CAPITAL BUDGETING

Dr. Vera O. Fiador

UGBS
Assigned Chapter Reading

RWJJ, Chapters 7 & 8

Slide 2
 Session Overview and Objective
The ultimate goal of any financial manager is wealth maximization. To
maximize the wealth, it must first be created, and wealth is created
when a firm undertakes a project that returns more cash inflows than
cash outflows. In other words, the more a finance manager is able to
identify and select such value-adding projects to the firm’s portfolio,
then clearly that financial manager is on the path of value
maximization. The capital budgeting process is one of the decision
points that contribute to quest for value creation. The capital
budgeting process requires analyzing many ideas and identifying the
profitable projects that fit with the company’s strategy.
At the end of this session, students should be able to describe the
capital budgeting process, including the typical steps of the process,
distinguish among the various categories of capital projects, and apply
the various techniques for the purpose of selecting viable projects
from a pool.

Slide 3
 1. Introduction
• Capital budgeting is the allocation of funds to long-lived capital projects.

• A capital project is a long-term investment in tangible assets.

• The principles and tools of capital budgeting are applied in many different
aspects of a business entity’s decision making and in security valuation
and portfolio management.

• A company’s capital budgeting process and prowess are important in

valuing a company.

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 2. The capital budgeting process
Step 1 Generating Ideas
• Generate ideas from inside or outside of the company

Step 2 Analyzing Individual Proposals

• Collect information and analyze the profitability of alternative projects

Step 3 Planning the Capital Budget

• Analyze the fit of the proposed projects with the company’s strategy

Step 4 Monitoring and Post Auditing

• Compare expected and realized results and explain any deviations

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 Classifying projects

Replacement New Products and

Expansion Projects
Projects Services

Regulatory, Safety,
and Environmental Other
Projects

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3. Basic principles of Capital Budgeting

Decisions are based The timing of cash

on cash flows. flows is crucial.

Cash flows are Cash flows are on an

incremental. after-tax basis.

Financing costs are

ignored.

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 Costs: include or exclude?
• A sunk cost is a cost that has already occurred, so it cannot be part of the
incremental cash flows of a capital budgeting analysis.

• An opportunity cost is what would be earned on the next-best use of the

assets.

• An incremental cash flow is the difference in a company’s cash flows with

and without the project.

• An externality is an effect that the investment project has on something

else, whether inside or outside of the company.

– Cannibalization is an externality in which the investment reduces cash flows

elsewhere in the company (e.g., takes sales from an existing company project).

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 Conventional and nonconventional
cash flows
Conventional Cash Flow (CF) Patterns

Today 1 2 3 4 5
| | | | | |
| | | | | |

–CF +CF +CF +CF +CF +CF

–CF –CF +CF +CF +CF +CF

–CF +CF +CF +CF +CF

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 Conventional and nonconventional
cash flows
Nonconventional Cash Flow Patterns

Today 1 2 3 4 5
| | | | | |
| | | | | |

–CF +CF +CF +CF +CF –CF

–CF +CF –CF +CF +CF +CF

–CF –CF +CF +CF +CF –CF

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 Independent vs. mutually
exclusive projects
• When evaluating more than one project at a time, it is
important to identify whether the projects are
independent or mutually exclusive
– This makes a difference when selecting the tools to evaluate the
projects.

• Independent projects are projects in which the

acceptance of one project does not preclude the
acceptance of the other(s).

• Mutually exclusive projects are projects in which the

acceptance of one project precludes the acceptance of
another or others.

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 Project sequencing
• Capital projects may be sequenced, which means a
project contains an option to invest in another
project.

– Projects often have real options associated with them; so

the company can choose to expand or abandon the project,
for example, after reviewing the performance of the initial
capital project.

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 Capital rationing
• Capital rationing is when the amount of expenditure
for capital projects in a given period is limited.
• If the company has so many profitable projects that
the initial expenditures in total would exceed the
budget for capital projects for the period, the
company’s management must determine which of
the projects to select.
• The objective is to maximize owners’ wealth, subject
to the constraint on the capital budget.
– Capital rationing may result in the rejection of profitable
projects.

