CAPITAL BUDGETING:

Outline:
1. Steps in Capital Budgeting
2. Measuring Project Probability
3. Cost of Capital
Capital Budgeting

Is the allocation of funds to long-lived capital projects.

The principles and tools of capital budgeting are applied in many
different aspects of a business entitys decision making and in security
valuation and portfolio management.
A companys capital budgeting process and prowess are important in
valuing a company.

Steps in Capital Budgeting

1.
2.
3.
4.

Generating Ideas
Analyzing Individual Proposals
Planning the Capital Budget
Monitoring and Post Auditing

Project Classifications
1. Replacement projects are expenditures necessary to replace wornout or damaged equipment.
2. Cost reduction projects include expenditures to replace
serviceable but obsolete plant and equipment. The purpose of these
projects is to lower production costs by reducing expenses for labor,
raw materials, heat or electricity.
3. Expansion projects involve expenditures to increase the availability
of existing products and services. These decisions are relatively
complex coz they require an explicit forecast of the firms future
supply and demand conditions.
Basic principles of Capital Budgeting

Decisions are based on cash flows

The timing of cash flows is crucial
Cash flows are incremental
Cash flows are on an after tax basis

Financing costs are ignored

Independent and Mutually Exclusive Projects

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.

Costs:
A sunk cost is a cost that has already occurred, so it cannot be part of the incremental
cash flows of a capital budgeting analysis.
An opportunity cost is what would be earned on the next-best use of
the assets.
An incremental cash flow is the difference in a companys cash flows
with and without the project.
An externality is an effect that the investment project has on
something else, whether inside or outside of the company.
Conventional and Nonconventional cash flows
Conventional Cash Flow

Nonconventional Cash Flow

Project Sequencing

Capital projects may be sequenced, which means a project contains an option to invest in
another project.
o Projects often have real options associated with them; so the
company can choose to expand or abandon the project, for
example, after reviewing the performance of the initial capital
project.

Capital Rationing
Capital rationing is when the amount of expenditure for capital projects in a given
period is limited.
If the company has so many profitable projects that the initial
expenditures in total would exceed the budget for capital projects for
the period, the companys management must determine which of the
projects to select.
The objective is to maximize owners wealth, subject to the constraint
on the capital budget.
o Capital rationing may result in the rejection of profitable projects.
Capital Budgeting Techniques
1.
2.
3.
4.
5.
6.

Net Present Value

Internal Rate of Return
Payback Period
Discounted Payback Period
Average Accounting Rate of Return
Profitability Index

Net Present Value

For a simple project with one investment outlay, made initially, the net
present value (NPV) is the present value of the future after -tax cash flows
minus the investment outlay, or :

INVESTMENT RULE: Invest if NPV>0 //Do not invest if NPV<0

Example: Net Present Value

Consider the Hoofdstad Project, which requires an investment of 1 billion
initially, with subsequent cash flows of 200 million, 300 million, 400 million,
and 500 million. We can characterize the project with the following end-ofyear cash flows:

Period
0
1
2
3
4

Cash Flow
(millions)
1,000
200
300
400
500

What is the net present value of the Hoofdstad Project if the required rate of
return of this project is 5%?

Solving for the NPV:

NPV = 1,000+

200
300
400
500
+
+
+
1
2
3
( 1+ 0.05 ) ( 1+0.05 ) ( 1+0.05 ) ( 1+0.05 ) 4

NPV =1,000+190.48+272.11 +345.54+ 411.35

NPV = 219.47 million

Internal Rate of Return

The internal rate of return is the rate of return on a project.

