THE CAPITAL BUDGETING DECISION

(CHAPTER 12)
Capital Budgeting: An Overview
Estimating Incremental Cash Flows
Payback Period
Net Present Value
Internal Rate of Return
Ranking Problems
Capital Rationing
Risk Adjustment
CAPITAL BUDGETING: AN OVERVIEW
Search for investment opportunities. This process
will obviously vary among firms and industries.
Estimate all cash flows for each project.
Evaluate the cash flows. a) Payback period. b) Net
Present Value. c) Internal Rate of Return. d)
Modified Internal rate of Return.
Make the accept/reject decision.
Independent projects: Accept/reject decision for a
project is not affected by the accept/reject decisions of
other projects.
Mutually exclusive projects: Selection of one
alternative precludes another alternative.
Periodically reevaluate past investment decisions.
ESTIMATING INCREMENTAL CASH
FLOWS
Only changes in after-tax cash flows that
would occur if the project is accepted
versus what they would be if the project is
rejected are relevant.
Initial Outlay: Includes purchase price of the
asset, shipping and installation, after-tax sale of
asset to be replaced if applicable, additional
required investments in net working capital (e.g.,
increases in accounts receivable and inventory
less any spontaneous increases in accounts
payable and accruals), plus any other cash flows
necessary to put the asset in working order.
Differential Cash Flows
Over the Projects Life:

Change in revenue
- Change in operating expenses
= Change in operating income before
taxes
- Change in taxes
= Change in operating income after
taxes
+ Change in depreciation
= Differential cash flow
Note: Interest expenses are excluded when
calculating differential cash flow. Instead,
they are accounted for in the discount rate
used to evaluate projects.
Terminal Cash Flow: Includes after-tax salvage
value of the asset, recapture of nonexpense
outlays that occurred at the assets initiation
(e.g., net working capital investments), plus
any other cash flows associated with project
termination.
PAYBACK PERIOD
The number of years required to recoup the initial
outlay. What is (n) such that:

CF CF
t
t
n
=
=
=

0
1
(n) = payback period (PP)
CF = initial outlay
CF after - tax cash flow in period (t)
0
t
PAYBACK PERIOD (CONTINUED)
Decision Rules:
PP = payback period
MDPP = maximum desired payback period
Independent Projects:
PP s MDPP - Accept
PP > MDPP - Reject
Mutually Exclusive Projects:
Select the project with the fastest payback, assuming
PP s MDPP.
Problems: (1) Ignores timing of the cash flows, and
(2) Ignores cash flows beyond the payback
period.
NET PRESENT VALUE (NPV)


The present value of all future after-tax cash flows
minus the initial outlay

return) (required capital of cost = k : where
) 1 (
...
) 1 ( ) 1 (
=

) 1 (
0
2
2 1
1
0
CF
k
CF
k
CF
k
CF
CF
k
CF
NPV
n
n
n
t
t
t

+
+ +
+
+
+

+
=

=
NPV (CONTINUED)
Decision Rules:
Independent Projects:
NPV > 0 - Accept
NPV < 0 - Reject
Mutually Exclusive Projects:
Select the project with the highest NPV, assuming NPV > 0.
INTERNAL RATE OF RETURN (IRR)
Rate of return on the investment. That rate of
discount which equates the present value of all
future after-tax cash flows with the initial outlay.
What is the IRR such that:




When only one interest factor is required, you can
solve for the IRR algebraically. Otherwise, trial
and error is necessary.


) 1 (
1
0
=
=
+
n
t
t
t
CF
IRR
CF
IRR (CONTINUED)
If you are not using a financial calculator:
1. Guess a rate.
2. Calculate:

3. If the calculation = CF
0
you guessed right
If the calculation > CF
0
try a higher rate
If the calculation < CF
0
try a lower rate
Note: Financial calculators do the trial and
error calculations much faster than we
can!
CF
IRR
t
t
t
n
( ) 1
1
+
=

IRR (CONTINUED)
Decision Rules (No Capital Rationing):
Independent Projects:
IRR > k - Accept
IRR < k - Reject
Mutually Exclusive Projects:
Select the project with the highest IRR, assuming IRR > k.
Multiple IRRs:
There can be as many IRRs as there are sign
reversals in the cash flow stream. When multiple IRRs
exist, the normal interpretation of the IRR loses its
meaning.
RANKING PROBLEMS
When NPV = 0, IRR = k
When NPV > 0, IRR > k
When NPV < 0. IRR < k
Therefore, given no capital rationing and
independent projects, the NPV and IRR methods
will always result in the same accept/reject
decisions.
However, the methods may rank projects differently.
As a result, decisions could differ if projects are
mutually exclusive, or capital rationing is
imposed. Ranking problems can occur when (1)
initial investments differ, or (2) the timing of
future cash flows differ. (See discussion on NPV
profiles)
RANKING PROBLEMS (CONTINUED)
Ranking Conflicts: Due to reinvestment rate
assumptions, the NPV method is generally more
conservative, and is considered to be the
preferred method.
NPV - Assumes reinvestment of future cash flows at
the cost of capital.
IRR - Assumes reinvestment of future cash flows at
the projects IRR.
In addition, the NPV method maximizes the value of
the firm.
CAPITAL RATIONING
Note:
Capital rationing exists when an artificial constraint is placed on the amount of
funds that can be invested. In this case, a firm may be confronted with more
desirable projects than it is willing to finance. A wealth maximizing firm would
not engage in capital rationing.
CAPITAL RATIONING: AN EXAMPLE
(FIRMS COST OF CAPITAL = 12%)
Independent projects ranked according to
their IRRs:
Project Project Size IRR
E $20,000 21.0%
B 25,000 19.0
G 25,000 18.0
H 10,000 17.5
D 25,000 16.5
A 15,000 14.0
F 15,000 11.0
C 30,000 10.0
CAPITAL RATIONING EXAMPLE
(CONTINUED)
No Capital Rationing - Only projects F and C
would be rejected. The firms capital budget
would be $120,000.

Capital Rationing - Suppose the capital budget is
constrained to be $80,000. Using the IRR
criterion, only projects E, B, G, and H, would
be accepted, even though projects D and A
would also add value to the firm. Also note,
however, that a theoretical optimum could be
reached only be evaluating all possible
combinations of projects in order to determine
the portfolio of projects with the highest NPV.
REQUIRED RETURNS FOR INDIVIDUAL
PROJECTS THAT VARY IN RISK LEVELS
Higher hurdle rates should be used for
projects that are riskier than the
existing firm, and lower hurdle rates
should be used for lower risk projects.
Measuring risk and specifying the tradeoff
between required return and risk,
however, are indeed difficult endeavors.
Interested students should read Chapter
13 entitled Risk and Capital Budgeting.
RISK ADJUSTED REQUIRED RETURNS
0
2
4
6
8
10
12
14
16
18
20
0 2 4 6
Required Return
Firms Risk Level
Risk
k
a

Risk-Return
Tradeoff
k
a
= Cost of
Capital for the
existing firm.