Chapter 6

Capital BudgetingTechniques

Sept 2010Dr. B. Asiri

© 2005 Thomson/South-Western

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What is Capital Budgeting?

The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one yearAnalysis of potential additions to fixed assets

Long-term decisions; involve large expenditures

Very important to firm’s future

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Generating Ideas for Capital Projects

A firm’s growth and its ability to remain competitive depend on a constant flow of ideas for new products, ways to make existing products better, and ways to produce output at a lower cost.

Procedures must be established for evaluating the worth of such projects.

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Project Classifications Replacement Decisions:Replacement Decisions: whether to

purchase capital assets to take the place of existing assets to maintain or improve existing operations

Expansion Decisions:Expansion Decisions: whether to purchase capital projects and add them to existing assets to increase existing operations

Independent Projects:Independent Projects: Projects whose cash flows are not affected by decisions made about other projects

Mutually Exclusive Projects:Mutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted

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Net Cash Flows for Project S and Project L

1,5001,200

800300

400900

1,3001,500

^Net Cash Flows, CFt

r e dp AEx cte fte -Tax

Year Project S Project L0 $(3,000) $(3,000)1234

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1. Payback Period: PB

The length of time before the original cost of an investment is recovered from the expected cash flows or . . . How long it takes to get our money back.

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Payback Period for Project S

=PaybackS 2 + 300/800 = 2.375 years

Net Cash Flow

Cumulative Net CF

1,500

-1,500

800

500

1,200

-300

-3,000

-3,000

300

800

PBS0 1 2 3 4

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=PaybackL 3 + 400/1,500 = 3.3 years

Net Cash Flow

Cumulative Net CF

400

- 2,600

1,300

- 400

900

- 1,700

- 3,000

- 3,000

1,500

1,100

PBL0 1 2 3 4

Payback Period for Project L

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Strengths of Payback:Strengths of Payback:• Provides an indication of a

project’s risk and liquidity• Easy to calculate and understand

Weaknesses of Payback:Weaknesses of Payback: • Ignores TVM• Ignores CFs occurring after the

payback period

Strengths and Weaknesses of Payback:

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2. Net Present Value: NPV

Sum of the PVs of Inflows + Outflows

Cost is CF0 and is generally negative.

NPV

CF

kt

nt

t 0 1

.^

NPV

CF

kCF

t

nt

t

0

01

.^

^

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What is Project S’s NPV?k = 10%

1,500 8001,200(3,000)

1,363.64

991.74

601.05

204.90

161.33

300

0 1 2 3 4

NPVS =

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What is Project L’s NPV?

k = 10%

400 1300900(3,000)

363.64

743.80

976.71

1024.52

108.67

1500

0 1 2 3 4

NPVL =

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Rationale for the NPV method:

NPV = PV inflows - Cost= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually exclusive projects on basis of higher NPV. Which adds most value?

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Using NPV method, which project(s) should be accepted?

If Projects S and L are mutually exclusive, accept S because NPVS > NPVL.

If S & L are independent, accept both; NPV > 0.

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3. 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 NPV = 0.

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t

nt

t

CF

kNPV

0 1.

t

nt

t

CF

IRR

0 10.

NPV:

IRR:

Calculating IRR

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What is Project S’s IRR?

NPVS = IRRS = 13.1%0

(3,000)

IRR = ?0 1 2 3 4

Sum of PVs for CF1-4 = 3,000

1,500 8001,200 300

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What is Project L’s IRR?

NPVL = IRRL = 11.4%0

IRR = ?

400 1300900 1500

0 1 2 3 4

Sum of PVs for CF1-4 = 3,000

(3,000)

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Rationale for the IRR Method:

If IRR (project’s rate of return) > the firm’s required rate of return, k, then some return is left over to boost stockholders’ returns.

Example: k = 10%,IRR = 15%. Profitable.

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IRR acceptance criteria:

If IRR > k, accept project. If IRR < k, reject project.

Decisions on Projects S and L per IRR If S and L are independent,

accept both. IRRs > k = 10%. If S and L are mutually exclusive,

accept S because IRRS > IRRL .