University of Technology, Jamaica

Financial Management (FIN3001)

Unit 8: Capital Budgeting

Capital budgeting is the process of using the company's resources to acquire long-term assets,
which allows the company to carry on its operations. These decisions are different from current
expenditure, which is concerned with short-term assets. They are also different from portfolio
investments (which is the allocation of excess cash to acquire financial assets). However, the
portfolio investment process is like the capital budgeting process.

Capital budgeting decisions are important because (i) they affect the future of the firm (ii) the
decision normally locks the company into a fixed path for some time (iii) It typically involves large
sums of money. The main objective of capital budgeting is the selection and implementation of
those projects which increase the value of the firm, that is, increase shareholders' wealth.

Four steps normally involved:(1) Identify the opportunities available to the company (2) Obtain
pertinent information (3). Apply one or more of the decision rules and select the best alternative or
alternatives (4) Complete a post-audit, that is, revisit the information gathering and decision-
making processes with the aim of improving them for future use.

Two broad classifications of projects are Expansion- firm acquires resources to produce new
products or to enter into new markets & Replacement Projects aimed at replacing obsolete
machinery in order to maintain current operations

Mutually Exclusive vs Independent Projects

Mutually exclusive projects: - the decision to accept one precludes the acceptance of any other.
Normally, mutually exclusive projects are aimed at achieving the same end but only one can be
selected. With independent projects the acceptance of one does not affect the decision to accept
the other, in other words, all can be accepted.
Accounting Income vs Cash flows
Net Income is not a good decision variable as it is very subjective, including sums not yet
received/paid. Project evaluation uses cash flows, ie. the cash flowing in and out of the company.

Capital Rationing
This occurs when available funding does not allow investing in all the good projects. It therefore
does not maximize the value of the company.

Project Selection Method: There are two basic categories: (i) Non-discounting eg Payback
method (PB) (ii) Discounting eg discounted payback (DPB), net present value (NPV), internal
rate of return (IRR), modified internal rate of return (MIRR), and profitability index (PI)

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 Project A Project B
Period After-tax Cash Flows After-tax Cash Flows
0 (5,000) (5,000)
1 3,000 1,000
2 2,500 2,200
3 1,700 4,700
4 800 3,000

The table above lists after-tax cash flows over four periods for two mutually exclusive projects of
Company X which has a cost of capital of 10%.

(a) Payback Period (PP) calculates the number of years before a company recovers its initial
investment. For Project A the investment is $5,000 and the firm recovers $3,000 in year 1, and its
remaining $2,000 from the project's year 2 cash flows. It doesn't require all the year 2 cash flows,
but a percentage found by dividing the amount needed to complete recovery of its investment by
the year's cash flows: - $2,000/$2,500 =0.8. Thus, the investment was recovered in 1.8years. For
project B, recovery of investment requires all year 1 and 2 cash flows and $1,800 from year 3's
giving a payback period of 2 years + $1,800/$4,700 = 2.38 years. For independent projects, a
project should be selected if its PP is less than or equal to the company's standard PP. For
mutually exclusive projects, select the project which has the shortest PP. In this case, Project A
should be selected.

Pros -(1) Simple to calculate (2) Indicates the project's liquidity (3) It gives some sort of measure
of risk, in that shorter recovery periods means that funds are tied up for shorter periods (4) It
can be used to supplement other methods. Cons -(1) does not factor in cash flows which occur
beyond the pay back period (2) It does not factor in the time value of money (3) It does not
indicate to shareholders any change in their wealth position.

(b) Discounted Payback Period (DPP)

This is a modification of the method in part (a) above. As the name suggests, this method factors
in the time value of money by first discounting the relevant cash flows using the
project's/company's cost of capital. The cash flows are discounted to their present value, as done
in Unit 5. Remember this equation for finding PV from any future value? PV = FV/(1 + i)n
Or using tables:- PV = FV(PVIFi,n,).We use those same methods to discount the cash flows to
their present value before calculating the payback period. Thus using tables, $3,000 in year 1 has
a present value of $3,000 (PVIF10%,1) = $3,000 (0.9091) = $2,727.30. Year 2's cash flow of
$2,500 has a PV of $2,500 (PVIF 10%,2) = $2,500 (0.8264) = $2,066 and so on. We then use the
discounted cash flows for projects A & B to find the recovery period for the initial investment
exactly as we did for the payback method (above). For independent projects, a project should be
selected if its DPP is less than or equal to the company's standard D PP. For mutually exclusive
projects, select the project which has the shortest D PP. In this case, Project A should be selected.
Pros -(1) Simple to calculate (2) It considers the time value of money (3) Indicates the project's
liquidity (4) It gives some sort of measure of risk, in that shorter recovery periods means that
funds are tied up for shorter periods (5) It can be used to supplement other methods. Cons -(1)

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does not factor in cash flows which occur beyond the pay back period (2) It does not indicate to
shareholders any change in their wealth position.

