Capital Budgeting
Chapter 11
1
Introduction
• Planning in advance for capital expenditures.
• Process used by companies for making decisions on
long term projects.
• Importance of capital budgeting for a financial analyst
• Principles we’ll study here will be used for valuation of
projects or valuation of entire companies.
• Capital budgeting – proper planning helps achieve the
goal of maximizing shareholder wealth.
2
Capital Budgeting Process
• Capital budgeting process comprises of the
following steps:
– Generating an investment decision
– Forecasting cash flow for each project
– Scheduling and prioritizing projects
– Monitoring and auditing
3
Categories of Capital Budgeting
Projects
• Replacement Projects
– Maintaining the business
– Cost reduction
• Expansion projects
– Requires complex decision making
• New products and services
– Complex decision making
– High uncertainty
4
Important Definitions
• Independent Projects
– Independent projects basically mean that if analysis reveal that
it is profitable to do both projects A and B, we will do both of
them.
• Mutually Exclusive Projects
– A set of projects where only one project can be accepted. Even
if analysis reveals it is profitable to do projects A and B we can
only do one of them. Example: Warehouse – fleet of forklift,
conveyor belt system.
• Unlimited Funds vs. Capital Rationing
5
Company’s Investment Decisions
• Short term
–
–
–
–
–
T-bills
CD’s
Bank deposit
Shares
Other
• Long term
6
Why Investment decisions are so
important to analyze in the beginning?
• Two most important reasons:
– The value of investment is very large
– Irreversible
7
Tools of Capital Budgeting
1. Payback Period
– Simple Payback
– Discounted Payback period
2. NPV
3. IRR
4. MIRR
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1. Payback Period
a.
•
Simple Payback Period
Definition: Number of years it takes for project’s cumulative cash flows to recover the cost of the
project.
The sooner the cost is recovered the better it is.
Calculation (Example)
•
•
–
Suppose the firm requires cost to be recovered within 3 years.
•
Formula:
•
Years before full recovery + unrecovered cost at the start of the year
cash flow during full recovery year
•
•
•

•
Which project we would accept?
What if the two projects are mutually exclusive?
What if the two projects are independent?
What if cash flows are received evenly during the year?
Formula:
Original investment
cash inflows per period
Cut-off payback period: It is
the pre-determined
(desired) length of time for
an investment to be
recovered.
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a. Simple Payback Period
Advantages
1.
2.
3.
4.
Easy to calculate.
Easy to comprehend.
Easy to analyze.
Very good indicator of liquidity of a project.
Disadvantages
1.
2.
3.
4.
Ignores the principal of TVM.
Sets off unrealistic expectations.
Does not consider cash inflows after the original investment is
recovered.
Biased against long-term projects that take longer time periods to
become lucrative .
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b.
•
Discounted Payback Period
Definition: Number of years it takes for project’s cumulative discounted cash
flows to recover its costs.
or
Length of time required to recover original investment from the present value of
expected future cash flows.
•
Calculation (Example)
–
Suppose the firm requires cost to be recovered within 3 years.
•
Formula:
•
Years before full recovery + unrecovered cost at the start of the year
cash flow during full recovery year
•
•
•
Which project we would accept?
What if the two projects are mutually exclusive?
What if the two projects are independent?
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a. Discounted Payback Period
Advantages
1. A more realistic measure than simple pay back period.
2. Takes into account the principle of time value of money (PV
of cash inflows taken into consideration).
Disadvantages
1. Ignores cash flows beyond cut-off point.
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2. Net Present Value
a.
•
Net Present Value (NPV)
Definition: NPV is the present value of cash inflows minus the present value of
cash outflows.
Characteristics
A very important capital budgeting tool.
Helps firm assess the level of importance various capital budgeting projects
have.
•
•
•
–
–
•
Why doing such a thing is important?
Capital budgeting projects normally requires expenditures in millions and billions of dollars,
before embarking on any such project they want to be reasonably sure that the cash inflows
generated from the project will pay off project’s costs within a reasonable amount of time.
Firms generally can carry out multiple projects, capital budgeting tools like NPV
help firms choose the best among them.
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2. Net Present Value (contd.)
•
i.
•
•
ii.
Formula:
NPV = Present value of cash inflows - Present value of cash outflows
Cash outflows: As on today (PV)
Cash inflows: Discounted back (To find PV)
.
•
Decision Criteria (3 scenarios):
– NPV = Positive (Cash inflows than outflow) => Accept the project.
– NPV = Zero (Cash inflows than outflow) => Indifferent
– NPV = Negative (Cash inflows than outflow) => Reject the project.
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2. Net Present Value (contd.)
•
•
•
•
•
•
In case of:
Independent projects: NPV > 0 (Accept both projects or all within budget)
Mutually exclusive projects: Accept the project with highest positive NPV
Example:
Global Enterprises is considering two projects. Each project requires an initial
outlay of $100,000 and provides the following cash flows. The firm requires a
required ROR of 10% on both projects.
Project A:
Cash Outflow = 100,000
Cash Inflows: 1st year = 30,000
•
2nd year = 40,000
3rd year = 50,000
4th year = 60,000
2nd year = 30,000
3rd year = 30,000
4th year = 20,000
Project B:
Cash Outflow = 100,000
Cash Inflows: 1st year = 40,000
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2. Net Present Value (contd.)
