Capital

Budgeting

Investment Decision
Cash

Investmen
Investment
Fir
Sharehold
t
opportunities
opportunit
m
er
(financial
y (real
assets)
asset)
Invest
Pay dividend
Shareholders
to
invest for
shareholders
themselves

Investment return must exceed the return on

investing in a financial asset of equivalent risk to
accept the project

C
F

N
P
V

1k
nt
t0

Net Present Value

Project Market Value - Project Cost

1. Estimate all cash flows, positive and negative
2. Estimate projects required return
3. Find the present value of the cash flows

Discount all future cash flows

NPV > 0 : Accept

Reject

NPV < 0 :

NPV: Value to Equity

Holders

Investors:
You $20,000 & Brother $30,000

Buy a thoroughbred horse $50,000

Present value of sale $60,000
NPV =

Gain for equity holders

Brothers share =
Your share =

Negative NPV

Air Quality Control Act requires a

firm to install 3 cleaner ventilation
systems
Cash Flows
Cost: $350,000/unit
Value: Avoid $100,000/unit in fines
annually over the 5 year life of the units.

At r =14%, NPV = -$20,075

Project Analysis

Alternative analysis of cash flow

estimates
Payback
Internal Rate of Return

Supplements to NPV analysis

Sensitivity Analysis
Break-even Analysis
Monte Carlo Simulation
Decision Trees

Payback

Payback Period
Number of years it takes before the
cumulative forecasted cash flow
equals the initial outlay

Payback Rule
Only accept projects that payback
in the desired time frame

Fixed & Variable Costs

Total Costs = Fixed + Variable Costs

Total variable costs = quantity * cost per unit
Fixed costs are constant over some time
period

Ex: Your firm pays $3000 per month in

fixed costs. You also pay $15 per unit to
produce your product.
What is your total cost if you produce 1000
units?
What if you produce 5000 units?

Example

New experimental laser medical treatment

Purchase of new laser costs $250,000

Installation will cost $20,000
Hourly labor costs are $830 (doctor, nurse,
tech)
Charge $3,000 vs. $1,500 for traditional
treatment

Break-even Calculation
Fixed costs =
Variable costs =
Break-even =

C
F
C
F

N
P
V

1r 1IR

nt0t tn0t

Internal Rate of
Return

IRR is the discount rate that forces

PV of the inflows equal to the
initial outflow (cost).

NPV:
IRR:
Enter r, solve for NPV.
Enter NPV=0,
solve for IRR.

IRR Rationale

IRR > Opportunity Cost of Capital

Projects rate of return is greater than
its cost
Extra return is left after repaying
financing to boost stockholders
returns

IRR > r : Accept

IRR < r : Reject

Mutually Exclusive
Projects
NPV: choose the project with the
higher NPV
IRR: choose the project with the
higher IRR
Perio Project Project Req. return for both
d
A
B
projects is 10%.
0
1

-500
325

-400
325

2
IRR
NPV

325
19.43%
64.05

200
22.17%
60.74

Which project
should you accept
and why?

Relevant Cash Flows

Incremental cash flows

Any and all changes in cash flows due
to accepting a project
Will this cash flow occur ONLY if we
accept the project?

Stand-alone principle
Analyze each project in isolation from
the firm

Common Cash Flows

Sunk costs
Costs that have accrued in the past

Opportunity costs
Costs of lost options

Side effects
Positive: benefits to other projects
Negative: costs to other projects

Taxes

Incremental Cash
Flows

Luxury Car currently sells

30,000 cars at $45,000 and 12,000 SUVs at
$85,000

Introduces a motorcycle

Expects to sell 21,000 at $12,000 = $252 mil

Changes brand

SUVs decrease: -1,300 * $85,000 = - $110.5 mil

Cars increase: 5,000 * $45,000 = $225 mil
Net sales

Evaluating NPV
Estimates

NPV estimates are just that

estimates
NPV Actual Profitability

Forecasting risk
More sensitive NPV estimates, the
greater the forecasting risk
Sources of value

Sensitivity Analysis

NPV impact when vary one

variable
Vary inputs separately
Determines projects realizations
with better/worse outcomes of key
variables

Scenario

Unit
Sales

Cash
Flow

NPV

IRR

Worst case

5500

53,200

10.3

Shows sensitivity to forecasting

Baseline
6000
59,800
15,56 15.1
errors
7
%

Sensitivity Analysis

Must identify key variables

Determines where additional information

is needed
Exposes confused forecasts

Results are often ambiguous

Difficult to evaluate true probability

distribution of outcomes

How likely is each state of the world?

Interactions?
Strong demand
size / price

higher market

Scenario Analysis

Alternative to sensitivity analysis

Examines outcome given certain

events
Ex: Increased oil prices and car market

Consider at least

Best case: high revenues, low costs

Worst case: low revenues, high costs
Measure of the range of possible outcomes

Simulation Analysis

Managers can consider many

possible combinations

Generates a probability
distribution and estimates
probability of positive NPV.

Discounting & Risk

High Risk Project with Cost of

$125,000
If successful, firm will build a $1 million
plant which would generate $250,000/yr
after taxes
Otherwise, project will be dropped
50% probability of success
Expected cash flows:

C0 = -125

Discounting & Risk

High risk so management uses a project

discount rate of 25%.

NPV
All: -125 - 500/1.25 +(125/.25)/1.252 =negative

Problematic approach
If the test is a failure, then there is no risk at
all!
If successful, there may be normal risk
afterwards.

Decision Tree Analysis

Low risk if pilot is successful

Discount rate of 10%
Success
NPV= -1000 + (250/.1)/1.1 = 1,272

50%

Pilot production
and test
marketing
Failure50%
NPV = 0