Chapter 9 & 10

The Basics of Capital

Budgeting
Should we
build this
plant?
 What is capital budgeting?
12-2

 Capital-refers to long term assets used in

production
 Budgeting-is a plan that outlines projected
expenditure during some future period
 Capital budgeting is a whole process of
analyzing projects and deciding which ones to
include in the capital budget.
 Firms generally categorize projects
3
differently

1. Replacement: needed to continue current

operations
2. Replacement: cost reduction
3. Expansion of existing products or market
4. Expansion of new products or market
5. Safety or environmental project
6. Other projects
 What is the payback period?
12-4

 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.
 Example
5

Project L S

Year 0 (100) (100)

1 10 30

2 60 50

3 80 70

Calculate payback and discounted payback for both project with similar
initial investment.
Cost of capital given is 10%.
 Calculating Payback
12-6

Project L’s Payback Calculation

0 1 2 3

CFt -100 10 60 80
Cumulative -100 -90 -30 50

PaybackL = 2 + 30 / 80
= 2.375 years
PaybackS = years
 Strengths and Weaknesses of
12-7
Payback
 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.
 Discounted Payback Period
12-8

 Uses discounted cash flows rather than raw

CFs.
0 10% 1 2 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79

Disc PaybackL = 2 + 41.32 / 60.11 = years

 Steps to Capital Budgeting
12-9

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
 What is the difference between independent and
mutually exclusive projects?
12-10

 Independent projects – if the cash flows of

one are unaffected by the acceptance of the
other.
 Mutually exclusive projects – if the cash flows
of one can be adversely impacted by the
acceptance of the other.
 What is the difference between normal and
nonnormal cash flow streams?
12-11

 Normal cash flow stream – Cost (negative CF)

followed by a series of positive cash inflows.
One change of signs.
 Non-normal cash flow stream – Two or more
changes of signs. Most common: Cost
(negative CF), then string of positive CFs,
then cost to close project. Nuclear power
plant, strip mine, etc.
 Net Present Value (NPV)
11-12

 NPV tells how much a project contributes to

shareholder wealth
 The larger the NPV, the more value the project
adds and added value means a higher stock
price. Thus, NPV is the best selection criterion.
 How to obtain NPV?
13

 First, cash flows has to adjusted to reflect

depreciation, taxes and salvage value.
 The present value of each cash flows is
calculated, discounted at the project’s risk-
adjusted cost of capital.
 The sum of discounted cash flows is defined as
the project’s NPV.
 Net Present Value (NPV)
12-14

 Sum of the PVs of all cash inflows and

outflows of a project:

N
CFt
NPV  
t 0 ( 1  r ) t

 CFt= expected net cash flow at time(t)

r = risk adjusted cost of capital
N = project life
 Example- NPV
15

Project L S

Year 0 (100) (100)

1 10 30

2 60 50

3 80 70

Calculate NPV for both project with similar initial investment.

Cost of capital given is 10%.
What is Project L’s NPV?
Year CFt DF@10% PV of CFt
0 -100 1.000 -100
1 10 0.909 9.09
2 60 0.826 49.59
3 80 0.751 60.11
NPVL = $ 18.79

NPVS =
 Rationale for the NPV Method
12-17

NPV = PV of inflows – Cost

= Net gain in wealth
 If projects are independent, accept if the
project NPV > 0.
 If projects are mutually exclusive, accept
projects with the highest positive NPV, those
that add the most value.
 In this example, accept S if mutually exclusive
(NPVS > NPVL), and accept both if
independent.
 Strengths and Weaknesses of NPV
12-18

 Strengths
 NPV gives important to the time value of money.
 Profitability and risk of the projects are given
high priority
 NPV helps in maximizing the firm's value
 Weaknesses
 requires an estimate of cost of capital in order to
calculate
 expressed on terms of ringgit ,not as percentage
 Internal Rate of Return (IRR)
12-19

 The IRR can be defined as the discount rate which,

when applied to the cash flows of a project,
produces a net present value (NPV) of nil. This
discount rate can then be thought of as the forecast
return for the project.
 Rationale for the IRR Method
12-20

 If IRR > WACC, the project’s return exceeds

its costs and there is some return left over to
boost stockholders’ returns.
If IRR > WACC, accept project.
If IRR < WACC, reject project.
 If projects are independent, accept both
projects, as both IRR > WACC = 10%.
 If projects are mutually exclusive, accept S,
because IRRs > IRRL.
 Reinvestment Rate Assumptions
12-21

 NPV method assumes CFs are reinvested at the

WACC.
 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.
 Perhaps a hybrid of the IRR that assumes cost
of capital reinvestment is needed.
 Strengths and Weaknesses of IRR
12-22

