Capital BudgetingConcepts

and Techniques
Capital Budgeting
Capital Budgeting Basics and Techniques
Project Cash Flows and Risk

Capital Budgeting Basics
Importance of capital budgeting
long-term effectcapital, or long-term funds, raised by
the firms are used to invest in assets that enable the firm
to generate revenues several years into the future.
timing of a decision is importantdecisions impact the
firm for several years.
Generating ideas for capital budgeting
employees, customers, suppliers, and so forth
based on needs and experiences of the firm and these
groups

Capital Budgeting Basics
Project classificationsreplacement decisions versus
expansion decisions
replacement decisionintended to maintain existing levels of
operations
expansion decisiona decision concerning whether the firm
should expand operations
Project classificationsindependent projects versus
mutually exclusive projects
independent projectaccepting one independent project
does not affect the acceptance of any other project
mutually exclusive projectsonly one project can be
purchased

Capital Budgeting Basics
Capital Budgeting Versus Asset Valuation
Value of an asset = PV of the cash flows the asset
is expected to generate during its life:

k) (1
CF
k) (1
CF
k) (1
CF
Value
Asset
n
n
2
2
1
1

+
+ +
+
+
+
=
. . .

An asset is an acceptable investment if the cost of

the asset is less than its value:

Acceptable if Value > Cost

Capital Budgeting Techniques
Payback period
Net present value
Internal rate of return

Capital Budgeting Techniques
Illustrative Investment
0 (7,000)
1 2,000
2 1,000
3 5,000
4 3,000

k = 15%

t
CF
.
Year Cash Flow,
Capital Budgeting Example
Cash Flow Time Line
2,000 1,000 5,000 3,000
1 0 2 3 4
(7,000.00)
15%
1,739.13
756.14
3,287.58
1,715.26
498.11 = 4 3 2 1
0
CF of PV CF of PV CF of PV CF of PV CF
.
+
.
+
.
+
.
+
E PV =
7,498.11

Capital Budgeting Techniques
Payback Period
Number of years it takes to recapture the initial
investment.
Year Cash Flow Cumulative CF
0 $(7,000) $(7,000)
1 2,000 (5,000)
2 1,000 (4,000)
3 5,000 1,000
4 3,000 4,000
} 2<Payback<3
Capital Budgeting Techniques
Payback Period
Year Cash Flow Cumulative CF
0 $(7,000) $(7,000)
1 2,000 (5,000)
2 1,000 (4,000)
3 5,000 1,000
4 3,000 4,000
} 2<Payback<3
years 2.80

=
remaining investment $

payback of year
in flow cash $

recaptured be to
investment original
of recovery full
before years of #
period
Payback
+ =
|
|
|
|
|
|
|
.
|







\
|
|
|
|
|
|
.
|





\
|
$5,000
$4,000
2
+ =

Capital Budgeting Techniques
Payback Period
Accept the project if Payback, PB < some number
of years established by the firm

PB = 2.8 years is acceptable if the firm has
established a maximum payback of 4.0 years

Capital Budgeting Techniques
Payback Period
Advantages
Simple
Cash flows are used
Provides an indication of the liquidity of a project
Disadvantages
Does not use time value of money concepts
Cash flows beyond the payback period are
ignored
Capital Budgeting Techniques
Payback Period
} PB = 2.80 yrs
Year Cash Flow Cumulative CF
0 $(7,000) $(7,000)
1 2,000 (5,000)
2 1,000 (4,000)
3 5,000 1,000
4 3,000 4,000

5 1,000,000 1,004,000

Capital BudgetingNet
Present Value (NPV)
NPV = present value of future cash flows
less the initial investment
An investment is acceptable if NPV > 0

.

=
+
=
n
0 t
t
t
k) (1
CF
+
+ +
+
+
+
+ =
. . .
n
n
2
2
1
1
0
k) (1
CF
k) (1
CF
k) (1
CF
CF NPV

Capital BudgetingNPV
$498.11 =
(1.15)
$3,000
(1.15)
$5,000
(1.15)
$1,000
(1.15)
$2,000
$7,000 NPV
4 3 2 1
+ + + + =
$1,715.26 $3,287.58 $756.14 $1,739.13 $7,000 + + + + =

NPV = $498.11 > 0, so the project is acceptable

Capital Budgeting Example
Cash Flow Time Line
1 0 2 3 4
2,000 1,000 5,000 3,000 (7,000.00)
15%
1,739.13
756.14
3,287.58
1,715.26
498.11 = NPV

Capital BudgetingNPV
Advantages:
Cash flows rather than profits are analyzed
Recognizes the time value of money
Acceptance criterion is consistent with the goal
of maximizing value
Disadvantage:
Detailed, accurate long-term forecasts are
required to evaluate a projects acceptance

Solving for NPV
Numerical solution
Financial Calculator solution
Spreadsheet solution

Solving for NPVNumerical
Solution
$498.11 =
$1,715.26 $3,287.58 $756.14 $1,739.13 $7,000 + + + + =

(1.15)
$3,00
(1.15)
$5,000
(1.15)
$1,000
(1.15)
$2,000
$7,000 NPV
4 3 2 1
+ + + + =

Solving for NPVFinancial
Calculator Solution
Input the following into the cash flow register:
CF
0
= -7,000
CF
1
= 2,000
CF
2
= 1,000
CF
3
= 5,000
CF
4
= 3,000
Input I = 15
Compute NPV = 498.12

Capital BudgetingDiscounted
Payback Period
Payback period computed using the present values
of the future cash flows.
0 $(7,000) $(7,000.00) $(7,000.00)
1 2,000 1,739.13 (5,260.87)
2 1,000 756.14 (4,504.73)
3 5,000 3,287.58 (1,217.15)
4 3,000 1,715.26 498.11
} PB
disc
= 3.71

PV of CF Cumulative

Year Cash Flow (k = 15%) PV of CF


A project is acceptable if PB
disc
< projects life

Capital BudgetingInternal
Rate of Return (IRR)
If NPV>0, projects return > k
IRR = projects rate of return
IRR = the rate of return that causes the NPV
of the project to equal zero, or where the
present value of the future cash flows equals
the initial investment.

