Capital Budgeting
Capital Budgeting: is the decision process that manager use to identify those projects that add to
the firm’s value and as such it is perhaps the most important task faced by financial managers
and their staff.
Methods of Capital Budgeting
1. Payback
2. Discounted Payback
3. Net Present Value (NPV)
4. Internal rate of Return (IRR)
5. Modified Internal rate of Return (MIRR)
6. Profitability Index (PI)
1. Payback Period Method
The payback period defined as the expected number of years required to recover the original
investment, it is the formal method used to evaluate capital budgeting project.
Example
0 1 2 3 4
* -----------------* ---------------* -------------------* -------------------*
-1000 500 400 300 100
-1000 + 500+400 = 100
100/300 = 0.33
Payback = 2.33 Years
Advantage
1. Easy to calculate
2. provide an indication of a project’s risk and liquidity
Disadvantage
1. Ignore cash flow after payback period
2. Doesn’t consider time value of money (TVM)
2. Discounted Payback
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It is a similar to the regular payback period except that the expected cash flow is discounted
by the project’s cost of capital. Thus the discounted payback period is defined as the number
of years required to cover the investment from discounted net cash flows.
0 1 2 3 4
* -----------------* -----------------* ------------------* -------------------*
-1000 500 400 300 100
455 330 225 68
Assume that cost of capital is equal to 10%
Year 1= 500 = 455
(1.10) ¹
Year 2= 400 = 330
(1.10) ²
Year 3= 300 = 225
(1.10) ³
Year 4= 100 = 68
(1.10) 4
- 1000 + 455 + 330 = 215/225 = 0.95
Discounted payback period = 2.95 Years
Advantage
Consider Time value of Money
Disadvantage
Ignore cash flow after payback period
3. Net Present Value (NPV)
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the net present value ( NPV) Method is based upon the discounted cash flow (DCF) Technique ,
it is based on all discounted cash flows of the project by using cost of capital rate and then sums
those cash flows, the project should be accepted if NPV is positive or = Zero.
0 1 2 3 4
* -----------------* -----------------* ------------------* -------------------*
-1000 500 400 300 100
455
330
225
68
---------------
NPV= + 78 (Cost of Capital @10%)
--------------
Year 1= 500 = 455
(1.10) ¹
Year 2= 400 = 330
(1.10) ²
Year 3= 300 = 225
(1.10) ³
Year 4= 100 = 68
(1.10) 4
Positive NPV so we will accept the project (√)
4. Internal Rate of Return (IRR)
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Internal rate of Return (IRR) is defined as the discounted rate that forces a project’s NPV to
equal zero. The project should be accepted if the IRR is greater than cost of capital.
0 1 2 3 4
* -----------------* -----------------* ------------------* -------------------*
-1000 500 400 300 100
-1000+ 500 + 400 + 300 + 100 = Zero
1 2 3
(1+IRR) (1+IRR) (1+IRR) (1+IRR) 4
Using trial and error or financial calculator, the internal rate of return will be 14.50%
If IRR > WACC we will accept the project because the project’s rate of return is greater than its
cost.
If IRR < WACC we will Reject the project because the project’s rate of return is less than its
cost.
For our example IRR = 14.50% while cost of capital is 10% therefore, IRR>WACC thus we will
accept the project (√)
Independent Project vs. mutually Exclusive Projects
Independent project: if the cash flows of one project is unaffected by the acceptance of the
other. IRR > WACC
Mutually exclusive projects: if the cash flows of one can be adversely impacted by the
acceptance of the other. IRRL > IRRS
The NPV and IRR make the same accept/reject decisions for independent projects, but if projects
are mutually exclusive, then conflicts can arise. If conflicts arise NPV Method should be used
because reinvestment at cost is more realistic as well as conservative, so NPV Method will be the
best one, therefore NPV should be used to select between mutually exclusive projects.
NPV & IRR (No Conflict)
IRR > WACC while NPV ≥ Zero Accept the project
IRR < WACC while NPV < Zero Reject the project
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NPV & IRR (Conflict)
Project (S) Project (L)
IRR 14% 13%
NPV 300 350
We will select the one with highest NPV
NPV assumes reinvest cash flow at cost of capital rate
IRR assume reinvest cash flow at IRR
5. Modified Internal rate of Return (MIRR)
Modified Internal rate of Return (MIRR) correct some of the problem with regular IRR since
MIRR involves finding the terminal value (TV) of the cash inflows, compounded at the firm’s
cost of capital and then determining the discount rate that forces the Present value of the TV to
equal the PV of the out flows.
0 1 2 3 4
* -----------------* -----------------* ------------------* -------------------*
-1000 500 400 300 100
330
484
665.50
============
TV 1579.50
============
PV = FV (TV)
(1+MIRR) 4
1000 = 1579.50
(1+MIRR) 4
MIRR = 12.10%
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6. Profitability Index (PI )
Profitability index shows the dollars of present value divided by the initial cost, so it measure
relative profitability.
0 1 2 3 4
* -----------------* -----------------* ------------------* -------------------*
-1000 500 400 300 100
455
330
225
68
========
1078
========
PI = 1078 = $ 1.08
1000
So the project is expected to produce $1.08 for each $ 1 of investment, if we compare 2 projects
we will select the project with higher (PI) and must be greater than (1).
Comparing 2 projects with unequal life:
Project (c) with 6 years cash flow
Project (F) with 3 years cash flow
Project (c) @ cost of capital 11.50%
0 1 2 3 4 5 6
* ---------------* -----------------* ----------------* ----------------*-----------------*--------------*
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-40000 8000 14000 13000 12000 11000 10000
Project (F) @ cost of capital 11.50%
0 1 2 3
* ---------------* -----------------* ----------------*
- 20000 7000 13000 12000
Here we will assume that cost and annual cash flow will not change, if the project is repeated
again in 3 years and cost of capital remain at 11.50%
Project (c) @ cost of capital 11.50%
0 1 2 3 4 5 6
* ---------------* -----------------* ----------------* ----------------*-----------------*--------------*
-40000 8000 14000 13000 12000 11000 10000
7175
11261
9378
7764
6383
5204
======
NPV + 7165
Project (F) @ cost of capital 11.50%
0 1 2 3 4 5 6
* ---------------* -----------------* ----------------* ----------------*-----------------*--------------*
-20000 7000 13000 (8000) 7000 13000 12000
6278
10456
(5770)
4529
7543
6245
Capital Budgeting Page 7
======
NPV + 9281
Therefore we will select the project with Highest NPV, so Project (F) is accepted (√)
Assignment
(ST-1), (11-1), (11-2), (11-3), (11-4), (11-5), (11-6), (11-7) (11-8), (11-9) , (11-10), (11-11),
(11-12), (11-13)
Capital Budgeting Page 8
