CHAPTER # 07

Long term investment and

Capital Budgeting
Should we
build this
plant?

10-1
 Chapter Outline

 Understanding Capital Budgeting

 Steps to capital budgeting
 Independent and mutually exclusive project
 Capital Budgeting Techniques:
 1. Traditional methods:

a) - Pay Back Period

b) Average Rate of Returns (ARR)

10-2
 Contd.
2. Discounted cash Flow methods:

a) Net Present Value (NPV)

b) IRR (Internal Rate of Return)

c) MIRR (Modified Internal Rate of

Return)

d) Profitability Index ((PI)

Comparing the NPV and IRR methods

Exercises
10-3
Understanding Capital Budgeting
The term capital budgeting is used to describe
actions relating to planning and financing capital
outlays for purposes such as: purchase of new
machines, introduction of new products,
modernization of facilities and replacement.

Capital budgeting involves a commitment of funds

now in order to receive cash flows in the future.
The main purpose of a capital budget is to plan
and to control capital expenditure.

10-4
 Contd.
Capital expenditure may consist of the followings:

 For addition or extensions to the existing plant to increase

production.
 For replacing worn-out / exhausted machinery to increase
the capacity to the existing facilities.
 For addition of new line of production or developing a
new product.
 For replacing machinery to achieve cost-saving or
reducing costs through technical improvements in
machinery.
10-5
 Feature of Capital Investment
Decision
The following are the main feature of capital
investment decision:
 The exchange of current funds for future
benefits.
 The funds are invested in long term assets.
 The future benefits will occur to the firm over a
series of years.
 It involves commitment of large amount of
funds.
10-6
 Types of Capital investment
Decision
Probable nature of capital investment
decision are as follows:
 Expansion project - expansion of existing
product or market
 Diversification- expansion of new
business
 Replacement project.
 Research and development.
10-7
 Relevant Data for evaluating
Capital investment decision:
The following data need to be considered before appraisal
is taken up:

 The amount and timing of initial investment outlays.

 The amount and timing of subsequent investment outlays

 The economic life of the project

 Salvage value at the end of the project

 Tax Rate

 Discount Rate / Cost of Capital

 Depreciation methods for calculation

 The amount and timing of Cash inflow / NCB

 Finding NCB

10-8
 Steps to Capital Budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.

10-9
 What is the difference between
independent and mutually exclusive
projects?
 Independent projects – if the cash flows of
projects are unaffected by the acceptance of the
other.

 Mutually exclusive projects – if the cash flows

of one project can be adversely impacted by the
acceptance of the other.
10-10
 What is the difference between
normal and non normal cash flow
streams?
 Normal cash flow stream – Cost
(negative CF) followed by a series of
positive cash inflows. One change of
signs.
 Non normal cash flow stream – Two
or more changes of signs. Most common:
Cost (negative CF), then string of positive
CFs, then cost to close project. Nuclear
power plant, strip mine, etc.
10-11
 What is the payback period?
 The number of years required to recover a
project’s cost, or “How long does it take to
get our money back?”
 Calculated by adding project’s cash inflows
to its cost until the cumulative cash flow
for the project turns positive.

10-12
Project Evaluation under Pay Back Period
The payback period is defined as the length of
time that it takes for an investment project to
get back its initial cost out of the cash flows that
it generates.
There are two ways of calculating the Pay Back
period. The first methods can be applied when
the cash flow stream is in the nature of annuity
for each year of the project’s life that is cash
flow after tax is uniform. In such a situation the
initial cost of investment is divided by the
constant annual cash flow.
10-13
 Contd.
The formula for calculating pay back period
in this regard is as follows:

Pay Back Period (Incase of Uniform cash

flow)
= Net Cash Outlay / Net Cash Benefits for
each period.

10-14
The second method is used when projects cash
flows are not uniform. i.e. mixed stream but vary
from year to year. In such a situation, Pay Back
Period is calculated by the process of cumulating
cash flows till the year when cumulative cash
flows become equal to the original investment
outlay. The formula for calculating pay back
period in this regard is as follows:

Pay Back Period = A +NCO - CD

10-15
 Contd.
Where:

A = Number of year immediately

preceding the year of final recovery.

NCO = Net Cash Outlay

C = The cumulative Cash flow from
the year A
D = Cash flow from the following year of
the year A

10-16
 Contd
 Pay Back Period = A +NCO – C / D

10-17
 Calculating payback
0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

10-18
 Example 1:
An investment of Tk. 48,000 in a machine
is expected to produce cash flow of Tk.
8,000 for 10 years. Calculate the Pay Back
Period of the project.

