SQ*

Topic 7 (Chapter 12)

The Basics of Capital Budgeting

(资本預算决策):
Investment Decision Rules (投資准則)
Overview
 Capital budgeting (also known as investment appraisal) refers
to the process of evaluating and selecting long-term investment
opportunities --- those expected to produce benefits (i.e. cash flows)
over more than a year.
 Examples: Should we buy a new machine, expand business in
another geographic area, replace a old delivery truck, launch a
new product, invest in a certain project?

 Capital budgeting is an ongoing process (=> what a firm lacks is

value-creating projects (+NPV), NOT investment opportunities).
C1 C2 Cn
NPV = C0 + + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) n
Investing
 An investment is worth undertaking if it creates value for its owners
(note: NOT profit).
 Share price goes up (primary goal of financial management)
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Overview (con’d)

 Inputs to making capital budgeting decisions

– establishing decision rules (Topic 7)
– estimating the project’s cash flows (Topic 8)
– determining discount rate/project’s cost of capital資本成本
(Topic 9)

 We need some decision rules / criteria 标准 (Topic 7).

 Decision rules: “Good” vs. “Bad” rules 5

– Good: Net Present Value (NPV), Internal Rate of Return (IRR)
and Profitability Index (PI)
歸本期
– Bad: Payback, Discounted Payback

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A Good Capital Budgeting Process should
1) focus on all relevant cash flows (i.e. all the expected additional cash
flows if a project is undertaken); not accounting income,
2) account for the time value of money (CFin and CFout occur in
different periods; can’t be compared directly),
3) account for risk (through using a correct discount rate), and
4) rank competing projects appropriately = the manager’s goal is to
choose only the best projects to undertake (because of limited funds).
=> Satisfying (1) – (4) would lead to investment decisions
that maximize shareholders’ wealth i.e. creates the greatest
value for shareholders (= earn the “most” for shareholders
given the risk taken).
=> For listed companies, share price goes up (primary goal
of financial management). NPV -> most reliable
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Independent vs. Mutually Exclusive Projects
• Independent projects are projects that are unrelated to
each other and allow for each project to be evaluated based
on its own profitability.
=> For example, if projects A and B are independent, and
both projects are profitable (NPV > 0), then the firm
should accept both projects.

• Mutually exclusive projects means that only one project

in a set of possible projects can be accepted because the
projects compete with each other.
=> If projects A and B were mutually exclusive, the firm
could accept either Project A or Project B, but not both.
=> Pick the project that has higher (positive) NPV!
(e.g. NPVA > NPVB > 0 => Pick A ) 4
 When, in theory, firms
Decision Rules in Practice should only be using the
best rule: NPV
In reality, firms use a variety of decision rules:
• Payback period: commonly used
• Discounted payback period: improved version of payback
period method
✓ Net present value (NPV): best technique theoretically;
difficult to calculate realistically (=> always follow its advice)
✓ Internal rate of return (IRR): widely used with strong
intuitive appeal (people usually feel more comfortable
working with return of a project)
• Profitability Index (PI): related to NPV

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Net Present Value Rule (淨現值)
CF in CF out
• NPV = PV (Project’s future CFs = benefits) – PV (Project Cost)
= PV of ALLCFexpected
in + CF outproject cash flows

• How much value is created from undertaking an investment?

• Estimate the NPV of a n-year project using the following equation.
• Step 1: Estimate the expected future cash flows (Topic 8).
C1 C2 Cn
NPV = C0 + + + ... +
(1 + r )1
(1 + r ) 2
(1 + r ) n
where C0 (negative) < 0 as it represents initial expenditure (the immediate cash
outflow necessary to purchase the asset => cost)
• Step 2: Estimate the required return (discount rate) for the project:
rE is the project’s required rate of return / cost of capital (資本成本
/Topic 9): the return the firm’s investors could expect to earn if they
invested in other equally risky assets.
• Step 3: Find the present value of the cash flows and subtract the initial
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investment.
Example: NPV
◼ You are looking at a new project and you have estimated the
following cash flows:
❑ Year 0: CF = ($165,000)
❑ Year 1: CF = $63,120
❑ Year 2: CF = $70,800
❑ Year 3: CF = $91,080
◼ Your required return for assets of this risk is 12%.
◼ Using the formulas:
❑ NPV = $63,120/(1.12) + $70,800/(1.12)2 +