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4. Investment decision criteria
Net Present Value (NPV)

Internal Rate of Return (IRR)

Payback Period

Discounted Payback Period

Average Accounting Rate of Return (AAR)

Profitability Index (PI)

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 Net present Value
The net present value is the present value of all incremental cash
flows, discounted to the present, less the initial outlay:
CFt
NPV = ∑n t=1 (1+r)t − Outlay (2-1)
Or, reflecting the outlay as CF0,
CFt
NPV = ∑n t=0 (1+r)t (2-2)
where
CFt = After-tax cash flow at time t
r = Required rate of return for the investment
Outlay = Investment cash flow at time zero

If NPV > 0:
• Invest: Capital project adds value
If NPV < 0:
• Do not invest: Capital project destroys value

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 Example: NPV
Consider the Hoofdstad Project, which requires an investment of
$1 billion initially, with subsequent cash flows of $200 million,
$300 million, $400 million, and $500 million. We can characterize
the project with the following end-of-year cash flows:
Cash Flow
Period (millions)
0 –$1,000
1 200
2 300
3 400
4 500

What is the net present value of the Hoofdstad Project if the

required rate of return of this project is 5%?

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 Example: NPV
Time Line 0 1 2 3 4
| | | | |
| | | | |

–$1,000 $200 $300 $400 $500

Solving for the NPV:

$200 $300 $400 $500

NPV = –$1,000 + + + +
1 + 0.05 1 1 + 0.05 2 1 + 0.05 3 1 + 0.05 4

NPV = −$1,000 + $190.48 + $272.11 + $345.54 + $411.35

NPV = $219.47 million

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 Internal rate of return
The internal rate of return is the rate of return on a project.
– The internal rate of return is the rate of return that results in
NPV = 0.
n CFt
∑t=1 t − Outlay = 0 (2-3)
(1 + IRR)
Or, reflecting the outlay as CF0,
n CFt
∑t=0 t =0 (2-4)
(1 + IRR)
If IRR > r (required rate of return):
• Invest: Capital project adds value
If IRR < r:
• Do not invest: Capital project destroys value

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 Example: IRR
Consider the Hoofdstad Project that we used to
demonstrate the NPV calculation:
Cash Flow
Period (millions)
0 –$1,000
1 200
2 300
3 400
4 500

$200 $300 $400 $500

$0 = −$1,000 + + + +
1 + IRR 1 1 + IRR 2 1 + IRR 3 1 + IRR 4
The IRR is the rate that solves the following:

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 A note on solving for IRR
• The IRR is the rate that causes the NPV to be equal to
zero.
• The problem is that we cannot solve directly for IRR,
but rather must either iterate (trying different values
of IRR until the NPV is zero) or use a financial
calculator or spreadsheet program to solve for IRR.
• In this example, IRR = 12.826%:
$200 $300 $400 $500
$0 = −$1,000 + + + +
1 + 0.12826 1 1 + 0.12826 2 1 + 0.12826 3 1 + 0.12826 4

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 Payback Period
• The payback period is the length of time it takes to recover the initial cash outlay
of a project from future incremental cash flows.
• In the Hoofdstad Project example, the payback occurs in the last year, Year 4:

Cash Flow Accumulated

Period (millions) Cash flows

0 –$1,000 –$1,000

1 200 –$800

2 300 –$500

3 400 –$100

4 500 +400

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 Payback Period: Ignoring Cash Flows
For example, the payback period for both Project X and Project Y is three years, even
through Project X provides more value through its Year 4 cash flow:

Project X Project Y
Year Cash Flows Cash Flows

0 –£100 –£100

1 £20 £20

2 £50 £50

3 £45 £45

4 £60 £0

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 Discounted Payback Period
• The discounted payback period is the length of time it takes for
the cumulative discounted cash flows to equal the initial outlay.
– In other words, it is the length of time for the project to reach NPV = 0.

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 Example: Discounted Payback Period
Consider the example of Projects X and Y. Both projects have a discounted payback
period close to three years. Project X actually adds more value but is not distinguished
from Project Y using this approach.

