Capital Budgeting

1.

INTRODUCTION

Capital budgeting refers to an investment decisionmaking process used by an organization to evaluate

and select long-term investment projects. Basically,
capital budgeting is associated with the justification of
capital expenditures. Capital expenditures are long-term
in nature and are amortized over period of years. For
example, investments in capital equipment, purchase or
lease of buildings, purchase or lease of vehicles, etc.
The specific capital budgeting procedures used by a
manager depend on following factors:
Managers level in the organization.
2.

Size and complexity of the project being

evaluated.
Size of the organization.
Importance of Capital Budgeting process: It indicates
two things regarding the quality of management of a
firm:
a) The degree to which management focuses on
the goal of maximizing wealth of shareholders.
b) Managements effectiveness in pursuing that
goal.

THE CAPITAL BUDGETING PROCESS

The typical steps in the capital budgeting process are as

follows:

Capital budgeting projects may be divided into the

following categories:

1) Generating ideas: It is the most important part of the

process. Investments ideas can be generated from:

1. Replacement projects: They include:

Top or the bottom of the organization

Any department or functional area
Outside the company.
2) Analyzing individual proposals: This step involves
forecasting cash flows and evaluating the project.
3) Planning the capital budget: This step involves
organizing the profitable proposals by taking into
account firms financial and real resource constraints,
projects timing; and deciding which projects fit into
the firms overall strategies.
4) Monitoring and post-auditing: In post-audit, actual
results are compared to planned or predicted results
and any differences between them are explained.
Post-auditing capital projects is important for several
reasons i.e.
i. It helps in monitoring the forecasting process and
to identify systematic errors i.e. overly optimistic
forecasts.
ii. It helps to improve business operations by
focusing attention on costs or revenues that are
not in accordance with expectations.
iii. It facilitates to generate concrete ideas for future
investments i.e. organization can decide to invest
in profitable projects and scale down or cancel
unprofitable investments.

i. Replacement of old equipment for the

maintenance of business.
They may not require careful analysis.
ii. Replacement of old/out-of-date equipment with
newer, more efficient equipment for cost savings
purposes.
They may require very detailed analysis.
2. Expansion projects: Expansion projects refer to
projects which are undertaken to increase the size of
the business. Expansion includes expansion of product
line or market-expansion decisions.
These expansion decisions may involve more
uncertainties compared to replacement decisions.
These expansion decisions require more careful
analysis.
3. New products and services: These investments are
relatively more complex and involve more
uncertainties than expansion projects. They require
very detailed and careful analysis and involve more
people in the decision-making process.
4. Regulatory, Safety, and Environmental projects: These
projects are usually mandatory projects for a firm i.e.
required by a governmental agency, an insurance
company or some other external party.
They may or may not generate any revenue.
Typically, they are not undertaken to maximize
own private interests of a firm.
These projects may be quite expensive; thus, a firm
may find it more feasible to either cease operating
altogether or to shut down any part of the business

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FinQuiz Notes 2 0 1 5

Reading 35

Reading 35

Capital Budgeting

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5. Other:They include pet projects or high risk projects.

that is related to the project.

They may be difficult to analyze using standard

techniques.
3.

BASIC PRINCIPLES OF CAPITAL BUDGETING

Capital budgeting usually uses the following

assumptions:
1. Decisions are based on cash flows:
In addition, intangible costs and benefits are often
ignored because it is assumed that if these benefits
or costs are real, they will eventually be reflected
in cash flows.
The relevant cash flows to be considered are
incremental cash flows. Sunk costs should be
ignored in the analysis.
2. Timing of cash flows is critical i.e. cash flows that are
received earlier are more valuable than cash flows
that are received later.
3. Cash flows are based on opportunity costs:
Opportunity costs should be included in project costs.
These costs refer to the cash flows that could be
generated from an asset if it was not used in the
project.
4. Cash flows are analyzed on an after-tax basis. Cash
flows on after-tax basis should be incorporated in the
analysis.
5. Financing costs are ignored. Financing costs are
reflected in the required rate of return which is used to
discount after-tax cash flows and investment outlays
to estimate net present value(NPV) i.e. only projects
with expected return > cost of the capital (required
return) will increase the value of the firm.
Financing costs are not included in the cash flows;
because when financing costs are included in
both cash flows and in the discount rate, it results
in double-counting of the financing costs.
6. Capital budgeting cash flows are not accounting net
income.
Differences between Accounting Net Income and
Economic Income
Accounting Net Income

Economic Income

1) Noncash charges (i.e.

accounting
depreciation) are
subtracted from
accounting net
income.
2) Interest expenses

Economic income = cash

inflows + in market value
of the firm.
i. Cost of debt is not
subtracted from
economic income.
ii. Economic income is

Accounting Net Income

(reflecting cost of
debt) are subtracted
from accounting net
income.

