MONASH

BUSINESS
SCHOOL

BFF2140-BFC2140
BUSINESS FINANCE/
CORPORATE FINANCE
SIMON YAP
 MONASH
BUSINESS
SCHOOL

Teaching Week Four

Capital Budgeting I:
Techniques for evaluation

Readings
Chapter 8, pp. 217-249
 MONASH
BUSINESS
SCHOOL

Learning Objectives

❑ Differentiate between independent & mutually exclusive projects.

❑ Differentiate between conventional and non-conventional cash flows.

❑ Compute and understand the roles of the main methods of project evaluation.

❑ Understand the advantages and disadvantages of these methods.

❑ Rank projects when a company’s resources are limited.

❑ Compare mutually exclusive projects that have different lives.

 What is capital budgeting?

• Analysis of potential additions to fixed assets.

• Long-term decisions; involve large expenditures.
• Very important to a firm’s future.
• Capital budgeting involves:
1. Estimating CFs (inflows & outflows).

2. Assessing the riskiness of CFs.

3. Determining an appropriate discount rate

4. Finding NPV and/or IRR.

5. Acceptance of project if NPV > 0 and/or IRR > r ( WACC).

 Types of Investment Decisions

➢ INDEPENDENT PROJECTS
• Projects that, if accepted or rejected, will not affect the
cash flows of another project.

➢ MUTUALLY EXCLUSIVE PROJECTS

• Projects that, if accepted, preclude the acceptance of
competing projects.
 Types of Project Cash Flows

➢ Conventional CF Project (C)

A negative CF (initial cost outlay) is followed by a series of
positive cash inflows – hence there is one change of signs (-vet
to +ve)

➢ Nonconventional CF Project (NC)

Two or more changes of signs – the most common is an outlay,
followed by positive CFs, then a terminal cost in order to
complete the project (e.g., repair damaged site)
 Project Cash Flows continued

Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 C NC
- + + + + + C
- + + + + - NC
- - - + + + C
+ + + - - - C
- + + - + - NC
 Alternative Decision Methods

➢ Non-discounting methods
▪ Payback

➢ Discounting methods
▪ Net Present Value (NPV)
▪ Internal Rate of Return (IRR)
▪ Profitability Index (PI)
 Payback Period Method

• The number of years required to recover a

project’s cost

• How long it takes to get our money back.

Decision Rule: An investment is acceptable if its

calculated pay back is less than a pre-specified cut
off rate.
Example 1:
Payback Period Method
Cash flows for projects L and S are given below: (This slide
will be used to explain Payback, NPV and IRR concepts.)

Assume cost of capital (when required) = 10%

YEAR Project L Project S

0 -$100 -$100
1 $10 $70
2 $60 $50
3 $80 $20
Example 1:
Payback Period for Project L

0 1 2 2.4 3

Ct -$100 $10 $60 $100 $80

Cumulative -$100 -$90 -$30 $0 $50

PaybackL = 2 + 30/80 = 2.375 years

Example 1 :
Payback Period for Project S

0 1 1.6 2 3

Ct -$100 $70 $100 $50 $20

Cumulative -$100 -$30 $0 $20 $40

PaybackS = 1 + 30/50 = 1.6 years

 Payback Period Method

Advantages:
1. Provides an indication of a project’s risk and liquidity
2. Easy to calculate and understand YEAR Project L Project S
0 -$100 -$100
1 $10 $70
Disadvantages: 2 $60 $50
3 $80 $20

1. Ignores the time value of money

2. Ignores CFs occurring after the payback period
 Payback Period Method

Advantages:
1. Provides an indication of a project’s risk and liquidity
2. Easy to calculate and understand
YEAR Project L Project S
0 -$100 -$100
1 $10 $70
Disadvantages: 2 $60 $50
3 $80 $20
4 $100,000,000 $0
1. Ignores the time value of money
2. Ignores CFs occurring after the payback period
3. Arbitrary choice of a cutoff date
 Net Present Value (NPV) Method

• The required rate of return (r) is the minimum return that a

project must earn in order to be acceptable.

