Chapter 3

Capital
Budgeting/Investment
Decision
 Definition and Importance
of Capital Budgeting
The investment decisions of a firm are
generally known as the capital budgeting, or
capital expenditure decisions.
It is analysis of potential additions to fixed
assets.
Very important to firm’s future. The goal of
these decisions is to select capital projects that
will increase the value of the firm
Long-term decisions; involve large expenditures.
Capital-budgeting techniques help management
to systematically analyze potential business
opportunities in order to decide which are worth
undertaking
 Project classifications
Capital budgeting projects can be
broadly classified into three types:
1. Independent projects
2. Mutually exclusive projects
3. Contingent projects
Classification of Investment
Projects

1. Independent Projects:
 Projects are independent when
their cash flows are unrelated
 If two projects are independent,
accepting or rejecting one project
has no bearing on the decision for
the other
 Classification of Investment
Projects

2. Mutually Exclusive Projects:

 When two projects are mutually
exclusive, accepting one
automatically precludes the other
 Mutually exclusive projects
typically perform the same
function
Classification of Investment Projects

3. Contingent Projects:
 Contingent projects are those
where the acceptance of one
project is dependent on another
project
 Capital Budgeting
Processes
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.
 Capital Budgeting Evaluation
Techniques
1. Discounted Cash Flow (DCF)
Criteria
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)
 Discounted Payback Period (DPB)
2. Non-discounted Cash Flow Criteria
 Payback Period (PB)
 Accounting Rate of Return (ARR)
 Net Present Value (NPV)
The difference between the market
value of a project and its cost
How much value is created from
undertaking an investment?
The first step is to estimate the expected
future cash flows.
The second step is to estimate the
required return for projects of this risk
level.
The third step is to find the present value
of the cash flows and subtract the initial
investment.
 Net Present Value
Method
Net present value should be found out by
subtracting present value of cash outflows
from present value of cash inflows. The
formula for the net present value can be
written as follows:
 C1 C2 C3 Cn 
NPV   2
 3
 n
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
n
Ct
NPV  t
 C0
t 1 (1  k )
 Project Example
Information
You are reviewing a new project and
have estimated the following cash
flows:
 Year 0: CF = -165,000
 Year 1: CF = 63,120; NI = 13,620
 Year 2: CF = 70,800; NI = 3,300
 Year 3: CF = 91,080; NI = 29,100
 Average Book Value = 72,000
Your required return for assets of this
risk level is 12%.
 NPV – Decision Rule
If the NPV is positive, accept the
project
A positive NPV means that the project
is expected to add value to the firm
and will therefore increase the wealth
of the owners.
Since our goal is to increase owner
wealth, NPV is a direct measure of how
well this project will meet our goal.
Computing NPV for the Project
Using the formulas:
NPV = -165,000 + 63,120/(1.12) +
70,800/(1.12)2 + 91,080/(1.12)3 =
12,627.41
Do we accept or reject the
project?
Since we have a positive NPV,
we should accept the project.
 Evaluation of the NPV
Method
NPV is most acceptable investment rule for
the following reasons:
Time value
Measure of true profitability
Shareholder value
Limitations:
Involved cash flow estimation
Discount rate difficult to determine
The NPV is expressed in absolute terms
rather than relative terms and hence does
not factor is the scale of investment.
The NPV does not consider the life of the
project.
 Internal Rate of Return (IRR)

