1. Capital BudgetingCapital Budgeting
TechniquesTechniques

2. CAPITAL BUDGETINGCAPITAL BUDGETING
 The process of identifying, analyzing andThe process of identifying, analyzing and
selecting investment projects whoseselecting investment projects whose
returns (cash flows) are expected to extendreturns (cash flows) are expected to extend
beyond one year.beyond one year.

3. Capital Budgeting TechniquesCapital Budgeting Techniques
 Project Evaluation and SelectionProject Evaluation and Selection
 Potential DifficultiesPotential Difficulties
 Capital RationingCapital Rationing
 Project MonitoringProject Monitoring
 Post-Completion AuditPost-Completion Audit

4. 1.1. New product or ExpansionNew product or Expansion
2.2. ReplacementReplacement
3.3. Research and DevelopmentResearch and Development
4.4. ExplorationExploration
5.5. Other purposes ( Advertisement, safety orOther purposes ( Advertisement, safety or
pollution related )pollution related )
Key Motives for Making CapitalKey Motives for Making Capital
ExpendituresExpenditures

5. Project Evaluation: AlternativeProject Evaluation: Alternative
MethodsMethods
 Payback Period (PBP)Payback Period (PBP)
 Internal Rate of Return (IRR)Internal Rate of Return (IRR)
 Net Present Value (NPV)Net Present Value (NPV)
 Profitability Index (PI)Profitability Index (PI)

6. Project RelationshipsProject Relationships
 Mutually ExclusiveMutually Exclusive -- A project whose-- A project whose
acceptance precludes the acceptance ofacceptance precludes the acceptance of
one or more alternative projects.one or more alternative projects.
• IndependentIndependent -- A project whose
acceptance (or rejection) does not
prevent the acceptance of other projects
under consideration.
• DependentDependent -- A project whose
acceptance depends on the acceptance
of one or more other projects.

7. Payback Period (PBP)Payback Period (PBP)
PBPPBP is the period of time required for theis the period of time required for the
cumulative expected cash flows from ancumulative expected cash flows from an
investment project to equal the initialinvestment project to equal the initial
cash outflow.cash outflow.

8. Proposed Project DataProposed Project Data
Julie Miller is evaluating a new project for her firmJulie Miller is evaluating a new project for her firm
Basket Wonders (BW)Basket Wonders (BW). She has determined that. She has determined that
the after-tax cash flows for the project will bethe after-tax cash flows for the project will be
$10,000, $12,000, $15,000, $10,000, and $7,000$10,000, $12,000, $15,000, $10,000, and $7,000
respectively for each of therespectively for each of the Years 1 through 5Years 1 through 5..
The initial cash outlay will beThe initial cash outlay will be $40,000$40,000..

9. (c)10 K 22 K 37 K 47 K 54 K
Payback SolutionPayback Solution
PBPPBP == aa + (+ ( bb -- cc ) /) / dd
== 33 + (+ (4040 -- 3737) /) / 1010 == 33 + (+ (33) /) / 1010
== 3.3 Years3.3 Years
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K
Cumulative
Inflows
(a)
(-b) (d)

10. PBP Acceptance CriterionPBP Acceptance Criterion
The management ofThe management of Basket WondersBasket Wonders has set ahas set a
maximum PBP ofmaximum PBP of 3.5 Years3.5 Years for projects offor projects of
this type.this type.
Should this project be accepted?Should this project be accepted?
Yes!Yes! The firm will receive back the initial cashThe firm will receive back the initial cash
outlay in less than 3.5 Years. [outlay in less than 3.5 Years. [3.3 Years3.3 Years << 3.53.5
Year MaxYear Max..]]

