Capital Budgeting

By
Sumit Gulati
Author of the book on ‘Financial Management’
Published by McGraw Hill Education
Founder: FINEXCELACADEMY
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Facebook Page: [Link]/SumitKiPaathshala
Capital Budgeting
 Capital budgeting is the allocation of funds to long-lived
capital-intensive projects.

 Such capital-intensive projects could be anything from

opening a new factory to a significant workforce expansion,
entering a new market, or the research and development of
new products.
Capital Budgeting
 The principles and tools of capital budgeting are applied in
many different aspects of a business entity’s decision making

 A company’s capital budgeting process and prowess are

important in valuing a company.
Types of Projects
 Replacement Projects
 Expansion Projects
 New Products and Services
 Regulatory, Safety, and Environmental Projects
 Other
Basic principles of Capital Budgeting
 Decisions are based on cash flows
 The timing of cash flows is crucial
 Cash flows are incremental
 Cash flows are on an after-tax basis
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 vs. mutually exclusive 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.
Project sequencing
 Capital projects may be sequenced, which means a project
contains an option to invest in another project.
Capital Rationing
 Capital rationing is when the amount of expenditure for
capital projects in a given period is limited.
Capital Rationing
 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.
Investment Evaluation Criteria
 There are a number of techniques which can be used to analyse
the relative worth of various projects.

 The various evaluation criteria or techniques of capital budgeting

may be classified into two groups:

 Discounted cash flow techniques

 Traditional/ Non- Discounted cash flow techniques
Investment Decision Criteria
Investment Evaluation Criteria
 Net Present Value (NPV) method
This method uses the discounted cash flow concept to convert the cash flows occurring
at different time durations.

Where,

C1, C2, C3 ....................Cn are the net cash inflows in respective years

r = cost of capital or opportunity cost of capital

C0 is the initial investment (cash outflow)

n is the expected life of the project

 If the combined value (NPV) of all cash flows is positive, then the project can be accepted.
Net present Value
The net present value is the present value of all incremental
cash flows, discounted to the present, less the initial outlay:
n CFt
NPV = t=1σ − Outlay
(1+r)t

where
CFt = After-tax cash flow at time t
r = Required rate of return for the investment
Outlay = Investment cash flow at time zero
Net present Value
If NPV > 0:
 Invest/ Accept the Project: Capital project adds value
If NPV < 0:
 Do not invest/ Reject the Project : Capital project destroys
value
Example: NPV
Consider a 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 Project if the required rate
of return of this project is 5%?
 Example: NPV
Time Line

0 1 2 3 4
| | | | |
| | | | |

–$1,000 $200 $300 $400 $500

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

–$1,000 $200 $300 $400 $500

Solving for the NPV:

NPV = –$1,000
$200 $300 $400 $500
+ 1 + 2 + 3 +
1 + 0.05 1 + 0.05 1 + 0.05 1 + 0.05 4

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

NPV = $219.47 million
 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
σt=1 − Outlay = 0
(1 + IRR)t
Or, reflecting the outlay as CF0,
n CFt
σt=0 =0
(1 + IRR)t
 Internal rate of return
If IRR > r (required rate of return):
 Invest: Capital project adds value, Accept the Project
If IRR < r:
 Do not invest: Reject the Project
 Example: IRR
Consider the 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 2 3 4
1 + IRR 1 + IRR 1 + IRR 1 + IRR

The IRR is the rate that solves the following:

 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)
 In this example, IRR = 12.826%:

$200 $300 $400 $500

$0 = −$1,000 + + + +
1 2 3 4
1 + 0.12826 1 + 0.12826 1 + 0.12826 1 + 0.12826
Limitations of IRR
 It may give multiple rates for non-conventional projects i.e. for projects
with more than one cash outflow.

 In some situations it may not give correct choice between mutually

exclusive projects in the following three situations:

 i) Project with unequal life

 ii) Project with unequal scale

 iii) Project with different cash flow patterns

 Since IRR is a rate and not absolute value, it is not possible to add IRR
of various projects to get combined IRR of all projects.
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

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

 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 at which NPV
becomes zero.

 This scenario is called the “multiple IRR problem.”

Example:
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?

 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
 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

PI =
Initial investment
 Profitability index
If PI > 1.0
 Invest (Accept the Project)

If PI < 1
 Do not invest (Reject the Project)
 Example: PI
In the Project, with a required rate of return of 5%,
Cash Flow
Period (millions)

0 -$1,000
1 200
2 300
3 400
4 500

 Compute Profitability Index.

 Example: PI
In the 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
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 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
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 itsYear 4 cash flow:
Project X Project Y
Year Cash Flows Cash Flows

–£100 –£100
0

1 £20 £20

2 £50 £50

3 £45 £45

4 £60 £0
 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.
 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
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.

Costs
 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.
 Costs: include or exclude?
 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).
 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?
 Decision at various required
rates of return
Project P Project Q
NPV @ 0%
NPV @ 4%
NPV @ 6%
NPV @ 10%
NPV @ 14%

IRR
Practice Question
 Suppose the head of the R&D group of a pizza firm
announces that they have developed a self rising pizza dough.
The cost is $ 3,00,000 to modify the production line. Sales of
the new product are estimated at $2,00,000 for the first year,
$3,00,000 for the next two years and $5,00,000 for the final
two years. It is estimated that production, sales and
advertising cost will be $2,50,000 for the first year and will
then decline to a constant of $2,00,000 per year. There is no
salvage value at the end of the products life and the
appropriate cost of capital is 15%. Is the project as proposed
economically viable?
Solution
 NPV = $118,567

 Accept the project

Practice Question 2
 If in the above example salvage value is $1,00,000. Will it
impact the NPV or your decision.
Solution
 NPV = $168,284

 Accept the project

Practice Question 3
 If in the above example salvage value is $1,00,000. The
discount rate is 30%. Will it impact the NPV or your
decision.
Solution
 NPV = $-211003.36

 Reject the project

Thank You