Capital Budgeting Techniques

Mona School of Business

Financial Management
Lecturer: Kathya Beckford
By the end of this session you will
understand:

1. What capital budgeting is

2. How to calculate and interpret a project’s:

 Payback Period
 Discounted Payback Period
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)

3. How to choose projects when capital is rationed

What is capital budgeting?

Capital budgeting is the process of planning

expenditure on assets or projects that can have a
long-term impact on an institution.
Examples of capital projects

 Adopting a new enterprise-wide software system

 Launching a new advertising campaign
 Replacing factory equipment
 Expanding sales into a new market
 Building a road
Why is capital budgeting
important?

 Helps firm make smart decisions

 Capital projects large and expensive- not easy to

change course

 Allows management team to give input and be on

same page
Capital budgeting techniques
include:

 Payback Period
 Discounted Payback Period
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)
Payback Period- The Concept

What is it?
The payback period for a project is the expected
time it will take to recover the original investment.

The decision rule:

Accept project if its payback period is less than the
maximum allowed.
Payback Period- An Example
A project requires a $100,000,000 investment and
is expected to generate the following cash flows in
the years after the investment is made

Year Cashflow ($)

1 20,000,000
2 40,000,000
3 60,000,000
4 30,000,000
5 10,000,000

What is the payback period?

Payback Period- Example cont’d
Workings:
Year Cashflow ($) Cumulative
Cashflow
1 20,000,000 20,000,000
2 40,000,000 60,000,000
3 60,000,000 120,000,000
4 30,000,000 150,000,000
5 10,000,000 160,000,000

The payback period is somewhere between the end

of year 2 and the end of year 3
Payback Period- Example cont’d
 Use linear interpolation to find the exact figure for payback
period

 By using linear interpolation, the assumption is that cashflows

occur evenly throughout the year

 We get:
X–2 = 100,000,000 – 60,000,000
3–2 120,000,000 – 60,000,000

X = 2.67 years (This is the payback period)

Payback Period- Example cont’d

If projects with a payback period of up to 4 years

are acceptable, should the firm accept this project?

Answer:
Yes, since the payback period is less than 4 years.
Payback Period- The Pros

 It is easy to calculate

 It is easy to explain

 It uses cashflows (not accounting profits)

 It gives a measure of the liquidity of a project

Payback Period- The Cons
 How to decide maximum allowable payback period?
Very subjective

 Time value of money not taken into consideration

 Project’s riskiness not accounted for properly

 Cashflows beyond the payback period are ignored

 No connection to maximizing the firm’s value

Discounted Payback Period-
The Concept
What is it?
The discounted payback period for a project is the
expected time it will take for the discounted cash
flows to recover the original investment.

The decision rule:

Accept project if its discounted payback period is
less than the maximum allowed.
Discounted Payback Period-
Example
A project requires a $100,000,000 investment and
is expected to generate the following cash flows in
the years after the investment is made

Year Cashflow ($)

1 20,000,000
2 40,000,000
3 60,000,000
4 30,000,000
5 10,000,000

What is the discounted payback period based on

a discount rate of 10%?
Discounted Payback Period-
Example cont’d
Workings:
Year Cashflow ($) PV of Cumulative PV of
Cashflow ($) cashflow ($)
1 20,000,000 18,181,818 18,181,818
2 40,000,000 33,057,851 51,239,669
3 60,000,000 45,078,888 96,318,557
4 30,000,000 20,490,404 116,808,961
5 10,000,000 6,209,213 123,018,174
The discounted payback period is somewhere
between the end of year 3 and the end of year 4
Discounted Payback Period-
Example cont’d
 Use linear interpolation to find the exact figure for the
discounted payback period

 By using linear interpolation, the assumption is that the

discounted cashflows occur evenly throughout the year

 We get:
Y–3 = 100,000,000 – 96,318,557
4–3 116,808,961 – 96,318,557

Y = 3.18 years (This is the discounted payback period)

Discounted Payback Period-
Example cont’d
If projects with a discounted payback period of up to
5 years are acceptable, should the firm accept this
project?