This is the most important alternative

to NPV
It is often used in practice and is
intuitively appealing
It is based entirely on the estimated
cash flows and is independent of
interest rates found elsewhere
IRR – Definition and
Decision Rule
Definition: IRR is the return that
makes the NPV = 0
Decision Rule: Accept the project if
the IRR is greater than the
required return
 Computing IRR for the Project
If you do not have a financial
calculator, then this becomes a trial
and error process
Calculator
 Enter the cash flows as you did with NPV
 Press IRR and then CPT
 IRR = 16.13% > 12% required return
Do we accept or reject the project?
Accept the project since IRR > R.
 Advantages of IRR
Knowing a return is intuitively
appealing
It is a simple way to communicate the
value of a project to someone who
doesn’t know all the estimation
details
If the IRR is high enough, you may
not need to estimate a required
return, which is often a difficult task
 Profitability Index (PI)
Profitability index is the ratio of the
present value of cash inflows, at the
required rate of return, to the initial cash
outflow of the investment.
Measures the benefit per unit cost, based
on the time value of money
A profitability index of 1.1 implies that for
every $1 of investment, we create an
additional $0.10 in value
This measure can be very useful in
situations in which we have limited capital
 Acceptance Rule
The following are the PI acceptance
rules:
Accept the project when PI is greater than
one. PI > 1
Reject the project when PI is less than one.
PI < 1
May accept the project when PI is equal to
one. PI = 1
The project with positive NPV will have PI
greater than one. PI less than means that the
project’s NPV is negative.
Disadvantages of Profitability
Index
Advantages Disadvantages
Closely related to May lead to
NPV, generally incorrect
leading to identical decisions in
decisions comparisons of
Easy to understand mutually
and communicate exclusive
May be useful investments
when available
investment funds
are limited
 Payback Period (PB)
How long does it take to get the initial
cost back in a nominal sense?
Computation
 Estimate the cash flows
 Subtract the future cash flows from the
initial cost until the initial investment has
been recovered
Decision Rule – Accept if the payback
period is less than standard
payback period set by management.
 Computing Payback for the
Project
Assume we will accept the project if it pays back
within two years.
 Year 1: 165,000 – 63,120 = 101,880 still to recover
 Year 2: 101,880 – 70,800 = 31,080 still to recover
 Year 3: 31,080 – 91,080 = -60,000 project pays back in year
3
Do we accept or reject the project?
The payback period is year 3 if you assume that the
cash flows occur at the end of the year, as we do
with all of the other decision rules.
If we assume that the cash flows occur evenly
throughout the year, then the project pays back in
2.34 years.
Either way, the payback rule would say to reject the
project.
Advantages and Disadvantages of Payback

Advantages Disadvantages
Easy Ignores the time
to
value of money
understand
Requires an arbitrary
Adjusts for
cutoff point
uncertainty Ignores cash flows
of later beyond the cutoff date
cash flows Biased against long-
Biased term projects, such as
toward research and
liquidity development, and
new projects
 Discounted Payback Period (DPB)
Compute the present value of each
cash flow and then determine how long
it takes to pay back on a discounted
basis
Compare to a specified required period
Decision Rule - Accept the project if
it pays back on a discounted basis
within the specified time
Computing Discounted Payback for the Project
Assume we will accept the project if it
pays back on a discounted basis in 2
years.
Compute the PV for each cash flow and
determine the payback period using
discounted cash flows
Year 1: 165,000 – 63,120/1.121 = 108,643
Year 2: 108,643 – 70,800/1.122 = 52,202
Year 3: 52,202 – 91,080/1.123 = -12,627
project pays back in year 3
Do we accept or reject the project?
No – it doesn’t pay back on a discounted
basis within the required 2-year period
Advantages and Disadvantages of Discounted
Payback
Advantages Disadvantages
Includes time May reject positive
value of money NPV investments
Easy to Requires an arbitrary
understand cutoff point
Does not accept
Ignores cash flows
negative
estimated NPV
beyond the cutoff
investments when point
all future cash Biased against long-
flows are positive term projects, such as
Biased towards R&D and new products
liquidity
Average Accounting Return (AAR)
There are many different definitions
for average accounting return
The one used in the book is:
Average net income / average book value
Note that the average book value
depends on how the asset is depreciated.
Need to have a target cutoff rate
Decision Rule: Accept the project if
the AAR is greater than a preset
rate
 Computing AAR for the
Project
Assume we require an average
accounting return of 25%
Average Net Income:
(13,620 + 3,300 + 29,100) / 3 =
15,340
AAR = 15,340 / 72,000 = .213 =
21.3%
Do we accept or reject the
project?
Advantages and Disadvantages of AAR
Advantages Disadvantages
Easy to Not a true rate of
calculate return; time value
Needed of money is
information ignored
will usually Uses an arbitrary
be available benchmark cutoff
rate
Based on
accounting net
income and book
Summary of Decisions for the
Project