Capital BudgetingInternal
Rate of Return (IRR)
n
n
2
2
1
1
0
IRR) (1
CF
IRR) (1
CF
IRR) (1
CF
CF
+
+ +
+
+
+
=
. . .

n
n
2
2
1
1
0
0
IRR) (1
CF
IRR) (1
CF
IRR) (1
CF
CF NPV =
+
+ +
+
+
+
+ =
. . .

A project is acceptable if its IRR > k

Capital BudgetingInternal
Rate of Return (IRR)
4 3 2 1
IRR) (1
$3,000
IRR) (1
$5,000
IRR) (1
$1,000
IRR) (1
$2,000
$7,000
+
+
+
+
+
+
+
=
4 3 2 1
0
IRR) (1
3,000
IRR) (1
5,000
IRR) (1
1,000
IRR) (1
2,000
7,000 NPV =
+
+
+
+
+
+
+
+ =

Solving for IRRNumerical
Solution
4 3 2 1
IRR) (1
$3,000
IRR) (1
$5,000
IRR) (1
$1,000
IRR) (1
$2,000
$7,000
+
+
+
+
+
+
+
=
Using the trial-and-error method plug in
values for IRR until the left and right side of
the following equation become equal.

Solving for IRRNumerical
Solution
Rate of Return NPV
15% 498.12
16 327.46
17 162.72
18 3.62
19 (150.08)
} 18<IRR<19

Solving for IRRFinancial
Calculator Solution
Input the following into the cash flow register:
CF
0
= -7,000
CF
1
= 2,000
CF
2
= 1,000
CF
3
= 5,000
CF
4
= 3,000
Compute IRR = 18.02%

Capital BudgetingIRR
Advantages:
Cash flows rather than profits are analyzed
Recognizes the time value of money
Acceptance criterion is consistent with the goal
of maximizing value
Disadvantages:
Detailed, accurate long-term forecasts are
required to evaluate a projects acceptance
Difficult to solve for IRR without a financial
calculator or spreadsheet

NPV versus IRR
When NPV>0, a project is acceptable because
the firm will earn a return greater than its
required rate of return (k) if it invests in the
project.
When IRR>k, a project is acceptable because
the firm will earn a return greater than its
required rate of return (k) if it invests in the
project.
When NPV>0, IRR>k for a projectthat is, if a
project is acceptable using NPV, it is also
acceptable using IRR

NPV Profile
A graph that shows the NPVs of a project at
various required rates of return.
Rate of Return NPV
15% 498.12
16 327.46
17 162.72
18 3.62
19 (150.08)
20 (298.61)
21 (442.20)

NPV Profile
IRR = 18.02%
($2,000)
($1,000)
$0
$1,000
$2,000
$3,000
$4,000
$5,000
5% 10% 15% 20% 25%
NPV
k
NPV > 0
NPV < 0

Capital Budgeting Techniques
Illustrative Projects A & B
0 (7,000.00) (8,000.00)
1 2,000.00 6,000.00
2 1,000.00 3,000.00
3 5,000.00 1,000.00
4 3,000.00 500.00
PB = 2.80 1.67
NPV = 498.12 429.22
IRR = 18.02% 19.03%

k = 15%

Cash Flow,
Year Project A Project B
t
CF
.
NPV Profiles for Projects A & B
-2000
-1000
0
1000
2000
3000
4000
5000
5% 10% 15% 20% 25%
NPV
k
IRR
B
= 19.03
IRR
A
= 18.02
Crossover = 16.15
Project A
Project B

NPV/IRR Ranking Conflicts
Asset A
Traditional PB 2.80 yrs
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Asset A
Traditional PB
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Discounted PB 3.71 yrs
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Discounted PB 3.71 yrs 2.78 yrs
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Discounted PB 3.71 yrs 2.78 yrs
NPV $498.12
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Discounted PB 3.71 yrs 2.78 yrs
NPV $498.12 $429.22
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Discounted PB 3.71 yrs 2.78 yrs
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Discounted PB 3.71 yrs 2.78 yrs
NPV $498.12 $429.22
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Discounted PB 3.71 yrs 2.78 yrs
NPV $498.12 $429.22
IRR 18.02%
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Discounted PB 3.71 yrs 2.78 yrs
NPV $498.12 $429.22
IRR 18.02% 19.03%
Asset A Asset B
Traditional PB 2.80 yrs 1.67 yrs
Discounted PB 3.71 yrs 2.78 yrs
NPV $498.12 $429.22
IRR 18.02% 19.03%
Which asset(s) should be purchased?

Which asset(s) should be purchased? Asset
A, because it has the higher NPV.

NPV/IRR Ranking Conflicts
Ranking conflicts result from:
Cash flow timing differences
reinvestment assumptions
Size differences
Unequal lives

Capital Budgeting
What are the various types of capital budgeting decisions? What
does it mean for projects to be independent? Mutually exclusive?
How do the payback period (both traditional and discounted), net
present value (NPV), and internal rate of return (IRR) techniques
differ?
What is the relationship between the firms required rate of return
and the projects IRR? What is the projects discounted payback
period relative to its life?
What is an NPV profile is, how it is used, and how it is
constructed?
How do capital budgeting decisions differ from general asset
valuation?