7 Budgeting

Course Name: Principles of Finance
Chapter 8: Capital Budgeting
TABLE OF CONTENTS
LEARNING OBJECTIVES ................................................................................... 2
ABSTRACT .......................................................................................................... 2
8.1 INTRODUCTION ............................................................................................ 3
8.2 TERMINOLOGY, PROCESS AND METHOD OF CAPITAL .......................... 5
8.2.1 Steps in Capital Budgeting ...................................................................................... 6
8.3 REGULAR PAYBACK PERIOD ..................................................................... 8
8.4 DISCOUNTED PAYBACK PERIOD ............................................................. 11
8.5 NET PRESENT VALUE (NPV) ..................................................................... 13
8.6 INTERNAL RATE OF RETURN (IRR) .......................................................... 16
8.7 NPV PROFILES............................................................................................ 20
8.8 MODIFIED INTERNAL RATE OF RETURN (MIRR) .................................... 21
8.9 PROBABILITY INDEX (PI) ........................................................................... 23
ADDITIONAL MATERIALS ................................................................................ 26
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LEARNING OBJECTIVES
At the end of this chapter, you will be able to:
Define capital budgeting, explain why it is important, and state how project proposals are
generally classified
Calculate Regular Payback Period, Discounted Payback Period, Net Present Value
(NPV), Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR) and
Profitability Index (PI) for a given project and evaluate each method
Define NPV profiles and explain the rationale behind the NPV and IRR methods, their
reinvestment rate assumptions, and which method is better when evaluating independent
versus mutually exclusive projects.
ABSTRACT
Capital budgeting is similar in principle to security valuation in such a way that future cash flows
are estimated, risks are appraised and reflected in a cost of capital discount rate, and all cash
flows are evaluated on a present value basis.
This chapter will provide methods which can be used to determine which projects should be
included in a firm's capital budget: (1) Regular Payback, (2) Discounted Payback, (3) Net Present
Value (NPV), (4) Internal Rate of Return (IRR), (5) Modified IRR (MIRR), and Probability Index
(PI).
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8.1 INTRODUCTION
In the normal course of business, companies will often have to make long-term investment
decisions. Investment in this context includes undertaking projects and acquiring assets that are
expected to last as well as to generate revenue for a period longer than a year. This type of
investment decision is commonly referred to as capital budgeting decision.
Capital budgeting decision is perhaps the most important decision to be made in a company as it
involves relatively large expenditures of funds and the latter are committed for lengthy periods of
time. Once a capital budgeting decision is made it would also be very difficult and costly for the
company to reverse the decision.
Some of the motives of capital budgeting are shown in the table below.
Figure 1: Capital Expenditure Motives
Note:
Normally, a more detailed analysis is required for cost-reduction replacements,

expansion, and new product decision than for simple replacement and maintenance
decision.
Projects requiring larger investments will be analyzed more carefully than smaller
projects.
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Below is the scenario in capital budgeting decision-making.

For example, Gammapro Industries, an instant food manufacturer made an RM10 million
investment in a project to produce Bihun. If the project turns out to be a failure or unprofitable, the
company will end up having its capital tied up in non-performing 'Bihun making assets'. This
situation is even made worse when the company has to now forgo other investment opportunities
that might have been more profitable and necessary to maintain its present market share due to
inadequate capital.
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8.2 TERMINOLOGY, PROCESS AND METHOD OF CAPITAL

Before developing the concepts, tools, and techniques related to the capital budgeting process, it
is useful to understand some of the basic terminology in capital budgeting as shown in the figure
below.
Terminology
Project
Descriptions
Generally refers to any long-term investment proposals.
Projects that do not compete with one another; acceptance of one does not
Independent
eliminate others from further consideration.
projects
Mutually
exclusive
projects
Unlimited
funds
Capital
rationing
Projects that have the same function and therefore compete; acceptance of one
eliminates all others.
A financial situation that allows the firm to accept all independent projects earning
at least the minimum return.
The mostly occur financial situation in which the firm has a limited amount of funds
to invest and, therefore, must allocate funds to projects contributing the most to
maximizing value.
The valuation of projects to determine whether they meet the firm's minimum
Accept-reject
acceptance criteria.
approach
The ordering of projects based upon some predetermined measure such as the
rate of each project. Normally used to:
Ranking
Choose the best of mutually exclusive projects

