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CHAPTER 11
The Basics of Capital Budgeting
Should we
build this
plant?
11-1
What is capital budgeting?



Analysis of potential additions to
fixed assets.
Long-term decisions; involve large
expenditures.
Very important to firm’s future.
11-2
Steps to capital budgeting
1.
2.
3.
4.
Estimate CFs (inflows & outflows).
Determine the appropriate cost of capital.
Find payback period, NPV and/or IRR.
Accept project if
1. payback period is less than the
maximum acceptable payback period,
2.NPV > 0
3. and/or 2.IRR > WACC.
11-3
What is the difference between
independent and mutually
exclusive projects?


Mutually Exclusive Projects are
investments that compete in some way for
a company’s resources—a firm can select
one or another but not both.
Independent Projects, on the
other hand, do not compete with the
firm’s resources. A company can
select one, or the other, or both—so
long as they meet minimum
profitability thresholds.
11-4
Payback Period




The payback method simply measures
how long (in years and/or months) it takes
to recover the initial investment.
The maximum acceptable payback period is
determined by management.
If the payback period is less than the
maximum acceptable payback period, accept
the project.
If the payback period is greater than the
maximum acceptable payback period, reject
the project.
11-5
Payback Periods (cont.)
11-6
What is Project L’s payback?
Year
0
1
2
3
CFt
-100
10
60
80
11-7
Calculating payback
Project L’s Payback Calculation
1
2
3
10
-90
60
-30
80
0
CFt
Cumulative
PaybackL
-100
-100
== 2
+
30 / 80
50
= 2.375 years
PaybackL = 2.375 years
11-8
Pros and Cons of Payback
Periods


The payback method is widely used as a
starting point by large firms to evaluate small
projects and by small firms to evaluate most
projects.
It is simple, intuitive.
It also gives implicit consideration to the
timing of cash flows and is widely used as a
supplement to other methods such as Net
Copyright © 2006
Present
Value and Internal Rate of Return.
Pearson
Addison
Wesley. All rights
reserved.
9-9
11-9
Pros and Cons
of Payback Periods (cont.)


One major weakness of the payback
method is that the appropriate payback
period is a subjectively determined number.
It also fails to consider the principle of
wealth maximization of which CF is
assume to be reinvested and thus provides
no indication as to whether a project adds to
firm value.
Thus, payback fails to fully consider the time
Copyright © 2006
value
Pearson
Addison- of money.

Wesley. All rights
reserved.
9-10
11-10
Reinvesting cash flow from
project
CF
CF
CF
CF
100
100
100
100
CF
100
“reinvest cash inflow at going market rates”
11-11
Pros and Cons
of Payback Periods (cont.)

It fails to consider the timing of the
cash flows of which are assumed to be
reinvested at going market rate. ( ie.
the 40,000 CF of project silver in year1 if
reinvested would generate higher return
compare to the 5,000 CF of project gold in
year1)
Copyright © 2006
Pearson AddisonWesley. All rights
reserved.
9-12
11-12
Pros and Cons
of Payback Periods (cont.)
Copyright © 2006
Pearson AddisonWesley. All rights
reserved.
9-13
11-13
Pros and Cons
of Payback Periods (cont.)

Payback method fails to recognize cash flows
that occur after the payback period.
Copyright © 2006
Pearson AddisonWesley. All rights
reserved.
9-14
11-14
Pros and Cons
of Payback Periods (cont.)
Copyright © 2006
Pearson AddisonWesley. All rights
reserved.
9-15
11-15
Discounted payback period

Uses discounted cash flows rather than
raw CFs.
0
CFt
PV of CFt
Cumulative
10%
-100
-100
-100
Disc PaybackL ==
2
+
1
2
10
9.09
-90.91
60
49.59*
-41.32
41.32 / 60.11
3
80
60.11
18.79
= 2.7 years
*FV = 60, n = 2, I/yr = 10%, Pmt = 0, PV = 49.59
11-16
Net Present Value (NPV)
(cont.)

Net Present Value (NPV): Net Present
Value is found by subtracting the
present value of the after-tax outflows
from the present value of the after-tax
inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
11-17
Capital Budgeting Techniques

Chapter Problem
Bennett Company is a medium sized metal fabricator
that is currently contemplating two projects: Project A
requires an initial investment of $42,000, project B an
initial investment of $45,000. The relevant operating
cash flows for the two projects are presented in Table
9.1 and depicted on the time lines in Figure 9.1.
11-18
Capital Budgeting Techniques
(cont.)
11-19
Capital Budgeting Techniques
(cont.)
11-20
Net Present Value (NPV)
(cont.)
11-21
Using financial Calculator to solve for NPV
& IRR ( Project A)
- 2th –> CF
-2th -> CE/C (clear work)
CO0
CO1
CO2
CO3
CO4
CO5
=
=
=
=
=
=
42,000
14,000
14,000
14,000
14,000
14,000
-> NPV
I= 10%
=> “Answer”
(NPV)
-> IRR
CPT
=> “Answer”
(IRR)
enter
enter
enter
enter
enter
enter
enter
FO1
FO2
FO3
FO4
FO5
NPV
CPT
*using financial
Calculator to solve
for NPV & IRR
11-22
Using financial Calculator to solve for
NPV & IRR ( Project B)
- 2th –> CF
-2th -> CE/C (clear work)
CO0
CO1
CO2
CO3
CO4
CO5
=
=
=
=
=
=
45,000
28,000
12,000
10,000
10,000
10,000
-> NPV
I= 10%
=> “Answer”
(NPV)
-> IRR
CPT
=> “Answer”
(IRR)
enter
enter
enter
enter
enter
enter
enter
FO1
FO2
FO3
FO4
FO5
NPV
CPT
*using financial
Calculator to solve
for NPV IRR
11-23
Internal Rate of Return (IRR)
(cont.)


The Internal Rate of Return (IRR) is the discount
rate that will equate the present value of the
outflows with the present value of
the inflows.
The IRR is the project’s intrinsic rate of return.
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
11-24
Internal Rate of Return (IRR)
(cont.)
11-25
Net Present Value Profiles
&Conflicting Rankings
9-26
11-26
Conflicting Rankings



This underlying cause of conflicting rankings is the
implicit assumption concerning the reinvestment of
intermediate cash inflows—cash inflows received
prior to the termination of the project.
NPV assumes intermediate cash flows are reinvested
at the cost of capital, while IRR assumes that they
are reinvested at the IRR.
Conflicting rankings between two or more projects
using NPV and IRR sometimes occurs also because of
differences in the timing and magnitude of cash
9-27
11-27
Which Approach is Better?

On a purely theoretical basis, NPV is the
better approach because:


NPV assumes that intermediate cash flows are
reinvested at the cost of capital whereas IRR
assumes they are reinvested at the IRR,
Despite its theoretical superiority, however,
financial managers prefer to use the IRR
because of the preference for rates of return
(ie. managers are so used describing return
in a project in percentage form- rates of
return is in percentage form)
9-28
11-28