Chapter 10:
The Basics Of Capital
Budgeting
The Basics Of Capital Budgeting :
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Chapter Outline:
 Introduction.
 Capital Budgeting Decision Rules:
Payback Period.
Discounted payback Period.
Net Present Value (NPV).
Internal Rate of Return (IRR).
Profitability Index (PI).
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Capital Budgeting:
 The process of planning expenditures
on assets whose cash flows are
expected to extend beyond one year.
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Capital Budgeting:
 Analysis of potential additions to fixed
assets.
 Long-term decisions; involve large
expenditures.
 Very important to firm’s future.
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Steps to Capital Budgeting:
1.
2.
3.
4.
5.
Estimate Cash Flow (inflows & outflows).
Assess riskiness of CFs.
Determine the appropriate cost of capital.
Find NPV and/or IRR.
Accept if NPV > 0 and/or IRR > WACC.
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Payback Period:
 The number of years required to recover a
project’s cost, or “How long does it take to
get our money back?”
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Calculating Payback:
Project L
CFt
Cumulative
PaybackL
Project S
CFt
Cumulative
PaybackS
0
-100
-100
== 2
2
2.4
3
10
-90
60
-30
100
0
80
30 / 80
+
0
1.6
1
-100
-100
== 1
1
70
-30
+
= 2.375 years
2
100 50
0 20
30 / 50
50
3
20
40
= 1.6 years 8
Example:
Initial investment is $5,000
Positive cash flow each year
Year 1 -- $1,500
Year 2 -- $2,500
Year 3 -- $3,000
Year 4 -- $4,500
Year 5 -- $5,500
Payback in 2 and 1/3rd years…ignore years 4 and
5 cash flows
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Strengths and Weaknesses of
Payback:
Strengths
Easy to calculate and understand.
Initial cash flows most important
Good for small dollar investments
Weaknesses
Ignores the time value of money.
Ignores CFs occurring after the payback period.
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Discounted Payback Period:
Attempt to correct one flaw of Payback
Period…time value of money
Discount cash flow to present and see if the
discount cash flow are sufficient to cover
initial cost within cutoff time period
Careful in consistency
Discounting means cash flow at end of period
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Appropriate discount rate for cash flow
Discounted payback period:
Uses discounted cash flows rather than raw
CFs.
0
10%
1
2
2.7 3
CFt
-100
10
60
80
PV of CFt
-100
9.09
49.59
60.11
Cumulative
-100
-90.91
-41.32
18.79
Disc PaybackL ==
2
+
41.32 / 60.11
= 2.7 years
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Net Present Value (NPV):
 Correction to discounted cash flow
Includes all cash flow in decision
Changes decision (go vs. no-go) to
dollars, not arbitrary cutoff period
 Need all cash flow
 Need appropriate discount rate
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Net Present Value (NPV):
NPV = PV of inflows minus Cost = Net gain in
wealth.
Acceptance of a project with a NPV > 0 will add
value to the firm.
Decision Rule:
Accept if NPV >0,
Reject if NPV < 0
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Net Present Value (NPV):
Sum of the PVs of all cash inflows and
outflows of a project:
CFt
NPV  
t
t 0 ( 1  k )
n
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Net Present Value (NPV):
Sum of the PVs of all cash inflows and
outflows of a project:
CF3
CFN
CF1
CF2
NPV  CF0 


 ... 
2
3
N
(1  r ) (1  r ) (1  r )
(1  r )
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Calculating the NPV:
Year
0
1
2
3
NPVS = $19.98
CFt
-100
10
60
80
NPVL =
PV of CFt
-$100
9.09
49.59
60.11
$18.79
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Net Present Value (NPV):
The Decision Model
Incorporates risk and return
Incorporates time value of money
Incorporates all cash flow
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NPV Profile and Shareholder
Wealth:
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Internal Rate of Return (IRR):
Model closely resembles NPV but…
Finding the discount rate (Internal Rate) that
implies an NPV of zero
Internal rate used to accept or reject project
If IRR > Cost of Capital, accept
If IRR < Cost of Capital, reject
Very popular model as “managers” like the single
return variable when evaluating projects
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Internal Rate of Return (IRR):
CF3
CFN
CF1
CF2
NPV  0  CF0 


 .... 
2
3
N
(1  r ) (1  r ) (1  r )
(1  r )
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Calculating the IRR:
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Comparing the NPV and IRR
methods:
If projects are independent, the two
methods always lead to the same
accept/reject decisions.
If projects are mutually exclusive …
If k > crossover point, the two methods
lead to the same decision and there is no
conflict.
If k < crossover point, the two methods
lead to different accept/reject decisions.
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Profitability Index (PI):
 Close to NPV as we calculate present value of
future positive cash flows (present value of
benefits) and initial cash flow (present value of
costs)
PI = (NPV + Initial cost) / Initial Cost
Answer is modified return
 Choosing between two different projects?
Higher PI is best choice…
Careful, cannot scale projects up and down
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Profitability Index (PI):
Modified version of NPV
Decision Criteria
PI > 1.0, accept project
PI < 1.0, reject project
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Capital Budgeting:
Methods to generate, review, analyze, select,
and implement long-term investment
proposals:
Payback Period
Discounted payback period
Net Present Value (NPV)
Internal rate of return (IRR)
Profitability index (PI)
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