$91,080/(1.12)3 – $165,000 = $12,627.42

◼ Step 2: Since NPV (project) > 0, Accept!
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NPV Decision Rule: Indep. and ME Projects
Step 2 Decision rule (for Indep. And ME projects)
(i) For independent projects, accept the project if its NPV > 0.
(ii) For mutually exclusive projects, take the project with the
positive AND highest NPV.
2-step approach:
1) Suppose there are three projects: A, B and C. If
NPV(A) > 0, NPV(B) < 0 and NPV(C) > 0, then
Projects A and C will proceed to step 2 for further
consideration.
2) If NPV(A) > NPV(C), then pick A!
=> (1) and (2) together: If NPV(A) > NPV(C) > 0, pick A!
=> In other words, pick the most value-creating project!
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NPV Decision Rule: A Closer Look
Decision rule:
(i) For independent projects, accept a project if NPV > 0 =>
Create Value
(In the unlikely event that the NPV turned out to be exactly 0, we
would be indifferent between taking the investment. WHY?
→ V0 = P0 → project just earned the required return

 In theory, the company will take a zero NPV project if the

company do not have any positive NPV projects.
(ii) For independent projects, reject a project if NPV < 0 => Accept
the project implies firm value and shareholder wealth be
destroyed => earn LESS compared to similar projects.
(iii) For mutually exclusive projects, take the project with the
highest
9 NPV as it is the most value-creating project!
Advantages and Disadvantages of
NPV Decision Rule
Advantages:
◼ Accounts for all cash flows

◼ Properly adjusts for time value of money

◼ Properly adjusts for the project’s risk (through using required rate
of return)
◼ Works equally well for independent and mutually exclusive
projects
◼ Provides a direct (dollar) measure of how much a capital project
will increase the value of the firm.
◼ Consistent with the goal of maximizing stockholder value.

Disadvantage:
◼ Can be difficult to understand without an accounting and finance
background.
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Internal Rate of Return (IRR)
◼ Step 1 Calculate internal rate of return (IRR) which is the
discount rate that equates the PV of a project’s expected CFin
to the project’s expected CFout, resulting in a zero NPV for the
project:
C0 = C1/(1 + IRR) +...+ Cn/(1 + IRR)n
=> [NPV =] 0 = C0 + C1/(1 + IRR) +...+ Cn/(1 + IRR)n
◼ Just as a bond’s YTM, IRR on a project is the project’s
expected rate of return (investment return).
◼ IRR is found by computer/calculator or manually by trial and
error.
◼ Step 2 The IRR decision rule is:
- If IRR ≥ r (the project’s cost of capital), accept the project.
- If IRR < r, reject the project. 11
Advantages of IRR
◼ Advantages of IRR:
- Accounts for all cash flows
- Properly adjusts for time value of money and risk
- Project IRR is a number with intuitive appeal

◼ Disadvantage of IRR:
- May lead to incorrect decision under certain situations
such as when dealing with mutually exclusive projects

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Interpreting NPV and IRR: A Summary

◼ IRR > 0 => profit-making: (C1 + C2 + … + Cn) > C0

◼ IRR < 0 => loss-making: (C1 + C2 + … + Cn) < C0
◼ NPV > 0 => Value-creating: [PV(C1) + … + PV(Cn)] > C0
◼ NPV < 0 => Value-destroying: [PV(C1) + … + PV(Cn)] < C0
-----
Note:
- Profit-making is a pre-condition for a project to be value-
creating.
- ONLY accept a project if it is value-creating!

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NPV vs. IRR: An Example

Which of the following statements is true?

