Capital Budgeting - Color (Compatibility Mode)

1 2
What is capital budgeting?

The Basics of Capital Budgeting:
Evaluating Cash Flows  Planning and evaluating investments in Fixed
assets with an expectation to receive cash
inflows for more than one year.
Should we
build this
plant? In other words:
 Finding out the best alternative for long term

investment.
Md. Shariful Islam, IBA, RU. Md. Shariful Islam, IBA, RU.
3 4
Some features of capital budgeting? What is the difference between

independent and mutually exclusive
projects?
 Indicates Analysis of potential Projects are:

additions to fixed assets. independent, if the cash flows of
 Involve large expenditures. one are unaffected by the
acceptance of the other.
 Featured as Long-term decisions;.
mutually exclusive, if the cash flows
of one can be adversely impacted
by the acceptance of the other.
5 6
An Example of Mutually Exclusive

An Example of Independent Projects
Projects
BRIDGE vs. FERRY to get

War Tank vs. Public Bus vehicles across a river.
7 8
Capital Budgeting Evaluation
Techniques:
 Non Discounting Technique:

 Payback Period. Payback Period
 Discounting Techniques:
 NPV
 IRR
9 10
What is the payback period? Criteria for accept/ reject decision:
The number of years required to  Mutually exclusive projects:

recover a project’s original cost or
Accept the project with lowest PBP.
investment.
Reject other projects.
or
 Independent projects:
How long does it take to get the
business’s money back? Accept projects with PBP less than target.
Reject projects with PBP greater than target.
11 12
Formula for PBP: Payback for Project U
(A) For projects with uniform cash inflows:

Initial investment 0 1 2 3
PBP =
Annual cash inflow
CFt -100 40 40 40
(B) For projects with fluctuating cash inflows:
Remaining amount to be recovered
Immediately preceding PaybackU = 100/40 = 2.5 years
PBP = year of full recovery + Total cash flow in the
year of full recovery
13 14
Payback for Project F Strengths of Payback:

1. Provides an indication of a
project’s risk and liquidity.
0 1 2 2.4 3 2. Easy to calculate and understand.
CFt -100 10 60 100 80

Weaknesses of Payback:
Cumulative -100 -90 -30 0 50
1. Ignores the Time Value of Money.
PaybackF = 2 + 30/80 = 2.375 years 2. Ignores CFs occurring after the
payback period.
15 16
Compare the following two projects: Discounted Payback: Uses discounted

rather than raw CFs.
Year A B 0 1 2 3
0 (20,000) (20,000) 10%
1 10,000 Nil
2 10,000 5,000 CFt -100 10 60 80
3 5,000 20,000
4 Nil 20,000 PVCFt -100 9.09 49.59 60.11
5 Nil 20,000
Cumulative -100 -90.91 -41.32 18.79
Question: # Which project are you going to select? Discounted
# Are you going to select the Project A payback = 2 + 41.32/60.11 = 2.7 yrs
only because it has the lowest PBP?
Why or why not? Recover invest. + cap. costs in 2.7 yrs.
17 18
NPV: Sum of the PVs of inflows and

outflows.
n CFt
Net Present Value (NPV)
NPV   t
.
t 0 1  k
19 20
What’s Project F’s NPV? Using NPV method, which project(s)

should be accepted?
Project L:
0 1 2 3
10%
 If Projects 1 & 2 are mutually
-100.00 10 60 80 exclusive, accept 1 when
NPV1> NPV2 and vice versa.
9.09
49.59  If 1 & 2 are independent, accept
60.11 both if NPV > 0 for both.
18.79 = NPVF
21 22
Rationale for the NPV Method
NPV = PV inflows – Cost = Net gain in wealth.
Accept project if NPV > 0. Internal Rate of Return

When NPV>0, value is added with the (IRR)
shareholders’ wealth.
Choose between mutually exclusive projects on

basis of higher NPV. That adds most value.
23 24
Internal Rate of Return: IRR What’s Project F’s IRR?
IRR is the discount rate that results 0 1 2 3

IRR = ?
PV inflows = cost.
-100.00 10 60 80
That is, IRR is the discounting rate that results
PV1
NPV = 0.
PV2
0 1 2 3 PV3
0 = NPV
CF0 CF1 CF2 CF3
Cost Inflows IRRF = 18.13
25 26
Comparative Equations: NPV & IRR IRR with financial calculator:
NPV: Enter k, solve for NPV. 0 1 2 3

IRR = ?
n CFt -100 40 40 40
 t  NPV.
t  0 1  k 
IRR: Enter NPV = 0, solve for IRR. INPUTS 3 -100 40 0

n N I/YR PV PMT FV
CFt
t  0.
 OUTPUT 9.70%
t  0 1  IRR
27 28
IRR with Numerical Calculation: IRR Acceptance Criteria
Use the Interpolation technique for

finding the Rate of Return where NPV
 If IRR > k, accept project.
will be ZERO.
 If IRR < k, reject project.
29 30
Decisions on Projects 1 and 2 per IRR Rationale for the IRR Method
If IRR > WACC, then the project’s

rate of return is greater than its
 If 1 & 2 are independent, accept both if cost. Here some return is left over
IRR1&2 > k .
to boost stockholders’ returns.
 If 1 & 2 are mutually exclusive, accept
1 if IRR1 > IRR2 and vice versa. Example:
WACC = 10%, IRR = 15%.
Profitable.
(15%-10%=5% is for shareholders)
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Do NPV and IRR always give the same decision? NPV Profile
• NPV Profile is a graph that shows a