• The cost of capital (k) is often used as the minimum required rate
of return for capital budgeting purposes.

• The cost of capital (k) is the cost of investment funds, usually

viewed as a weighted average of the cost of funds from all
sources.
 Net Present Value (NPV) Method

NPV: Sum of the PVs of inflows and outflows

minus cost CF0 which is often negative.

n NCFt
NPV = 
t = 0 (1 + k ) t

Decision Rule: Accept a project if NPV > 0.

 YEAR Project L Project S
Example 1 (continued): 0 -$100 -$100
What’s Project L’s NPV? 1 $10 $70
2 $60 $50
3 $80 $20
Project L:
0 1 2 3
10%

-$100.00 $10 $60 $80

$9.09
$49.59
$60.11
$18.78 = NPVL
NPVS = $19.99.
 YEAR Project L Project S
Example 1 (continued): 0 -$100 -$100
What’s Project L’s NPV? 1 $10 $70
2 $60 $50
3 $80 $20
 YEAR Project L Project S
Example 1 (continued): 0 -$100 -$100
What’s Project S’s NPV? 1 $10 $70
2 $60 $50
3 $80 $20
 Rationale for the NPV Method

NPV = PV (Benefits or Inflows) – PV (Costs)

= Net gain in wealth. Accept project if NPV > 0

• Choose between mutually exclusive projects on the basis of

higher NPV. (Recall Corporate Objective – lecture 1 Intro).

• The project with the highest NPV adds greatest value

– If Projects S and L are mutually exclusive: Accept S because NPVs > NPVL .
– If S & L are independent: Accept both as NPV > 0 for both projects
 Strengths and Weakness
of the NPV Method

Advantages
– Uses cash flows (not earnings)
– Uses ALL cash flows of a project
– Discounts cash flows properly

Disadvantages
– Relies on accurate estimate of cash flows (teaching week 5)
and the discount rate (teaching week 10)
– Projects likely to be replicated with maturity of differing
lengths (teaching week 5)
 NPV Example 1– Excel Application
Calculating NPV at various discount rates (Project L)
NPV Example 1 – Excel Application
Creating the NPV Profile for Project L
Internal Rate of Return (IRR)

0 1 2 3

CF0 CF1 CF2 CF3

Cost Inflows

• IRR is the discount rate that forces PV inflows = cost

This is the same as forcing the NPV = 0

• IRR is popular because it provides a single number that summarizes

the merit of a project.
Internal Rate of Return (IRR)

IRR: Enter NPV = 0, solve for IRR.

n
NCFt
IRR  NPV =  =0
t =0 (1 + irr)
t

Decision Rule: If IRR > k, accept project; If IRR < k, reject project
 YEAR Project L Project S
Example 1 (continued): 0 -$100 -$100
What’s Project L’s IRR? 1 $10 $70
2 $60 $50
3 $80 $20

0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV

IRRL = 18.13%.
IRRS = 23.56%.
 YEAR Project L Project S
Example 1 (continued): 0 -$100 -$100
What’s Project L’s IRR? 1 $10 $70
2 $60 $50
3 $80 $20
 YEAR Project L Project S
Example 1 (continued): 0 -$100 -$100
What’s Project S’s IRR? 1 $10 $70
2 $60 $50
3 $80 $20
 Rationale for the IRR Method

If IRR > k, then the project’s rate of return is greater

than its cost - some return is left over to boost
stockholders’ returns.

Illustration:

If k = 10% and IRR = 15%, the project is profitable.

 IRR Example 1– Excel Application
Calculating IRR (Project L)

• IRR = 18.13%
 Decisions on Projects S and L
using the IRR Method

• If S and L are independent projects:

➢ Accept both because IRRs > k , if k = 10%.

