Chapter 10

The Basics of Capital

Budgeting: Evaluating Cash
Flows.
Learning Objectives November 09,2020.
 Definition of Capital Budgeting.
 Corporate Valuation and Capital Budgeting.
 Various types of the projects.
 Project evaluation criterias.
 Detail discussion of the merits and demerits of
the project evaluation criterias.
 Other issues in Capital Budgeting.
Definition of Capital Budgeting.
 The term the Capital Budgeting is comprised of two words,
one is the capital, and it refers to the long-term assets that
are used in production.
 Budget is a process that outlines projected expenditure in
future. So, capital budget, is planned investments in the
assets that last for more than one year.
 Thus capital budgeting is the whole process of analyzing
projects and deciding which ones to be accepted and thus
to be included in capital budget.
 In this chapter we will cover the methods that companies
use to evaluate the projects.
 The strengths and weaknesses of these methods are also
discussed along with other issues that arise in capital
budgeting process.
Corporate Valuation and Capital
Budgeting.
An Overview of Capital Budgeting
 The projects are of different kinds and require different
set of skills, efforts and time for their evaluation.
 The projects within firms can be categorize in following
ways.

 Replacement needed to continue profitable operation.

 Replacement to reduce costs.
 Expansion of existing products or markets.
 Expansion into new products or markets.
 Contraction decisions.
 Safety and/or environmental projects.
 Mergers
Continued…
 The projects are screened out using the following
methods.
The First Step in Project Analysis.
 The firm is GPC and we want to evaluate two of its
projects, S and L, (details are given in the section 10-2).
 We are not discussing as yet the estimation of cash
flows of the projects.
 Further, as we know that the projects are evaluated as
per project’s risk-adjusted cost of capital rather than the
WACC of the firm.
 Both the cash flows and risk-adjusted cost of capital of
the project are discussed in detail in Chapter 11.
 For the project evaluation we assume that the cash flows
of both of the projects are estimated already, and the
cost of both the projects is 10%.
Continued…
Net Present Value (NPV).
 The net present value is defined as the present value of
a project’s expected cash flows discounted at the
appropriate risk adjusted rate.
 The NPV measures how much wealth the project
contributes to shareholders.
Continued…
 Applying the equation 10-1 to the project S, we have:

 In above equation the cash flows CFt, associated with

the projects are discounted using, the cost of the
projects and the cash flows related timing.
 The initial cost flow is negative, as it shows project
related initial investments, such as buying of equipment,
product development etc.
 The NPV is simply solution of the initial outflow plus the
PV value of the future cash flows.
Continued…
Applying NPV as an Evaluation Measure
 Before using the NPV decision process, we need to
know whether Projects S and L are independent or
mutually exclusive.
 The cash flows of the independent projects are not
affected by each other. Therefore, if both of the projects
are independent then both positive NPV projects are
accepted.
 If two projects are mutually exclusive the one project is
accepted then other is rejected.
 The project with higher positive value is accepted.
 What if project S and L are independent.
 What of project S and L are mutually exclusive.
Self-Test
Internal Rate of Return (IRR).
 IRR and YTM, the relationship.
 The PV of all cash flows equal to the initial project out
flow.
 This is equivalent to the forcing the NPV of the project
equal to zero.
 Why the IRR is important and what kind of information
about project it give.
 IRR is an estimate of the projects rate of return, if it is
higher than the cost of the project, then it benefits the
shareholders.
 If IRR is lesser than the project cost, then the shortfall
has to make up by the shareholders.
Calculating the IRR
The Procedure of Calculating IRR
 There are three ways in which IRR can be calculated.
Finding the IRR
A potential Problem with the IRR:
Multiple Internal Rates of Return.
 If the project has a normal cash flow, like one or more
cash outflows followed only by cash inflows (or the
reverse), the project can have only one positive real IRR.

 However, some projects have cash flows changed more

than once, these nonnormal cash flow pattern such as,

 Then the project may have multiple IRRs. Lets assume

the following nonnormal cash flows,
Continued…
 Now we can find the IRR as under,

 To find, IRR we need to have NPV=0, and this we

achieve for the two values IRR, such as, 25% and
400%.
 Are either of these IRR are helpful, no. In fact
whenever the cash flows of the projects are
nonnormal, the use of IRR becomes useless.
 By creating the NPV profile one can learn about the
IRRs.
Continued…
 Graphs for the Multiple IRRs.
Potential Problems When Using the IRR
to Evaluate Mutually Exclusive Projects.
 Potential problem for using IRR comes when the projects
are mutually exclusive, not for independent projects.
 Lets take the example of the project S and L that we
have used so, far

 If using NPV as a decision criterion, the Project L is

preferred, But project S is preferred if using IRR.
 How do we resolve this conflict ?
Figure 10-5
 NPV profile of the project L and S.
The Causes of Possible Conflicts Between
The IRR and NPV for Mutually Exclusive
Projects: Timing and Scale Differences
 To understand the causes of the differences between
IRR and NPV based projects, we need to graph the net
present value profile for each project.
 The net present value profile is a graph between the
NPVs of the projects on the y-axis for the given cost of
the projects shown on the x-axis.
 The each project IRR will cross the x-axis when NPV=0.
 Now for our project S the IRR is at the right side of
project L.
 Whereas, the NPV of the project L, when r = 10 is higher
than the project S.
Continued…
 There is a crossover rate as well, where the NPVs of the
both projects cut each other.
 The crossover is the IRR of the difference of the cash
flows of both projects.