Accumulated
Discounted Discounted
Cash Flows Cash Flows Cash Flows
Year Project X Project Y Project X Project Y Project X Project Y
0 –£100.00 –£100.00 –£100.00 –£100.00 –£100.00 –£100.00
1 20.00 20.00 19.05 19.05 –80.95 –80.95
2 50.00 50.00 45.35 45.35 –35.60 –35.60
3 45.00 45.00 38.87 38.87 3.27 3.27
4 60.00 0.00 49.36 0.00 52.63 3.27

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 Average Accounting rate of return
• The average accounting rate of return (AAR) is the
ratio of the average net income from the project to
the average book value of assets in the project:

Average net income

AAR =
Average book value

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 Profitability index
The profitability index (PI) is the ratio of the present value
of future cash flows to the initial outlay:
Present value of future cash flows NPV
PI = =1+ (2-5)
IniSal investment IniSal investment

If PI > 1.0:
• Invest
• Capital project adds value

If PI < 1.0:
• Do not invest
• Capital project destroys value

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 Example: PI
In the Hoofdstad Project, with a required rate of return of 5%,
Cash Flow
Period (millions)
0 -$1,000
1 200
2 300
3 400
4 500

the present value of the future cash flows is $1,219.47. Therefore, the
PI is:

$1,219.47
PI = = 1.219
$1,000.00

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 Net present value profile
The net present value profile is the graphical
illustration of the NPV of a project at different required
rates of return.
The NPV profile intersects the
vertical axis at the sum of the
cash flows (i.e., 0% required rate
of return).
The NPV profile crosses the
horizontal axis at the project’s
internal rate of return.
Net
Present
Value

Required Rate of Return 28

NPV Profile: Hoofdstad Capital project
$500

$400

$300

NPV $200
(millions)
$100

$0

-$100

-$200
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Required Rate of Return

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NPV Profile: Hoofdstad Capital project
$500

$400
$361
$323
$400

$287
$253
$219
$300

$188
$157
$127
$200
NPV

$99
$72
(millions) $100

$46
$20
–$4
–$28
–$50
–$72
$0

–$114
–$93

–$133
–$152
-$100

-$200
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Required Rate of Return

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 Ranking conflicts: NPV vs. IRR
• The NPV and IRR methods may rank projects differently.
– If projects are independent, accept if NPV > 0 produces the
same result as when IRR > r.
– If projects are mutually exclusive, accept if NPV > 0 may produce
a different result than when IRR > r.
• The source of the problem is different reinvestment rate
assumptions
– Net present value: Reinvest cash flows at the required rate of
return
– Internal rate of return: Reinvest cash flows at the internal rate of
return
• The problem is evident when there are different patterns
of cash flows or different scales of cash flows.

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 Example: Ranking conflicts
Consider two mutually exclusive projects, Project P and Project
Q: End of Year Cash Flows

Year Project P Project Q

0 –100 –100
1 0 33
2 0 33
3 0 33
4 142 33

Which project is preferred and why?

Hint: It depends on the projects’ required rates of return.

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 Decision at various required
rates of return
Project P Project Q Decision
NPV @ 0% $42 $32 Accept P, Reject Q
NPV @ 4% $21 $20 Accept P, Reject Q
NPV @ 6% $12 $14 Reject P, Accept Q
NPV @ 10% –$3 $5 Reject P, Accept Q
NPV @ 14% –$16 –$4 Reject P, Reject Q

IRR 9.16% 12.11%

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NPV Profiles: Project P and Project Q
$50 NPV of Project P NPV of Project Q
$40
$30
$20
NPV $10
$0
-$10
-$20
-$30
0% 2% 4% 6% 8% 10% 12% 14%
Required Rate of Return

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 The multiple IRR problem
• If cash flows change sign more than once during the
life of the project, there may be more than one rate
that can force the present value of the cash flows to
be equal to zero.
– This scenario is called the “multiple IRR problem.”
– In other words, there is no unique IRR if the cash flows are
nonconventional.

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Example: The multiple IRR problem
Consider the fluctuating capital project with the
following end of year cash flows, in millions:

Year Cash Flow

0 –€550
1 €490
2 €490
3 €490
4 –€940

What is the IRR of this project?

