Capital Budgeting

Techniques
The Statement of Financial
Position Illustration

2
 Section 1
Estimating Cash Flows

3
 What is
Capital Budgeting?
 The process of identifying, analyzing, and selecting
investment projects whose returns (cash flows) are
expected to extend beyond one year;
 The examples are;
a. New products or expansion of
existing products;
b. Replacement of existing equipment
or buildings;
c. Research and development;
d. Exploration;
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 The Capital Budgeting
Process
 Generate investment proposals consistent with the firm’s
strategic objectives;

 Evaluate projected cash flows;

 Select projects based on a value-maximizing acceptance

criterion;

 Reevaluate implemented investment projects continually

and perform post audits for completed projects;

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 Relevant Cost
Assumption
 Cash flows of a project must be calculated based on
relevant costing assumptions;

 Relevant cost is a decision specific cost which arises as

a direct consequence of decision made;

A company produces tires.It can manufacture 1,000 units in a month for a fixed
cost of $300,000 and variable cost of $500 per unit. Its current demand is
600 units which it sells at $1,000 per unit. Company B considers to order
200 units of tire at $700 per unit. Should the company accept the order?
Solution
a)700-(300000/1000+500)=$100 Reject
b)Relevant costing assumption
(700-500)=$200 Accept 6
 Relevant Cash Flows

 Basic characteristics of relevant project flows;

a. future cash flows;
b. incremental flows;
c. after-tax flows;
d. operating(not financing)flows;

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 Estimating Cash Flows
 Principles that must be adhered to in the
estimation;
a. ignore sunk costs;
b. ignore committed costs;
c. include opportunity costs;
d. include project-driven
changes in working capital;
e. include effects of inflation;

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 Calculating Project Cash
Flows
 Initial cash outflow is the initial net cash investment;

 Interim incremental net cash flows are

those net cash flows occurring after the
initial cash investment but not
including the final period’s cash flow;

 Terminal-year incremental net cash

flows are the final period’s net cash flow;
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 Initial Cash Outflow
a) Cost of “new” assets
b) +Capitalized expenditures
c) + (-)Change in NWC
d) -Net proceeds from sale of
“old” asset(s) if replacement;
e) + (-)Taxes (savings) due to the sale of
“old” asset(s) if replacement
f) =Initial cash outflow

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 Incremental Cash Flows
a)Cash inflow

b)-Cash outflow

c)Net Change in Operating Income

d)-Tax Charge****
=Incremental net cash flow for
period
Tax Charge=(Cash Inflow-Cash Outflow-
Depreciation)x Tax Rate 11
 Terminal-Year
Incremental Cash Flows
a) Calculate the incremental net cash
flow for the terminal period
b) + (-)Salvage value (disposal/reclamation
costs) of any sold or disposed assets
c) - (+)Taxes (tax savings) due to asset sale
or disposal of “new” assets
d) + (-)Change in NWC
e) = Terminal year incremental net
cash flow

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 Example of an Asset
Expansion Project
Basket Wonders (BW) is considering the purchase of
a new basket weaving machine. The machine will
cost $50,000 plus $20,000 for shipping and
installation and falls under the 3-year MACRS class.
NWC will rise by $5,000. Lisa Miller forecasts that
revenues will increase by $110,000 for each of the
next 4 years and will then be sold (scrapped) for
$10,000 at the end of the fourth year, when the
project ends. Operating costs will rise by $70,000 for
each of the next four years. BW is in the 40% tax
bracket.(MACRS 33.3,44.45,14.81,7.41) 13
 Initial Cash Outflow
a) $50,000
b) + 20,000
c) + 5,000
d) - 0 (not a replacement)
e) + (-) 0 (not a replacement)
f) = $75,000

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Incremental Cash Flows
Year 1 Year 2 Year 3 Year 4
a) $40,000 $40,000 $40,000 $40,000
b) - 23,331 31,115 10,367 5,187
c) = $16,669 $ 8,885 $29,633 $34,813
d) - 6,668 3,554 11,853 13,925
e = $33,332 $36,446 $28,147 $26,075

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 Terminal-Year
Incremental Cash
Flows
a) $26,075 The incremental cash flow
from the previous slide in
Year 4.
b) +10,000 Salvage Value.
c) - 4,000 .40*($10,000 - 0) Note, the
asset is fully depreciated at
the end of Year 4.
d) + 5,000 NWC - Project ends.
e) = $37,075 Terminal-year incremental
cash flow.
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 Summary of Project Net
Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
-$75,000* $33,332 $36,446 $28,147 $37,075

* Notice that this value is a negative cash flow as we

calculated it as the initial cash outflow

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 SECTİON 2
Capital Budgeting
Techniques

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Project Evaluation:
Alternative Methods

 Payback Period (PBP)

 Internal Rate of Return (IRR)
 Net Present Value (NPV)
 Profitability Index (PI)

