NPV and Making Capital Investment Decisions(Capital Budgeting)

Capital Budgeting is the process of identifying, evaluating, and implementing a

firms investment opportunities.
It seeks to identify investments that will enhance a firms competitive
advantage and increase shareholder wealth.
The typical capital budgeting decision involves a large up-front investment
followed by a series of smaller cash inflows.
Poor capital budgeting decisions can ultimately result in company bankruptcy
Key Motives for Capital Expenditures (>1 yr)
Replacing worn out or obsolete assets
improving business efficiency
acquiring assets for expansion into new products or markets
acquiring another business
complying with legal requirements
satisfying work-force demands
environmental requirements

Evaluation and Selection

- What are the costs and benefits?
- What is the projects return?
- What are the risks involved?

Mutually Exclusive Projects are investments that compete in some way for a
companys resources. A firm can select one or another but not both. If you
choose one, you cant choose the other
Example: You can choose to attend graduate school next year at either
UCT or Wits, but not both

Independent Projects, on the other hand, do not compete with the firms
resources. A company can select one, or the other, or both -- so long as
they meet minimum profitability thresholds
External Economic & Political Data
Business Cycle Stages
Inflation Trends
Interest Rate Trends
Exchange Rate Trends
Freedom of Cross-Border Currency Flows
Political Stability
Regulations
Taxation

Internal Financial Data

Initial Outlay & Working Capital
Estimated Cash Flows
Financing Costs
Transportation, Shipping and Installation Costs
Competitor Information

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Net Present Value and Other Investment Criteria

Good Decision Criteria

We need to ask ourselves the following questions when evaluating decision
criteria
Does the decision rule adjust for the time value of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on whether we are creating
value for the firm?
Example 1
You are looking at a new project and you have estimated the following cash
flows:
Year 0 1 2 3
Cash flow -165 000 63 120 70 800 91 080
NPAT 13 620 3 300 29 100
Average Book Value = 72 000
Your required return for assets of this risk is 12%.

Net Present Value

The difference between the market value of a project and its cost
How much value is created from undertaking an investment?
The first step is to estimate the expected future cash flows.
The second step is to estimate the required return for projects of this
risk level.
The third step is to find the present value of the cash flows and subtract
the initial investment

NPV = PV of cash inflows initial investment

= pmt(PVIFA k,n) Initial investment
Using the formulas:
NPV = [63 120(1.12) -1 + 70 800(1,12) -2 + 91 080(1,12) -3] 165 000 = 12 627,42
Using the calculator:
CF0 = -165 000; CF1 = 63 120; CF2 = 70 800; CF3 = 91 080; I/YR = 12;
NPV = 12 627,42
Do we accept or reject the project?

Example 2: Calculate the NPVs for the following 20 yr projects, assuming a cost of
capital of 14%.
A) Initial investment is R10 000 and cash inflows of R2 000 pa.
PV of cash flows= pmt x PVIFA
= 2 000 x 6.623
= R13 246
NPV = 13 246 10 000
= 3 246

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 Because NPV is positive, it will be accepted.

B) Initial investment is R25 000; cash inflows of R3 000 pa.

PV of cash inflows = 3 000 x 6.623
= 19 869
NPV = 19 869 25 000
= -R 5 131
Reject; NPV is negative.
NPV Decision Rule
If the NPV is positive, accept the project
A positive NPV means that the project is expected to add value to the firm and
will therefore increase the wealth of the owners.
Since our goal is to increase owner wealth, NPV is a direct measure of how
well this project will meet our goal

Payback Period
How long does it take to get the initial cost back in a nominal sense?
Computation
Estimate the cash flows
Subtract the future cash flows from the initial cost until the initial
investment has been recovered
Decision Rule Accept if the payback period is less than some preset limit

Assume we will accept the project if it pays back within two years.
Year 1: 165 000 63 120 = 101 880 still to recover
Year 2: 101 880 70 800 = 31 080 still to recover
Year 3: 31 080 91 080 = -60 000 project pays back in year 3

To be exact: 2 yrs + 31 080/91 080 = 2.3 yrs

Do we accept or reject the project?