Economic Income
based on changes in
market value of the
firm rather than
changes in its book
value (accounting
depreciation).

Required rate of return: The required rate of return

represents the discount rate that is required by investors
given the riskiness of the project.
Opportunity cost of funds: When a firm can invest
elsewhere and earn a return r or when a firm can save
a cost of r by repaying its sources of capital, discount
rate is referred to as the Opportunity cost of funds.
A firm should not invest when return earned <
opportunity cost of funds.
Cost of capital: It refers to the cost of funds that is
supplied by firms suppliers of capital.
A firm should not invest when return earned < cost of
capital.
Important Capital Budgeting Concepts:
Sunk costs: These refer to costs that have already been
incurred regardless of whether a project is taken on or
not e.g. consulting fees paid to prepare a report on the
feasibility of a project. These costs should not to be
included in cost; decisions should be based on current
and future cash flows.
An opportunity cost: These costs refer to the cash flows
that could be generated from an asset if it was not used
in the project. Opportunity costs should be taken into
account.
Examples:
If a company uses some idle property, opportunity
costs will be the current market value of that
property.
If a company replaces an old machine with a new
one, opportunity cost will be the cash flows
generated by old machine.
If a company invests $10 million; $10 million
represents opportunity costs.

Reading 35

Capital Budgeting

Incremental cash flow: Only incremental cash flows

should be considered. They refer to total cash flows that
occur as a direct result of undertaking a specific project.

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Effects of project interactions on the evaluation of a

capital project:
1) Independent versus mutually exclusive projects:

Incremental cash flow = Cash flow with a decision - Cash

flow without that decision
Externality: An externality refers to effect of a project on
other parts of a firm (either positive or negative effect). It
should be taken into account in the analysis. For
example, cannibalization is a type of externality which
occurs when new investment takes customer and sales
away from another part of the company.
Conventional versus nonconventional cash flows:
A conventional cash flow pattern is one with an
initial cash outflow followed by a series of cash
inflows i.e. cash flows change signs once.
A nonconventional cash flow pattern is one in
which the initial cash outflow is not followed by
cash inflows only i.e. cash inflows are followed by
cash outflows and so on. In nonconventional
pattern, cash flows change signs two or more
times.

Independent projects are projects whose cash

flows are independent of each other. Since
projects are unrelated, each project is evaluated
on the basis of its own profitability.
Mutually exclusive projects compete directly with
each other e.g. if Projects A and B are mutually
exclusive, you can choose A or B, but you cannot
choose both.
2) Project sequencing: It refers to projects that are
sequenced through time i.e. investing in a project
creates the option to invest in future projects e.g.
A company may invest in a project today and
then in invest in a second project after one year
only if the financial results of the first project or new
economic conditions are favorable; otherwise,
investment in the second project is avoided.
3) Unlimited funds versus capital rationing:
When unlimited funds are available to a firm, it can
invest in all profitable projects.
In capital rationing, a firm has constraints on the
amount of capital that can be raised. Since a firm
has fixed amount of capital to invest, it will invest
only in those profitable projects that will maximize
shareholder value subject to capital constraints.

4.

INVESTMENT DECISION CRITERIA

Measures used to determine whether a project is

profitable or unprofitable are as follows:

Net present value (NPV)

Internal rate of return (IRR)
Payback period
Discounted payback period
Average accounting rate of return (AAR)
Profitability index (PI)

4.1

Net Present Value

NPV = Present value of cash inflows initial investment



 = 






1 +

where,
CFt = After-tax cash flow at time t
r = required rate of return for the investment
CF0 = investment cash outflow at time zero

Decision Rule:
Accept a project if NPV 0
Do not Accept a project if NPV< 0
Independent projects: All projects with positive NPV are
accepted.
Mutually exclusive projects: A project with the highest
NPV is accepted.
Positive NPV investments increase shareholders wealth.
Advantages:
1) NPV directly measures the increase in value of the
firm.
2) NPV assumes reinvestment at r (opportunity cost
of capital).