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

 For this project we will assume that it is

independent of any other potential
projects that Basket Wonders may
undertake;

 Independent project is a project

whose acceptance (or rejection) does
not prevent the acceptance of other
projects under consideration;
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 Payback Period
 The payback method of investment appraisal is popular
appraisal technique despite of it’s limitations;

 It is the time it takes the cash inflows from a capital

investment project to equal the cash outflows, usually
expressed in years;

 In other words payback is the amount of time it takes

for cash inflows = cash outflows;

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 Payback Solution of
Example
0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K
-40 K -30 K -18 K -3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K
Cumulative = 3.3 Years
Cash Flows Note: If the required payback time by
company is 4 years then the project
will be accepted 23
 Payback Period
(cont.)
Advantages Disadvantages
 Simple to calculate and  It ignores the cash flows
understand; after the end of payback
 It can be used as a period;
screening device as a  It ignores the time value
first stage in eliminating of money;
obviously inappropriate  Unable to distinguish
projects; between projects with the
 It uses cash flows rather same payback period;
than accounting profits;  It may lead to excessive
investment in short-term
projects;
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Internal Rate of Return
(IRR)
IRR is the discount rate that equates the
present value of the future net cash flows
from an investment project with the
project’s initial cash outflow.

CF1 CF2 CFn

ICO = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n
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 IRR Solution

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the

discounted cash flows to equal $40,000.
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 IRR Acceptance
Criterion
The management of Basket Wonders
has determined that the hurdle rate
is 13% for projects of this type.
Should the project be accepted?
No! The firm will receive 11.57% for
each dollar invested in this project at a
cost of 13%. [ IRR < Hurdle Rate ]
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 Internal Rate of Return
Advantages Disadvantages
 Accounts for time value of
money; Multiple IRR problem;

 Considers all cash flows; Difficulty in project

rankings;
 It uses cash flows rather
than accounting profits; It may yield contradicting
answers with NPV in
 Managers feel more mutually exclusive projects;
comfortable with a return
measure; 28
Net Present Value (NPV)

NPV is the present value of an

investment project’s net cash flows
minus the project’s initial cash
outflow.

CF1 CF2 CFn

NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k)n
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 NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this project
is 13%.
NPV = $10,000 + $12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)
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 NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428
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 NPV Acceptance
Criterion
The management of Basket Wonders has
determined that the required rate is 13%
for projects of this type.
Should this project be accepted?

No! The NPV is negative. This means

that the project is reducing shareholder
wealth. [Reject as NPV < 0 ]
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 NPV
Pros and Cons
Advantages Disadvantages
 Accounts for time value of  Project size is not
money; measured;

 Considers all cash flows;  Difficulty in calculating

discount rate;
 Reveals the dollar
amount that the project  Over sensitivity to change
will produce; in rates;

 May not include

managerial options; 33
Profitability Index (PI)
PI is the ratio of the present value of a
project’s future net cash flows to the
project’s initial cash outflow.

CF1 CF2 CFn

PI = + +...+ ICO
(1+k)1 (1+k)2 (1+k)n

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 PI Acceptance
Criterion
PI = $38,572 / $40,000
= .9643 (Method #1, 13-34)

Should this project be accepted?

No! The PI is less than 1.00. This

means that the project is not profitable.
[Reject as PI < 1.00 ]
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 Evaluation Summar y

Basket Wonders Independent Project

Method Project Comparison Decision
PBP 3.3 3.5 Accept
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
 Other Project
Relationships
 Dependent -a project whose
acceptance depends on the
acceptance of one or more
other projects;

 Mutually Exclusive - a
project whose acceptance
precludes the acceptance of one or more alternative projects;
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 Potential Problems
Under Mutual
Exclusivity
 Ranking of project proposals may create
contradictory results;
a.scale of investment;
b.cash flow pattern;
c.project life;

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 Scale Differences
Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?
Project IRR NPV PI

S 100% $ 231 3.31

L 25% $29,132 1.29
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 Cash Flow Pattern
Let us compare a decreasing cash-flow (D) project
and an increasing cash-flow (I) project.

NET CASH FLOWS

END OF YEAR Project D Project I
0 -$1,200 -$1,200
1 1,000 100
2 500 600
3 100 1,080
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Cash Flow Pattern
Calculate the IRR, NPV@10%,
and PI@10%.
Which project is preferred?
Project IRR NPV PI

D 23% $198 1.17

I 17% $198 1.17
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 Project Life
Differences
Let us compare a long life (X) project and a
short life (Y) project.

NET CASH FLOWS

END OF YEAR Project X Project Y
0 -$1,000 -$1,000
1 0 2,000
2 0 0
3 3,375 0
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 Project Life
Differences
Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?
Project IRR NPV PI

X 50% $1,536 2.54

Y 100% $ 818 1.82

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Thank You

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