Summary
Net Present Value Accept

Payback Period Reject

Discounted Payback Period Reject

Average Accounting Return Reject

Internal Rate of Return Accept

 NPV vs. IRR
NPV and IRR will generally give us the
same decision
Exceptions
Nonconventional cash flows – cash
flow signs change more than once
Mutually exclusive projects
Initial investments are substantially
different (issue of scale)
Timing of cash flows is substantially
different
 Summary of Decision Rules
The NPV is positive at a required
return of 15%, so you should Accept
If you use the financial calculator,
you would get an IRR of 10.11%
which would tell you to Reject
You need to recognize that there are
non-conventional cash flows and look
at the NPV profile
 IRR and Mutually
Exclusive Projects
Mutually exclusive projects
If you choose one, you can’t choose the
other
Example: You can choose to attend
graduate school at either Wollo or Unity,
but not both
Intuitively, you would use the following
decision rules:
NPV – choose the project with the
higher NPV
IRR – choose the project with the higher
Example With Mutually Exclusive Projects

Period Project Project

A B The required
return for both
0 -500 -400
projects is
1 325 325 10%.
2 325 200

IRR 19.43 22.17 Which project

% % should you
NPV 64.05 60.74 accept and
why?
 Conflicts Between NPV and IRR
NPV directly measures the increase in
value to the firm
Whenever there is a conflict between
NPV and another decision rule, you
should always use NPV
IRR is unreliable in the following
situations
Nonconventional cash flows
Mutually exclusive projects
 Modified IRR
 Calculate the net present value of all
cash outflows using the borrowing
rate.
 Calculate the net future value of all
cash inflows using the investing rate.
 Find the rate of return that equates
these values.
 Benefits: single answer and specific
rates for borrowing and reinvestment
 Summary – DCF Criteria
Net present value
Difference between market value and cost
Take the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required
return
Same decision as NPV with conventional cash flows
IRR is unreliable with nonconventional cash flows or
mutually exclusive projects
Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of
 Summary – Payback Criteria
Payback period
Length of time until initial investment is
recovered
Take the project if it pays back within some
specified period
Doesn’t account for time value of money,
and there is an arbitrary cutoff period
Discounted payback period
Length of time until initial investment is
recovered on a discounted basis
Take the project if it pays back in some
specified period
 Summary – Accounting
Criterion
Average Accounting Return
Measure of accounting profit
relative to book value
Similar to return on assets measure
Take the investment if the AAR
exceeds some specified return level
Serious problems and should not be
used
 Quick Quiz
Consider an investment that costs
$100,000 and has a cash inflow of
$25,000 every year for 5 years. The
required return is 9%, and required
payback is 4 years.
What is the payback period?
What is the discounted payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
What decision rule should be the
primary decision method?
When is the IRR rule unreliable?
 Comprehensive Problem
 An investment project has the following cash flows: CF0 = -
1,000,000; C01 – C08 = 200,000 each
 If the required rate of return is 12%, what decision should be
made using NPV?
 How would the IRR decision rule be used for this project, and
what decision would be reached?
 How are the above two decisions related?

Solution
 NPV = -$6,472; reject the project since it would lower the value
of the firm.
 IRR = 11.81%, so reject the project since it would tie up
investable funds in a project that will provide insufficient return.
 The NPV and IRR decision rules will provide the same decision for
all independent projects with conventional/normal cash flow
patterns. If a project adds value to the firm (i.e., has a positive
NPV), then it must be expected to provide a return above that
which is required. Both of those justifications are good for
shareholders.