Answer:
Yes, since the discounted payback period is less
than 5 years.
Discounted Payback Period-
The Pros & Cons
 The pros and cons are almost the same as with the
basic payback period technique

 Only improvement is that cashflows are discounted

 However, since cashflows beyond discounted

payback period are ignored, TVM still not handled
adequately
Net Present Value (NPV)-
The Concept
What is it?
The net present value of a project is the sum of the
present values of its expected cash flows.

The decision rule:

Accept project if its NPV > 0.
NPV- An Example
A project requires a $100,000,000 investment and
is expected to generate the following cash flows in
the years after the investment is made

Year Cashflow ($)

1 20,000,000
2 40,000,000
3 60,000,000
4 30,000,000
5 10,000,000

What is the NPV for this project if the discount

rate is 10%?
NPV- Example cont’d
Workings:
Year Cashflow ($) PV of Cashflow ($)

0 -100,000,000 -100,000,000
1 20,000,000 18,181,818
2 40,000,000 33,057,851
3 60,000,000 45,078,888
4 30,000,000 20,490,404
5 10,000,000 6,209,213
Total 23,018,174

The NPV of the project is $23,018,174

NPV- Example cont’d

Should this project be accepted?

Answer:
Yes, since NPV > 0.
NPV Exercise
1. Calculate the NPV of the same project we just
looked at, this time using a discount rate of 20%.

2. Would you still accept this project?

3. Why or why not?

4. Under what circumstances would a discount rate of

20% be more appropriate than a discount rate of
10% for this project?
NPV Exercise Results
1. NPV = -2,346,965
Year Cashflow ($) PV of Cashflow ($)
0 -100,000,000 -100,000,000
1 20,000,000 16,666,666
2 40,000,000 27,777,777
3 60,000,000 34,722,222
4 30,000,000 14,467,592
5 10,000,000 4,018,775
Total -2,346,965

2. We would reject this project

3. Reject since NPV <0
NPV-
The Discount Rate Used:
 Has a significant impact on NPV result

 Should be the required return on the project

 Should be in line with the project’s risk

 Are the estimated cash flows almost a certainty or very
uncertain?
 Will the fixed costs (operating leverage) be high ?
 Will the amount of debt used (financial leverage) be high?
NPV-
The Discount Rate Selection Cont’d
 Projects with higher risk should use higher discount
rate

 Many firms use WACC and adjust up or down to

account for project’s riskiness

 Alternatively, project’s beta can be calculated and

used to determine project’s required return via
CAPM
NPV- The Pros
 Relatively easy to calculate

 Uses cash flows (not accounting profits)

 Time value of money handled properly

 Project’s riskiness considered appropriately

 Shows expected impact on company’s value

Internal Rate of Return (IRR)-
The Concept
A project’s IRR is the discount rate that causes the
NPV of all project cash flows to equal zero.

Set NPV to zero, and solve for r.

IRR- Decision Rule
 A typical project has outflows at the beginning

 For a typical project:

If IRR > Project’s required return, accept project

 The required return is used as a hurdle rate

 The required return should be in keeping with the

riskiness of the project
IRR- An Example
A project requires a $100,000,000 investment and
is expected to generate the following cash flows in
the years after the investment is made
Year Cashflow ($)
1 20,000,000
2 40,000,000
3 60,000,000
4 30,000,000
5 10,000,000

What is the IRR of this project?

IRR- Example cont’d
To find IRR we would use:

 Trial and error

 A financial calculator, or
 A spreadsheet

Result is IRR = 18.9%

IRR- Example cont’d
 If required return = 10% accept project
(Since IRR > 10%)

 If required return = 20%, reject project

(Since IRR < 20%)

 Notice that IRR and NPV provide consistent accept/

reject decision here
IRR- Things to be mindful of
 Projects with inflows first

 Multiple IRRs

 No real solution

 The reinvestment rate assumption

 Ranking projects
IRR- Projects with inflows first
 The decision rule changes

 Accept if IRR < Project’s required return

 Reason: Having Inflows first is equivalent to

borrowing

 Lower rate preferred when borrowing

IRR- Multiple IRRs
When cash flows alternate between negative an
positive values

Project can have more than one IRR

 Incorrect conclusions can be made

 Use NPV to make conclusion

IRR- No Real Solution
 Sometimes, no interest rate exists that can make the
PV of cash flows equal zero.