Pay Back Period =Net Cash Outlay/ Net

Cash Benefits for each period.
= 48, 000/ 8000= 6 years
10-19
 Example 2
Suppose a sum of Tk 10,00,000 has to be
invested in a project whose expected net cash
flows after tax are as follows:
. Year Cash Flows
1 2,00,000
2 3,00,000
3 4,00,000
4 5,00,000
5 6,00,000

10-20
 Contd.
Calculate the pay back period of the project.
We know that formula for calculating pay back period in
case of unequal cash inflows is as follows:

Pay Back Period = A +NCO – C/ D

Table for calculation of Pay Back Period

Year Cash flow after tax Cumulative cash flow after tax
1 2,00,000 2,00, 000
2 3,00,000 5,00,000
3 4,00,000 9,00,000
4 5,00,000 14,00,000
5 6,00,000 20,00,000

10-21
 Contd
Now putting the values in the formula we
get,

Pay Back Period =

3+ (10,00,000 - 9,00,000)/5,00,000

= 3+0.2 = 3.2 years

10-22
Project Evaluation under Accounting
Rate of Return / Average Rate of
Return
Return on Investment is based upon
accounting information rather than cash
flows. There are no unanimity regarding the
definition of the rate of return. There are a
number of alternative methods for
calculating the ARR.

10-23
 Contd.
Simple rate of return is based on incremental net
income, which is the difference between
incremental revenues and incremental expenses.

Remember that revenues are not the same thing

as cash inflows and that expense is not the same
thing as cash outflows. One big difference is
depreciation, which is an expense but not a cash
flow. The biggest problem with the simple rate of
return is that it ignores the time value of money.
10-24
 Contd.
The most common usages of the average rate of
return expresses is as follows:

ARR = (Average annual profits after taxes/

Average investment over the life of the project )
X 100
Average annual profits= Total annual Profits/
no. of years

Average investment = Net working capital +

salvage value + ½ of initial cost – salvage value.
10-25
 Contd.
Given the information: initial investment is
Tk. 11,000; salvage value Tk. 1,000;
working capital Tk. 2,000; service life 5
years; and that the straight line method of
depreciation is adopted,
The average investment is: 1,000 + 2,000
+ ½ of 11,000-1,000 = Tk. 8,000

10-26
 Contd.
Decision Rule:
The decision rule regarding Accounting
Rate of Return (ARR) is as follows:

In case of independent project ARR >

expected rate of return Accepted

In case of mutually exclusive project,

project with higher ARR Accepted
10-27
Example 3:
Determine the average rate of return from the following
data of two machines, A and B
Particular Machine A Machine B

Cost 56,125Tk Tk.. 56,125

Annual estimated income after
depreciation and income tax: 3,375 11,375
1 5,375 9,375
2 7,375 7,375
3 9,375 5,375
4
11,375 3,375
5
Total Tk. 36,875 Tk. 36,875
Estimated Life 5 5

Estimated salvage value

3,000 3,000

10-28
 Contd
Depreciation has been charged on straight-
line basis.
We know,
ARR= Average annual profits after taxes /
Average investment over the life of the
project * 100

10-29
 Contd.
 Workings for calculation of Average income:
 Total Income / no. of years
A & B= 36,875 /5=7,535

 Average investment = salvage value + ½ of

cost of machine – salvage value
= Tk. 3,000+1/2 of 56,125 - 3,000 = 29, 562.50
ARR= 7,375 / 29,562.5 *100= 24.9%

10-30
 Discounted payback period
 Uses discounted cash flows rather than
raw CFs.
0 10% 1 2 2.7 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79

Disc PaybackL == 2 + 41.32 / 60.11 = 2.7 years

10-31
 Discounted Cash Flow (DCF)

Methods for ranking investment

proposals that employ time value of
money concepts.

10-32
 Project Evaluation under Net Present
Value Method:
The net present value of a project is the difference
between the present value of all cash inflows and
the present value of all cash outflows.
The present value or recognize that cash inflow in
different time periods differ in value and can be
compared only when they are expressed in terms
of a common denominator, that is, present values.
It, thus, take into account the time value of
money.

10-33
 Contd.

 NPV = PV. Of Net Cash Inflows – PV. of

Net Cash outflows.

10-34
Decision Rule for NPV -Method

10-35
 The Internal Rate of Return
Method
The internal rate of return method is an
alternative to the net present value
method. It too uses the time value of
money. Specifically, the internal rate of
return (IRR) is the rate of return that
equates the present value of future cash
flows to the investment outlay.

