1. The Capital Budgeting Decision12
Chapter

2. Chapter 12 - Outline What is Capital Budgeting?
4 Methods of Evaluating Investment Proposals
Payback Period
Net Present Value
Internal Rate of Return
Profitability index
Accept/Reject Decision
Net Present Value Profile
Summary and Conclusions

3. Capital Budgeting Techniques
Should we
build this
plant?

4. What is Capital Budgeting?
represents a long-term investment decision
for example, buy a new computer system or build a new plant
involves the planning of expenditures for a project with a life of 1 or more years
emphasizes amounts and timing of cash flows and opportunity costs and benefits
investment usually requires a large initial cash outflow with the expectation of future cash inflows
considers only those cash flows that will change as a result of the investment
all cash flows are calculated after tax

5. Table 12-1 Cash flow for Alston Corporation
Earnings before amortization and taxes (cash inflow) $20,000
Amortization (non-cash expense) ,000
Earnings before taxes ,000
Taxes (cash outflow) ,500
Earnings after taxes ,500
Amortization ,000
Cash flow $12,500

6. 4 Methods of Evaluating Investment Proposals
Payback Period (PP)
Internal Rate of Return (IRR)
Net Present Value (NPV)
Profitability Index (PI)

7. Types of Capital Projects
Independent Projects
Projects whose cash flows are not affected by the acceptance or rejection of other projects.
Ex: A book publishing company trying to purchase a TV network
Mutually Exclusive Projects
A set of projects where the acceptance of one project means the others cannot be accepted
Ex: Got a parcel of land: Build apartments or Amusement parks

8. Figure 12-1 Capital budgeting procedures
PPT 12-4
Figure 12-1 Capital budgeting procedures
Accounting,
finance,
engineering
Collection
of data
Idea development
Decision making
Results
Assign probabilities
Reassign probabilities
Reevaluation

9. Payback Period Payback Period (PP): Advantages: Disadvantages:
computes the amount of time required to recoup the initial investment
a cutoff period is established
Advantages:
easy to use (“quick and dirty” approach)
emphasizes liquidity
Disadvantages:
ignores inflows after the cutoff period
fails to consider the time value of money

10. Formula For Pay Back period
where,
A= The year in which the cumulative net cash flow is nearer to NCO
NCO= Net cash outlay
C=Cumulative net cash flow of year A.
D= Net cash flow of the year following the year A

11. Net Present Value Net Present Value (NPV):
the present value of the cash inflows minus the present value of the cash outflows
the future cash flows are discounted back over the life of the investment
the basic discount rate is usually the firm’s cost of capital (WACC)(assuming similar risk)

12. Net Present Value (NPV) Method
NPV is a method of evaluating capital investment proposals by finding the present value of future net cash flows, discounted at the rate of return required by the firm
One of two discounted cash flow (DCF) techniques using time value of money that we will cover
NPV = PV of inflows – Cost (Initial Investment)
= Net gain in wealth

13. NPV Method: Disadvantage
NPV Method: Advantage
It Considers the time value of money concept.
It considers the total benefit arising out of invest proposal over its life time.
It is particularly useful for the selection of mutually exclusive project.
NPV Method: Disadvantage
It involves the calculation of the required rate of return to discount the cash flows.
It is absolute measures that favors the higher present value project that may also involves a larger initial outlay.
In case of projects having different lives it may not give dependable results.

14. Internal Rate of Return
PPT 12-12
Internal Rate of Return
Internal Rate of Return (IRR):
represents a yield on an investment or an interest rate
requires calculating the discount rate that equates the initial cash outflow (cost) with the future cash inflows (benefits)
is the discount rate where the cash outflows equal the cash inflows (or NPV = 0)

15. Formula for IRR PV of inflows = Investment Cost (Initial Investment)
So the discount rate at which NPV=O is IRR.

16. IRR: Advantage
Business executives and non-technical people understand the concept of IRR much more readily than they understand the concept of NPV.
IRR recognizes the time value of money concepts.
It considers all the cash flows occurring over the entire life of the project.
It does not use the concept of required rate of return.
It is consistent with the overall objective of maximizing shareholders’ wealth.

17. IRR: Disadvantage Multiple IRRs Calculation is very much difficult.
It is determined based on the assumption that all intermediate cash inflows are reinvested at IRR.

18. Profitability Index Method
The method measures the present value of returns per unit of present value of investment.
The profitability index is defined as the ratio which is obtained by dividing the present value of future cash inflows by cash outflows.

19. The Profitability Index (PI)
Advantages:
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
Disadvantages:
Problems with mutually exclusive investments> ignores differences in scale

20. Accept/Reject Decision
Payback Period (PP):
if PP < cutoff period, accept the project
if PP > cutoff period, reject the project
Internal Rate of Return (IRR):
if IRR > cost of capital, accept the project
if IRR < cost of capital, reject the project
Net Present Value (NPV):
if NPV > 0, accept the project
if NPV < 0, reject the project
Profitability Index (PI)
if PI > 1, accept the project
if PI > 1, reject the project

21. Net Present Value Profile
a graph of the NPV of a project at different discount rates shows the NPV at 3 different points:
a zero discount rate
the normal discount rate (or cost of capital)
the IRR
allows an easy way to visualize whether or not an investment should be undertaken

22. Figure 12-2 Net present value profile
6,000
4,000
2,000
Net present value ($) 5%
10%
15%
20%
25%
IRRB = 14.33%
IRRA = 11.16%
Discount rate (percent)
Investment B
Investment A B A A B

23. Multiple IRRs (Project C)
There are two IRRs for this project:
$ $800
-$200
- $800
Which one should we use?
100% = IRR2
0% = IRR1

24. Summary and Conclusions
Payback period indicates risk and liquidity of a project
NPV gives a direct measure of the dollar benefit to the shareholders
IRR provides information about a project’s “safety margin”
IRR reinvestment assumption may be unrealistic
Watch out for multiple IRRs

25. Summary and Conclusions
This chapter evaluates the most popular alternatives to NPV:
Payback period
Internal rate of return
Profitability index
When it is all said and done, they are not the NPV rule; for those of us in finance, it makes them decidedly second-rate.