Reading 35

4.2

Capital Budgeting

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Internal Rate of Return (IRR)

IRR is the discount rate that makes

Present value of cash inflows = initial investment
In simple words, IRR is the discount rate where NPV
= 0.
IRR is calculated using trial and error method or by
using a financial calculator.
Example:
IRR is found by solving the following:
10,000 

2,000
2,500
3,000
3,500



1  
 1  
 1  
 1  

4,000

1  

Solution: IRR = 13.45%

Decision Rule:
Accept a project if IRR Cost of Capital.
Do not Accept a project if IRR< Cost of Capital.
If projects are independent, accept both if IRR of
both projects Cost of Capital.
If projects are mutually exclusive and Project A
IRR>Project B IRR, accept Project A because
IRRA>IRRB .

Decision Rule: Shorter the payback period, better it is.

Advantages:
1) It is simple and easy to calculate and understand.
2) It is a measure of the liquidity of the project i.e.
lower payback period project is more liquid than
another project with a longer payback period.
Limitations:
1) It ignores the time value of money.
2) It ignores all cash flows beyond the payback
period.
3) Its cutoff period is subjective.
4) It is a measure of payback; not a measure of
profitability.
5) It is not consistent with wealth maximization
because it focuses on short-run profits at the
expense of larger long-term profits.
6) It is not economically sound.

Practice: Example 1,
Volume 4, Reading 35.

Advantages of IRR:
1)
2)
3)
4)
5)

IRR considers time value of money.

IRR considers all cash flows.
IRR involves less subjectivity.
It is easy to understand.
It is widely accepted.

4.4

Discounted Payback Period

Discounted payback period is similar to payback period

but it uses discounted rather than raw CFs i.e. it measures
the amount of time that a project takes to recover initial
investment given the PV of cash inflows.

Limitations of IRR:
1) IRR is based on the assumption that cash flows
are reinvested at the IRR; however, this may not
always be realistic.
2) IRR provides result in percentages; however,
percentages can be misleading and involves
difficulty in ranking projects i.e. a firm rather earn
100% on a $100 investment, or 10% on a $10,000
investment.
3) In case of non-conventional cash flow pattern,
there can be multiple IRRs or no IRR at all.
4.3

Payback Period

The payback period measures the time that a project

takes to recover the cost of the investment.

Important: Note that discounted payback period is

always longer than the regular payback period.
Decision Rule: Shorter the discounted payback period,
better it is.
Advantages:
1) It is simple and easy to calculate and understand.
2) It is a measure of the liquidity of the project i.e.
lower discounted payback period project is more

Reading 35

Capital Budgeting

liquid than another project with a longer

discounted payback period.
3) It takes into account time value of money.

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Decision rule for the PI:

Invest if PI > 1.0
Do not invest if PI < 1.0

Limitations:
PI v/s NPV:
1) It ignores all cash flows beyond the discounted
payback period.
2) Its cutoff period is subjective.
3) It is a measure of payback; not a measure of
profitability.
4) It is not consistent with wealth maximization
because it focuses on short-run profits at the
expense of larger long-term profits.
5) It is not economically sound.
Discounted payback versus NPV:
If a project has a negative NPV, it will usually not
have a discounted payback period because it will
not recover the initial investment.
However, it is possible for a project to have a
reasonable discounted payback period in spite of
having a negative NPV due to positive cumulative
discounted cash flows in the middle of its life.
4.5

PI: Ratio of the PV of future cash flows to the initial

investment.
NPV: Difference between the PV of future cash
flows and the initial investment.
Whenever NPV is positive, the PI > 1.0.
Whenever NPV is negative, the PI < 1.0.
Advantages:
1) PI is useful in capital rationing i.e. when available
investment funds are limited.
2) It is easy to understand and communicate.
3) It provides correct decisions when independent
projects are evaluated.
4) It is closely related to NPV.
Limitation: It is not a reliable measure to evaluate
mutually exclusive projects.

Average Accounting Rate of Return

AAR =

Practice: Example 2,
Volume 4, Reading 35.

   

      

Decision Rule: If the AAR is greater than some arbitrarily

specified cutoff rate, accept the project.
Advantage: It is easy to understand and easy to
calculate.
Limitations:
1) AAR is based on accounting numbers and not
based on cash flows.
2) AAR ignores the time value of money.
3) AAR is not adjusted for risk.
4) AAR uses an arbitrarily specified cutoff rate to
distinguish between profitable and unprofitable
investments.