11. PBP Strengths and WeaknessesPBP Strengths and Weaknesses
StrengthsStrengths::
 Easy to use andEasy to use and
understandunderstand
 Can be used as aCan be used as a
measure of liquiditymeasure of liquidity
Weaknesses:
•Does not account for
TVM
•Does not consider
cash flows beyond the
PBP
• Cutoff period is
subjective

12. Net Present Value (NPV)Net Present Value (NPV)
NPVNPV is the present value of an investmentis the present value of an investment
project’s net cash flows minus the project’sproject’s net cash flows minus the project’s
initial cash outflow.initial cash outflow.
CF1 CF2 CFn
(1+k)1
(1+k)2
(1+k)n
+ . . . ++ - ICOICONPV =

13. Decision Criteria
 If NPV > 0, accept the project
 If NPV < 0, reject the project
 If NPV = 0, technically indifferent

14. Basket WondersBasket Wonders has determined that the appropriatehas determined that the appropriate
discount rate (k) for this project is 13%.discount rate (k) for this project is 13%.
$10,000 $7,000
NPV SolutionNPV Solution
$10,000 $12,000 $15,000
(1.13)1
(1.13)2
(1.13)3
+ +
+ - $40,000$40,000(1.13)4
(1.13)5
NPVNPV = +

15. NPV SolutionNPV Solution
NPVNPV == $10,000$10,000(PVIF(PVIF13%13%,,11) +) + $12,000$12,000(PVIF(PVIF13%13%,,22) +) +
$15,000$15,000(PVIF(PVIF13%13%,,33) +) + $10,000$10,000(PVIF(PVIF13%13%,,44) +) +
$ 7,000$ 7,000(PVIF(PVIF13%13%,,55) -) - $40,000$40,000
NPVNPV == $10,000$10,000(.885) +(.885) + $12,000$12,000(.783) +(.783) +
$15,000$15,000(.693) +(.693) + $10,000$10,000(.613) +(.613) +$ 7,000$ 7,000(.543) -(.543) -
$40,000$40,000
NPVNPV == $8,850 + $9,396 + $10,395 +$8,850 + $9,396 + $10,395 +
$6,130 + $3,801 -$6,130 + $3,801 - $40,000$40,000
== - $1,428- $1,428

16. NPV Acceptance CriterionNPV Acceptance Criterion
No!No! TheThe NPVNPV isis negativenegative. This means that the. This means that the
project is reducing shareholder wealth. [project is reducing shareholder wealth. [RejectReject asas
NPVNPV << 00 ]]
The management ofThe management of Basket WondersBasket Wonders hashas
determined that the required rate is 13% fordetermined that the required rate is 13% for
projects of this type.projects of this type.
Should this project be accepted?Should this project be accepted?

17. NPV Strengths and WeaknessesNPV Strengths and Weaknesses
StrengthsStrengths::
 Cash flowsCash flows
assumed to beassumed to be
reinvested at thereinvested at the
hurdle rate.hurdle rate.
 Accounts for TVM.Accounts for TVM.
 Considers allConsiders all
cash flows.cash flows.
WeaknessesWeaknesses::
 May not includeMay not include
managerial optionsmanagerial options
embeddedembedded in thein the
project.project.

18. Profitability Index (PI)Profitability Index (PI)
PI is the ratio of the present value of a project’sPI is the ratio of the present value of a project’s
future net cash flows to the project’s initial cashfuture net cash flows to the project’s initial cash
outflow.outflow.
CF1 CF2 CFn
(1+k)1
(1+k)2
(1+k)n
+ . . . ++ ICOICOPI =
PI = 1 + [ NPVNPV / ICOICO ]
<< OR >>

19. PI Acceptance CriterionPI Acceptance Criterion
No!No! TheThe PIPI isis less than 1.00less than 1.00. This. This meansmeans
that the project is not profitable. [that the project is not profitable. [RejectReject asas PIPI <<
1.001.00 ]]
PIPI = $38,572 / $40,000= $38,572 / $40,000
= .9643= .9643
Should this project be accepted?Should this project be accepted?