• If S and L are mutually exclusive projects:

➢ Accept S because IRRS > IRRL

Note that there are some potential errors with the use of
IRR in deciding between mutually exclusive projects.
 WARNING
PITFALLS WITH
THE INTERNAL RATE OF RETURN

WARNING
 YEAR Project L Project S
Pitfall 1: 0 -$100 -$100
Mutually Exclusive Projects 1 $10 $70
2 $60 $50
Construct an NPV Profile 3 $80 $20

Find NPVL and NPVS at different discount rates assuming projects

are mutually exclusive:

Cost of capital (k) NPV (Project L) NPV (Project S)

0% $50.00 $40.00
5% $33.05 $29.29
10% $18.78 $19.98
15% $6.67 $11.83
20% -$3.70 $4.63
 Cost of capital (k) NPV (Project L) NPV (Project S)
NPV Profile 0% $50.00 $40.00
5% $33.05 $29.29

NPV ($) 10% $18.78 $19.98

60 15% $6.67 $11.83
20% -$3.70 $4.63
50

40

30

20 S
IRRS = 23.56%
10 L
0 Discount Rate (%)
0 5 10 15 20 23.6
-10
IRRL = 18.13%
 YEAR Project L Project S Cash Flow
NPV Profile L-S
0 -$100 -$100 $0
NPV ($) 1 $10 $70 -$60
60
2 $60 $50 $10
3 $80 $20 $60
50

Crossover
40
Point = 8.68%
30

20 S
IRRS = 23.56%
10 L
0 Discount Rate (%)
0 5 10 15 20 23.6
-10
IRRL = 18.13%
 About the Crossover Point

• Crossover Point is the discount rate at which the NPV for the two
projects are equal (it can be thought of as the rate of indifference).
• It is also the IRR of the incremental cash flows
k1 < 8.68: NPVL> NPVS , IRRS > IRRL
CONFLICT

k2 > 8.68: NPVS> NPVL , IRRS > IRRL

NO CONFLICT
 Conflict between IRR and NPV
37

• When k is larger than the crossover rate, IRR & NPV leads to
the same decision

• When k is smaller than the crossover there is conflict between

IRR and NPV

Which should we use?

• NPV is always preferred as it measures additional wealth

obtained.
 To Find the Crossover Rate

1. Find cash flow differences between the projects (i.e. find the
incremental cash flows – the change in cash flow).

2. Incremental CF’s L-S

YEAR Project L Project S Cash Flow
L-S
0 -$100 -$100 $0
1 $10 $70 -$60
2 $60 $50 $10
3 $80 $20 $60

and calculate the IRR of incremental cash flow = 8.68%

3. You Can subtract S from L or vice versa, but better to have first CF
negative
4. If profiles don’t cross, one project dominates the other.
 Two Reasons NPV Profiles Cross

1. Size (scale) differences.

Smaller project frees up funds at T = 0 for investment.
The higher the opportunity cost, the more valuable these funds,
so high k favours small projects.

2. Timing differences.
Project with faster payback provides more CF in early years for
reinvestment.
If k is high, early CFs are especially good, NPVS > NPVL
 Reinvestment Rate Assumptions

• NPV assumes reinvestment at k (opportunity cost of capital).

• IRR assumes reinvestment at IRR.

• Reinvestment at opportunity cost, k, is more realistic, so NPV

method is best.

• NPV should always be used to choose between mutually

exclusive projects (CASH IS KING).
Pitfall 2:
Multiple rates of returns
Example 2
Assume a company cost of capital of 15%.

4
What are they? (Hint: Search between 20% and 70%)
Pitfall 2:
Multiple rates of returns

From our text:

“In cases where there is more than one IRR, the spreadsheet or
calculator will simply produce the first one that it finds, with no
mention that there could be others!” (Berk et al., 2014, p. 233)
We have four IRRs.
Non-conventional CFs - four sign changes.