Which project is preferred?

Advantages and Disadvantages of Payback

Advantages
Easy to understand
Adjusts for uncertainty of later cash flows

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 Biased towards liquidity

Disadvantages
Ignores the time value of money
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff date
Biased against long-term projects, such as research and development,
and new projects

Payback Weakness: Failure to consider the time value of money (pattern of

cash flows).

Computing Discounted Payback for the Project

Assume we will accept the project if it pays back on a discounted basis in 2

years.
Compute the PV for each cash flow and determine the payback period using
discounted cash flows
Year 1: 165 000 63 120(1,12) -1 = 108 643
Year 2: 108 643 70 800(1,12) -2 = 52 202
Year 3: 52 202 91 080(1,12) -3 = -12 627 project pays back in year 3

Or 2 yrs + 52 202/91 080 = 2.6 yrs

Do we accept or reject the project?

Advantages and Disadvantages of Discounted Payback

Advantages
Includes time value of money
Easy to understand
Does not accept negative estimated NPV investments
Biased towards liquidity
Disadvantages
May reject positive NPV investments
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff point
Biased against long-term projects, such as R&D and new products

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Internal Rate of Return
This is the most important alternative to NPV
It is often used in practice and is intuitively appealing
It is based entirely on the estimated cash flows and is independent of interest
rates found elsewhere
Definition: IRR is the return that makes the NPV = 0
Decision Rule: Accept the project if the IRR is greater than the required
return
If you do not have a financial calculator, then this becomes a trial and error
process
Calculator
Enter the cash flows as you did with NPV
Press IRR and then .
IRR = 16,13% > 12% required return
Do we accept or reject the project?
Example:
Benson Designs has prepared the following estimates for along term project it is
considering. The initial investment is R18 250 and the project is expected to yield
after tax cash inflows of R4 000 pa for 7 yrs. The firm has a 10% cost of capital.
1) Determine NPV
2) Determine IRR
3) What is your recommendation
Soln:
1) PV of cash inflows= pmt x (PVIFA 10%, 7yrs)
= 4 000 x 4.868
= 19 472
NPV = 19 472 18 250
= 1 222
2) PV = pmt x PVIFA k%, 7 yrs
18 250 = 4 000 x PVIFA k%, 7 yrs
4.563 = PVIFA k%, 7 yrs
IRR = 12%
(accept project (NPV>0 and IRR> 10%)

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Advantages of IRR
Knowing a return is intuitively appealing
It is a simple way to communicate the value of a project to someone who
doesnt know all the estimation details
If the IRR is high enough, you may not need to estimate a required return,
which is often a difficult task
NPV Vs. IRR
NPV and IRR will generally give us the same decision
Exceptions
Non-conventional cash flows cash flow signs change more than once
Mutually exclusive projects
Initial investments are substantially different
Timing of cash flows is substantially different

Mutually exclusive projects

Intuitively you would use the following decision rules:
NPV choose the project with the higher NPV
IRR choose the project with the higher IRR

Conflicts Between NPV and IRR

NPV directly measures the increase in value to the firm
Whenever there is a conflict between NPV and another decision rule, you
should always use NPV
IRR is unreliable in the following situations
Non-conventional cash flows
Mutually exclusive projects

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Profitability Index
Measures the benefit per unit cost, based on the time value of money
A profitability index of 1,1 implies that for every R1 of investment, we create
an additional R0,10 in value
This measure can be very useful in situations where we have limited capital

The profitability index which is also sometimes called the benefit/cost ratio, is the
ratio of the present value of the inflows to the present value of the outflows

PI = PV Inflows
PV Outflows
Decision Criteria
If PI > 1, accept the project
If PI < 1, reject the project
If PI = 1, indifferent

