Chapter 6:

The Basics of Capital

Budgeting

Financial management

The Basics of Capital Budgeting

1. An Overview of Capital Budgeting
2. Net Present Value (NPV)

3. Internal Rate of Return (IRR)

4. Multiple Internal Rates of Return

5. Modified Internal Rate of Return (MIRR)

6. Payback Period (PP)

2 Faculty of Finance & Banking

2

1
 Concepts
Independent Projects

Projects with cash flows that are not affected by the acceptance or non-
acceptance of other projects.

Mutually Exclusive Projects

A set of projects where only one can be accepted.

3 Faculty of Finance & Banking

3

Concepts
Normal cash flows: one or more cash outflows (costs) followed by a series
of cash inflows.

Nonnormal cash flows: the signs of the cash flows change more than
once.

4 Faculty of Finance & Banking

4

2
 1. An Overview of Capital budgeting

Capital Budgeting: The process of planning expenditures on assets with

cash flows that are expected to extend beyond 1 year.

Strategic Business Plan: A long-run plan that outlines in broad terms

the firm’s basic strategy for the next 5 to 10 years.

Should we
build this
plant?

1. An Overview of Capital Budgeting

Project category

• Replacement: needed to continue current operations.

• Replacement: cost reduction.

• Expansion of existing products or markets.

• Expansion into new products or markets.

• Safety and/or environmental projects.

• Mergers.

• Other projects.

6 Faculty of Finance & Banking

6

3
 1. An Overview of Capital Budgeting
The criteria for deciding to accept or reject projects:

1. Net present value (NPV)

2. Internal rate of return (IRR)

3. Modified internal rate of return (MIRR)

4. Payback

7 Faculty of Finance & Banking

7

2. Net Present Value (NPV)

A method of ranking investment proposals using the NPV, which is equal
to the present value of the project’s free cash flows discounted at the cost
of capital.

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑁

𝑁𝑃𝑉 = 𝐶𝐹0 + 1
+ 2
+. . . + 𝑁
1+𝑟 1+𝑟 1+𝑟
𝑁
𝐶𝐹𝑡
=෎ 𝑡
1+𝑟
𝑡=0

8 Faculty of Finance & Banking

8

4
 2. Net Present Value (NPV)
Example:

Initial cost After-Tax, End-of-Year Cash Inflows, CFt

Year 0 1 2 3 4
Project S -1,000 500 400 300 100
Project L -1,000 100 300 400 675
WACC for both projects is 10%.

9 Faculty of Finance & Banking

9

2. Net Present Value (NPV)

Project S
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4
𝑁𝑃𝑉 = 𝐶𝐹0 + 1
+ 2
+ 3
+ 4
1+𝑟 1+𝑟 1+𝑟 1+𝑟

10 Faculty of Finance & Banking

10

5
 2. Net Present Value (NPV)
Project L

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4

𝑁𝑃𝑉 = 𝐶𝐹0 + 1
+ 2
+ 3
+ 4
1+𝑟 1+𝑟 1+𝑟 1+𝑟

Excel: =NPV(rate,CF1:CFn) + CF0

Note: CF0 is negative.

11 Faculty of Finance & Banking

11

2. Net Present Value (NPV)

The NPV decision rules

➢ Independent projects: If NPV exceeds zero, accept the project.

➢ Mutually exclusive projects: Accept the project with the highest positive
NPV. If no project has a positive NPV, reject them all.

A positive NPV → the project is expected to add value to the firm → increase
the wealth of the owners.

12 Faculty of Finance & Banking

12

6
 3. Internal Rate of Return (IRR)
The discount rate that forces a project’s NPV to equal zero.

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑁

𝑁𝑃𝑉 = 𝐶𝐹0 + 1
+ 2
+. . . + 𝑁
=0
1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅
𝑁
𝐶𝐹𝑡
0=෎ 𝑡
1 + 𝐼𝑅𝑅
𝑡=0

13 Faculty of Finance & Banking

13

3. Internal Rate of Return (IRR)

Project S

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4

𝑁𝑃𝑉 = 𝐶𝐹0 + 1
+ 2
+ 3
+ 4
=0
1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅

14 Faculty of Finance & Banking

14

7
 3. Internal Rate of Return (IRR)
Project L

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4

𝑁𝑃𝑉 = 𝐶𝐹0 + 1
+ 2
+ 3
+ 4
=0
1+𝑟 1+𝑟 1+𝑟 1+𝑟

Excel: =IRR(CF0:CFn,guess for rate)

15 Faculty of Finance & Banking

15

3. Internal Rate of Return (IRR)

The decision rules

➢ Independent projects: If IRR exceeds the project’s WACC, accept the

project. If IRR is less than the project’s WACC, reject it.

