Professor K.

Ozgur Demirtas
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CAPITAL BUDGETING

Capital Budgeting Decision: evaluation and choice of investment projects.

Goal: maximize shareholder wealth.

Steps of the Capital Budgeting Process

1. Forecast the projects’ cash flows

2. Estimate the opportunity cost of capital =

= expected rate of return given up by investing in the project =

= required rate of return

3. Evaluate the projects using one of the following methods

1. Net Present Value (NPV)

2. Profitability Index (PI)
3. Internal Rate of Return (IRR)
4. Payback Period

4. Select a project using one of these selection rules.

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Professor K. Ozgur Demirtas
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DECISION RULES

Basic Data

Expected Net Cash Flow

Year Project L Project S

0 ($100) ($100)

1 10 70

2 60 50

3 80 20

1. Net Present Value (NPV) Method

The net present value (NPV) of a project is the sum of the present values of its cash
flows (both in and out) discounted at the opportunity cost of capital.
n
CF1 CF2 CFn CFt
NPV  CF0  
(1  r ) (1  r )
1 2
 ... 
(1  r ) n
 
t 0 (1  r )
t

Project L: NPVL = -100 + 10 / 1.1 + 60 / 1.12 + 80 / 1.13 = $18.79

Project S: NPVS = -100 + 70 / 1.1 + 50 / 1.12 + 20 / 1.13 = $19.98.

 The NPV selection rule: accept the project if the NPV  0

 Therefore, if the projects are independent, accept both.

 If the projects are mutually exclusive, accept Project S since NPVS > NPVL.

Note: NPV declines as r increases and NPV rises as r decreases.

Assuming r = 5%

NPVL = -100 + 10 / 1.05 + 60 / 1.052 + 80 / 1.053 = 33.05 > 0

NPVS = -100 + 70 / 1.05 + 50 / 1.052 + 20 / 1.053 = 29.30 > 0

 Both projects are acceptable, but project L is better.

 Which of these projects is more sensitive to changes in interest rates?

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Professor K. Ozgur Demirtas
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 Let us now find the rate at which the NPVs of the 2 projects are equal, i.e., the
crossover rate.

Year Project L Project S L-S

0 ($100) ($100) 0

1 10 70 (60)

2 60 50 10

3 80 20 60

NPV(L-S) = 0

Crossover rate = 8.68%

2. Profitability Index

Profitability Index = PV(Cash flows) / Initial cost.

Assuming r = 10%

PIL = 118.79/100 = 1.19

PIS = 119.98/100 = 1.20

 The Profitability Index selection rule: accept the project if the PI  1.

 Therefore, if the projects are independent, accept both (both PIs > 1).

 If the projects are mutually exclusive, accept Project S since PIS > PIL.

Note: PI declines as r increases and PI rises as r decreases.

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Professor K. Ozgur Demirtas
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3. Internal Rate of return (IRR)

The internal rate of return (IRR) is the discount rate at which project NPV=0, i.e.
PV(Cash flows) = Initial cost.
n
CF1 CF2 CFn CFt
NPV  CF0  
(1  IRR ) (1  IRR )
1 2
 ... 
(1{ IRR ) n
 
t 0 (1  IRR )
t
 0.

Project L:

NPVL = -100 + 10 / (1 + IRR) + 60 / (1 + IRR)2 + 80 / (1 + IRR)3 = 0

=> IRRL = 18.1%

Project S:

NPVS = -100 + 70 / (1 + IRR) + 50 / (1 + IRR)2 + 20 / (1 + IRR)3 = 0

IRRS = 23.6%

 The IRR selection rule: accept the project if the IRR  required rate of
return (cost of capital).

 Therefore, if the projects are independent, accept both (both IRRs > 10%).

 If the projects are mutually exclusive, accept Project S since IRRS > IRRL.