(c) Net Present Value (NPV): all the cash flows associated with the project (including the
initial investment) are discounted using the project's/firm's cost of capital to arrive at an NPV.
NPVA = (5,000) + 3,000 (PVIF 10%,1) + 2,500 (PVIF10%,2) + 1,700 (PVIF 10%,3) + 800 (PVIF10%,4)
. . = (5,000) + 3,000 (.9091) + 2,500 (.8264) + 1,700 (.7513) + 800 (.6830)
. = (5,000) + 2,727.30 + 2.066 + 1.277.21 + 546.40
NPVA = $1,616,91

. NPVB = (5,000) + 1,000(PVIF 10%,1) + 2,200(PVIF10%,2) + 4,700(PVIF10%,3) + 3,000(PVIF10%,4)

. = (5,000) + 1,000(.9091) + 2,200(.8264) + 4,700(.7513) + 3,000(.6830) .
NPVB =(5,000) + 909.10 + 1,818.08 + 3,531.11 + 2,049 = $3,307.29

Note - The NPV method assumes that cash flows are reinvested at the cost of capital rate.

For independent projects select those with NPV equal to or greater than zero (0). For mutually
exclusive projects select the one with the highest NPV (assuming it is positive). In this case,
project B should be selected. Pros -(1) It considers the time value of money (2) Indicates how
much each project will cause the shareholders' wealth to increase/decrease by (In conjunction
with the goal of financial management). Cons-(1) May be difficult to explain to a non-finance
person (2) The cost of capital for a particular project may be difficult to estimate

(e) Internal Rate of Return (IRR)

This method determines that particular rate of return that equates the present value of all the cash
flows that are derived from a project to its initial investment. In other words, it is that rate of
return that causes the NPV = 0 or that rate of return that causes the project to 'breakeven'. It is
difficult to calculate without a financial calculator or spreadsheet. Without them the only
practical method is to exploit IRR's relationship to NPV graphically. Since a project's IRR is that
discount rate that make NPV = 0, we could plot a graph with discount rate on the “X” axis and
NPV on the “Y”. As discount rate increases, NPV decreases until at some rate it becomes zero,
that is, the NPV line cuts the “X” axis. This discount rate is the IRR.

Note - The IRR method assumes that cash flows are reinvested at the IRR.

For independent projects select those whose IRR is equal to or greater than the company's cost of
capital. For some companies, there may be a 'hurdle rate' in place and projects whose IRR exceed
this 'hurdle rate' would be taken on. For mutually exclusive projects select the one with the
highest IRR.

Pros - (1) It is relatively easy to understand and use because it incorporates the notion of
'breakeven'. (2) It considers the time value of money (3) Indirectly, it indicates movement in
shareholder's wealth. Cons: (1) The IRR method may arrive at the wrong accept -reject decision,
or there may be multiple or no IRR if cash flows are not “normal” ie, there is a series of positive
annual cash flows followed by a series of negative annual cash flows.

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(f) Modified Internal Rate of Return (MIRR)seeks to eliminate the pitfalls which may
be experience by the IRR method (above). In this approach, a rate of return is determined which
equates the terminal (future) value of the annual cash flows at k% to the present value of the
initial investment. .

The procedure is as follows:(i) find the FV of the annual cash flows @ i%. (ii) let the PV of the
initial investment = PV and use either of these equations to find MIRR%. FV = PV (i + MIRR)n
or PV (FVIFi,n)

Note - The MIRR method assumes that cash flows are reinvested at the cost of capital rate. Pros
- (1) Avoids the problems of multiple IRRs, no IRRs and incorrect accept-reject decisions. (2)
Other Pros are similar to IRR above.

The Post-audit

Firstly, the Post-audit is a process which involves (1) comparing actual results with expected
results and (2) explaining why any differences occurred. The main purposes of this exercise is to
improve forecasts and improve operations.

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