Business Finance

Introductory Capital Budgeting

Net present value
‫ܥ‬ଵ ‫ܥ‬ଶ ‫ܥ‬௡
ܸܰܲ = + + ⋯+ − ‫ܫ‬଴
(1 + ݇) (1 + ݇)ଶ (1 + ݇)௡
If all cash flows are the same:
‫ܥ‬ 1
ܸܰܲ = × ൬1 − ൰ − ‫ܫ‬଴
݇ (1 + ݇)௡
Note that cash flows are after tax
For independent projects, accept all projects with an NPV > 0

ܸܰܲ The effect of the project on the share price

݊‫݋‬. ‫ݏ ݂݋‬ℎܽ‫ݏ݁ݎ‬

IRR: Internal rate of return

To calculate the IRR, set NPV = 0

‫ܥ‬ଵ ‫ܥ‬ଶ ‫ܥ‬௡
ܸܰܲ = 0 = + + ⋯+ − ‫ܫ‬଴
(1 + ݇) (1 + ݇) ଶ (1 + ݇)௡

The project is accepted when IRR (or r) > k

IRR < discount rate (k) = NPV < 0

IRR > discount rate (k) = NPV > 0

Note: the IRR assumes that all cash flows can be re-invested at the same rate of return (common to all annuities)

Problems with the IRR

1. In some cases, it is possible to have two IRRs
A necessary condition for multiple IRRs is that there is more than one sign change in the future expected net cash
flows. This is not a sufficient condition however. That is, two sign changes does not guarantee multiple IRRs

Number of sign changes Maximum number of IRRs

–+++ 1 sign change 1
–+–+ 2 sign changes 2
– + – + +– + – 4 sign changes 4

Say we find two IRRs – 7.2% and 28.6%

Should we accept? We need to plot the IRRs against the NPV (y-axis) to determine this
But how do we know if the NPV is positive or negative between these numbers?
We would have to calculate the NPV at a point in between, or graph the function
In either case, we still need the NPV

2. In some cases, there is no IRR – that is, the function never crosses the x-axis so IRR is undefined

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Independent projects
Projects are evaluated independently of one another – there is no restriction on the number of projects that are
accepted
Decision rule: accept all projects with NPV > 0 and IRR > k

Mutually exclusive projects

The acceptance of one project rules out the acceptance of another project
Decision rule: accept the project with the highest NPV
IRR is problematic
 • Sometimes, the IRR will be higher for the lower NPV project and vice-versa. This occurs because the graphs
of discount rate vs. NPV intersect, so for any discount rate below the crossover rate, the IRR gives a
misleading result.

We can make the IRR consistent by using the incremental method

A B B–A
0 –$120,000 –$120,000 $0
1 $100,000 $10,000 –$90,000
2 $50,000 $60,000 $10,000
3 $15,000 $120,000 $105,000
NPV $23,501 $28,835 –
IRR 24.8% 19.8% 13.7% - crossover rate

‫ݎ‬஻ି஺ = 13.7%

If the required rate of return is 10%, then we should accept project B

Accounting rate of return

Decision rule: a project is acceptable if its ARR exceeds a minimum specified rate of return. For mutually exclusive
projects, managers choose the project with the highest ARR

ARR using the initial investment

ܽ‫ݏ݃݊݅݊ݎܽ݁ ݁݃ܽݎ݁ݒ‬
‫= ܴܴܣ‬ × 100
݅݊݅‫ܫ(ݐ݊݁݉ݐݏ݁ݒ݊݅ ݈ܽ݅ݐ‬଴ )

ARR using the average investment

ܽ‫ݏ݃݊݅݊ݎܽ݁ ݁݃ܽݎ݁ݒ‬
‫= ܴܴܣ‬ × 100
ܽ‫ݐ݊݁݉ݐݏ݁ݒ݊݅ ݁݃ܽݎ݁ݒ‬

Problems
• Earnings are not net cash flows (earnings are subject to accounting choices)
• The time value of money is ignored
• Favours projects with shorter lives

Payback period
The time it takes for the initial cash outlay to be recovered from the net after-tax cash flows
Decision rule: a project is acceptable if its payback period is less than the specified payback period. For mutually
exclusive projects, managers choose the project with the lowest payback period

Method:
Add the cash flows – if the initial outlay is $100,000 and you receive $50,000 in year 1 and $50,000 in year 2, the
payback period is 2 years. If the same outlay applies and you receive $50,000 in year 1, $30,000 in year 2 and $30,000
in year 3, the payback period is 1 + 1 + (20000/30000=0.7) = 2.7 years. Note that this assumes cash flows are
distributed evenly throughout the year.

Problems
• Time value of money is ignored
• Biased against projects that have a longer development period
• Fails to take into account cash flows that occur after the cut-off date
However, useful when evaluating a risky project (i.e. investment in Iraq) where risk is lowered for shorter
payback periods.

In general:
• The ARR and payback period may be useful when used in conjunction with the NPV and IRR
• When used independently, however, they may destroy firm value