10-36
Estimating the Required Rate
of Return
In the problems presented earlier, we stated a
required rate of return that could be used to
calculate an investment’s net present value
or that could be compared with an
investment’s internal rate of return. In
practice, the required rate of return must be
estimated by management. Under certain
conditions, the required rate of return should
be equal to the cost of capital for the firm.
10-37
Decision Rule The Internal Rate
of Return Method

10-38
 Net Present Value (NPV)
 Sum of the PVs of all cash inflows and outflows
of a project:

n
CFt
NPV   t
t 0 ( 1  k )

10-39
 What is Project L’s NPV?
Year CFt PV of CFt
0 -100 -$100
1 10 9.09
2 60 49.59
3 80 60.11
NPVL = $18.79

NPVS = $19.98
10-40
Rationale for the NPV method
NPV = PV of inflows – Cost
= Net gain in wealth
 If projects are independent, accept if the
project NPV > 0.
 If projects are mutually exclusive, accept
projects with the highest positive NPV,
those that add the most value.
 In this example, would accept S if
mutually exclusive (NPVs > NPVL), and
would accept both if independent. 10-41
Internal Rate of Return (IRR)
 IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:

n
CFt
0 t
t 0 ( 1  IRR )

 Solving for IRR with a financial calculator:

 Enter CFs in CFLO register.
 Press IRR; IRRL = 18.13% and IRRS = 23.56%.

10-42
NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)
IRR > r r > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.

r (%)
IRR
10-43
 Rationale for the IRR methdo
 If IRR > WACC, the project’s rate of
return is greater than its costs. There
is some return left over to boost
stockholders’ returns.

10-44
 IRR Acceptance Criteria
 If IRR > k, accept project.
 If IRR < k, reject project.

 If projects are independent, accept both

projects, as both IRR > k = 10%.
 If projects are mutually exclusive,
accept S, because IRRs > IRRL.

10-45
 NPV Profiles
 A graphical representation of project NPVs at
various different costs of capital.

k NPVL NPVS
0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5

10-46
 Drawing NPV profiles
NPV 60
($)
50 .
40 .
. Crossover Point = 8.7%
30 .
20 . IRRL = 18.1%

10 .. S IRRS = 23.6%
L . .
0 . Discount Rate (%)
5 10 15 20 23.6
-10
10-47
 Comparing the NPV and IRR
methods
 If projects are independent, the two
methods always lead to the same
accept/reject decisions.
 If projects are mutually exclusive …
 If k > crossover point, the two methods
lead to the same decision and there is no
conflict.
 If k < crossover point, the two methods
lead to different accept/reject decisions.
10-48
 Finding the crossover point
1. Find cash flow differences between the
projects for each year.
2. Enter these differences in CFLO register, then
press IRR. Crossover rate = 8.68%, rounded
to 8.7%.
3. 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.

10-49
 Reasons why NPV profiles cross
 Size (scale) differences – the smaller project
frees up funds at t = 0 for investment. The
higher the opportunity cost, the more valuable
these funds, so high k favors small projects.
 Timing differences – the project with faster
payback provides more CF in early years for
reinvestment. If k is high, early CF especially
good, NPVS > NPVL.

10-50
 Reinvestment rate assumptions
 NPV method assumes CFs are reinvested at
k, the opportunity cost of capital.
 IRR method assumes CFs are reinvested at
IRR.
 Assuming CFs are reinvested at the
opportunity cost of capital is more realistic,
so NPV method is the best. NPV method
should be used to choose between mutually
exclusive projects.
 Perhaps a hybrid of the IRR that assumes
cost of capital reinvestment is needed.
10-51
 Since managers prefer the IRR to the NPV
method, is there a better IRR measure?
 Yes, MIRR is the discount rate that causes
the PV of a project’s terminal value (TV) to
equal the PV of costs. TV is found by
compounding inflows at WACC.
 MIRR assumes cash flows are reinvested
at the WACC.

10-52
 Calculating MIRR
0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% 12.1
MIRR = 16.5%
158.1
-100.0 $158.1 TV inflows
$100 =
(1 + MIRRL)3
PV outflows
MIRRL = 16.5%

10-53
 Why use MIRR versus IRR?
i) MIRR correctly assumes reinvestment
at opportunity cost = WACC. MIRR
also avoids the problem of multiple
IRRs.
ii) Managers like rate of return
comparisons, and MIRR is better for
this than IRR.

10-54
 Project P has cash flows (in 000s): CF0 =
-$800, CF1 = $5,000, and CF2 = -$5,000.
Find Project P’s NPV and IRR.
0 1 2
k = 10%

-800 5,000 -5,000

 Enter CFs into calculator CFLO register.