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 Example: The Multiple IRR Problem
€40
€20 IRR = 34.249%

€0
-€20
NPV IRR = 2.856%
-€40
(millions)
-€60
-€80
-€100
-€120
0% 8% 16% 24% 32% 40% 48% 56% 64%
Required Rate of Return

Copyright © 2013 CFA Institute 37

 Popularity and usage of capital
budgeting methods
• In terms of consistency with owners’ wealth
maximization, NPV and IRR are preferred over other
methods.
• Larger companies tend to prefer NPV and IRR over
the payback period method.
• The payback period is still used, despite its failings.
• The NPV is the estimated added value from investing
in the project; therefore, this added value should be
reflected in the company’s stock price.

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 5. Cash flow projections
The goal is to estimate the incremental cash flows of the
firm for each year in the project’s useful life.
0 1 2 3 4 5
| | | | | |
| | | | | |

Investment After-Tax After-Tax After-Tax After-Tax After-Tax

Outlay Operating Cash Operating Cash Operating Cash Operating Cash Operating Cash
Flow Flow Flow Flow Flow
+
Terminal
Nonoperating
Cash Flow

= Total After- = Total After- = Total After- = Total After- = Total After- = Total After-
Tax Cash Flow Tax Cash Flow Tax Cash Flow Tax Cash Flow Tax Cash Flow Tax Cash Flow
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After-tax operating cash flow
Start with Sales
Subtract Cash operating expenses
Subtract Depreciation
Equals Operating income before taxes
Subtract Taxes on operating income
Equals Operating income after taxes
Plus Depreciation
Equals After-tax operating cash flow

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 Terminal year after-tax
non-operating cash flow

Start with After-tax salvage value

Add Return of net working capital

Equals Nonoperating cash flow

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6.More on cash flow projections
Depreciation
Issues
Replacement
Decisions

Inflation

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Effects of inflation on capital budgeting
analysis
• Issue: Although the nominal required rate of return
reflects inflation expectations and sales and
operating expenses are affected by inflation,
– The effect of inflation may not be the same for sales as
operating expenses.
– Depreciation is not affected by inflation.
– The fixed cost nature of payments to bondholders may
result in a benefit or a cost to the company, depending on
inflation relative to expected inflation.

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 7.Project analysis and evaluation
What if we are choosing among mutually exclusive
projects that have different useful lives?

What happens under capital rationing?

How do we deal with risk?

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 Mutually exclusive projects
with unequal lives
• When comparing projects that have different useful lives,
we cannot simply compare NPVs because the timing of
replacing the projects would be different, and hence, the
number of replacements between the projects would be
different in order to accomplish the same function.
• Approaches
1. Determine the least common life for a finite number of
replacements and calculate NPV for each project.
2. Determine the annual annuity that is equivalent to investing in
each project ad infinitum (that is, calculate the equivalent annual
annuity, or EAA).

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 Example: Unequal lives
Consider two projects, Project G and Project H, both with a
required rate of return of 5%:

End-of-Year
Cash Flows
Year Project G Project H
0 –$100 –$100
1 30 38
2 30 39
3 30 40
4 30

NPV $6.38 $6.12

Which project should be selected, and why?

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 Example: Unequal lives
NPV with a Finite number of replacements
Project G: Two replacements
Project H: Three replacements

0 1 2 3 4 5 6 7 8 9 10 11 12
| | | | | | | | | | | | |
| | | | | | | | | | | | |

Project G $6.38 $6.38 $6.38

Project H $6.12 $6.12 $6.12 $6.12

NPV of Project G: original, plus two replacements = $17.37

NPV of Project H: original, plus three replacements = $21.69

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 Example: Unequal lives
Equivalent annual annuity
Project G Project H
PV = $6.38 PV = $6.12
N=4 N=3
I = 5% I = 5%
Solve for PMT Solve for PMT

PMT = $1.80 PMT = $2.25

Therefore, Project H is preferred (higher equivalent annual annuity).

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 Decision making under
Capital rationing
• When there is capital rationing, the company may
not be able to invest in all profitable projects.
• The key to decision making under capital rationing is
to select those projects that maximize the total net
present value given the limit on the capital budget.

