Capital Budgeting

Techniques
13-1

Pearson Education Limited 2004

Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI

Capital Budgeting
Decisions

13-2

1.

Capital Budgeting Decisions include

the acquisition of long-lived assets.

2.

Require that capital (company funds)

be expended to acquire additional
resources.

3.

Also known as Capital Expenditure

Decisions.

Why Capital Budgeting

13-3

1.

Perhaps most important function financial managers must

perform

2.

Results of Capital Budgeting decisions continue for many

future years, so firm loses some flexibility

3.

Cap Budgeting decisions define firms strategic direction.

4.

Timing is key since Capital Assets must be put in place

when needed

5.

Capital Budgeting Decisions are not easily reverseable

6.

These investments require significant capital outlay

Capital Budgeting
Decisions: Examples
1.

New retail store outlets.

2.

Robotic manufacturing equipment.

3.

Digital imaging systems for healthcare facilities.

4.

New chairlift for a ski resort.

5.

New fleets:

6.
13-4

Ships

Planes

Cars

New equipment for food preparation

Capital Budgeting
Techniques

13-5

Project Evaluation and Selection

Potential Difficulties

Capital Rationing

Project Monitoring

Post-Completion Audit

Project Evaluation:
Alternative Methods

13-6

Payback Period (PBP)

Accounting Rate of Return

Discounted Payback Period

Internal Rate of Return (IRR)

Net Present Value (NPV)

Profitability Index (PI)

Independent versus
Mutually Exclusive Project
Projects

are:
independent, if the cash flows
of one are unaffected by the
acceptance of the other.
mutually exclusive, if the cash
flows of one can be adversely
impacted by the acceptance of
the other.

13-7

Normal vs. Nonnormal

Cash Flows

Normal Cash Flow Project:

Cost

(negative CF) followed by a series of

positive cash inflows.

One

change of signs.

Nonnormal Cash Flow Project:

Two

or more changes of signs.

Most

common: Cost (negative CF), then string

of positive CFs, then cost to close project.

For

example, nuclear power plant or strip

mine.

13-8

Proposed Project Data

Julie Miller is evaluating a new project
for her firm, Basket Wonders (BW).
She has determined that the after-tax
cash flows for the project will be
$10,000; $12,000; $15,000; $10,000;
and $7,000, respectively, for each of
the Years 1 through 5. The initial
cash outlay will be $40,000.
13-9

Payback Period (PBP)

0

-40 K

10 K

12 K

15 K

4
10 K

PBP is the period of time

required for the cumulative
expected cash flows from an
investment project to equal
the initial cash outflow.
13-10

5
7K

Payback Solution (#1)

0
-40 K (-b)

Cumulative
Inflows

13-11

10 K
10 K

12 K
22 K

PBP

3 (a)
15 K
37 K(c)

4
10 K(d)
47 K

=a+(b-c)/d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years

5
7K
54 K

Payback Solution (#2)

0

-40 K

10 K

12 K

15 K

10 K

-40 K

-30 K

-18 K

-3 K

7K

PBP
Cumulative
Cash Flows

13-12

5
7K
14 K

= 3 + ( 3K ) / 10K
= 3.3 Years

Note: Take absolute value of last

negative cumulative cash flow
value.

PBP Acceptance Criterion

The management of Basket Wonders
has set a maximum PBP of 3.5
years for projects of this type.
Should this project be accepted?
Yes! The firm will receive back the
initial cash outlay in less than 3.5
years. [3.3 Years < 3.5 Year Max.]
13-13

PBP Strengths
and Weaknesses
Strengths:

Weaknesses:

Easy to use and

understand

Does not account

for TVM

Can be used as a
measure of
liquidity

Does not consider

cash flows beyond
the PBP

Easier to forecast
ST than LT flows

Cutoff period is
subjective

13-14

Accounting Rate of
Return
1. Accounting Rate of Return (ARR) is the
average after-tax income from a project
divided by the average investment in the
project.

2. Example: ARR = Average Net Income

Average Investment
3. Ignores the time value of money.

13-15

Time Value of Money

Approaches
1.

The Time Value of Money says: a dollar

today is worth more than a dollar tomorrow.

2.

It is necessary to convert future dollars into

their equivalent present value dollars.

3.

Three methods:

4.

a. Discounted Payback Period

b. Net Present Value.

c. Internal Rate of Return.
13-16

Basic Time Value of

Money Calculations
1.

