1. Capital Budgeting Techniques1

2. What is Capital Budgeting?
The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

3. The Capital Budgeting Decision
Capital budgeting describes decisions where expenditures and receipts for a particular undertaking will continue over a period of time.
These decisions usually involve outflows of funds in the early periods while the inflows start somewhat later and continue for a significant number of periods.

4. The Capital Budgeting Decision
Types of capital budgeting decisions
Replacement projects are expenditures necessary to replace worn-out or damaged equipment.
Cost reduction projects include expenditures to replace serviceable but obsolete plant and equipment.
Safety and environmental projects are mandatory investments that may not produce revenues.
Expansion projects increase the availability of existing products and services

5. Project Classifications
Independent Projects: Projects whose cash flows are not affected by decisions made about other projects.
Mutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted. e.g. buying computers of different brands.
Dependent( contingent)projects: e.g. buying a new machine may force to extend the construction

6. Project Evaluation: Alternative Methods
Payback Period (PBP)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)

7. Net Cash Flows for Project S and Project L1, 5 00 2 80 30 40 90 3 ^ N et C as h F lo w s
, C t r e d p A Ex ct
fte -T ax Y ea ( T ) P o
jec S L a $
3,00 1 4

8. What is the Payback Period?
The length of time before the original cost of an investment is recovered from the expected cash flows or . . .
How long it takes to get our money back. 7

9. Payback Period for Project S
Net Cash Flow
Cumulative Net CF
1,500
-1,500
800
500
1,200
-300
-3,000
300
PBS 1 2 3 4 =
PaybackS
/800 = years 8

10. Payback Period for Project L
Net Cash Flow
Cumulative Net CF
400
- 2,600
1,300
- 400
900
- 1,700
- 3,000
1,500
1,100
PBL 1 2 3 4 =
PaybackL
/1,500 = 3.3 years

11. Net Present Value (NPV)
NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow.
CF CF CFn
- ICO
NPV = +
(1+k)1 (1+k) (1+k)n

12. Proposed Project Data
Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.

13. NPV Solution $10,000 $12,000 $15,000 NPV = + + +
Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%.
$10, $12,000 $15,000
NPV = + + +
(1.13) (1.13) (1.13)3
$10, $7,000 +
- $40,000
(1.13) (1.13)5

14. NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $ 7,000(PVIF13%,5) - $40,000 NPV = $10,000(.885) + $12,000(.783) + $15,000(.693) + $10,000(.613) + $ 7,000(.543) - $40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $40,000 = - $1,428

15. NPV Acceptance Criterion
The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted?
No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ]

16. Internal Rate of Return (IRR)
IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow.
CF CF CFn
ICO = +
(1+IRR)1 (1+IRR) (1+IRR)n

17. IRR Solution $10,000 $12,000 $40,000 = + + (1+IRR)1 (1+IRR)2
$10, $12,000
$40,000 = + +
(1+IRR) (1+IRR)2
$15, $10, $7,000 + +
(1+IRR) (1+IRR) (1+IRR)5
Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000.

18. IRR Solution (Try 10%)
$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) $15,000(.751) + $10,000(.683) $ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11, $6,830 + $4, = $41,444 [Rate is too low!!]

19. IRR Solution (Try 15%)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) $15,000(.658) + $10,000(.572) $ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9, $5,720 + $3, = $36,841 [Rate is too high!!]

20. IRR Solution (Try 15%) NPV at Lower Rate (10%) NPV = PV - ICO
NPV at Higher Rate (15%)
NPV = $ 36,881 - $ 40,000 = $

21. IRR Solution
IRR= LR + NPv L X (HR – LR)
NPVL – NPvH

22. IRR Solution
IRR= x (15 – 10) 1444 – (-3159) IRR= x IRR= x 5 IRR= = 11.57%

23. Profitability Index (PI)
PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow.
PI = PV / ICO

24. PI Acceptance Criterion
PI = $38,572 / $40,000 = Should this project be accepted?
No! The PI is less than This means that the project is not profitable. [Reject as PI < 1.00 ]

25. Assignment
Calculate NPV,PBP,IRR and PI for the following projects. Which project should be selected.(discount rate =13%)

26. Years
Project A
Project B
$ 28,000
$ 20,000 1
8000
5000 2 3
6000 4 5
7000 6 7