5,000
$5,000
Reasons
 For Project A, the cash inflows mainly
occur at the first two years
 For Project B, the cash inflows mainly
come in at the last two years
 Due to the time value of money, money
received earlier has higher value than that
received later
 Hence, Project B is not acceptable (negative NPV)
Flexibility of NPV - Using
various discount rates across time
 The longer the time horizon, the higher the
risk
 Sometimes, we may have to use a higher
discount rate for income in the latest year
 Instead of 10%, we may use 12% to
discount the latest cash inflow at the end of
third year
 NPV method provides such a flexibility
Flexibility of NPV – allow
reversal of cash flows
 NPV method can be applied to any type of
cash flows even cash flows with reversal
 Cash flows with reversal means that there
are more than one cash outflows
 Example: a 2-year project with cash flows:
 Yr 0 – Initial cash outflow – (-$1000)
 Yr 1 – Cash inflow – (+$5000)
 Yr 2 – Another cash outflow – (-$3000)
Profitability Index
 It is a variation of the NPV method
 Profitability index (PI)
= PV of cash inflows/PV of cash outflows
 If PI > 1, PV of cash inflows is greater than
PV of cash outflows. That is NPV > 0
 Hence project with PI > 1 is financially
viable
Another method - IRR
 IRR = Internal Rate of Return
 The IRR is the discount rate at which the
PV of cash inflows = PV of the cash outflows
 I.E., IRR is the discount rate which makes
the NPV = 0
 Project is financially acceptable when the
IRR is greater than the cost of capital
IRR of Project A
Year
PVIF at
11.16%
0
Net cash
flows ($)
-10000
Present
Value ($)
-10000
1
5000
0.8996
4498
2
5000
0.8093
4046
3
2000
0.7280
1456
NPV =
0
IRR of Project B
Year
PVIF at
8.53%
0
Net cash
flows ($)
-10000
Present
Value ($)
-10000
1
2000
0.9214
1843
2
5000
0.8490
4245
3
5000
0.7823
3912
NPV =
0
Project Evaluation
 Project A has an IRR of 11.16% which is
higher than the cost of capital, 10%. Hence
project A is financially acceptable.
 Project B has an IRR of 8.53% which is
lower than the cost of capital, 10%. Hence
project B is financially not acceptable.
Why bother to use IRR?
 Since both NPV and IRR generate similar
results, why bother to use IRR
 Yield derived from IRR may be more
comprehensible than the absolute value
derived from NPV
 In fact, we use IRR when we cannot use the
cost of capital (the risk of the project differs
from the risk of the firm)
Limitations of IRR method
 A single discount rate (the IRR) throughout
the project life – inability to account for
cash flows of different risk levels
 Possibly unrealistic to assume reinvestment
of the generated cash inflow at the IRR
 Inapplicable when more than one reversal
of cash flows exists – will generate multiple
IRRs in that case
Graphical Illustration of NPV
and IRR
See Examples Below
Cash Flows of Investment A&B





Investment A
Yr 0
-10000
Yr 1
5000
Yr 2
5000
Yr 3
2000







Investment B
Yr 0
-10000
Yr 1
1500
Yr 2
2000
Yr 3
2500
Yr 4
5000
Yr 5
5000
NPV Profile – NPVs at different
Discounting rate
NPV
6000
INV. B
4000
2000
0
INV. A
5
IRR= 14.33%
15
10
IRR= 11.16%
Discount Rate
Cash Flows of Investment B & C







Investment B
Yr 0
-10000
Yr 1
1500
Yr 2
2000
Yr 3
2500
Yr 4
5000
Yr 5
5000





Investment C
Yr 0
-10000
Yr 1
9000
Yr 2
3000
Yr 3
1200
NPV Profile with crossover
NPV
6000
Crossover point
INV.B
4000
2000
0
INV.C
5
IRR= 14.33%
10
Discount Rate
15
20
IRR= 22.49%
Where are we?
 How to raise capital?
 We have learned the three ways of raising longterm capital for a firm. What are they?
 How to use the capital to generate more money?
 Underlying principle – to generate an investment
return that is greater than cost of capital
 The lowest required rate of return = cost of
capital
Project Valuation
 Similar to the valuation of financial instruments,
we must assess the fair market value for any
capital expenditure project.
 The highest price we pay is the present value of
expected cash flows (derived from the project)
discounted at the rate equivalent to the cost of
capital
 Basic concept – lowest rate of return = highest
price to be paid
Cash Flows Determination
 Net of tax i.e. after tax net cash flow
 Gross of all financing costs (they have been
reflected in the discount rate)
 Shortfalls:
- Future projection may base on extrapolation
- Bias built into the cash flows estimation
- Over/under estimate of the inflation
- Neglect other qualitative factors such as better
corporate image, fairer treatment of employee, etc
Capital Rationing
 Management, for some reasons, may
impose a dollar constraint in certain kind of
investment
 Projects become mutually exclusive
 Project is selected based on the amount of
benefit generated by the project
 That is, projects with the greatest NPV or
the highest IRR
Table 12-7
Capital rationing
Net
Project Investment
•Capital
rationing
•solution
A $2,000,000
B 2,000,000
C 1,000,000
•Best
•solution
D
E
F
Total
Present
Investment
Value
400,000
380,000
$5M
150,000
1,000,000
100,000
800,000
$6.8M 40,000
800,000
(30,000)
.