20. PI Strengths and WeaknessesPI Strengths and Weaknesses
StrengthsStrengths::
 Same as NPVSame as NPV
 AllowsAllows
comparison ofcomparison of
different scaledifferent scale projectsprojects
WeaknessesWeaknesses::
 Same as NPVSame as NPV
 Provides only relativeProvides only relative
profitabilityprofitability
 Potential RankingPotential Ranking
ProblemsProblems

21. Internal Rate of Return (IRR)Internal Rate of Return (IRR)
IRR is the discount rate that equates the presentIRR is the discount rate that equates the present
value of the future net cash flows from anvalue of the future net cash flows from an
investment project with the project’s initial cashinvestment project with the project’s initial cash
outflow.outflow.
CF1 CF2 CFn
(1+IRR)1
(1+IRR)2
(1+IRR)n
+ . . . ++ICO =

22. $15,000 $10,000 $7,000
IRR SolutionIRR Solution
$10,000 $12,000
(1+IRR)1
(1+IRR)2
Find the interest rate (Find the interest rate (IRRIRR) that causes the discounted cash) that causes the discounted cash
flows to equalflows to equal $40,000$40,000..
+ +
++$40,000 =
(1+IRR)3 (1+IRR)4 (1+IRR)5

23. IRR Solution (Try 10%)IRR Solution (Try 10%)
$40,000$40,000 == $10,000(PVIF$10,000(PVIF10%10%,,11) + $12,000(PVIF) + $12,000(PVIF10%10%,,22))
+ $15,000(PVIF+ $15,000(PVIF10%10%,,33) + $10,000(PVIF) + $10,000(PVIF10%10%,,44) +) +
$ 7,000(PVIF$ 7,000(PVIF10%10%,,55))
$40,000$40,000 == $10,000(.909) + $12,000(.826) +$10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +$15,000(.751) + $10,000(.683) +
$ 7,000(.621)$ 7,000(.621)
$40,000$40,000 == $9,090 + $9,912 + $11,265 +$9,090 + $9,912 + $11,265 +
$6,830 + $4,347$6,830 + $4,347
== $41,444$41,444 [[Rate is too low!!Rate is too low!!]]

24. IRR Solution (Try 15%)IRR Solution (Try 15%)
$40,000$40,000 == $10,000(PVIF$10,000(PVIF15%15%,,11) + $12,000(PVIF) + $12,000(PVIF15%15%,,22) +) +
$15,000(PVIF$15,000(PVIF15%15%,,33) + $10,000(PVIF) + $10,000(PVIF15%15%,,44) +) +
$7,000(PVIF$7,000(PVIF15%15%,,55))
$40,000$40,000 == $10,000(.870) + $12,000(.756) +$10,000(.870) + $12,000(.756) + $15,000(.658) +$15,000(.658) +
$10,000(.572) + $ 7,000(.497)$10,000(.572) + $ 7,000(.497)
$40,000$40,000 == $8,700 + $9,072 + $9,870 + $5,720 + $3,479$8,700 + $9,072 + $9,870 + $5,720 + $3,479

25. IRR Solution (Interpolate)IRR Solution (Interpolate)
IRRIRR = .10 += .10 + .0157.0157 == .1157.1157 oror 11.57%11.57%

26. Decision Criteria
 If IRR > cost of capital, accept the project
 If IRR < cost of capital, reject the project
 If IRR = cost of capital, technically
indifferent

27. IRR Acceptance CriterionIRR Acceptance Criterion
No!No! The firm will receiveThe firm will receive 11.57%11.57% for eachfor each
dollar invested in this project at a cost ofdollar invested in this project at a cost of 13%13%..
[[ IRRIRR << Hurdle RateHurdle Rate ]]
The management ofThe management of Basket WondersBasket Wonders hashas
determined that thedetermined that the hurdle ratehurdle rate isis 13%13% forfor
projects of this type.projects of this type.
Should this project be accepted?Should this project be accepted?

28. IRR Strengths and WeaknessesIRR Strengths and Weaknesses
StrengthsStrengths::
 Accounts forAccounts for
TVMTVM
 Considers allConsiders all
cash flowscash flows
 LessLess
SubjectivitySubjectivity
WeaknessesWeaknesses::
 Assumes all cashAssumes all cash
flows reinvested atflows reinvested at the IRRthe IRR
 Difficulties withDifficulties with
project rankings andproject rankings and MultipleMultiple
IRRsIRRs

29. Evaluation SummaryEvaluation Summary
Method Project Comparison Decision
PBP 3.3 3.5 Accept
IRR 11.57% 13% Reject
NPV -$1,428 $0 Reject
PI .96 1.00 Reject
Basket Wonders Independent Project

