Chapter 11: The Basics of Capital Budgeting

I. What is Capital Budgeting?

The process of determining what capital projects to accept
Project Classification is the starting point for determining the appropriate discount rate
Replacement to maintain current operations
Replacement to reduce costs
Expansion of existing products or markets
Expansion into new products or markets
Pure research & development (example: pharmaceutical firms)
Exploration (example: energ firms)
!afet and "or environmental (government mandated) projects
II. Decision Criteria
What are the major investment decision criteria?
#et Present $alue % #P$
&nternal Rate of Return % &RR
'odified &nternal Rate of Return % '&RR
Pa(ack Period % Pa(ack
)iscounted Pa(ack Period * )iscounted Pa(ack
Profita(ilit &ndex % P&
What are they used for?
To evaluate the cash flows from capital investment projects
To make the accept or reject decision
+in ,,-. /hapter 00 page 0
. The !"# $ule:
1. Why Is !et "resent #alue the Best Decision Criteria?
% &t considers the time value of money (T$')1 a dollar toda is worth more than a
dollar in the future
% &t considers all cash flows during the project2s entire life
% #P$ lets ou know exactl how much value is (eing added ( the project
% 3ou can set the appropriate re4uire rate of return (discount rate or hurdle rate)
depending on a project2s risk
%. Calculating !et "resent #alue &!"#:
#P$ 5/+
6
7 /+
0
7 /+
8
7 999 7 /+
t

(0 7 r)
0
(0 7 r)
8
(0 7 r)
t

'. The !"# decision &accept/reject( rule:
% Accept the project (investment) if #P$ : ;ero
% Reject the project if #P$ < ;ero
). What does a positive !"# mean?
% The PV of cash inflows : PV of cash outflows
% The value of the compan is (eing increased ( the amount of #P$
% The project meets the re4uired rate of return1and then some
+in ,,-. /hapter 00 page 8
!"# *+ample 1:
= friend asks ou to invest >86.666 and promises to pa ou >8?.666 at the end of 8
ears9 3our re4uired rate of return is 0-@9 )o ou take the offerA
#P$ 5/+
6
7 /+
8

(0 7 r)
8
#P$ 5 %86.666 7 8?.666 5: %86.666 7 0B.??6
090-
8
!"# , -.')/ 0ou should reject your friend1s offer2
C &f this were a capital investment project. acceptance would reduce the value of the
compan ( >,D6E
C =cceptance of the project would not increase the value of the compan ( >?.666E
The ke varia(le here is the re4uired rate of return (or discount rate)9
The re4uired rate of return (RRR) is:
C The hurdle rate
C The cost of capital (funds)
C The (est rate of return the compan could expect on other projects of similar risk
!ote:
&n a competitive market. positive #P$ projects are considered rare and re4uire diligent
effort to uncover
+in ,,-. /hapter 00 page ,
!"# *+ample %:
Two projects with identical cash outflows (investment 5>0.666) (ut different timing of
cash inflows9 )iscount rate 5 06@
!"# for project 3: &4arge cash inflo5s come sooner(
6 0 8 , D
F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%F
#et /+ %0.666 -66 D66 ,66 066
!"#&3( , -67.7%
!"# for project 4: &4arge cash inflo5s come later(
6 0 8 , D
F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%F
#et /+ %0.666 066 ,66 D66 -66
!"#&4( , .-18.1%
+in ,,-. /hapter 00 page D
B. The "ay9ac: $ule:
Time period re4uired for a project to generate enough cash inflows to recover the initial
cost9

The "ay9ac: decision &accept/reject( rule:
% Accept if pa(ack period < maximum accepta(le pa(ack period9
% Reject if pa(ack period : maximum accepta(le pa(ack period9
dvantages
% Eas to understand: the shorter the pa(ack period. the (etter
% Guick indicator of the liquidity risk of the project (how long funds will (e tied up)
Disadvantages
% &gnores time value of mone
% &gnores cash flows (eond accepta(le pa(ack date
% =ccepta(le pa(ack date is usuall an ar(itrar cutoff point9 Risk is not
4uantified in a re4uired rate of return9 The li4uidit risk is simpl a Hrule of
thum(I
"roject 3:
6 0 8 , D
F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F
#et /+ %0.666 -66 D66 ,66 066
/umulative %0.666 %-66 %066 866 ,66
#/+