 Enter I/YR = 10.
 NPV = -$386.78.
 IRR = ERROR Why?
10-55
 Multiple IRRs
NPV NPV Profile

IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800
10-56
 Why are there multiple IRRs?
 At very low discount
rates, the PV of CF2 is
large & negative, so NPV
< 0.
 At very high discount
rates, the PV of both CF1
and CF2 are low, so CF0
dominates and again NPV
< 0.
 In between, the discount
rate hits CF2 harder than
CF1, so NPV > 0. 10-57
Solving the multiple IRR problem
 Using a calculator
 Enter CFs as before.
 Store a “guess” for the IRR (try 10%)
10 ■ STO
■ IRR = 25% (the lower IRR)
 Now guess a larger IRR (try 200%)
200 ■ STO
■ IRR = 400% (the higher IRR)
 When there are nonnormal CFs and more than
one IRR, use the MIRR.
10-58
When to use the MIRR instead of the
IRR? Accept Project P?
 When there are non-normal CFs and
more than one IRR, use MIRR.
 PV of outflows @ 10% = -$4,932.2314.
 TV of inflows @ 10% = $5,500.
 MIRR = 5.6%.
 Do not accept Project P.
 NPV = -$386.78 < 0.
 MIRR = 5.6% < k = 10%.
10-59
NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)
IRR > r r > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.

r (%)
IRR
10-60
 Mutually Exclusive Projects

NPV r < 8.7: NPVL> NPVS , IRRS > IRRL

CONFLICT
L r > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT

S IRRS

r 8.7 r %
IRRL
10-61
 To Find the Crossover Rate

1. Find cash flow differences between the

projects. See data at beginning of the
case.
2. Enter these differences in CFLO register,
then press IRR. Crossover rate = 8.68%,
rounded to 8.7%.
3. 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.
10-62
To find TV with 10B, enter in CFLO:

CF0 = 0, CF1 = 10, CF2 = 60, CF3 = 80

I = 10
NPV = 118.78 = PV of inflows.
Enter PV = -118.78, N = 3, I = 10, PMT = 0.
Press FV = 158.10 = FV of inflows.
Enter FV = 158.10, PV = -100, PMT = 0,
N = 3.
Press I = 16.50% = MIRR.
10-63
 Why use MIRR versus IRR?

MIRR correctly assumes reinvestment

at opportunity cost = WACC. MIRR
also avoids the problem of multiple
IRRs.
Managers like rate of return
comparisons, and MIRR is better for
this than IRR.

10-64
Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN

10-65
 Logic of Multiple IRRs

1. At very low discount rates, the PV of

CF2 is large & negative, so NPV < 0.
2. At very high discount rates, the PV of
both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
3. In between, the discount rate hits CF2
harder than CF1, so NPV > 0.
4. Result: 2 IRRs.
10-66
 Accept Project P?

NO. Reject because MIRR =

5.6% < r = 10%.

Also, if MIRR < r, NPV will be

negative: NPV = -$386,777.

10-67
 Choosing the Optimal Capital
Budget
 Finance theory says to accept all positive
NPV projects.
 Two problems can occur when there is
not enough internally generated cash to
fund all positive NPV projects:
 An increasing marginal cost of capital.

 Capital rationing

10-68
 Capital Rationing
 Capital rationing occurs when a
company chooses not to fund all
positive NPV projects.
 The company typically sets an upper
limit on the total amount of capital
expenditures that it will make in the
upcoming year.

(More...)

10-69
Reason: Companies want to avoid the
direct costs (i.e., flotation costs) and the
indirect costs of issuing new capital.
Solution: Increase the cost of capital by
enough to reflect all of these costs, and
then accept all projects that still have a
positive NPV with the higher cost of
capital.

(More...)
10-70
Reason: Companies don’t have enough
managerial, marketing, or engineering
staff to implement all positive NPV
projects.

Solution: Use linear programming to

maximize NPV subject to not exceeding
the constraints on staffing.

(More...)
10-71
Reason: Companies believe that the
project’s managers forecast unreasonably
high cash flow estimates, so companies
“filter” out the worst projects by limiting the
total amount of projects that can be
accepted.
Solution: Implement a post-audit process
and tie the managers’ compensation to the
subsequent performance of the project.

10-72
 Review Questions
 What are the various steps followed in capital
budgeting decision?
 What are the various data used for evaluating any
capital investment project?
 Define Discounted Cash Flow Method. Distinguish
between the NPV and IRR methods in case of long-term
investment evaluation.
 What are the Rationale for the IRR method?
 What is the difference between independent and
mutually exclusive projects?
 Why are there multiple IRRs in capital investment
projects?
 Why use MIRR versus IRR?
 When to use the MIRR instead of the IRR?
10-73