Capital
Budgeting
Techniques
What is Capital Budgeting?
The process of identifying, analyzing,
and selecting investment projects
whose returns (cash flows) are
expected to extend beyond one year.
Project Classifications
•
Independent Projects: Projects whose cash flows are not
affected by decisions made about other projects.
•
Mutually Exclusive Projects: A set of projects where the
acceptance of one project means the others cannot be
accepted. e.g. buying computers of different brands.
Dependent( contingent)projects: e.g. buying a new
machine may force to extend the construction
•
3
Project Evaluation:
Alternative Methods
– Payback Period (PBP)
– Net Present Value (NPV)
– Internal Rate of Return (IRR)
– Profitability Index (PI)
Net Cash Flows for
Project S and Project L
Expected After-Tax
^
Net Cash Flows, CF
t
Year (T)
0a
1
2
3
4
Project S
$(3,000)
1,500
1,200
800
300
Project L
$(3,000)
400
900
1,300
1,500
5
What is the Payback Period?
The length of time before the original cost of an
investment is recovered from the expected cash
flows or . . .
How long it takes to get our money back.
 Unre cov ered cost at start 
Number
of
years
before

  of full - recovery year 


Payback  PB  
full recovery of

  T otal cash flow during 
 original investment  

full
recovery
year


6
Payback Period for Project S
0
Net
Cash Flow
1
2
PBS
3
4
-3,000
1,500
1,200
800
300
Cumulative
-3,000
Net CF
-1,500
-300
500
800
PaybackS = 2 + 300/800 = 2.375 years
7
Payback Period for Project L
0
1
2
3 PB
L
4
Net
Cash Flow - 3,000
400
900
1,300
1,500
Cumulative
- 3,000
Net CF
- 2,600
- 1,700
- 400
1,100
PaybackL = 3 + 400/1,500 = 3.3 years
8
Net Present Value (NPV)
NPV is the present value of an investment project’s
net cash flows minus the project’s initial cash
outflow.
CF1
NPV =
(1+k)1
+
CF2
(1+k)2
CFn
- ICO
+...+
n
(1+k)
9
Proposed Project Data
Julie Miller is evaluating a new project for her firm,
Basket Wonders (BW). She has determined that
the after-tax cash flows for the project will be
$10,000; $12,000; $15,000; $10,000; and $7,000,
respectively, for each of the Years 1 through 5.
The initial cash outlay will be $40,000.
10
NPV Solution
Basket Wonders has determined that the appropriate
discount rate (k) for this project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1
(1.13)2
(1.13)3
$10,000 $7,000
+
$40,000
4
5
(1.13)
(1.13)
11
NPV Solution
NPV =
$10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $
7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$
7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428
12
NPV Acceptance Criterion
The management of Basket Wonders has determined that
the required rate is 13% for projects of this type.
Should this project be accepted?
No! The NPV is negative. This means that the project
is reducing shareholder wealth. [Reject as NPV < 0 ]
13
Internal Rate of Return (IRR)
IRR is the discount rate that equates the present
value of the future net cash flows from an
investment project with the project’s initial
cash outflow.
CF1
CF2
CFn
+
+...+
ICO =
1
2
(1+IRR)
(1+IRR)
(1+IRR)n
IRR Solution
$10,000
$12,000
$40,000 =
+
+
(1+IRR)1
(1+IRR)2
$15,000
$10,000
$7,000
+
+
(1+IRR)3
(1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the
discounted cash flows to equal $40,000.
IRR Solution (Try 10%)
$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444
[Rate is too low!!]
$
IRR Solution (Try 15%)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841
[Rate is too high!!]
$
IRR Solution (Try 15%)
NPV at Lower Rate (10%)
NPV = PV - ICO
NPV = $ 41,444 - $ 40,000 = $ 1,444
NPV at Higher Rate (15%)
NPV = PV - ICO
NPV = $ 36,881 - $ 40,000 = $ - 3159
IRR Solution
IRR= LR + NPv L
X
(HR – LR)
NPVL – NPvH
19
IRR Solution
IRR= 10 +
1444
x (15 – 10)
1444 – (-3159)
IRR= 10 +
1444 x 5
4603
IRR= 10 + 0.3137 x 5
IRR= 10+ 1.57 = 11.57%
20
Profitability Index (PI)
PI is the ratio of the present value of a
project’s future net cash flows to the
project’s initial cash outflow.
PI = PV / ICO
PI Acceptance Criterion
PI
= $38,572 / $40,000
= .9643
Should this project be accepted?
No! The PI is less than 1.00. This means
that the project is not profitable. [Reject as PI
< 1.00 ]
Assignment
Calculate NPV,PBP,IRR and PI for the
following projects. Which project
should be selected.(discount rate =13%)
Years
Project A
Project B
0
$ 28,000
$ 20,000
1
8000
5000
2
8000
5000
3
8000
6000
4
8000
6000
5
8000
7000
6
8000
7000
7
8000
7000