 If the project cost of capital r is lesser than crossover

rate, then the project L has higher NPV then the project
S. But if the cost of the project is higher than crossover
rate, the NPV of the project S is higher than the NPV of
the project L.
Timing of the Cash Flows
 Many projects do not have different ranking, that is, the
project that has higher NPV also has higher IRR.
 If the conflict exist, the both projects must have positive
cash flows and there must be crossover rate.
 For the crossover rate to exist, the difference in the cash
flows must have normal pattern, such that IRR exists.
 The crossover rate can only exists when the projects
have positive NPVs and cash flows have timing
differences, size (or scale) differences. For example,
Continued….
 The Both projects have the same scale that is, the initial
investment is the same, therefore the difference is zero.
 However, project sooner has the most of the future cash
flow in year 1, and the project later has the most of the
cash flow is the year 2.
 Essentially there is only one change in the future cash
flows of both of the projects. Therefore, the crossover
rate exists.
 This indicates that the project with the same scale must
have the timing differences in the future cash flows. This
is a must condition to have just one change in the sign of
the difference in the cash flows of the projects.
Difference of the Scales.
 If the project do not have the timing differences but have
the scale difference. Such as,

 The difference in the scale causes the initial difference to

be positive.
 However, the difference in the future cash flows are
negative, but the sign only changes once, therefore
crossover rate exist.
 In both examples of difference in timing of cash flows
and as of scaled difference, the cost of capital is 10%
Applying IRR as an Evaluation Measure.
 When the projects are independent then both the IRR
and NPV have the same verdict.
 For instance, in the figure 10-5, IRR says accept the
projects whose cost of project is lesser than IRR.
 As for the cost of capital lesser than IRR, the NPV of the
project is positive. Resultantly, all project with cost of
capital lesser than 14.686% are to be accepted. Same is
the case with project L.
 Now when S and L are mutually exclusive then, if IRRs >
IRRL , now IRR rule says to accept the project S, but that
is only possible, if the cost of capital is higher than
crossover rate. No conflict situation.
 Conflict only exist when COC is lower than crossover
rate.
Figure 10-5 Again.
Self-Test
Modified Internal rate of Return (MIRR)
 The equivalence between IRR and YTM means that the
project related cash flows are reinvested in the IRR, to
get the return on the project.
 This may inflate the project related rate of return, the
better strategy be, that the project cash flows are
reinvested in the COC.
 The Modified IRR (MIRR) is similar to the regular IRR,
except it is based on the assumption that cash flows are
reinvested at the WACC.
 The calculation of the MIRR is explained on the next
slide, there are three excel based functions that can be
used to estimate the value of MIRR.
 Present value calculation, RATE() and MIRR()
Figure 10-6, Finding the NIRR fro
Projects S and L.
Explanation of the Figure
 The following steps are required to calculate MIRR
shown in the previous table.
The Advantages of MIRR over IRR.
 The MIRR has two significant advantages over IRR,
 First the MIRR assumes that cash flows are reinvested in COC.
 Second, MIRR eliminates the issue of the multiple IRR.
 MIRR is better than IRR but still not better than NPV.
 For the independent projects, the NPV, IRR, and MIRR
always reach the same conclusion.
Self-Test for MIRR
Profitability Index (PI)
 The fourth method is profitability index and it is
calculated as under.

 The ratio PI indicates the relative profitability of any

project, or the present value per dollar of initial cost.
 For instance, the project S, has the present value of its
expected cash flows equivalent to, $10,804.33, the initial
cost of the project is, $10,000. Therefore, PI will be
1.0804.
 This the project S is expected to produce $1.0804 of the
present value for the each dollar invested.
Continued…
 Similarly, for the project L, the PI is $1.1048. Therefore,
the return on $1 is higher for the project L.
 The following table shows the calculation of the PI for the
both projects.
Continued…
 PI and the acceptability of the projects and the
comparison with NPV, IRR, MIRR.

 The Self-Test
Payback Period.
 Historically, the Payback Period was the most common
measure to evaluate the project.
 It intrinsically gauges the number of years required to
recover the amount invested in the project from its
operating cash flows.
 It is estimated such as the initial outflow is added to first
cash flow, then the remainder is added to other cash
flows, these cumulative cash flow are noted.
 The payback year is the year prior to the full recovery,
plus a fraction equal to shortfall, at the end of prior year
(when the cumulative cash flow gets positive), is then
divided by the cash flow during the year when the full
recovery is made.
Continued….
 The following formula is used to compute the PP.