A) Accept the project if its IRR is greater than zero.
B) Accept the project if its IRR is less than the project’s
required return.
C) Accept the project if its NPV is less than zero.
D) Reject the project if its IRR is less than zero.
Ans:

Note: Required rate of return is also called the

opportunity cost of capital

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Rationale (meaning / 原則) for the
NPV and IRR Method

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 C1 C2 Cn
NPV = C0 + + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) n

Rationale for the NPV Method

“NPV = 0” (NOT the same as return/profit = 0)
 implies the project’s cash inflows (C1, CProfit
2 ,…, Cn) are NOT JUST able to
i) repay the invested capital (C0) BUT ALSO direct cost
ii) earn a rate of return (E(r)) that is the SAME AS the required
rate of return on that capital (rE – cost of capital). indirect cost
In other words, “NPV = 0” => E(r) = rE (> 0)
𝐶1 𝐶2 𝐶𝑛
0= 𝐶0 + + +. . . + NPV
(1+𝐼𝑅𝑅)1 (1+𝐼𝑅𝑅)2 (1+𝐼𝑅𝑅)𝑛

where E(r) is IRR of the project or project’s expected rate of return

=> Project’s expected return (IRR) = Project’s required return
(i.e. ALTHOUGH the project is profit-making BUT it is not
value-creating or value-destroying.)
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 C1 C2 Cn
NPV = C0 + + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) n

Rationale for the NPV Method

“NPV > 0”
 The project is generating cash inflows that NOT ONLY CAN
i) repay the invested capital (C0) BUT ALSO
ii) provide a rate of return that is HIGHER THAN the required
rate of return on that capital (rE). This excess cash will go
solely to the firm’s stockholders.
In other words, E(r) > rE (> 0) (i.e.The project is NOT
ONLY profit-making BUT ALSO value-creating.)
=> Positive NPV project increase shareholders’ wealth !

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 C1 C2 Cn
NPV = C0 + + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) n

Rationale for the NPV Method

NPV < 0 => The project’s cash inflows are
i) loss-making AND value-destroying (because the project’s cash
flows are NOT even large enough to recover the invested capital
(C0)
=> E(r) < 0 < rE OR
ii) profit-making BUT value-destroying (because although the
project’s cash flows can provide a positive rate of return (and
thus cover C0) but is still LESS THAN the required rate of
return on the capital (rE).
=> 0 < E(r) < rE
where E(r) is IRR of the project (i.e., project’s expected rate of
return)
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Rationale for the IRR Method (OPTIONAL)

• Create value for

the firm
• Create wealth • Destroy value
for stockholders

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NPV vs
=
IRR
C1 C2 Cn
NPV = C0 + + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) n

C1 C2 Cn
NPV = C 0 + + + ... + = 0
1 2 n
(1 + IRR ) (1 + IRR ) (1 + IRR )

 NPV and IRR generally give us the same decision.

 NPV measures the value of a project in monetary terms.

 IRR measures the rate of return of the project in percentage.

 Whenever there is a conflict between NPV and IRR, you

should always use NPV because NPV directly measures the
increase in value to the firm
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Profitability Index (PI) (獲利能力指數)
◼ Step 1 Calculate PI, which is the ratio of the PV of change in
operating cash flows to the PV of investment cash flows:

C1 C2 Cn
+ + ... +
PV benefits (1 + r) (1 + r) 2
(1 + r) n
PI = =
PVcosts Co

◼ Step 2 Decision rule: Accept project if PI > 1.0 as we get

more than $1 for each $1 invested (which is equal to NPV > 0)
◼ Both projects’ PI > 1.0, accept both if they are independent.
◼ For mutually exclusive projects, pick the one with the highest
PI.