➢ Mutually exclusive projects: Accept the project with the highest IRR,
provided that IRR is greater than WACC. Reject all projects if the best
IRR does not exceed WACC.

16 Faculty of Finance & Banking

16

8
 4. Multiple Internal Rate of Return
The situation where a project has two or more IRRs.

Example: Project P has the following cash flow:

0 WACC = 10% 1 2

-800 5.000 -5.000

NPV = -$386,78 < 0

IRR1 = 25%

IRR2 = 400%

17 Faculty of Finance & Banking

17

4. Multiple Internal Rate of Return

NPV

IRR2 = 400%
450

0 WACC
100 400

IRR1 = 25%
-800

18 Faculty of Finance & Banking

18

9
 5. Modified Internal Rate of Return (MIRR)
The discount rate at which the present value of a project’s cost is equal to
the present value of its terminal value, where the terminal value is found
as the sum of the future values of the cash inflows, compounded at the
firm’s cost of capital.

Initial Cost After-Tax, End-of-Year Cash Inflows, CFt

Year 0 1 2 3 4
Project S -1.000 500 400 300 100
Project L -1.000 100 300 400 675
WACC for both projects is 10%.
19 Faculty of Finance & Banking
19

5. Modified Internal Rate of Return (MIRR)

The decision rules

➢ Independent projects: If MIRR > Required rate of return, accept projects.

➢ Mutually exclusive projects: Accept the project with the highest MIRR.

20 Faculty of Finance & Banking

20

10
 NPV, IRR & MIRR
Independent projects: the NPV, IRR, and MIRR always reach the same
accept/reject conclusion
→ the three criteria are equally good when evaluating independent projects.
Mutually exclusive projects that differ in size: the NPV is best because it
selects the project that maximizes value.
→ The MIRR is superior to the regular IRR as an indicator of a project’s
“true” rate of return
→ NPV is better than IRR and MIRR when choosing among competing
projects.
21 Faculty of Finance & Banking
21

6. Payback period
The length of time required for an investment’s cash flows to cover its cost.

Calculated by adding project’s cash inflows to its cost until the cumulative
cash flow for the project turns positive.

Number of years Unrecovered cost at start of year

Payback = +
prior to full recovery Cash flow during full recovery year

22 Faculty of Finance & Banking

22

11
 6. Payback period

Initial Cost After-Tax, End-of-Year Cash Inflows, CFt

Year 0 1 2 3 4
Project S -1.000 500 400 300 100
Project L -1.000 100 300 400 675

23 Faculty of Finance & Banking

23

6. Payback period
Project S

Year 0 1 2 3 4

Cash flow -1.000 500 400 300 100

Cumulative cash flow

Payback =

24 Faculty of Finance & Banking

24

12
 6. Payback period
Project L

Year 0 1 2 3 4

Cash flow -1.000 100 300 400 675

Cumulative cash flow

Payback =

25 Faculty of Finance & Banking

25

6. Payback period
The decision rule

➢ Independent projects: Accept if the payback period is less than some

preset limit

➢ Mutually exclusive projects: The shorter the payback, the better the
project

26 Faculty of Finance & Banking

26

13
 6. Payback period
Three flaws of the PP method

1. Ignores the time value of money

2. Ignores CFs occurring after the payback period

3. No necessary relationship between a given payback and investor

wealth maximization

27 Faculty of Finance & Banking

27

6. Payback period
Discounted Payback

The length of time required for an investment’s cash flows, discounted at the
investment’s cost of capital, to cover its cost.

Compute the present value of each cash flow and then determine how long it
takes to pay back on a discounted basis

Although the payback methods have faults as ranking criteria, they do provide
information about liquidity and risk

Decision Rule – same as PP

28 Faculty of Finance & Banking

28

14
 6. Payback period
Discounted Payback - Project S

Year 0 1 2 3 4
Cash flow -1000 500 400 300 100
Discounted cash flow
Cumulative discounted cash flow

Discounted Payback =

29 Faculty of Finance & Banking

29

6. Payback period
Discounted Payback - Project L

Year 0 1 2 3 4
Cash flow -1.000 100 300 400 675
Discounted cash flow
Cumulative discounted cash flow

Discounted Payback =

30 Faculty of Finance & Banking

30

15
 Summary
We should consider several investment criteria when making decisions

NPV and IRR are the most commonly used primary investment criteria

Payback is a commonly used secondary investment criteria

31 Faculty of Finance & Banking

31

End of Chapter 6

Financial management

32

16