To convert future value to present value:

P

F
(1 + i)n

Where:
P = present value

F = future value
i = (interest) rate of return
13-17

n = number of units of time

Basic Time Value of Money

Calculations: Example
Calculate the present value of $1.00 to be
paid (or collected) 5-years from now
assuming an interest rate of 8%. Set it up
as follows:
P

1.00

(1 + .08)5

13-18

1.00
(1 + .08)5

1.00
1.46933

Thus: $0.68
13-19

Discounted Payback:
Uses Discounted CFs
0

10%

10

60

80

CFt

-100

PVCFt

-100

9.09

49.59

60.11

Cumulative -100

-90.91

-41.32

18.79

Discounted
= 2 + $41.32/$60.11 = 2.7 yrs
payback
Recover investment + capital costs in 2.7 yrs.
13-20

Net Present Value (NPV)

NPV is the present value of an
investment projects net cash
flows minus the projects initial
cash outflow.
CF1
NPV =
(1+k)1
13-21

CF2
(1+k)2

CFn
- ICO
+...+
n
(1+k)

The Net Present Value

Method
1. Based on the time-value of
money.
2. Recall that only incremental
cash flows are relevant.
3. Three-step process.

13-22

The Net Present Value

Method: Step 1
Identify the amount and time
period of each cash flow
associated with a potential
investment.
Note: Investment projects have
both cash inflows and cash
outflows
13-23

The Net Present Value

Method: Step 2
Discount the cash flows to their
present values using a required
rate of return (a.k.a. hurdle rate).
Note: This is the minimum
return that management will
accept.
13-24

The Net Present Value

Method: Step 3
Evaluate the net present value-the sum of all of the cash
inflows less cash outflows.
Note: if the net present value
(NPV) is greater than or equal to
zero, the investment should be
made. If less than zero, it
should not be made.
13-25

The Net Present Value

Method: Example, Step 1
Identify the amount and time period of
each cash flow associated with a
potential investment.
1. Initial cash outlay: $70,000
2. Year 1 4 net cash savings: $21,000
per year.

3. Year 5 net cash savings: $26,000.

4. Required rate of return: 12%.
13-26

The Net Present Value

Method: Example Step 2
Discount the cash flows to their present
values using a required rate of return
(a.k.a. hurdle rate).
Initial outlay: $70,000 x 1.00

Year 1: $21,000 x .8929

Year 2: $21,000 x .7972
Year 3: $21,000 x .7118
Year 4: $21,000 x .6355
13-27

Year 5: $26,000 x ..5674

The Net Present Value

Method: Example Step 3
Evaluate the net present value--the sum
of all of the cash inflows less cash
outflows.
Year 0: ($70,000)
Year 1: $18,751
Year 2: $16,741
Year 3: $14,948
Year 4: $13,346
Year 5: $14,752
13-28
NPV: $ 8,538

The Net Present Value

Method: Example
Do

13-29

it! $8,538 > $0

NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1
(1.13)2
(1.13)3

$10,000 $7,000
+
$40,000
4
5
(1.13)
(1.13)
13-30

NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428
13-31

NPV Acceptance Criterion

The management of Basket Wonders
has determined that the required
rate is 13% for projects of this type.
Should this project be accepted?
No! The NPV is negative. This means
that the project is reducing shareholder
wealth. [Reject as NPV < 0 ]
13-32

The Net Present Value

Method: Summary

13-33

NPV Strengths
and Weaknesses
Weaknesses:

Strengths:

Cash flows
assumed to be
reinvested at the
hurdle rate.

Accounts for TVM.

Considers all
cash flows.

13-34

May not include

managerial
options embedded
in the project. See
Chapter 14.

Internal Rate of Return (IRR)

IRR is the discount rate that equates the
present value of the future net cash
flows from an investment project with
the projects initial cash outflow.
CF1
CF2
+
ICO =
(1+IRR)1 (1+IRR)2
13-35

+...+

CFn
(1+IRR)n

The Internal Rate of

Return Method
1. Internal Rate of Return (IRR) is an
alternative to the Net Present Value (NPV)
method.
2. IRR uses the time value of money.

