Basics of
Capital Budgeting
An Overview of Capital Budgeting
Capital Budgeting
 Capital budgeting is the process of analyzing potential
expenditures on fixed assets and deciding whether the
firm should undertake those investments.
 Capital budgeting = Strategic asset allocation
 Capital budgeting decision = Strategic long-term
investment decision
Capital Budgeting Process
 Determine the cost of the project.
 Estimate the expected cash flows from the project and
the riskiness of those cash flows.
 Determine the appropriate cost of capital at which to
discount the cash flows.
 Determine the present values of the expected cash
flows and of the project.
Investment Criteria
Evaluation of Decision Criteria
 Does it consider all cash flows throughout the entire




life of a project?
Does it consider the time value of money?
Does it consider the risk?
Does it provide information on whether you are
creating value for the firm?
When it is used to select from a set of mutually
exclusive projects, does it choose the project which
maximizes the wealth of the shareholders?
Example
 The firm is considering a new project with the
following estimated cash flows:
 Year 0:




CF = -158,000
Year 1: CF = 54,200; NI = 12,100
Year 2: CF = 66,900; NI = 5,800
Year 3: CF = 89,300; NI = 27,600
Average Book Value = 64,000
 The required return is 11%.
Net Present Value (NPV)
 The NPV of an investment is the difference
between the market value of a project and its cost.
 Steps
 The first step is to estimate the expected future cash
flows.
 The second step is to estimate the required return for
projects of this risk level.
 The third step is to find the present value of the cash
flows and subtract the initial investment.
 Decision Rule : If the NPV is positive, accept the
project. If the NPV is negative, reject the project.
Net Present Value (NPV): Example
 NPV = -$158,000 + 54,200/(1.11) + 66,900/(1.11)2 +
89,300/(1.11)3 = $10,421.76
 NPV is positive.
 Do you accept the project? Yes!
Net Present Value (NPV)
 NPV has no serious flaws.
 NPV selects the project which adds the most to
shareholder wealth.
 NPV is the preferred decision criterion.
 When there is a conflict between NPV and another
decision rule, you should always use NPV.
Payback Period
 The payback period is the length of time until the
sum of an investment’s cash flows equals to its
cost.
 Steps
 Estimate the cash flows.
 Subtract the future cash flows from the initial cost until
the initial investment has been recovered.
 Decision Rule: If the payback period is less than
some prespecified cutoff, accept the project.
Payback Period: Example
 Assume you will accept the project if it pays back
within two years.
 Year 1: $158,000 – 54,200 = $103,800
 Year 2: $103,800 – 66,900 = $36,900
 Year 3: $36,900/89,300=0.41
 The project pays back in year 2.41 years.
 The payback period is more than the prespecified
cutoff.
 Do you accept the project? No!
Advantages and Disadvantages
of Payback Period
 Advantages
 Easy to understand
 Adjusts for uncertainty
of later cash flows
 Biased toward liquidity
 Disadvantages
 Ignores the time value of
money
 Requires an arbitrary
cutoff point
 Ignores cash flows
beyond the cutoff date
 Biased against long-term
projects, such as research
and development, and
new projects
Discounted Payback Period
 The discounted payback period is the length of
time until the sum of an investment’s discounted
cash flows equals its cost.
 Decision Rule: If the discounted payback period is
less than some prespecified cutoff, accept the
project.
Discounted Payback Period: Example
 Assume you will accept the project if it pays back
on a discounted basis in 2 years.
 Year 1: $158,000 – 54,200/1.111 = $109,171.17
 Year 2: $109,171.17 – 66,900/1.112 = $54,873.63
 Year 3: $54,873.63 / (89,300/1.113)= 0.84
 The project pays back in 2.84 years .
 The discounted payback period is more than the
prespecified cutoff.
 Do you accept the project? No!
Advantages and Disadvantages
of Discounted Payback Period
 Advantages
 Includes time value of
money
 Easy to understand
 Does not accept
negative estimated NPV
investments
 Biased towards liquidity
 Disadvantages
 May reject positive NPV
investments
 Requires an arbitrary
cutoff point
 Ignores cash flows
beyond the cutoff date
 Biased against longterm projects, such as
research and
development, and new
products
Average Accounting Return (AAR)
 The AAR is a measure of accounting profit relative
to book value.
 One form of the AAR is:
 Average net income / average book value
 Decision Rule: If the AAR exceeds a target AAR,
accept the project.
Average Accounting Return (AAR): Example
 Assume the firm requires an average accounting
return of 25%
 ($12,100 + 5,800 + 27,600) / 3 = $15,166.67