Pa(ack 5 ears (efore 7 uncovered cost at end of ear
full recover #/+ during following ear
5 8 7 066",66
5 89,, ears
If accepta9le pay9ac: period is %.'' or more years; you accept project 3
+in ,,-. /hapter 00 page -
C. The Discounted "ay9ac: $ule:
Time period re4uired for a project to generate enough discounted cash inflows to recover
the initial cost9

The Discounted "ay9ac: decision &accept/reject( rule:
% Accept if discounted pa(ack period < maximum accepta(le pa(ack period9
% Reject if discounted pa(ack period : maximum accepta(le pa(ack period9
dvantages
% Eas to understand: the shorter the pa(ack period. the (etter
% Guick indicator of the liquidity risk of the project (how long funds will (e tied up)
% )oes consider the time value of mone
Disadvantages
% &gnores cash flows (eond accepta(le pa(ack date
% =ccepta(le pa(ack date is usuall an ar(itrar cutoff point9
"roject 3: ssume a 1/ percent discount rate
6 0 8 , D
F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F
#et /+ %0.666 -66 D66 ,66 066
P$#/+ %0.666 D-D ,,0 88- ?J
/umulative %0.666 %-D? %80- 06
P$#/+

Pa(ack 5 ears (efore 7 uncovered cost at end of ear
full recover #/+ during following ear
5 8 7 80-"88-
5 89B? ears
If accepta9le pay9ac: period is %.8< or more years; you accept project 3
+in ,,-. /hapter 00 page ?
D. Internal $ate of $eturn
The &RR is similar to a (ond2s ield to maturit9 &t is the rate that makes the present value
of cash inflows (/&+) e4ual to the present value of cash outflows (/K+)9 Thus. it is the
rate of return that results in a ;ero #P$ when it is used as the discount rate9
#P$ 5 /+
6
7 /+
0
7 /+
8
7 999 7 /+
t

(0 7 r)
0
(0 7 r)
8
(0 7 r)
t

6 5 /+
6
7 /+
0
7 /+
8
7 999 7 /+
t

(0 7 &RR)
0
(0 7 &RR)
8
(0 7 &RR)
t

I$$ Decision $ule
% Accept the project if &RR : re42d rate of return (discount rate)
% Reject the project if &RR < re42d rate of return (discount rate)
dvantages
% /onsiders T$'
% /onsiders all cash flows
% Eas to understand
Disadvantages
% 'a use unreasona(le discount rate
% /an conflict with #P$ if projects are mutually exclusive
+in ,,-. /hapter 00 page L
I$$ *+amples:
I$$ for "roject 3
6 0 8 , D
"roject 3 F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F
%0.666 -66 D66 ,66 066
6 5 %0666 7 -66 7 D66 7 ,66 7 066
(07&rr)
0
(07&rr)
8
(07&rr)
,
(07&rr)
D
3olve for the I$$. That is the discount rate that solves this e4uation and makes the
answer (#P$) e4ual to ;ero9
&RR for Project ! 5 0D9DB@
I$$ for "roject 4
6 0 8 , D
"roject 4 F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%F%%%%%%%%%%%%%%%%F
%0.666 066 ,66 D66 -66
6 5 %0666 7 066 7 ,66 7 D66 7 -66
(07&rr)
0
(07&rr)
8
(07&rr)
,
(07&rr)
D
I$$ for "roject 4, 8.%6=
The &RR is the most popular method. after #P$. for evaluating cash flows and is almost
as good9
+in ,,-. /hapter 00 page J
"ro9lems 5ith I$$:
There are pro(lems with using &RR rather than #P$ with ou are choosing (etween
mutually exclusive projects:
% Independent projects: Mhen evaluating multiple projects and an. none. or all of
them can (e accepted9 =cceptance of an project has no (earing on the acceptance
or rejection of another9
% utually exclusive projects: Mhen evaluating multiple projects and onl one can
(e accepted9 =cceptance of one project means rejection of the other(s)9
There is never a conflict (etween &RR and #P$ criterion when evaluating independent
projects9 Nut when choosing (etween mutuall exclusive projects. the &RR choice ma
conflict with the #P$ choice under certain conditions9
The Scale Problem: = potential conflict exists when there are significant differences in
the si;e of the cash flows9 =n example would (e if comparing a project with a >066.666
initial investment (/K+) with another project with a >0.666.666 initial investment9
The Timing Problem: = potential conflict exists when the timing of the cash flows for
two projects are radicall different9 This can result in a conflict (etween the #P$ choice
and the &RR choice at low discount rates9
Multiple IRRs: Projects with non!normal "non!conventional# cash flows ma have
multiple &RRs9 = normal (or conventional) cash flow is a cash outflow at the (eginning
of a project. followed ( cash inflows thereafter9
+in ,,-. /hapter 00 page B
The !"# "rofile: !"# graphed against the discount rate
Recall the #P$ & &RR acceptance rules:
#P$: Accept the project if #P$ : ;ero
&RR: Accept the project if &RR : RRR
#P$
/ash +lows
%0666
>,66 -66
D66
,66
066
&RR
6 r
90DDB
=n project with a positive #P$ will also have an &RR that exceeds the discount rate
(re4uired rate of return)9
#P$ Profiles for Mutually Exclusive Projects:
#P$ /ash +lows
= N
Project N %06.666 %06.666
06.666 0.666
0.666 0.666
0.666 08.666
/rossover rate