3. IRR is the rate of return that equates the

present value of future cash flows to the
investment outlay.
4. IRR analysis yields a yes or no, < or >
result.
13-36

The Internal Rate of

Return Method: Setup
Present value factor =

Initial Outlay
Annuity Amount

13-37

The Internal Rate of

Return Method: Example
Investment: $100
Expected 2-year return: $60 per year

Present value factor =

100
60

13-38

The Internal Rate of

Return Method: Example
1. Present value factor = 1.667
2. Approximately equal to the PV
factor of 1.6681 or 13%.

13-39

The Internal Rate of Return

With Unequal Cash Flows

1. For cases with unequal yearly

cash flows.
2. Thus one cannot use a single
present value factor.
3. Must estimate the IRR.

13-40

IRR Solution
$10,000
$12,000
$40,000 =
+
+
(1+IRR)1 (1+IRR)2
$15,000
$10,000
$7,000
+
+
(1+IRR)3
(1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the

discounted cash flows to equal $40,000.
13-41

IRR Solution (Try 10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444
[Rate is too low!!]
13-42

IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841
[Rate is too high!!]
13-43

IRR Solution (Interpolate)

.05

.10

IRR $40,000
.15

X
.05

13-44

$41,444
$36,841

$1,444
$4,603

$1,444
$4,603

IRR Solution (Interpolate)

.05

.10

IRR $40,000
.15

X
.05

13-45

$41,444
$36,841

$1,444
$4,603

$1,444
$4,603

IRR Solution (Interpolate)

.05

.10

$41,444

$1,444

IRR $40,000
.15

$4,603

$36,841

X = ($1,444)(0.05)
$4,603

X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

13-46

IRR Acceptance Criterion

The management of Basket Wonders
has determined that the hurdle rate
is 13% for projects of this type.
Should this project be accepted?
No! The firm will receive 11.57% for
each dollar invested in this project at
a cost of 13%. [ IRR < Hurdle Rate ]
13-47

The Internal Rate of Return

Method: Summary

13-48

IRR Strengths
and Weaknesses
Strengths:

Accounts for
TVM

Considers all
cash flows

13-49

Less
subjectivity

Weaknesses:

Assumes all cash

flows reinvested at
the IRR

Difficulties with
project rankings and
Multiple IRRs

Summary of Net Present

Value and Internal Rate of
Return Methods
1. Both the Net Present Value
method and the Internal Rate of
Return method take into
account the time value of
money.
2. They differ in their approach to
evaluating investment
alternatives
13-50

Net Present Value Profile

Net Present Value

$000s
15

Sum of CFs

Plot NPV for each

discount rate.

10
5

IRR
NPV@13%

0
-4
0

13-51

6
9
12
Discount Rate (%)

15

Profitability Index (PI)

PI is the ratio of the present value of
a projects future net cash flows to
the projects initial cash outflow.
Method #1:

CF1
PI =
(1+k)1

CF2
CFn
+...+
2
(1+k)
(1+k)n
<< OR >>

Method #2:
13-52

PI = 1 + [ NPV / ICO ]

ICO

PI Acceptance Criterion
PI

= $38,572 / $40,000
= .9643 (Method #1, 13-34)

Should this project be accepted?

No! The PI is less than 1.00. This
means that the project is not profitable.
[Reject as PI < 1.00 ]
13-53

PI Strengths
and Weaknesses
Strengths:

Weaknesses:

Same as NPV

Same as NPV

Allows
comparison of
different scale
projects

Provides only
relative profitability

Potential Ranking
Problems

13-54

Evaluation Summary
Basket Wonders Independent Project

Method Project Comparison Decision

13-55

PBP

3.3

3.5

Accept

IRR

11.47%

13%

Reject

NPV

-$1,424

$0

Reject

PI

.96

1.00

Reject

Other Project
Relationships
Dependent

-- A project whose
acceptance depends on the
acceptance of one or more other
projects.
Mutually Exclusive -- A project
whose acceptance precludes the
acceptance of one or more
alternative projects.
13-56

Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may
create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern

C. Project Life
13-57

A. Scale Differences
Compare a small (S) and a
large (L) project.
END OF YEAR

13-58

NET CASH FLOWS

Project S
Project L

-$100

-$100,000

$400

$156,250

Scale Differences
Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?
Project

IRR

100%

25%

13-59

NPV

PI

231

3.31

$29,132

1.29

B. Cash Flow Pattern

Let us compare a decreasing cash-flow (D)
project and an increasing cash-flow (I) project.