30. 9-30
Which Approach is Better?Which Approach is Better?
 On a purely theoretical basis, NPV is the better approachOn a purely theoretical basis, NPV is the better approach
because:because:
 NPV assumes that intermediate cash flows are reinvested at theNPV assumes that intermediate cash flows are reinvested at the
cost of capital whereas IRR assumes they are reinvested at thecost of capital whereas IRR assumes they are reinvested at the
IRR,IRR,
 Certain mathematical properties may cause a project with non-Certain mathematical properties may cause a project with non-
conventional cash flows to have more than one real IRR.conventional cash flows to have more than one real IRR.
 Despite its theoretical superiority, however, financialDespite its theoretical superiority, however, financial
managers prefer to use the IRR because of the preferencemanagers prefer to use the IRR because of the preference
for rates of return.for rates of return.

31. Potential Ranking Problems UnderPotential Ranking Problems Under
Mutual ExclusivityMutual Exclusivity
A. Scale of InvestmentA. Scale of Investment
B. Cash-flow PatternB. Cash-flow Pattern
C. Project LifeC. Project Life
Ranking of project proposalsRanking of project proposals maymay create contradictorycreate contradictory
results.results.

32. A. Scale DifferencesA. Scale Differences
Compare a small (S) and a large (L) project.Compare a small (S) and a large (L) project.
NET CASH FLOWS
Project S Project LEND OF YEAR
0 -$100 -$100,000
1 0 0
2 $400 $156,250

33. SS .50 Yrs 100%.50 Yrs 100% $231$231 3.313.31
L 1.28 Yrs 25%L 1.28 Yrs 25% $29,132$29,132 1.291.29
Scale DifferencesScale Differences
Calculate the PBP, IRR, NPV@10%, andCalculate the PBP, IRR, NPV@10%, and
PI@10%.PI@10%.
Which project is preferred? Why?Which project is preferred? Why?
ProjectProject PBPPBP IRRIRR NPVNPV PIPI

34. B. Cash Flow PatternB. Cash Flow Pattern
Let us compare aLet us compare a decreasingdecreasing cash-flow (D) project and ancash-flow (D) project and an
increasingincreasing cash-flow (I) project.cash-flow (I) project.
NET CASH FLOWS
Project D Project IEND OF YEAR
0 -$1,200 -$1,200
1 1,000 100
2 500 600
3 100 1,080

35. DD 23%23% $198 1.17$198 1.17
II 17%17% $198 1.17$198 1.17
Cash Flow PatternCash Flow Pattern
Calculate the IRR, NPV@10%, and PI@10%.Calculate the IRR, NPV@10%, and PI@10%.
Which project is preferred?Which project is preferred?
ProjectProject IRRIRR NPVNPV PIPI

36. Examine NPV ProfilesExamine NPV Profiles
Discount Rate (%)
0 5 10 15 20 25
-2000200400600
IRR
NPV@10%
Plot NPV for each
project at various
discount rates.
NetPresentValue($)

37. Fisher’s Rate of IntersectionFisher’s Rate of Intersection
Discount Rate ($)
0 5 10 15 20 25
-2000200400600
NetPresentValue($)
At k<10%, I is best!At k<10%, I is best! Fisher’sFisher’s RateRate ofof
IntersectionIntersection
At k>10%, D is best!At k>10%, D is best!

38. Let us compare aLet us compare a longlong life (X) project and alife (X) project and a
shortshort life (Y) project.life (Y) project.
NET CASH FLOWS
Project X Project YEND OF YEAR
0 -$1,000 -$1,000
1 0 2,000
2 0 0
3 3,375 0
C. Project Life DifferencesC. Project Life Differences

39. Project Life DifferencesProject Life Differences
X 50%X 50% $1,536 2.54$1,536 2.54
YY 100%100% $ 818 1.82$ 818 1.82
Calculate the PBP, IRR, NPV@10%, andCalculate the PBP, IRR, NPV@10%, and
PI@10%.PI@10%.
Which project is preferred? Why?Which project is preferred? Why?
ProjectProject IRRIRR NPVNPV PIPI

40. Capital RationingCapital Rationing
Capital RationingCapital Rationing occurs when a constraint (oroccurs when a constraint (or
budget ceiling) is placed on the total size ofbudget ceiling) is placed on the total size of
capital expenditures during a particular period.capital expenditures during a particular period.
ExampleExample
Julie Miller must determine what investmentJulie Miller must determine what investment
opportunities to undertake foropportunities to undertake for Basket WondersBasket Wonders
(BW)(BW). She is limited to a. She is limited to a maximum expendituremaximum expenditure
of $32,500of $32,500 onlyonly for 199X.for 199X.