Evaluate and "rank order" projects under capital rationing
Cash flows that are characterized by an initial outflow followed by a series of

inflows.
Conventional
cash flows
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Cash flows that are characterized by an initial outflow followed by a mixed series
of both inflows and outflows.
Nonconventional
cash flows
Figure 2: Basic Terminology in Capital Budgeting
8.2.1 Steps in Capital Budgeting

The capital budgeting process consists of five distinct but interrelated steps. These steps are:
Proposal generation
Review and analysis
Decision-making
Implementation
Follow-up
Proposal Generation
People at all levels in one organization can make proposals for capital investments. Many firms
offer cash rewards to stimulate a flow of idea that could result in a profitable outcome.
Review and Analysis

In this process, major time and effort is needed to review all capital investment proposals. Its
costs are estimated against the appropriateness of the proposal over firms overall objectives and
their validity over the economy.
Decision-Making
The process of approving proposals that produce the most benefits to the firm. It also requires
major time and effort as in the review and analysis phase. The higher the cost of the proposal, the
more detailed the formal decision-making analysis should be.
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Implementation
The implementation phase begins once a proposal has been approved and the fund is available.
For minor proposals, the implementation is generally routine. For major proposals, however, the
implementation requires great control to ensure the objective is achieved.
Follow-up
Follow-up or post audit is a phase of monitoring the result of the project. The actual outcomes
against the projected outcomes for each funded proposal are being compared. If the outcomes
deviate from the projected outcomes, the project may be improved or terminated. Follow-up is the
most often ignored step. It actually has an equal importance because it is needed for continuous
effectiveness and improvement of cash flows.
There are six primary methods used to determine the viability and feasibility of a project in capital
budgeting. Each method provides unique information in the decision-making process. These
methods are:
1.
2.
3.
4.
5.
6.
Regular payback period

Discounted payback period
Net present value (NPV)
Internal rate of return (IRR)
Modified internal rate of return (MIRR)
Profitability index (PI).
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8.3 REGULAR PAYBACK PERIOD

The first method that can be used to evaluate capital budgeting projects is the regular payback
period. This method measures the expected amount of time for a firm to recover its original
investment in a project. Payback period can be calculated as:
Figure 3: Formula to Calculate Payback Period
When payback is used to make accept-reject decision, the general decision criterion is the
shorter the payback period, the better the project. In other words, this method prefers projects
with high liquidity. However, if firm has set its maximum acceptable payback period, the acceptreject decisions differ.
ACCEPT project: payback period < maximum payback period.

In case of mutually exclusive projects, accept the project that has the shortest payback
period.
If the projects were independent, accept any project with payback period shorter than
maximum acceptable period.
REJECT project: payback period > maximum payback period.
Below is the sample calculation on payback period.

Deltacom Corporation Berhad is considering the cash flow of two projects, Project Alpha and
Project Beta, as diagrammed. It is the policy of the company to select project with payback period
less than four years. Calculate the payback periods for these projects.
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Figure 4: Cash Flows for Project Alpha and Project Beta
Using equation 8.1, we can calculate the payback period of both projects as follows:
PaybackAlpha
= 2 + 1000
5000
= 2.2 years
PaybackBeta
= 3 + 1000
8000
= 3.125 years
If the projects were mutually exclusive projects, Project Alpha will be selected as it has a lower
payback period.
If the projects were independent, both projects Alpha and Beta would be accepted because the
payback periods are less than the maximum acceptable period.
However, there are several advantages and disadvantages of regular payback period method, as
explained in the graphic below.
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Figure 5: Advantages and Disadvantages of Regular Payback Period
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8.4 DISCOUNTED PAYBACK PERIOD

The second method that can be used to evaluate capital budgeting projects is the discounted
payback period. This method is similar to the regular payback period, except that the project's net
cash flows are discounted by the cost of capital. Discounted payback can be calculated using the
same formula as equation in Figure 3.
The accept-reject decision of discounted payback is similar to regular payback.
Below is the sample calculation on discounted payback period.
Calculate the discounted payback for projects Alpha and Beta given that the cost capital for both
projects is 10%. Assume that the company's policy is to accept project with payback period less
than four years.
Figure 6: Figures to Calculate the Discounted Payback Period
PaybackAlpha = 2 + 2, 232 = 2.59 years

