ASPEK KEUANGAN

Capital Budgeting
MANAJEMEN PROYEK

Investment decisions
y Objectives for this session :
y Review investment rules
y NPV, IRR, Payback

y BOF Project
P j t
y Free Cash Flow calculation
y Sensitivity analysis, break even point
y Inflation

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Investment rules
y Net Present Value (NPV)

NPV

y Di
Discounted
t d incremental
i
t l free
f cashh flflows
y Rule: invest if NPV>0

y Internal Rate of Return (IRR)

y IRR: discount rate such that NPV=0
y Rule: invest if IRR > Cost of capital

y Payback period
y Numbers of year to recoup initial investment
y No precise rule

y Profitability
P fi bili Index
I d (PI)
y PI = NPV / Investment
y Useful to rank projects if capital spending is limited
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IRR

Internal Rate of Return

y Alternative rule: compare the internal rate of return for the

project to the opportunity cost of capital

y Definition of the Internal Rate of Return IRR : (1-period)
IRR = Profit/Investment = (C1 - I)/I
y In
I our example:
l
IRR = (125 - 100)/100 = 25%
y The Rate of Return Rule: Invest if IRR > r

y In this simple setting, the NPV rule and the Rate of Return Rule

lead to the same decision:

y NPV = -I+C1/(1+r) >0 C1>I(1+r) (C1-I)/I>r IRR>r

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MBA 2007 Capital Budgeting (1)

IRR: a general definition

y The Internal Rate of Return is the discount

rate such that the NPV is equal

q to zero.
30.00

y -I + C1/(1+IRR) 0

25.00

20.00

y -100 + 125/(1+IRR)=0
y

IRR=25%
2 %

15.00
Net Present Value

y In our example:

10.00

5.00

IRR
0.00
0.0%

2.5%

5.0%

7.5%

10.0%

12.5%

15.0%

-5.00

-10.00
Discount Rate

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MBA 2007 Capital Budgeting (1)

17.5%

20.0%

22.5%

25.0%

27.5%

30.0%

Internal Rate of Return IRR

y Can be viewed as the yield to maturity of the project
y Remember: the yield to maturity on a bond is the rate that set the present

value of the expected cash flows equal to its price

y Consider the net investment as the p

price of the pproject
j
y The IRR is the rate that sets the present value of the expected cash flows

equal to the net investment

y The IRR is the rate that sets the net present value equal to zero

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MBA 2007 Capital Budgeting (1)

What do CFOs Use?

% Always or Almost Always

y
y
y
y
y
y
y

Internal Rate of Return

N t Present
Net
P
t Value
Vl
Payback period
Discounted payback period
Accounting rate of return
Profitability index

75.6%
74 9%
74.9%
56.7%
29.5%
30.3%
11.9%

y Based on a survey of 392 CFOs

Source: Graham, John R. and Harvey R. Campbell, The Theory and Practice of Corporate Finance: Evidence from the Field, Journal of Financial Economics 2001

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MBA 2007 Capital Budgeting (1)

IRR Pitfall 1: Lending or borrowing?

y Consider following projects:

IRR: borrowing or lending?

-30.00
Discount rate
Project A

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MBA 2007 Capital Budgeting (1)

Project B

-20.00

30

27

24

21

Rule IRR<r

y B: borrowing

-10.00

Rule IRR>r

0.00

18

y A: lending

10.00

-9.09
9 09

20.00

15

20%

9.09

12

y B +100 -120
120

20%

30.00

9%

-100 +120

NPV(10%)

6%

IRR

3%

0%

y A

N e t P re se n t V a llu e

IRR Pitf
Pitfallll 2 Multiple
M lti l Rates
R t off Return
R t
y Consider the following project
y Year
y CF

2
Multiple Rates of Return

-1,600 10,000 -10,000

-1500.00

y To overcome problem, use modified IRR

method
h d
y Reinvest all intermediate cash flows at the cost of

capital till end of project

y Calculate IRR using the initial investment and the
future value of intermediate cash flows
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MBA 2007 Capital Budgeting (1)

-2000.00
Discount Rate

495%
4

450%
4

405%
4

360%
3

315%
3

270%
2

-1000.00

225%
2

-500.00

180%

0.00
135%

sign off cashh flflows

500.00
90%

y This happens if more than one change in

1000.00

45%

+400%

0%

y 2 IRR
IRRs : +25% &

Net Present Value

1500.00

IRR Pitfall 3 - Mutually Exclusive

P j t
Projects
y Scale Problem

y Timing Problem

C0
C0

C1 NPV10% IRR

y Small
S ll

-10
10

+20

y Large

-50

+80

y L-S

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-40

22.7

60%

C1 NPV10% IRR
+60

NPV8% IRR

-100 +20 +120

19.8 20%

-100 +100 +30

17.0 24.2%

88.22 100%

y To choose, look at incremental cash flows

C0

C2

y Look at incremental cash flows

C0
y

C1

14.5

50%

MBA 2007 Capital Budgeting (1)