END OF YEAR

13-60

NET CASH FLOWS

Project D
Project I

0
1

-$1,200
1,000

-$1,200
100

500

600

100

1,080

Cash Flow Pattern

Calculate the IRR, NPV@10%,
and PI@10%.
Which project is preferred?
Project

13-61

IRR

NPV

PI

23%

$198

1.17

17%

$198

1.17

13-62

600

Plot NPV for each

project at various
discount rates.

400

Project I

200

NPV@10%
IRR
Project D

0
-200

Net Present Value ($)

Examine NPV Profiles

10
15
20
Discount Rate (%)

25

Net Present Value ($)

600
-200 0 200 400

Fishers Rate of Intersection

13-63

At k<10%, I is best!

Fishers Rate of
Intersection

At k>10%, D is best!

10
15
20
Discount Rate ($)

25

C. Project Life Differences

Let us compare a long life (X) project
and a short life (Y) project.

END OF YEAR

13-64

NET CASH FLOWS

Project X
Project Y

0
1

-$1,000
0

-$1,000
2,000

3,375

Project Life Differences

Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?

13-65

Project

IRR

NPV

PI

50%

$1,536

2.54

100%

$ 818

1.82

Another Way to
Look at Things
1.

Adjust cash flows to a common terminal

year if project Y will NOT be replaced.
Compound Project Y, Year 1 @10% for 2 years.

Year
CF

-$1,000

$0

$0

Results:

IRR* = 34.26%

3
$2,420

NPV = $818

*Lower IRR from adjusted cash-flow stream. X is still Best.

13-66

Replacing Projects
with Identical Projects
2.

Use Replacement Chain Approach (Appendix B)

when project Y will be replaced.
0

-$1,000

-$1,000
Results:

$2,000
-1,000

$1,000
IRR = 100%

$2,000
-1,000

$2,000

$1,000

$2,000

NPV* = $2,238.17

*Higher NPV, but the same IRR. Y is Best.

13-67

Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for
this capital budgeting period.
13-68

Available Projects for BW

Project
A
B
C
D
E
F
G
H
13-69

ICO
$

500
5,000
5,000
7,500
12,500
15,000
17,500
25,000

IRR
18%
25
37
20
26
28
19
15

NPV

PI

50
6,500
5,500
5,000
500
21,000
7,500
6,000

1.10
2.30
2.10
1.67
1.04
2.40
1.43
1.24

Choosing by IRRs for BW

Project
C
F
E
B

ICO

IRR

NPV

PI

$ 5,000
15,000
12,500
5,000

37%
28
26
25

$ 5,500
21,000
500
6,500

2.10
2.40
1.04
2.30

Projects C, F, and E have the

three largest IRRs.

The resulting increase in shareholder wealth

is $27,000 with a $32,500 outlay.
13-70

Choosing by NPVs for BW

Project
F
G
B

ICO
$15,000
17,500
5,000

IRR

NPV

PI

28%
19
25

$21,000
7,500
6,500

2.40
1.43
2.30

Projects F and G have the

two largest NPVs.
The resulting increase in shareholder wealth
is $28,500 with a $32,500 outlay.
13-71

Choosing by PIs for BW

Project
F
B
C
D
G

ICO

IRR

NPV

PI

$15,000
5,000
5,000
7,500
17,500

28%
25
37
20
19

$21,000
6,500
5,500
5,000
7,500

2.40
2.30
2.10
1.67
1.43

Projects F, B, C, and D have the four largest PIs.

The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
13-72

Summary of Comparison
Method Projects Accepted

Value Added

PI

F, B, C, and D

$38,000

NPV

F and G

$28,500

IRR

C, F, and E

$27,000

PI generates the greatest increase in

shareholder wealth when a limited capital
budget exists for a single period.
13-73

Single-Point Estimate
and Sensitivity Analysis
Sensitivity Analysis: A type of what-if
uncertainty analysis in which variables or
assumptions are changed from a base case in
order to determine their impact on a projects
measured results (such as NPV or IRR).

13-74

Allows us to change from single-point (i.e.,

revenue, installation cost, salvage, etc.) estimates
to a what if analysis
Utilize a base-case to compare the impact of
individual variable changes
E.g., Change forecasted sales units to see
impact on the projects NPV

Post-Completion Audit
Post-completion Audit
A formal comparison of the actual costs and
benefits of a project with original estimates.

Identify any project weaknesses

Develop a possible set of corrective actions

Provide appropriate feedback

Result: Making better future decisions!

13-75