3, 757
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PaybackBeta = 3 + 2, 855 = 3.52 years

5, 464
If the projects were mutually exclusive projects, Project Alpha will be selected as it has a lower
discounted payback period.
If the projects were independent, both projects Alpha and Beta would be accepted because the
discounted payback periods are less than the maximum acceptable period, four years.
In this example, both payback methods give the same result i.e. project Alpha is preferred over
project Beta because of its lower payback period. However, it is also important to realize that
these two payback methods can sometimes give two conflicting results.
The advantages and disadvantages of payback periods are explained in the graphic below.
Figure 7: Advantages and Disadvantages of Discounted Payback Period Method
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8.5 NET PRESENT VALUE (NPV)

The third method of evaluating capital budgeting projects is net present value (NPV). NPV
basically measures how much an investment is worth in today's dollar terms after taking into
account the all the cash flows using cost of capital rate.
Figure 8: Formula to Calculate NPV
CFt
CF0
k
n
= expected net cash flow at period t

= Initial investment of a project
= cost of capital or opportunity cost
= life of the project
Below is the accept-reject decision of NPV approach.
ACCEPT project: NPV > 0 (positive).

If the projects were mutually exclusive, projects with higher NPV would be chosen.
If the projects were independent, accept any project with NPV > 0.
REJECT project: NPV < 0 (negative)
When NPV is greater than 0, the firm will earn a return greater than its cost of capital (NPV = PV
inflows - Cost = Net gain in wealth). Such action should enhance the market value of the firm and
therefore the wealth of its owners.
Below is the sample calculation on NPV method.
NPV of Constant or Annuity Cash Flows
Consider a capital budgeting project that requires an initial investment of RM24, 000 and will
generate after-tax cash inflows of RM5, 000 per annum for 8 years. For 10 percent cost of capital,
calculate the NPV of the project.
NPV value of the annuity project is:
NPV
= CF0 + CFt (PVIFA k,n)

= -RM24, 000 + RM5, 000( PVIFA10%,8)
= -RM24,000 + RM5,000(5.3349)
= RM2, 675
Since the NPV is positive or more than zero, the project should be accepted.
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NPV of Mixed Cash Flows

Consider the cash flow of project Alpha and Project Beta as below:
Figure 9: NPV of Project Aplha and Beta
On NPV basis, if both projects were independent, project Alpha and Beta would be accepted
because both have positive NPVs.
But if the projects were mutually exclusive, project Alpha should be chosen because NPVAlpha >
NPVBeta.
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The advantages and disadvantages of NPV approach are shown in the graphic below.
Figure 10: Advantages and Disadvantages of NPV Method
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8.6 INTERNAL RATE OF RETURN (IRR)

Internal rate of return (IRR) method is a method to evaluate and select capital budgeting projects
based on discount rate that equates the present value of a project's cash flows to the present
value of the project's costs. IRR can be found by using the following formula:
Figure 11: Formula for IRR
The concept of internal rate of return or IRR is exactly the same as finding the yield to maturity
(YTM) on bonds; a bond's YTM is the IRR of the bond you invest in.
In other words, IRR is the discount rate where the net present value (NPV) is equal to zero.
Figure 12: Internal Rate of Return (IRR)
IRR is actually the rate of return that a project earns. Solving for IRR manually involves trial and
error procedure, which is tedious especially in mixed stream cash flows. Below are the suggested
steps to help you solve for IRR:
Step 1:
On a trial and error basis find 2 discount rates, one giving a positive NPV and another one giving
a negative NPV for the project. Note that the closer the positive and negative NPVs to zero, the
more accurate the IRR will be.
Step 2:
Substitute the 2 discount rates and NPVs into the equation below:
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Figure 13: The Second Step in Calculation of IRR
The equation above is the interpolation of IRR as shown below.
Figure 14: Interpolation of IRR
Where,
A: discount rate where NPV is positive
B: discount rate where NPV is negative
a: NPV at discount rate A
b: NPV at discount rate B
The accept-reject criterion of IRR is to compare the IRR to a required rate of return, known as the
hurdle rate.
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ACCEPT project: IRR > cost of capital, k

If the projects were independent,
accept
any
project
with
IRR
>
k.
REJECT project: IRR < cost of capital, k
Below is the sample calculation of IRR method.