Usually yes.
project’s NPV at various rates of return.
In some special circumstances they differ. • Cross over rate is a rate of return where
If in the NPV Profile there is a cross over rate, they
the NPV of two projects are equal.
differ.
If before Cross over rate NPV(x)>NPV(y),
then after Cross over rate NPV(x)<PV(y).
33 34
NPV ($) k NPVg Summary of NPV Profile:
NPVp
60
0 50 40
•At Cross over rate NPV(x)=NPV(y).
50 5 33 29
Crossover 10 19 20 •If before Cross over rate NPV(x)>NPV(y),
40
Point = 8.7% 15 7 12 then after Cross over rate NPV(x)<NPV(y).
30
20 (4) 5
• At a Rate of return above Cross over rate
20 g no conflict between NPV and IRR.
IRRg = 23.6%
10 p • At a Rate of return below Cross over rate
0 Discount Rate (%) NPV and IRR conflict.
0 5 10 15 20 23.6
-10
IRRp= 18.1% • Where the NPV curve cuts horizontal axis,
there we get the IRR of the project.
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Mutually Exclusive Projects NPV or IRR during conflict?
NPV k < 8.7: NPVp> NPVg , IRRg > IRRp  NPV assumes reinvest at k (opportunity
CONFLICT cost of capital).
P
k > 8.7: NPVg> NPVp , IRRg > IRRp  IRR assumes reinvest at IRR.
NO CONFLICT
 Reinvest at opportunity cost, k, is more
realistic, so NPV method is better. NPV
should be used to choose between
g IRRg
mutually exclusive projects.
k 8.7 k
%
IRRp
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Because of the non conventional pattern
Can there be more than one IRR?
there are 2 IRRs: 25% and 400%.
0 1 2
NPV
NPV Profile
-1.6m 10m -10m
•This is a Non conventional pattern of cash flow. IRR2 = 400%
•Compare a Conventional pattern. 450
•In a Non conventional pattern of cash flow there 0 k
can be more than one IRR (Multiple IRR). 100 400
•In case of Multiple IRR, the IRR approach is not IRR1 = 25%
-800
usable.
39 40
Managers like rates, i.e, prefer IRR to

NPV. Can we give them a better IRR?
Modified Internal Yes, Modified IRR (MIRR) is the

discount rate which
Rate of Return causes the PV of a project’s terminal
value (TV) to equal the PV of costs.
(MIRR) TV is found by compounding inflows
at WACC.
Thus, MIRR assumes cash inflows are
reinvested at WACC.
41 42
MIRR for Project L (k = 10%) To find TV with 10B, enter in CFLO:
0 1 2 3 CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80

10%
I = 10
-100.0 10.0 60.0 80.0
10% NPV = 118.78 = PV of inflows.
66.0
10%
12.1 Enter PV = -118.78, N = 3, I = 10, PMT = 0.
MIRR =
158.1 Press FV = 158.10 = FV of inflows.
16.5%
-100.0 $158.1 Enter FV = 158.10, PV = -100, PMT = 0,
$100 = TV inflows
(1+MIRRL)3 N = 3.
PV outflows
MIRRL = 16.5% Press I = 16.50% = MIRR.
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Why use MIRR versus IRR? When there are nonnormal CFs and
more than one IRR, use MIRR:
MIRR correctly assumes reinvestment 0 1 2

at opportunity cost = WACC. MIRR
also avoids the problem of multiple -800,000 5,000,000 -5,000,000
IRRs.
Managers like rate of return PV outflows @ 10% = -4,932,231.40.
comparisons, and MIRR is better for
this than IRR. TV inflows @ 10% = 5,500,000.00.
MIRR = 5.6%
45 46
Accept Project P?
NO. Reject because MIRR =

5.6% < k = 10%.
Also, if MIRR < k, NPV will be

negative: NPV = -$386,777.
Thank You.

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1 2

What is capital budgeting?

 Finding out the best alternative for long term

Some features of capital budgeting? What is the difference between

 Indicates Analysis of potential Projects are:

An Example of Mutually Exclusive

BRIDGE vs. FERRY to get

 Non Discounting Technique:

What is the payback period? Criteria for accept/ reject decision:

The number of years required to  Mutually exclusive projects:

Formula for PBP: Payback for Project U

(A) For projects with uniform cash inflows:

Payback for Project F Strengths of Payback:

CFt -100 10 60 100 80

Compare the following two projects: Discounted Payback: Uses discounted

NPV: Sum of the PVs of inflows and

What’s Project F’s NPV? Using NPV method, which project(s)

Rationale for the NPV Method

NPV = PV inflows – Cost = Net gain in wealth.

Accept project if NPV > 0. Internal Rate of Return

Choose between mutually exclusive projects on

Internal Rate of Return: IRR What’s Project F’s IRR?

IRR is the discount rate that results 0 1 2 3

Comparative Equations: NPV & IRR IRR with financial calculator:

NPV: Enter k, solve for NPV. 0 1 2 3

IRR: Enter NPV = 0, solve for IRR. INPUTS 3 -100 40 0

IRR with Numerical Calculation: IRR Acceptance Criteria

Use the Interpolation technique for

 If IRR < k, reject project.

If IRR > WACC, then the project’s

• NPV Profile is a graph that shows a

Mutually Exclusive Projects NPV or IRR during conflict?

Managers like rates, i.e, prefer IRR to

Modified Internal Yes, Modified IRR (MIRR) is the

MIRR for Project L (k = 10%) To find TV with 10B, enter in CFLO:

0 1 2 3 CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80

MIRR correctly assumes reinvestment 0 1 2

NO. Reject because MIRR =

Also, if MIRR < k, NPV will be

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