The internal rate of return is the rate of return that results in NPV = 0.
n

CF

t
Outlay
(1+IRR)
t
t =1

=0

Or, reflecting the outlay as CF ,

0
n

CF

t
=0
(1+ IRR)
t
t=0

If IRR > r (required rate of return):

Invest: Capital project adds value

If IRR < r:

Do not invest: Capital project destroys value

Example: Internal Rate of Return

Consider the Hoofdstad Project that we used to demonstrate the NPV

calculation:

Period

Cash Flow
(millions)

1,000

200

300

400

500

The IRR is the rate that solves the following:

$ 0=1,000

+200
300
400
500
+
+
+
1
2
3
( 1+ IRR ) (1+ IRR ) (1+ IRR ) ( 1+ IRR )4

The IRR is the rate that causes the NPV to be equal to zero.
The problem is that we cannot solve directly for IRR, but rather must either iterate
(trying different values of IRR until the NPV is zero) or use a financial calculator or
spreadsheet program to solve for IRR.
In this example, IRR = 12.826%:

$ 0=1,000

+200
300
400
500
+
+
+
1
2
3
( 1+0.12826 ) ( 1+ 0.12826 ) ( 1+0.12826 ) ( 1+0.12826 ) 4

Payback Period
The payback period is the length of time it takes to recover the initial cash outlay
of a project from future incremental cash flows.
In the Hoofdstad Project example, the payback occurs in the last year, Year 4:

Cash Flow
(millions)
1,000
200
300
400
500

Period
0
1
2
3
4

Accumulated
Cash flows
1,000
800
500
100
+400

For example, the payback period for both Project X and Project Y is three years,
even though Project X provides more value through its Year 4 cash flow:

Year

Project X
Cash
Flows

Project Y
Cash
Flows

100

100

20

20

50

50

45

45

60

Discounted Payback Period

The discounted payback period is the length of time it takes for the cumulative
discounted cash flows to equal the initial outlay.
In other words, it is the length of time for the project to reach NPV = 0.
Compared to ordinary payback periods discounted payback periods are longer . It
may result in a different project ranking
The discounted payback period rule says that a project is acceptable if its
discounted payback period is shorter or equal to the cutoff period
Among several projects, the one with the shortest period should be accepted

Cash Flows

Discounted
Cash Flows

Accumulated
Discounted
Cash Flows

Year

Project X

Project Y

Project X

Project Y

Project X

Project Y

0
1
2

100.00
20.00
50.00

100.00
20.00
50.00

100.00
19.05
45.35

100.00
19.05
45.35

100.00
80.95
35.60

100.00
80.95
35.60

3
4

45.00
60.00

45.00
0.00

38.87
49.36

38.87
0.00

3.27
52.63

3.27
3.27

Consider the example of Projects X and Y. Both projects have a discounted payback
period close to three years. Project X actually adds more value but is not
distinguished from Project Y using this approach.

Average Accounting Rate of Return

The average accounting rate of return (AAR) is the ratio of the average
net income from the project to the average book value of assets in the
project:
AAR =

Average net income

Average book value

Unlike the other capital budgeting criteria AAR is based on accounting numbers, not
on cash flows. This is an important conceptual and practical limitation.
The AAR also does not account for the time value of money, and there is no
conceptually sound cutoff for the AAR that distinguishes between profitable and
unprofitable investments.

Profitability index
The profitability index (PI) is the ratio of the present value of future cash flows to
the initial outlay:

PI =

Present value of futurecash flows

NPV
=1+
Initial investment
Initial investment
(2-5)

Whenever the NPV is positive, the PI will be greater than 1.0, and conversely,
whenever the NPV is negative, the PI will be less than 1.0
Investment Rule:

Invest if PI >1.0

Do not invest if PI <1.0

Example: Profitability Index

In the Hoofdstad Project, with a required rate of return of 5%,
Period

0
1
2
3
4

Cash
Flow
(million
s)
-1,000
200
300
400
500

The present value of the future cash flows is 1,219.47. Therefore, the PI is:
PI =

1,219.47
=1.219
1,000.00

Cost of Capital
The cost of capital represents the firms cost of financing, and is the
minimum rate of return that a project must earn to increase firm value.

Financial managers are ethically bound to only invest in projects that they expect to
exceed the cost of capital.
The cost of capital reflects the entirety of the firms financing activities.

Most firms attempt to maintain an optimal mix of debt and equity financing.

To capture all of the relevant financing costs, assuming some desired mix of financing,
we need to look at the overall cost of capital rather than just the cost of any single source
of financing.