4.6

4.7

NPV Profile

NPV profile refers to a graph that shows NPV as a

function of various discount rates i.e. NPV is plotted on
the vertical axis (y-axis) and discount rates are plotted
on the horizontal axis (x-axis).

Profitability Index
PI =

     !

 

=1+

" 
 

It indicates the value received by a company in

exchange for one unit of currency invested.
In corporation, it is referred to as the profitability
index.
In governmental and not-for-profit organizations, it
is referred to as a benefit-cost ratio.

Vertical axis represents a discount rate of zero. Point at

which the NPV profile intersects (crosses) the vertical axis
represents the sum of undiscounted cash flows from a
project.
Horizontal axis represents an NPV of 0. Point at which the
NPV profile intersects (crosses) the horizontal axis
represents points where NPV = 0 i.e. projects IRR.
Cross-over rate: The rate at which two NPV profiles
intersect with each other is called crossover rate. It is the
point where NPVs of the projects are the same.

Reading 35

Capital Budgeting

As shown in the graph,

NPV decreases at a decreasing rate as the
discount rate increases.
NPV profile is convex from the origin.
It is important to note that if the cost of capital<discount
rate at the cross-over point, choosing the project with
the highest IRR results in selecting the project which
contributes the least to the firms equity value.

Practice: Example 3,
Volume 4, Reading 35.

4.8

4.9

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The Multiple IRR Problem and the No IRR Problem

Multiple IRRs problem: When the cash flows change sign

more than once (i.e. non-conventional cash flow
pattern), there can be more than one IRR. This problem is
referred to as Multiple IRR problem e.g.

In this case, NPV profile of the project intersects the

horizontal line twice i.e. at discount rate 100% and
discount rate 200%.

Ranking Conflicts between NPV and IRR

No conflict exists between the decision rules for NPV and

IRR when:
1) Projects are independent.
2) Projects have conventional cash flow pattern.

No IRR problem: There maybe no IRR when the cash flow

pattern is of following type:

Conflict exists between the decision rules for NPV and IRR
when:
1) Projects are mutually exclusive.
2) Projects have non-conventional cash flow pattern.

In this case, NPV profile may never cross the horizontal

axis.

NPV and IRR rank projects differently due to following

reasons:
1) Differences in cash flow patterns.
2) Size (scale) differences: Sometimes, the larger,
low rate of return project has the better NPV.
NPV versus IRR:
NPV assumes that cash flows are reinvested at r
(opportunity cost of capital).
IRR assumes that cash flows are reinvested at IRR.
It is more realistic to assume reinvestment at
opportunity cost r; thus, NPV method is best. It
implies that whenever there is a conflict between
NPV and IRR decision rule and to choose between
mutually exclusive projects, we should always use
NPV.

Practice: Example 4 & 5,

Volume 4, Reading 35.

When there is no IRR, it implies that NPV is always >

0.
Various capital budgeting methods are used depending
on following four criteria:
a) Location: European countries tend to prefer
payback period method to the IRR and NPV
methods.
b) Size of the company: Larger companies tend to
prefer discounted cash flow techniques i.e. NPV
and IRR methods.
c) Public vs. private: Private companies use the
payback period more often than public
companies. Public companies tend to prefer
discounted cash flow methods.
d) Management education: Companies managed
by an MBA tend to prefer discounted cash flow
techniques i.e. NPV and IRR methods.

Reading 35

Capital Budgeting

The Relationship between NPV and Stock Price:

NPV investment decision criterion is considered the
criterion that is most directly related to stock price of a
firm. Investing in a positive NPV project leads to increase
in wealth of the firms shareholders.
According to theory, a positive NPV project should
result in a proportionate increase in the companys
stock price.
Value of a company = value of companys existing
investments + Net PV of all of
companys future investments
However, in reality, changes in the stock price will
primarily result due to changes in expectations
about a projects profitability.
o When NPV is positive but, its profitability <
expected profitability, stock price may
decrease.

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Example: Suppose NPV = $1,550and there are 1,000

shares outstanding, then
Value created per share =
=

" 

#    $
$, 
,

= $1.55

This implies that if the project is accepted, then the

price of the stock should increase by $1.55.

Practice: Example 6,
Volume 4, Reading 35.

Practice: End of Chapter Practice

Problems for Reading 35.