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 Profitability Index (PI) and Its Potential Problem
◼ Consider two mutually exclusive projects with the following
CFs:
Project 1: Cost $5m with a PV of revenues of $10m at t=0
Project 2: Cost $100m with a PV of revenues of $150m at t=0
NPV(1) = $10m - $5m ; PI(1) = $10m / $5m = 2 (>1)
= $5m (>0)
NPV(2) = $150m - $100m ; PI(2) = $150m / $100m
Most reliable = $50m (> 0) = 1.5 (> 1)
◼ So, PI may lead to incorrect decisions in comparisons of
mutually exclusive investments as PI (and IRR) ignores
the size (scale) effect of the project.
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The Profitability Index
◼ Disadvantages:
- Problems with mutually exclusive investments
◼ Advantages:
- May be useful when available investment funds are
limited
- Easy to understand and communicate
- Correct decision when evaluating independent projects

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Payback Period (回本期)
◼ Step 1 Estimate the payback period of a project which is
found by counting the number of years it takes before
cumulative forecasted project cash flows equal the initial
investment (C0).

◼ Step 2 The payback period rule:

- If payback period is less than (greater than) the cutoff
period set by the management, accept (reject) the project.
- Independent projects: Accept ALL projects whose payback
periods are less than the cutoff time.
- Mutually exclusive projects: Take the project with the
shortest payback period.

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Example Long term project investment = Capital project

An investment project has annual cash inflows of $5,000,

$6,500, $8,000, and $9,000 at the end of each of the next four
years. What is the payback period for these cash flows if the
initial cost is $10,500?
1 + ( C0 - C1 ) / C2
Payback = 1 + ($10,500 – $5,000)/$6,500 = 1.85 years
2 + (17500-5000-6500) / 8000)

If the company accepts all projects with a 2 year or less

payback period (i.e. the cutoff period is 2 years), will the above
project be accepted? Target

Ans: YES as the Payback period (1.85 years) < Cutoff period (2
years)!!!
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Pros and Cons of Payback Method
◼ Advantages of payback method:
- Computational simplicity
- Easy to understand
- Provide information on how long funds will be tied up
i.e., the shorter the payback period, other things held
constant, the greater is the project’s liquidity
◼ Disadvantages of payback method:
- Ignore time value of money and hence risk of the project
- Ignores cash flows after the cutoff period
- Cutoff period is arbitrary (set by the managers, not the
market) (refer example to next slide).
- Biased against long-term projects
- Does not lead to value-maximizing decisions 26
Discounted Payback Rule
◼ Step 1 Estimate the discounted payback period of a
project is defined as the number of years required to
recover the initial outlay of the project from discounted
net cash flows.
◼ Still ignores cash flows after the cutoff period
◼ Step 2 Decision Rule - Accept the project if it pays back
on a discounted basis within the specified time.

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Example
An investment project has annual cash inflows of $5,000, $6,500,
$8,000, and $9,000, and a relevant discount rate of 10%. What is
the discounted payback period for these cash flows if the initial
cost is $10,500?

Value today of Year 1 cash flow = $5,000/1.1 = $4,545.45

Value today of Year 2 cash flow = $6,500/1.12 = $5,371.90
Value today of Year 3 cash flow = $8,000/1.13 = $6,010.52
Value today of Year 4 cash flow = $9,000/1.14 = $6,147.12

Discounted payback
= 2 + ($10,500 - $4,545.45 – $5,371.90) / $ 6,010.52 = 2.10 years
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Decision Rules: Conclusion
❑ Always look at the NPV of the project if alternative
decision rules (such as IRR, payback period and discounted
payback period) make conflicting recommendations
because NPV directly measures the increase in value to the
firm.

C1 C2 Cn
NPV = C0 + + + ... +
(1 + r )1
(1 + r ) 2
(1 + r ) n

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Readings: Chapter 12

Required Textbook: Brigham (5th edition)

Chapter 12, page 433 – 453
 Excluded section 12.4, 12.6 and 12.7

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Exercises – Chapter 12
Optional Exercises (textbook 5th edition):
A. Practice “Self-Test Questions and Problems”, page 454
 ST-2a (no need to do MIRR), 2b and 2c
 Solutions appear in textbook Appendix A, page A-14

B. Supplementary Exercises: Topic 7 – Revision Exercises

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~END~

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