Consider the same problem of Project Alpha and Project Beta.
Figure 15: IRR of Project Alpha
Recall the tips mentioned before:

Step 1:On a trial and error basis we managed to find that at 27% discount rate the NPV is 146.45
and at 28% discount rate the NPV is -30.43.
Step 2:Thus, A =27%, a = 146.45, B =28%, and b = -30.43.
Substitute these values into the equation below:
IRR = A + [ -a (B - A) ]
(b - a)
= 27% + [-146.45(28% - 27%)]
(-30.43 - 146.45)
Thus, IRRAlpha = 27.83%
If we use the same procedure to calculate IRR of Project Beta, we get IRRBeta = 26.45%.
Therefore, if project Alpha and Beta were independent, accept both projects.
If both projects are mutually exclusive, accept project Alpha because IRRAlpha > IRRBeta.
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The advantages and disadvantages of IRR method are shown in the table below.
Figure 16: Advantages and Disadvantages of IRR Method
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8.7 NPV PROFILES

Recall that in net present value (NPV) method the discount rate, k, is specified and the NPV is
found, whereas in the internal rate of return (IRR) method, the NPV is specified to equal to zero,
and the rate of return that forces this equality (the IRR) is calculated. Technically, the NPV and
IRR method can lead to the same acceptance decision in independent projects but can give
conflicting rankings in mutually exclusive acceptance decision.
To solve the problem, projects can be compared and analyzed graphically by plotting the NPV
value against the cost of capital rates through NPV profiles as shown in below.
Figure 17: NPV Profiles
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8.8 MODIFIED INTERNAL RATE OF RETURN (MIRR)

Even though net present value (NPV) method is better than internal rate of return (IRR) in many
aspects most managers, however, favor IRR to NPV. Managers find it intuitively more appealing
to evaluate investments in terms of rates of return rather than dollars of NPV. Here, another
method that can give these managers a better IRR is modified IRR, or MIRR.
MIRR is basically the same as the IRR, except it assumes that the revenue (cash flows) from the
project are reinvested back into the company, and are compounded by the company's cost of
capital.
Is MIRR method more superior to NPV method?
The answer is NO because MIRR does not provide the best indication of how much each project
will increase the value of the firm. MIRR method, however, is superior to the regular IRR
because:
1.
2.
3.
4.
It indicates a project's expected rate of return,

It assumes reinvestment at capital cost,
It is applicable in a project with non-conventional or non-normal cash flows, and
It is applicable when multiple IRRs problem occurs.
The equation to calculate MIRR is:
Figure 18: Equation to Calculate MIRR
TV
MIRR
= compounded value, FV, of cash inflows

= discount rate that forces the PV of the TV to equal to PV of the cost
Below is the sample calculation on MIRR.

Consider the same example of Project Alpha. Assume that the return rate, k, is 10%.
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Figure 19: MIRR For Project Alpha
Based on the calculation shown above, MIRRAlpha is 17.98%.
The advantages and disadvantages of MIRR method are shown in the graphic below.
Figure 20: Advantages and Disadvantages of MIRR Method
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8.9 PROBABILITY INDEX (PI)

The sixth method of project is profitability index. PI method shows the relative profitability of
projects for every present value (PV) of its investment cost. It uses the ratio of two current values
as shown in the equation below.
Figure 21: Equation for Probability Index
Below is the accept-reject decision of PI method.
ACCEPT project: PI > 1.00

REJECT project: PI < 1.00
Below is the sample calculation on PI.