Rates < 25% REJECT

25% < Rates < 33.33% ACCEPT
33.33% < Rates < 42.86% REJECT
42.86% < Rates < 66.66% ACCEPT
Rates > 66.66% REJECT
 FAQ

❑ So what does this mean with regards testing and examination purposes?
❑ Simple: We can never ask you to find the rates. All we could ask is the following:
Pitfall 3:
Lending or Borrowing?
Illustration

Consider the following projects A and B

Project Lending Project Borrowing

CF (t=0) -$1,000.00 +$1,000.00
CF (t=1) +$1,500.00 -$1,500.00
IRR 50% 50%
NPV @10% +$364 -$364

Each project has an IRR of 50%. Does this mean that they
are equally attractive?
Pitfall 4:
No Feasible Solution
Illustration

Consider Project A:
YEAR Cash Flow
0 $1,000.00
1 -$3,000.00
2 $2,500.00

NPV at 10% = $339

IRR = None
 Capital Rationing

• Capital rationing is a limit set on funds available for investment.

• Soft rationing limits imposed by top management

• Hard rationing - Firm is unable raise the money it requires to

undertake all profitable projects.

• Under 'hard' rationing the firm may be forced to pass up positive

NPV projects, whereas 'soft' rationing should never cost the firm
anything as top management can relax capital control at any time.
 Project Selection with Resource
Constraints
The Profitability index is a relative measure of value.

The PI is an investment return measurement much like net present

value (NPV) with one notable difference.

=> NPV finds "the dollar amount difference" between the sum of
present values of all future cash flows and the amount of
initial investment whereas profitability index finds "the
ratio".

Value Created NPV

Profitability Index = =
Resource Consumed Initial Investment
 Profitability Index

The profitability index measures the ratio between cash flow to investment.
Therefore, the higher the ratio the more cash flow to investment

Decision Rule:

Accept a project if the profitability index is greater than 0, stay indifferent

if the profitability index is zero and don't accept a project if the profitability
index is below 0.
Example 2: Profitability Index

Taken Inn is planning to open cafes in several cities and has estimates the required outlay and
NPV for each of the following cities. Taken Inn is subject to hard capital rationing from its
bank who has set a limit at $1,000,000 this year. Develop a profitability index for the
following four centres and state which would be selected. All three centres plan to last for
three years and the firm uses a 10% discount rate. In which cities should Taken Inn open
cafes and why?

INITIAL ANNUAL PV of Profitability

CITY OUTLAY INFLOWS Inflows Index
@10%
Sydney 500,000 $220,000

Melbourne 300,000 $130,000

Perth 250,000 $100,000

Hobart 125,000 $60,000

50
Example 2: Profitability Index - solution

INITIAL ANNUAL PV of Profitability

CITY OUTLAY INFLOWS Inflows Index
@10%
Sydney 500,000 $220,000 $47,107.44 0.094

Melbourne 300,000 $130,000 $23,290.76 0.078

Perth 250,000 $100,000 -$1,314.80 -0.005

Hobart 125,000 $60,000 $24,211.12 0.194

Hobart, Melbourne and Sydney and a total budget of $925,000

51
Profitability Index
Strengths and Weaknesses

Advantages:
▪ it considers time value of money
▪ It presents a relative profitability of the project. Relative profitability
allows comparison of two investments irrespective of their amount of
investment. A higher PI would indicate a better IRR and a lower PI would
have lower IRR.

Disadvantages:
▪ is also its relative indications. Two projects having vast difference in
investment and dollar return can have same PI. In such situation, therefore,
the NPV method remains the best method.
Mutually Exclusive Projects
with Different Lives
Example 1 – Mutually Exclusive
Projects with Different Lives
There are times when direct application of the NPV rule can lead
to a wrong decision.
For example consider a factory which must have an air cleaner.

• There are two choices:

– “Cleaner X” costs $4,000 today, has annual operating costs
of $100 and lasts for 10 years.
– “Cleaner Y” costs $1,000 today, has annual operating costs
of $500 and lasts for 5 years.
• Which one should we choose?
• Assume cost of capital for this investment is 10%.
Mutually Exclusive Projects
with Different Lives

• At first glance, project Y appears to be best.