 AAR = 15,166.67 / 64,000 = 23.70%
 The AAR is less than the target AAR.
 Do you accept the project? No!
Advantages and Disadvantages
of AAR
 Advantages
 Easy to calculate
 Needed information will
usually be available
 Disadvantages
 Not a true rate of return;
time value of money is
ignored
 Uses an arbitrary
benchmark cutoff rate
 Based on book values,
not cash flows and
market values
Internal Rate of Return (IRR)
 The IRR is the discount rate that makes the
estimated NPV of an investment equal to zero.
 It is sometimes called the discounted cash flow
(DCF) return.
 Decision Rule: if the IRR exceeds the required
return, accept the project.
 It is the most important alternative to NPV.
 It is very popular in practice, more so than even the
NPV.
Internal Rate of Return (IRR): Example
 Trial and error or using a financial calculator or
using a spreadsheet.
 -158,000 + 54,200/(1+r) + 66,900/(1+r)2 +
89,300/(1+r)3 =0
 IRR = 14.45% > 11%
 The IRR exceeds the required return.
 Do you accept the project? Yes!
NPV Profile for the Project
60,000.00
50,000.00
IRR = 14.45%
40,000.00
NPV
30,000.00
20,000.00
10,000.00
0.00
(10,000.00)
0
0.02
0.04
0.06
0.08
0.1
0.12
(20,000.00)
(30,000.00)
Discount Rate
0.14
0.16
0.18
0.2
0.22
Summary of Decisions for the Project
 Do you accept the project?
 Net Present Value –Yes
 Payback Period – No
 Discounted Payback Period – No
 Average Accounting Return – No
 Internal Rate of Return – Yes
 The final decision should be based on the NPV.
 You should accept the project.
NPV vs. IRR
 NPV and IRR usually lead to identical decisions.
 The project’s cash flows must be conventional: the
first cash flow is negative and all the rest are
positive.
 The project must be independent: a project whose
cash flows are unaffected by the decision to
accept or reject some other project.
 Exceptions
 Nonconventional cash flows
 Mutually exclusive projects
IRR and Nonconventional Cash Flows
 When the cash flows change sign more than once, there is
more than one IRR.
 This is the multiple rates of return problem.
 You need to look at the NPV profile.
IRR and Mutually Exclusive Projects
 Mutually exclusive projects
 A set of projects of which only one can be
accepted.
 Decision rules
 NPV – choose the project with the higher NPV
 IRR – choose the project with the higher IRR
 You need to look at the NPV profile.
Mutually Exclusive Projects: Example
Period
Project A
Project B
0
$-1000
$-800
1
650
650
2
650
400
IRR
19.43%
22.17%
NPV
$128.10
$121.49
 The required return
for both projects is
10%.
 Which project should
you accept and why?
NPV Profiles
$350.00
IRR for A = 19.43%
$300.00
IRR for B = 22.17%
$250.00
Crossover Rate = 11.8%
NPV
$200.00
$150.00
A
$100.00
B
$50.00
$0.00
($50.00)
0
0.05
0.1
0.15
($100.00)
Discount Rate
0.2
0.25
0.3
Mutually Exclusive Projects: Example
 The crossover rate is the discount rate the makes the
NPVs of two projects equal.
 When there is a conflict between NPV and another
decision rule, you should always use NPV.
 If the required return is less than the crossover rate of
11.8%, then you should choose A.
 If the required return is greater than the crossover rate
of 11.8%, then you should choose B.
Advantages and Disadvantages
of IRR
 Advantages
 Closely related to NPV,
often leading to
identical decisions
 Easy to understand and
communicate
 Disadvantages
 May result in multiple
answers or not deal with
nonconventional cash
flows.
 May lead to incorrect
decisions in
comparisons of
mutually exclusive
investments
Modified Internal Rate of Return
(MIRR)
 The MIRR is a modification to the IRR.
 Steps:
 A project’s cash flows are modified by:




Discounting the negative cash flows back to the present.
Compounding cash flows to the end of the project’s life.
Combining the above two.
Compute the IRR on the modified cash flows.
 It avoids the multiple rate of return problem, but it is
unclear to interpret them.
Profitability Index (PI)
 The PI is the ratio of present value to cost.
 It is also called the benefit-cost ratio.
 It measures the present value of an investment per
dollar invested.
 Decision rule: If the PI exceeds 1, accept the project.
Advantages and Disadvantages of PI
 Advantages
 Disadvantages
 Closely related to NPV,
 May lead to incorrect
generally leading to
identical decisions
 Easy to understand and
communicate
 May be useful when
available investment
funds are limited
decisions in
comparisons of
mutually exclusive
investments
Capital Budgeting in Practice
 Firm use multiple criteria for evaluating a proposal.
 NPV and IRR are the most commonly used primary
investment criteria.
 Payback period is a commonly used secondary
investment criteria.
 Less commonly used were discounted payback period,
AAR and PI.