 Note: IRR is independent of the required rate of return

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Professor K. Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

Pitfalls of the IRR rule

1. Multiple IRR's or no IRR

Project CF0 CF1 CF2 IRR NPV at 10%

A -4000 +25000 -25000 25% and 400% -1934

Project CF0 CF1 CF2 IRR NPV at 10%

B +1000 -3000 +2500 none +339

2. Mutually Exclusive Projects: Conflict between NPV and IRR criteria arises when
the cost of capital is less than the cross-over rate.

a) Different Project Scale

Project CF0 CF1 IRR NPV at 10%

C -10000 +20000 100% +8,182

D -20000 +35000 75% +11,818

CF1
NPV  CF0   $0
1  IRR

IRRC = 100%

IRRD = 75%

NPVC = -10,000 + 20,000/(1.1) = $8,182

NPVD = -20,000 + 35,000/(1.1) = $11,818

If we compare only IRRs, Project C is better (100 > 75)

Based on the NPVs, Project D is better (11818 > 8182)

Which project should we choose?

When IRR & NPV give different solutions, we go with NPV; i.e., project D.

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Professor K. Ozgur Demirtas
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b) Different Project Lives

Cash Flow, Dollars

Project CF0 CF1 CF2 CF3 CF4 CF5 Etc. IRR NPV at
(%) 10%

H -9000 +6000 +5000 +4000 0 0 ... 33 3592

I -9000 +1800 +1800 +1800 +1800 +1800 ... 20 9000

Which project should we choose?

Again, reinforcing the intuition of (a), choose project with the highest NPV, project I.

4. Payback Period

Payback Period = time until cash flows recover the initial investment of the project

The payback selection rule: accept the project if the payback period < cutoff

Example 2. Consider two investments, Long and Short. Both cost $250. Suppose we
have somehow decided that we will accept projects with payback period of
two years or less.

Year Long Short

CF Cumulative CF Cumulative

0 -$250 -250 -$250 -250

1 100 -150 100 -150
2 100 -50 200 100
3 100 50 0
4 100 0

Payback(Long) = 2 + $50/100 = 2.5 years

Payback(Short) = 1 + $150/200 = 1.75 years

Suppose that we require a 15% return on this type of investment:

NPV(Long) = -$250 + 100  (1 - 1/1.154)/.15 = $35.50

NPV(Short) = -$250 + 100/1.15 + 200/1.152 = -$11.81

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Professor K. Ozgur Demirtas
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 Weaknesses of Payback:

 Ignores the time value of money

 Ignores cash flows occurring after the payback period

 Cutoff period is arbitrary

Problems

1. If a project has conventional cash flows (a cash outflow at the beginning and a
number of positive cash inflows in the following periods) and a positive NPV, what
do you know about its payback? Its profitability index? Its IRR?

 payback < life of project

 profitability index > 1

 IRR > required rate of return

2. Project L has a cost of $65,000, and its expected net cash inflows are $10,000 per year
forever.

 What is the project's payback period?

 65,000 / 10,000 = 6.5 years
 The cost of capital is 14%. What is the project's NPV?

 NPV = -65,000 + 10,000/0.14 = $6,428.6

 What is the project's IRR?

-65,000 + 10,000/IRR = 0

IRR = 10,000 / 65,000  15,4%

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Professor K. Ozgur Demirtas
These materials are copyrighted. Copying, modifying or distributing without permission of the Professor is prohibited.

3. The Caviar Co. owns 140 acres of prime oceanfront property. It is considering
several different development options. One option is a hotel and resort complex
(Option A). Also under consideration is a more expensive motel/amusement park
development (Option B). The cash flows (in millions of dollars) for the two options
are projected to be:

Year Option A Option B

0 -$600 -$800
1 -40 -60
2 95 175
3 203 210
4 245 270
5 290 375
6 1,240 1,510

 What is the payback of Option A? For Option B?

A: 4.33 years B: 4.55 years

 Assuming a required return of 20%, what are the profitability indices for the
projects?

 Find the NPVs assuming a 20% discount rate.