 − $ 100  
N P V X , 0 = − $ 4 , 000 +  1 −
1
  = − $ 4 , 614 . 46
 0 . 10  ( + )10  
  1 0 . 10 

 − $ 500  
N P VY , 0 = − $ 1, 000 +  1 −
1
  = − $ 2 ,895 . 39
 0 . 10  ( + )5 
  1 0 . 1 

• But Cleaner X lasts twice as long.

• When we incorporate that, Cleaner X is actually cheaper.

55
Mutually Exclusive Projects
with Different Lives

• Matching Cycle or Replacement Chain Approach

– Repeat projects until they begin and end at the same
time - like we just did with the air cleaners.
– Compute NPV for the “repeated projects”.

• The Equivalent Annual Cash Flow Method (EAC)

Mutually Exclusive Projects ASIDE
with Different Lives
57

Matching Cycle or Replacement Chain Approach

Cleaner X’s time line of cash flows:
-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100

0 1 2 3 4 5 6 7 8 9 10
Cleaner Y’s time line of cash flows over ten years:
-$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500

0 1 2 3 4 5 6 7 8 9 10
Matching Cycle or ASIDE
Replacement Chain Approach
When we make a fair comparison,

 − $100  
NPV X = −$4,000 +  1 −
1
  = −$4,614.46
 0.10  (1 + 0.1)10  
  

− $2,895.39
NPVY = −$2,895.39 + 5
= −$4,693.20
1.1

Decision: Cleaner X is cheaper

Mutually Exclusive Projects
with Different Lives
The Equivalent Annual Cash Flow Method

• EAC method puts costs on a per-year basis.

• EAC is the value of the payment annuity that has the same NPV
as our original set of cash flows.

NPV0  k
EAC0 =
  1 
1 −  t


  (1 + k) 

Where EAC = Equivalent Annual Cash Flow

k = cost of capital
t = time
Investments of Unequal Lives:
Equivalent Annual Cash Flow Method

 − $ 100  
N PV X = − $ 4 , 000 +   1 −
1
  = − $ 4 , 614 . 46
 0 . 10  (1 + 0 .1)10  
 

− $4,614.46  0.10
EAC X = = −$750.98
1
1−
(1 + 0.10)10
Investments of Unequal Lives:
Equivalent Annual Cash Flow Method

 − $500  
NPVY = −$1,000 +    = −$2,895.39
1
 1 −
 0.10  (1 + 0.10)5  
  

− 2,895.39  0.10
EACY = = −763.80
1
1−
(1 + 0.10 )5

Decision: Cleaner X is cheaper (750.98/yr vs. 763.80/yr)

61
❑ Today we have been talking about the fundamental capital budgeting evaluation
techniques used in practice.

The most popular decision rules used by CFOs for listed Australian firms

❑ Next week we will turn our attention to learning how to construct cash flows.
 MONASH
BUSINESS
SCHOOL

POP QUIZ ( CAPITAL BUDGETING )

Recap Teaching Week 4:
Capital Budgeting Exam Question

General Foods (GF) owns a machine that is 6 years old and has an estimated remaining
physical life of no more than 2 years. The table below shows the net cash flows and
residual value estimates for the machine. Assume the cost of capital is 10%. When should
the machine be retired? Assume a no tax world.

End of Year Net Cash Flow Residual Value

6 $- $18,000
7 $22,000 $9,000
8 $14,000 $0
Recap Teaching Week 4: Solution
Capital Budgeting Exam Question

Option One: Retire the machine at the end of year 6.

NPV = $18,000

or

Retire the machine at the end of year 7.

PV = (22000+9,000)/1.1 = $28,181.82

or

Keep the machine until the end of year 8

PV = 22,000/1.1 + 14,000/1.12 = $31,570.25

Therefore, the machine should be retired at the end of year 8 as this is

where shareholder wealth is maximised.
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