Value Project Alpha profitability index with the cash flows shown below. Assume that its capital
cost is 10%. What is your decision on the project?
Figure 22: Probability Index for Project Alpha
PV of cash flow = (RM4, 000X PVIF10%,1) + (RM5, 000X PVIF10%,2) + (RM5, 000X PVIF10%,3) +
(RM3, 000X PVIF10%,4) + (RM1, 000X PVIF10%,5)
= RM12, 142.
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Substitute the value into equation (8.5):

PIAlpha = 12, 142
10, 000
= 1.2142
Since the profitability index of project Alpha is more than 1.00, accept the project.
Now, what is Project Beta profitability index if the capital cost is 10%?
Figure 23: Probability Index for Project Beta
PV = (RM1, 000 X PVIF10%,1) + (RM3, 000 X PVIF10%,2) + (RM5, 000 X PVIF10%,3) + (RM8, 000 X
PVIF10%,4) + (RM4, 000 X PVIF10%,3)
= RM15, 090
Thus, the PI of Project S is: PIBeta = 15, 090
10, 000
= 1.509
Profitability index of Project Beta is also more than 1.00. Project Beta is accepted.
The graphic below shows the advantages and disadvantages of PI method.
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Figure 24: Advantages and Disadvantages of PI
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ADDITIONAL MATERIALS
Hyperlinks
Capital Budgeting: Part 1

http://www.teachmefinance.com/capitalbudgeting.html
Capital Project Accounting Procedures

http://www.finance.upenn.edu/comptroller/accounting/cppd/index.shtml
Capital Budgeting: The Key Numerical Techniques

http://duncanwil.co.uk/invapp.html
Introduction to Capital Budgeting

http://www.business.umt.edu/faculty/manuel/Finance%20322/Handouts%5CCh%209%20not
es.doc
Interactive Tutorials on Corporate Governance

http://www-ec.njit.edu/%7Emathis/interactive/
Advanced Topics in Capital Budgeting

http://www.exinfm.com/training/6301l6.rtf
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Course Name: Principles of Finance

Chapter 8: Capital Budgeting

Course Name: Principles of Finance

Course Name: Principles of Finance

Figure 1: Capital Expenditure Motives

Normally, a more detailed analysis is required for cost-reduction replacements,

Course Name: Principles of Finance

Below is the scenario in capital budgeting decision-making.

Course Name: Principles of Finance

8.2 TERMINOLOGY, PROCESS AND METHOD OF CAPITAL

Choose the best of mutually exclusive projects

Cash flows that are characterized by an initial outflow followed by a series of

Course Name: Principles of Finance

Figure 2: Basic Terminology in Capital Budgeting

8.2.1 Steps in Capital Budgeting

Review and Analysis

Course Name: Principles of Finance

Regular payback period

Course Name: Principles of Finance

8.3 REGULAR PAYBACK PERIOD

Figure 3: Formula to Calculate Payback Period

ACCEPT project: payback period < maximum payback period.

REJECT project: payback period > maximum payback period.

Below is the sample calculation on payback period.

Course Name: Principles of Finance

Figure 4: Cash Flows for Project Alpha and Project Beta

Course Name: Principles of Finance

Figure 5: Advantages and Disadvantages of Regular Payback Period

Course Name: Principles of Finance

8.4 DISCOUNTED PAYBACK PERIOD

Figure 6: Figures to Calculate the Discounted Payback Period

PaybackAlpha = 2 + 2, 232 = 2.59 years

Course Name: Principles of Finance

PaybackBeta = 3 + 2, 855 = 3.52 years

Figure 7: Advantages and Disadvantages of Discounted Payback Period Method

Course Name: Principles of Finance

8.5 NET PRESENT VALUE (NPV)

Figure 8: Formula to Calculate NPV

= expected net cash flow at period t

Below is the accept-reject decision of NPV approach.

ACCEPT project: NPV > 0 (positive).

REJECT project: NPV < 0 (negative)

= CF0 + CFt (PVIFA k,n)

Course Name: Principles of Finance

NPV of Mixed Cash Flows

Figure 9: NPV of Project Aplha and Beta

Course Name: Principles of Finance

Figure 10: Advantages and Disadvantages of NPV Method

Course Name: Principles of Finance

8.6 INTERNAL RATE OF RETURN (IRR)

Figure 11: Formula for IRR

Figure 12: Internal Rate of Return (IRR)

Course Name: Principles of Finance

Figure 13: The Second Step in Calculation of IRR

The equation above is the interpolation of IRR as shown below.

Figure 14: Interpolation of IRR

Course Name: Principles of Finance

ACCEPT project: IRR > cost of capital, k

REJECT project: IRR < cost of capital, k

Below is the sample calculation of IRR method.