Advantages and Disadvantages of Profitability Index

Advantages
Closely related to NPV, generally leading to identical decisions
Easy to understand and communicate
May be useful when available investment funds are limited
Disadvantages
May lead to incorrect decisions in comparisons of mutually exclusive
investments

Summary Discounted Cash Flow Criteria

Net present value
Difference between market value and cost
Take the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than required return
Same decision as NPV with conventional cash flows
IRR is unreliable with non-conventional cash flows or mutually
exclusive projects
Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing

Payback period
Length of time until initial investment is recovered
Take the project if it pays back in some specified period

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 Doesnt account for time value of money and there is an arbitrary
cutoff period
Discounted payback period
Length of time until initial investment is recovered on a discounted
basis
Take the project if it pays back in some specified period
There is an arbitrary cutoff period
Quick Quiz
Consider an investment that costs R100 000 and has a cash inflow of R25 000 every
year for 5 years. The required return is 9% and required payback is 4 years.
What is the payback period?
What is the discounted payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
What decision rule should be the primary decision method?
When is the IRR rule unreliable?

Worked Example
Oak Enterprises accepts projects earning more than the firms 15% cost of capital.
Oak is currently considering a 10 year project that provides annual cash inflows of
R10 000 and requires an initial investment of R 61 450.
1) Determine the IRR of this project. Is it acceptable?

PVn = PMT x (PVIFAk%,n)

R61,450 = R10,000 x (PVIFA k%,10 yrs.)
R61,450 R10,000 = PVIFAk%,10 Yrs.
6.145 = PVIFAk%,10 yrs.
k= IRR = 10% (calculator solution: 10.0%)

2) Assuming that the cash inflows continue to be R10 000 per year, how many
additional years would the flows have to continue to make the project
acceptable( ie to make IRR of 15%)?

PVn = PMT x (PVIFA%,n)

R61,450 = R10,000 x (PVIFA15%,n)
R61,450 R10,000 = PVIFA15%,n
6.145 = PVIFA15%,n
18 yrs. < n < 19 yrs.
Calculator solution: 18.23 years

The project would have to run a little over 8 more years to make the project acceptable with
the 15% cost of capital
3) With the given life , initial investment and cost of capital, what is the minimum
annual cash inflow that the firm should accept?

PVn = PMT x (PVIFA15%,10)

R61,450 = PMT x (5.019)
R61,450 5.019 = PMT
R12,243.48 = PMT

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Example (Payback, NPV, IRR)
Rieger International is attempting to evaluate the feasibility of investing R95 000 in a
piece of equipment that has a 5 yr life. The estimated cash inflows are given.The firm
has a cost of capital of 12%.
Yr CFt
1 20 000
2 25 000
3 30 000
4 35 000
5 40 000
1) Calculate the payback period.
2) Calculate the NPV.
3) Calculate the IRR (nearest whole %)(difficult)
4) Evaluate the acceptability of the proposed investment using NPV and IRR.
What recommendations would you make relative to the implementation of the project?
Why?

1) Payback period
3 + (R20,000 R35,000) = 3.57 years

2) PV of cash inflows

Year CF PVIF12%,n PV

1 R20,000 .893 R 17,860

2 25,000 .797 19,925
3 30,000 .712 21,360
4 35,000 .636 22,260
5 40,000 .567 22,680
R104,085

NPV = PV of cash inflows - Initial investment

NPV = R104,085 - R95,000
NPV = R9,085
Calculator solution: R9,080.61

$20,000 $25,000 $30,000 $35,000 $40,000

3) $0 $95,000
(1 IRR )1
(1 IRR ) 2
(1 IRR ) 3
(1 IRR ) 4
(1 IRR )5

IRR = 15%
Calculator solution: 15.36%

4) NPV = R9,085; since NPV > 0; accept

IRR = 15%; since IRR > 12% cost of capital; accept

The project should be implemented since it meets the decision criteria for both NPV
and IRR.