FIN303
Vicentiu Covrig
The basics of capital
budgeting
(chapter 11)
Should we
build this
plant?
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FIN303
Vicentiu Covrig
What is capital budgeting?


Analysis of potential additions to fixed assets
Long-term decisions; involve large expenditures

Independent projects – if the cash flows of one are
unaffected by the acceptance of the other
(see text page 372)

Mutually exclusive projects – if the cash flows of one can
be adversely impacted by the acceptance of the other
(see text page 372)
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FIN303
Vicentiu Covrig
Steps to capital budgeting
1.
2.
3.
4.
5.
Estimate CFs (inflows & outflows).
Assess riskiness of CFs.
Determine the appropriate cost of capital.
Find NPV and/or IRR.
Accept if NPV > 0 and/or IRR > WACC.
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What is the payback period?




The number of years required to recover a project’s cost, or “How
long does it take to get our money back?”
Calculated by adding project’s cash inflows to its cost until the
cumulative cash flow for the project turns positive.
Strengths
- Provides an indication of a project’s risk and liquidity.
- Easy to calculate and understand.
Weaknesses
- Ignores the time value of money.
- Ignores CFs occurring after the payback period.
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Vicentiu Covrig
Calculating payback
Project L
CFt
Cumulative
PaybackL
Project S
CFt
Cumulative
PaybackS
1
2
2.4
3
10
-90
60
-30
100
0
80
0
-100
-100
== 2
30 / 80
+
0
-100
-100
== 1
1.6
1
70
-30
5
= 2.375 years
2
100 50
0 20
30 / 50
+
50
3
20
40
= 1.6 years
FIN303
Vicentiu Covrig
Discounted payback period

Uses discounted cash flows rather than raw
CFs.
0
CFt
PV of CFt
Cumulative
-100
-100
-100
Disc PaybackL ==
1
2
10
9.09
-90.91
60
49.59
-41.32
10%
2
+
41.32 / 60.11
6
2.7 3
80
60.11
18.79
= 2.7 years
FIN303
Vicentiu Covrig
Net Present Value (NPV)

Sum of the PVs of all cash inflows and outflows of a project:
CFt
NPV  
t
t 0 ( 1  k )
n
Advantages:
1. Uses cash flows
2. Uses ALL cash flows of the project
3. Discounts ALL cash flows properly
 Reinvestment assumption: the NPV rule assumes that all cash
flows can be reinvested at the discount rate
 The BEST capital budgeting method
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Vicentiu Covrig
What is Project L’s NPV?
Year
0
1
2
3
CFt
-100
10
60
80
NPVL =
NPVS = $19.98
8
PV of CFt
-$100
9.09
49.59
60.11
$18.79
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Vicentiu Covrig
Solving for NPV:
Financial calculator solution







Enter CFs into the calculator’s CF register.
For Texas Instruments:
Press CF key
- CF0 = -100 Enter 
- C01 = 10 Enter 
- F01 = 1
Enter 
- C02 = 60 Enter 
- F02 = 1
Enter 
- CF3 = 80 Enter 
Press NPV key
10 (I) Enter
 CPT
to get NPVL = $18.78.
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Vicentiu Covrig
Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of inflows equal to
cost, and the NPV = 0:
CFt
0
t
(
1

IRR
)
t 0
n

Solving for IRR with a financial calculator:
- Enter CFs in CF register.
- Press IRR key
- CPT
- to get IRRL = 18.13% and IRRS = 23.56%.
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Vicentiu Covrig
Rationale for the IRR method

If IRR > WACC, the project’s rate of return is greater than its costs. There is
some return left over to boost stockholders’ returns.

If IRR > k, accept project.
If IRR < k, reject project.
If projects are independent, accept both projects, as both IRR > k = 10%.
If projects are mutually exclusive, accept S, because IRRs > IRRL
Advantages:
- Easy to understand and communicate
Disadvantages:
- IRR may not exist or there may be multiple IRR
- Problems with mutually exclusive investments





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Vicentiu Covrig
The Scale Problem
Mutually exclusive vs independent projects
Would you rather make 100% or 50% on your investments?
What if the 100% return is on a $1 investment while the 50% return is
on a $1,000 investment?
IRR method assumes CFs are reinvested at IRR
Assuming CFs are reinvested at the opportunity cost of capital is
more realistic, so NPV method is the best
NPV method should be used to choose between mutually exclusive
projects
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FIN303
Vicentiu Covrig
Learning objectives





Know the steps to capital budgeting
Know how to calculate payback period, discounted payback period, NPV, IRR;
the advantages and disadvantages of each method
Sections 11.6, 11.7 will NOT be on the exam
Recommended end-of-chapter questions: 11-2,11-3, 11-4, 11-8
Recommended end-of-chapter problems:ST-2 (without MIRR); 11-1, 11-2,11-4,
11-5, 11-6, 11-7 (without MIRR), 11-10,11-11,11-12;
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