Project =
r
+in ,,-. /hapter 00 page 06
*+ample: I$$ vs !"# for >utual *+clusive "rojects
/ash +lows
= N
%06.666 %06.666
06.666 0.666
0.666 0.666
0.666 08.666
&RR for = OOOOOOOOOOOOO &RR for N is OOOOOOOOOOO
#P$ at 6@ OOOOOOOOOOOO #P$ at 6@ OOOOOOOOOOOO
#P$ at 06@ OOOOOOOOOOO #P$ at 06@ OOOOOOOOOOO
#P$ at 0-@ OOOOOOOOOOO #P$ at 0-@ OOOOOOOOOOO
Mhich project is accepta(le if the are independentA MhA
Mhich project is accepta(le if the are mutuall exclusiveA MhA
*. >odified Internal $ate of $eturn
% Accept the project if '&RR : re42d rate of return (discount rate)
% Reject the project if '&RR < re42d rate of return (discount rate)
dvantage: 4et1s you decide the reinvestment rate2
/ost 5 Terminal $alue
T

(0 7 '&RR)
T
Piven: /ost. T$
!olve: '&RR
+in ,,-. /hapter 00 page 00
?. "rofita9ility Inde+ &"I(
"I , &"# of Cash Inflo5s(@&"# of Cash Autflo5s(
The P& is the ratio of the P$ of the project2s cash inflows to the P$ of the project2s cash
outflows9
"I for "roject 3
P$/&+
!
5 -66 7 D66 7 ,66 7 066 5 0.6LJ9J8
(07906)
0
(07906)
8
(07906)
,
(07906)
D
P$/K+
!
5 0.666
P&
!
5 0.6LJ9J8"0.666 5 096LJJ8
"I Decision $ule
% Accept if P& : 0966
% Reject if P& < 0966
dvantages
% /onsiders T$'
% /onsiders all cash flows
% Qses reasona(le discount rate
% Qseful when faced with capital rationing9
Disadvantages
% /annot distinguish projects of vastl different scale
% 'a conflict with #P$ when evaluating mutuall exclusive projects
+in ,,-. /hapter 00 page 08
"rofita9ility Inde+ vs !"# for Mutually Exclusive "rojects
6 0
F%%%%%%%%%%%%%%%%%%%%%F
Cash ?lo5s
Project = %>06 >0-
Project N %>0.666 >0.8-6
= N
#P$ at 906 > ,9?D >0,?9,?
P& at 906 09,?D 090,?
=ccording to #P$. ou choose N9
=ccording to P&. ou choose =9
+in ,,-. /hapter 00 page 0,