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 Example: Capital rationing
• Consider the following projects, all with a required rate of return of 4%:
Initial
Project Outlay NPV PI IRR
One –$100 $20 1.20 15%
Two –$300 $30 1.10 10%
Three –$400 $40 1.10 8%
Four –$500 $45 1.09 5%
Five –$200 $15 1.08 5%
Which projects, if any, should be selected if the capital budget is:
1. $100?
2. $200?
3. $300?
4. $400?
5. $500?

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 Example: Capital rationing
Possible decisions:
Budget Choices NPV Choices NPV Choices NPV
$100 One $20
$200 One $20 Two $15
$300 One + Five $35 Two $15
$400 One + Two $50 Three $40
$500 One + Three $60 Four $45 Two + Five $45

Optimal choices

Key: Maximize the total net present value for any given budget.

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Risk analysis: Stand-alone methods
• Sensitivity analysis involves examining the effect on NPV
of changes in one input variable at a time.
• Scenario analysis involves examining the effect on NPV
of a set of changes that reflect a scenario (e.g., recession,
normal, or boom economic environments).
• Simulation analysis (Monte Carlo analysis) involves
examining the effect on NPV when all uncertain inputs
follow their respective probability distributions.
– With a large number of simulations, we can determine the
distribution of NPVs.

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 Real options
• A real option is an option associated with a real asset
that allows the company to enhance or alter the project’s
value with decisions some time in the future.
• Real option examples:
– Timing option: Allow the company to delay the investment
– Sizing option: Allow the company to expand, grow, or abandon
a project
– Flexibility option: Allow the company to alter operations, such
as changing prices or substituting inputs
– Fundamental option: Allow the company to alter its decisions
based on future events (e.g., drill based on price of oil,
continued R&D depending on initial results)

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Common capital budgeting pitfalls
• Not incorporating economic responses into the investment analysis
• Misusing capital budgeting templates
• Pet projects
• Basing investment decisions on EPS, net income, or return on equity
• Using IRR to make investment decisions
• Bad accounting for cash flows
• Overhead costs
• Not using the appropriate risk-adjusted discount rate
• Spending all of the investment budget just because it is available
• Failure to consider investment alternatives
• Handling sunk costs and opportunity costs incorrectly

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 9. Summary
• Capital budgeting is used by most large companies to select among
available long-term investments.
• The process involves generating ideas, analyzing proposed projects,
planning the budget, and monitoring and evaluating the results.
• Projects may be of many different types (e.g., replacement, new
product), but the principles of analysis are the same: Identify
incremental cash flows for each relevant period.
• Incremental cash flows do not explicitly include financing costs, but
are discounted at a risk-adjusted rate that reflects what owners
require.
• Methods of evaluating a project’s cash flows include the net
present value, the internal rate of return, the payback period, the
discounted payback period, the accounting rate of return, and the
profitability index.

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 Summary (continued)
• The preferred capital budgeting methods are the net present
value, internal rate of return, and the profitability index.
– In the case of selecting among mutually exclusive projects, analysts
should use the NPV method.
– The IRR method may be problematic when a project has a
nonconventional cash flow pattern.
– The NPV is the expected added value from a project.
• We can look at the sensitivity of the NPV of a project using the
NPV profile, which illustrates the NPV for different required
rates of return.
• We can identify cash flows relating to the initial outlay,
operating cash flows, and terminal, nonoperating cash flows.
– Inflation may affect the various cash flows differently, so this should
be explicitly included in the analysis.

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 Summary (continued)
• When comparing projects that have different useful lives, we can
either assume a finite number of replacements of each so that the
projects have a common life or we can use the equivalent annual
annuity approach.
• We can use sensitivity analysis, scenario analysis, or simulation to
examine a project’s attractiveness under different conditions.
• The discount rate applied to cash flows or used as a hurdle in the
internal rate of return method should reflect the project’s risk.
– We can use different methods, such as the capital asset pricing model, to
estimate a project’s required rate of return.
• Most projects have some form of real options built in, and the value
of a real option may affect the project’s attractiveness.
• There are valuation alternatives to traditional capital budgeting
methods, including economic profit, residual income, and claims
valuation.

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