41. Available Projects for BWAvailable Projects for BW
Project ICO IRR NPV PIProject ICO IRR NPV PI
A $ 500 18%A $ 500 18% $ 50 1.10$ 50 1.10
BB 5,0005,000 2525 6,500 2.306,500 2.30
CC 5,0005,000 3737 5,500 2.105,500 2.10
DD 7,5007,500 2020 5,000 1.675,000 1.67
EE 12,50012,500 2626 500 1.04500 1.04
FF 15,00015,000 2828 21,000 2.4021,000 2.40
GG 17,50017,500 1919 7,500 1.437,500 1.43
HH 25,00025,000 1515 6,000 1.246,000 1.24

42. Choosing by IRRs for BWChoosing by IRRs for BW
Project ICO IRR NPV PIProject ICO IRR NPV PI
C $ 5,000C $ 5,000 37%37% $ 5,500 2.10$ 5,500 2.10
FF 15,00015,000 2828 21,000 2.4021,000 2.40
EE 12,50012,500 2626 500 1.04500 1.04
BB 5,0005,000 2525 6,500 2.36,500 2.3
Projects C, F, and E have the threeProjects C, F, and E have the three largest IRRslargest IRRs..
The resultingThe resulting increaseincrease inin shareholder wealthshareholder wealth isis $27,000$27,000
with awith a $32,500 outlay$32,500 outlay..

43. Choosing by NPVs for BWChoosing by NPVs for BW
Project ICO IRR NPV PIProject ICO IRR NPV PI
F $15,000F $15,000 28%28% $21,000$21,000 2.402.40
G 17,500G 17,500 1919 7,5007,500 1.431.43
B 5,000B 5,000 2525 6,500 2.306,500 2.30
Projects F and G have the twoProjects F and G have the two largest NPVslargest NPVs..
The resultingThe resulting increaseincrease inin shareholder wealthshareholder wealth isis $28,500$28,500
with awith a $32,500 outlay$32,500 outlay..

44. Choosing by PIs for BWChoosing by PIs for BW
Project ICO IRR NPV PIProject ICO IRR NPV PI
FF $15,000$15,000 28%28% $21,000$21,000 2.402.40
BB 5,0005,000 2525 6,5006,500 2.302.30
CC 5,0005,000 3737 5,5005,500 2.102.10
DD 7,5007,500 2020 5,0005,000 1.671.67
GG 17,50017,500 1919 7,500 1.437,500 1.43
Projects F, B, C and D have the fourProjects F, B, C and D have the four largest PIslargest PIs..
The resultingThe resulting increaseincrease inin shareholder wealthshareholder wealth isis $38,000$38,000
with awith a $32,500 outlay$32,500 outlay..

45. Summary of ComparisonSummary of Comparison
MethodMethod Projects AcceptedProjects Accepted Value AddedValue Added
PIPI F, B, C, and D $38,000F, B, C, and D $38,000
NPVNPV F and G $28,500F and G $28,500
IRRIRR C, F and E $27,000C, F and E $27,000
PIPI generates thegenerates the greatestgreatest increaseincrease inin shareholder wealthshareholder wealth whenwhen
a limited capital budget exists for aa limited capital budget exists for a single periodsingle period..

46. Post-Completion AuditPost-Completion Audit
Post-completion AuditPost-completion Audit
A formal comparison of the actual costs and benefits of aA formal comparison of the actual costs and benefits of a
project with original estimates.project with original estimates.
 Identify any project weaknessesIdentify any project weaknesses
 Develop a possible set of corrective actionsDevelop a possible set of corrective actions
 Provide appropriate feedbackProvide appropriate feedback
Result:Result: Making better future decisions!Making better future decisions!