 Strengths
 more easily understood by managers than NPV
 discounted CF method, takes account of the
time value of money
 considers CF over the whole life of the project
 relative measure in form of percentage to be
able to compare with company cost of capital
 Weaknesses
 ignores relative sizes of investment
 may produce more than one IRR, difficult for
decision making
 Multiple IRRs
12-23

NPV

IRR2 = 400%
450
0 WACC
100 400
IRR1 = 25%
-800
 Why are there multiple IRRs?
12-24

 At very low discount rates, the PV of CF2 is

large and negative, so NPV < 0.
 At very high discount rates, the PV of both
CF1 and CF2 are low, so CF0 dominates and
again NPV < 0.
 In between, the discount rate hits CF2 harder
than CF1, so NPV > 0.
 Result: 2 IRRs.
 Reinvestment Rate
9-25

• Another problem with the IRR approach is that

it inherently assumes that the cash flows are
being reinvested at the IRR, which if unusually
high, can be highly unrealistic.
• In other words, if the IRR was calculated to be
40%, this would mean that we are implying
that the cash inflows from a project are being
reinvested at a rate of return of 40%
throughout the remainder of the project, for
the IRR to materialize.
 Modified Internal Rate of Return
(MIRR)
9-26

• Despite several shortcomings, managers like to use IRR since it is

expressed as a percent or return (%) rather than in dollars.
• The MIRR was developed to get around the unrealistic reinvestment
rate criticism of the traditional IRR
• Under the MIRR, all cash outflows are assumed to be reinvested at
the firm’s cost of capital or hurdle rate, which makes it more
realistic.
• We calculate the future value of all positive cash flows at the
terminal year of the project, the present value of the cash outflows
at time 0; using the firm’s hurdle rate; and then solve for the
relevant rate of return that would be implied using the following
equation:
1/n
MIRR = Terminal Value -1
Initial Outlay
 Modified Internal Rate of
9-27
Return (Timeline effect)
 Modified Internal Rate of Return

Example: Calculating MIRR.

Using the cash flows given in Example below, and a
discount rate of 10%; calculate the MIRRs for Projects
A and B. Which project should be accepted? Why?
Year A B
0 -10,000 -7,000
1 5,000 7,000
2 7,000 5,000
3 9,000 2,000
IRR 42.98% 77.79%
 Modified Internal Rate of
Return
Project A:
PV of cash outflows at time 0 = $10,000
FV of cash inflows at year 3, @ 10% = 5,000 x(1.1)2 +
$7,000 x (1.1)1 + $9,000
$6,050 + $7,700 + $9,000 = $22,750
MIRRA = (22750/10000)1/3 – 1 = 31.52%
Project B:
PV of cash outflows at time 0 = $7,000
FV of cash inflows at year 3, @10% = $9,000 x (1.1)2 +
$5,000 x (1.1)1 + $2,000
$8,470 + $5,500 + $2,000 = $15,970
MIRRB = ( /7000)1/3 – 1 = 31.64%
So, accept Project B since its MIRR is higher.
 STRENGTHS AND WEAKNESS
30
OF MIRR
Strengths of MIRR:
 MIRR overcomes 2 major drawbacks of IRR including the elimination of
multiple IRRs in case of investments with unusual timing of cash flows and
secondly the re-investment problem discussed earlier.
 Helps in the measurement of sensitivity of an investment towards variation in
the cost of capital
Weakness of MIRR:
 As with IRR, MIRR may lead to sub-optimal decision making when multiple
investment options are being considered. As MIRR does not quantify the
impact of different investments on the wealth of investors in absolute terms,
NPV provides a more effective theoretical basis for selecting investments that
are mutually exclusive
 MIRR can be hard to understand for people belonging from a non-financial
background. The theoretical basis for MIRR is also disputed among academics
 Example
31

Year Investment A Investment B

0 (10,000) (10,000)
1 5,000 1,500
2 5,000 2,000
3 2,000 2,500
4 5,000
5 5,000

Calculate NPV, IRR and payback period when the cost of capital of
the company is 10%.
 Net Present Value (cont’d)
12-32
$10,000 Investment, 10% Discount Rate
Year Investment A
1……… $5,000 X 0.909 = $4,545
2……… $5,000 X 0.826 = $4,130
3……… $2,000 X 0.751 = $1,502
$10,177
Present value of inflows…..$10,177
Present value of outflows -$10,000
Net present value……………..$177
Year Investment B
1………. $1,500 X 0.909 = $1,364
2………. $2,000 X 0.826 = $1,652
3………. $2,500 X 0.751 = $1,878
4………. $5,000 X 0.683 = $3,415
5………. $5,000 X 0.621 = $3,105
$11,414
Present value of inflows…..$11,414
Present value of outflows -$10,000
Net present value…………...$1,414