•
Remember: For doing NPV analysis always make a timeline.
Advantages
1.
2.
3.
4.
Adjusts for the TVM.
Provides a straight forward method for controlling risk of competing projects, higher
risk cash flows can be discounted at higher costs whereas lower risk cash flows are
discounted at lower costs.
Tells whether the investment will increase firm’s value.
Considers all the cash flows.
Disadvantages
1.
2.
3.
May not be considered as simple or intuitive as some other methods.
Requires an estimate of cost of capital in order to calculate NPV.
Expressed in dollar terms, not as a percentage.
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3. IRR
• IRR stands for ‘Internal Rate of Return’.
• Concept:
– IRR quite simply tells you what is the return on a project.
– IRR is the discount rate at which NPV of a project is equal to
‘zero’.
– When we say NPV of a project is equal to ‘zero’ we mean PV of
cash inflows = PV of cash outflows.
• Definition:
IRR is the discount rate at which PV of cost is equal to PV of
future cash inflows.
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3. IRR
– We stated, “IRR is the discount rate at which NPV of a project is equal
to zero”.
– Using the NPV formula
– In IRR we calculate the discount rate, the ‘r’ at which NPV = 0
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3. IRR
• Decision Criteria
• For Independent Projects
IF IRR > cost of capital => accept the project
IF IRR < cost of capital => reject the project
• For Mutually Exclusive Projects
Accept the project with highest IRR provided IRR
for the project is greater than cost of capital.
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3. IRR
Advantages
1. Considers all cash flows of the project.
2. Considers time value of money.
Disadvantages
1. Requires an estimate of cost of capital in order to make a
decision.
2. Cannot be used in situations where sign of the cash flows of
the project change more than once during project’s life.
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Class Practice Question 1
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4. MIRR
•
•
•
MIRR stands for ‘Modified Internal Rate of Return’.
Definition: MIRR is the discount rate at which the
present value of a project’s cost is equal to the PV of
its terminal value where the terminal value is found
by summing up the future value of the cash inflows,
compounded at company’s cost of capital.
Formula:
PV costs = Terminal Value
(1+MIRR)n
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4. MIRR
• Decision Criteria
• For Independent Projects
IF MIRR > cost of capital => accept the project
IF MIRR < cost of capital => reject the project
• For Mutually Exclusive Projects
Accept the project with highest MIRR provided MIRR
for the project is greater than cost of capital.
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4. MIRR
Advantages
1.
2.
3.
Considers all cash flows of the project.
Considers time value of money.
A better capital budgeting tool than IRR as it assumes cash inflows
are reinvested at the cost of capital.
Disadvantages
1.
2.
Requires an estimate of cost of capital in order to make a decision.
Cannot be used in situations where sign of the cash flows of the
project change more than once during project’s life.
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Class Practice Question 2
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Key differences between NPV, IRR and MIRR
NPV
•
Calculation
–
•
•
•
MIRR
IRR
•
We determine the PV of
future cash inflows and
then subtract the initial
cash outflow from them to
obtain NPV.
Cost of capital is used as
the actual discount rate.
•
Projects with positive NPV’s
are accepted.
•
NPV assumes cash flows
are reinvested at cost of
•
capital.
Calculation
–
–
•
We calculate the rate at
which NPV is zero ‘or’ simply
stated we calculate the rate
of return on a project.
IRR is the rate at which PV of
cost is equal to PV of future
cash inflows.
IRR is compared with cost of
capital to determine if it is
feasible to accept the project.
Projects with IRR > cost of
capital are accepted.
IRR assumes cash flows are
reinvested at IRR.
Calculation
–
–
•
•
•
We calculate the terminal value
(TV) by summing up the future
value of the cash inflows,
compounded at company’s cost
of capital then find the PV of
the TV.
MIRR is the rate at which PV of
cost is equal to PV of the TV.
MIRR is compared with cost of
capital to determine if it is feasible
to accept the project.
Projects with MIRR > cost of
capital are accepted.
MIRR assumes cash flows are
reinvested at cost of capital.
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Reinvestment Rate Assumption
• In slide no. 26 the last difference points towards an
important assumption built into the three capital
budgeting tools.
– NPV: The NPV technique assumes that cash inflows are
reinvested at the cost of capital (i.e. the same rate by
which they were discounted).
– IRR: The IRR technique assumes that cash inflows are
reinvested at IRR.
– MIRR: The MIRR technique assumes that cash inflows are
reinvested at the cost of capital.
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Conclusion
• MIRR is a superior method to the regular IRR
as an indicator of a project’s true rate of
return.
but,
• NPV is better than IRR and MIRR when
choosing among competing projects.
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Conclusion
• Independent Projects
– For independent projects, NPV, IRR and MIRR all give
the same result if NPV says accept, IRR and MIRR also
say reject and vice versa.
• Mutually Exclusive Projects
– For mutually exclusive projects, NPV is the best
method to use because it focuses on maximizing
shareholder value.
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Class Practice Question 3
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Class Practice Question 4
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Class Practice Question 5
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