A-B 0

C1

C2

-80 +90

NPV8% IRR
2.9 12.5%

M t ll Exclusive
Mutually
E l i P
Project
j t - Illustration
Ill t ti
50.0

40.0

A
30.0

20.0

B
10 0
10.0

0.0
0.0%

2.5%

5.0%

7.5%

-10.0

-20.0

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MBA 2007 Capital Budgeting (1)

10.0%

12.5%

15.0%

17.5%

20.0%

22.5%

25.0%

27.5%

30.0%

32.5%

Payback
y The payback period is the number of years it takes before the

cumulative
l ti fforcasted
t d cashh flflows equals
l th
the initial
i iti l iinvestment.
t
t
0
1
2
3
Payback
N PV
y Example:Y e a r
r= 1 0%
A

- 1 ,0 0 0

500

500

1 ,0 0 0

619

- 1 ,0 0 0

1 ,0 0 0

-1 7 4

- 1 ,0 0 0

500

500

-1 3 2

y A very flawed method, widely used

y Ignores time value of money
y Ignores
g
cash flows after cutoff date
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MBA 2007 Capital Budgeting (1)

Profitability Index
y Profitability Index = PV(Future Cash Flows) / Initial

Investment
y A useful
f l tooll for
f selecting
l
among projects when
h capitall

budget limited.
y The highest weighted average PI

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MBA 2007 Capital Budgeting (1)

NPV - Review
y NPV: measure change in market value of company if project

accepted
y As market value of company V = PV(Future
Free Cash Flows)
FCF
NPV = V =

t (1 + r )

y V =Vwith project - Vwithout project

y Cash flows to consider:

t
t

y cash flows (not accounting numbers)

y do not forget depreciation and changes in WCR
y incremental (with project - without project)
y forget sunk costs
y include opportunity costs
y include all incidental effects
y beware of allocated overhead costs

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MBA 2007 Capital Budgeting (1)

Inflation
y Be consistent in how you handle inflation
y Discount nominal cash flows at nominal rate
y Discount real cash flows at real rate

y Both approaches
pp
lead to the same result.
y

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Example: Real cash flow in year 3 = 100 (based on price level at time 0)
y Inflation rate = 5%
y Real discount rate = 10%

Discount real cash flow using real rate

Discount nominal cash flow using nominal rate

PV = 100 / (1.10)3 = 75.13

Nominal cash flow = 100 (1.05)3 = 115.76

Nominal discount rate = (1.10)(1.05)-1 = 15.5%
PV = 115.76 / (1.155)3 = 75.13

MBA 2007 Capital Budgeting (1)

Interest rates and inflation: real

i t
interest
t rate
t
Nominal interest rate = 10%
Date 0
Date 1
Indi idual in
Individual
invests
ests
$ 1,000
1 000
Individual receives
$ 1,100
Hamburger sells for
$1
$1.06
Inflation rate = 6%
Purchasing power (# hamburgers)
H1,000
H1,038
y Real interest rate = 3.8%
(1+Nominal interest rate)=(1+Real interest
) (
rate))
rate)(1+Inflation
y Approximation:
Real interest rate Nominal interest rate - Inflation rate
y
y
y
y
y
y

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MBA 2007 Capital Budgeting (1)

Investment Project Analysis:

BOF
Big Oversea Firm is considering the project
Year

Initial Investment

60

Resale value

20

Sales

100

100

Cost of sales

50

50

Corporate
C
t tax
t rate
t = 40%
Working Capital Requirement = 25% Sales
Discount rate = 10%

MBA 2007 Capital Budgeting (1)

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BOF: Free Cash Flow

Calculation
Year

100

100

C off sales
Cost
l

50

50

EBITDA

50

50

Depreciation

30

30

EBIT

20

20

Taxes

Net income

12

12

-8

Net income

12

12

-8

D
Depreciation
i ti

30

30

DWCR

25

-25

Sales

CFInvestment

-60

Free Cash Flow

-60

20
17

MBA 2007 Capital Budgeting (1)

42

37
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BOF: go ahead?
y NPV calculation:

NPV = 60 +

17
42
37
+
+
= 17.96
2
3
1.10 (1.10)
(1.10)

y Internal Rate of Return = 24%

y Payback period = 2 years

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MBA 2007 Capital Budgeting (1)

BOF: checking the numbers

y Sensitivity analysis
y What if expected sales below expected value?

Sales

60

70

80

90

100

NPV

-1.28

3.53

8.34

13.15

17.97

y Break-even point
y What is the level of sales required to break even?
y Break even sales = 62.7

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MBA 2007 Capital Budgeting (1)

BOF Project with inflation rate

= 100%
Nominal free cash flows
Year
Sales
Cost of sales
EBITDA
Depreciation
EBIT
Taxes
Net income

Net income
Depreciation
WCR
CFInvestment
Free Cash Flow

-60
-60

1
200
100
100
30
70
28
42

2
400
200
200
30
170
68
102

42
30
50

102
30
50

22

82

64
-64
64
-64
0
-100
160
196

Nominal discount rate = (1+10%)(1+100%)-1 = 120%

NPV = -14.65

IRR = 94%
MBA 2007 Capital Budgeting (1)

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REFERENSI
y Solvay Business School
y Universit Libre de Bruxelles
y Fall 2007

MBA 2007 Capital Budgeting (1)

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