 The solution involves imaginary numbers

 In these cases, calculator/ spreadsheet shows an

error message
IRR- The Reinvestment Rate
Assumption
 Assumption is that interim cash inflows can be
invested at the IRR

 If IRR is high, that assumption may not be met

 Actual return will be lower than what IRR suggests

Exercise- IRR and Ranking Projects
1. Given the following, which project should be
ranked higher? Why?

Project Name NPV at 15% IRR

Renovate 25,000,000 42%
Totally New 53,000,000 18%

2. Why might “Project Renovate” have the higher IRR

but the lower NPV?
Exercise- Answers
Project “Totally New” should be ranked higher

Why? It has higher NPV

NPV shows value to shareholders

Exercise- Answers cont’d
Project “Renovate” may have higher IRR but lower
NPV due to:

1. Difference in project scale

2. Difference in timing of cash flows

IRR- The Scale Problem
 When projects are of different size take care when
using IRR

 Determine IRR of incremental project to rank them

 Necessary when dealing with mutually exclusive

projects

 Unnecessary otherwise (Accept both)

IRR- The Timing Problem
 When the cash flow timing of two projects is
significantly different, take care when using IRR

 Determine IRR of incremental project to rank them

 Necessary when dealing with mutually exclusive

projects

 Unnecessary otherwise (Accept both)

IRR- Pros
 Results intuitive

 Uses cash flows

 Takes account of time value of money

 Takes account of risk

 Connected to impact on firm’s value

IRR- The Cons
 Possibility of multiple IRRs

 Possibility of no real solution

 The reinvestment rate assumption

 The scale problem

 The timing problem

Profitability Index (PI)
What is it?

Profitability = _PV of future cash flows__

Index Initial Investment

It shows the value created per dollar invested

PI- Decision Rule
 If PI > 1, accept project
PI- An Example
A project requires a $100,000,000 investment and
is expected to generate the following cash flows in
the years after the investment is made

Year Cashflow ($)

1 20,000,000
2 40,000,000
3 60,000,000
4 30,000,000
5 10,000,000

What is the profitability index of this project based

on a discount rate of 10%?
PI- Example cont’d
Workings:
Year Cashflow ($) PV of
Cashflow ($)
1 20,000,000 18,181,818
2 40,000,000 33,057,851
3 60,000,000 45,078,888
4 30,000,000 20,490,404
5 10,000,000 6,209,213
Total 123,018,174

PI = 123,018,174_ = 1.23
100,000,000
PI- Example cont’d

Should this project be accepted?

Answer:
Yes, since PI > 1.
PI- The Scale Problem
 PI suffers same scale problem as IRR

 Thus, care required when handling mutually

exclusive projects

 Determine PI of incremental project to make

decision
Capital Rationing

Capital rationing is the act of putting a limit on

the amount of money that can be spent on new
projects.
Reasons for capital rationing
include:
 Inability or unwillingness to issue more debt or
equity

 Limited qualified personnel to implement all projects

 Discouraging cash flow assumptions that are over-

optimistic
Choosing projects under capital
rationing
 Objective: Choose combination of projects that
gives the highest NPV

 Profitability Index can be useful in this regard

 But take care when using PI due to scale problem

Capital Rationing Example
Which of the following independent projects should
be embarked upon if the capital constraint this year
is $300,000,000?

Project Investment NPV PI

A 70,000,000 59,200,000 1.8
B 80,000,000 52,000,000 1.6
C 100,000,000 59,600,000 1.6
D 150,000,000 38,400,000 1.3
E 200,000,000 71,000,000 1.4
Capital Rationing Example cont’d
Answer:
Projects A, B & C

No other combination that adheres to the capital

constraint gives a higher combined NPV
So, what have we learnt?

1. What capital budgeting is

2. How to calculate and interpret a project’s:

 Payback Period
 Discounted Payback Period
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)

3. How to choose projects when capital is rationed