 The Calculation of the PP for the project S is shown in

the following figure
Mistaken Figure
Continued…
 The shorter the payback period, better the project is,
here the project S has payback period of 2.21 and the
project L has a payback period of 3.39.
 Therefore, the project S will be selected.
 The regular payback has three flaws:
 Dollars received in different years are all given same weights.
 The cash flows beyond the payback year are given no
consideration.
 Unlike NPV or IRR, which tell us how much wealth a [project
adds or how long it takes to recover our investment. There is no
necessary relationship between given payback period and
investor wealth.
Continued…
 To, counter the first drawback, there is another technique
that rely on the discounted payback.
 The cash flows are discounted by the project related
CoC, then these discounted cash flows are used to find
the discounted payback period.
Figure 10-9, Discounted Payback.
How to Use the Different Capital
Budgeting Methods. (April 21, 2020)
 One of the impression that emerges is that the NPV is
the only project evaluation criteria that is used.
 However, as a matter of fact, all of six evaluation
methods are used and each evaluation criteria has
something to add.
 For instance, IRR, MIRR and PI, inform about “safety
margin”.
 For example, two projects SS and LL are mutually
exclusive, the WACC of both is 10%.
 The cost of SS is $10,000 and of LL is $ 100,000.
Whereas, the return on the SS is $16,650 and on LL is $
115,550. The IRR of SS is 65% and of LL is 15.6%.
Continued…
 However, NPV of SS is $5,000 and of LL is $5,045, By
NPV rule the project LL is accepted.
 For instance, if cash flow is decreased by 39% even then
SS can still recover its initial investment of $10,000.
 Whereas, if cash flow is decreased by only 13.5%, the
project LL cannot recover even the initial investment.
 Similarly, MIRR avoids multiple rates related issues of
IRR, it further uses more realistic rate for the
reinvestment Income.
 PI, for SS project is 1.50 and for LL, the PI is 1.05. So,
like IRR, the PI also alludes about the security margin.
 Whereas, the payback and discounted payback, indicate
the project’s illiquidity and risk.
Some explanation of previous slides.
 The project SS has an initial outlay of $10,000 and the WACC
is 10%. The cash it receives is $16,500 at t = 1.
 Now IRR equates the outflow with the present value of the
inflow, that is, $10,000 = $16,500/(1 + IRR), solving for IRR =
65%. On the other hand the NPV and PI are NPV = -$10,000
+ $16,500/(1 + WACC) = $5,000 and the PI = PVss/$10,000 =
$15,000/$10,000 = 1.50.
 What is the safety margin of the project SS, this can be
explained by IRR, for instance if the cash flows are reduced
by 39%, the project will still survive the initial cost such as,
10,000 x 1.65 x (1 -.39) = 10,065/-.
 Although the NPV of project LL is $5,045, but the project does
not have the safety margin of 13.5%. As the IRR of this
project is only 15.6%. That is, 100,000 X 1.15 X (1 - .135) =
99,475.
The Sources of Project’s NPV.
 Are these evaluation criteria's enough for the success of the
projects. Is the managerial input also essential?
 The managerial input is essential, as the projects with the
higher NPV, IRR and PI, needs to explain the underlying
ingredients of their success in the competitive business
conditions.
 One of the main reason for the positive NPV project is market
imperfection. The longer it exists, more chances are there that
the project will give positive returns.
 The valid explanations include patents or proprietary
technology. Keep in mind the Microsoft, Apple and other
pharmaceutical firms.
 Companies can also create Positive NPV by being the first
entrant into new market or by creating new products that meet
some previously unidentified needs of the customers.
Continued…
 The following paragraph from the book is reproduced to
summarize the source of positive NPV projects.
Other Issues in Capital Budgeting.

 The other issues that are required to be

discussed are:
 How to deal with the mutually exclusive
projects whose lives differs.
 The potential benefits of the termination of
the projects before its physical life.
 The optimal capital budget when the cost
of capital rises as the size of the capital
budget increases.
Mutually Exclusive Projects with Unequal Lives.
 When choosing between the two mutually exclusive
projects with different lives some adjustments are
required to be made.
 Lets assume that we have two projects C and F, the NPV
of the project C is $6,491 and for the project F, the NPV
is $5,155.
 The IRR of the project C is 17.5% and for the project F
the IRR is 25.2%.
 On the basis of NPV, the project C is destined to be
accepted but, the project C has a life of 6 years, whereas
the project F has the average life of 3 years.
 How to compare these projects. There are two
approaches that are usually used.
Replacement Chains
 The key to the replacement chain, the common life approach,
is to analyze both projects over an equal life.
 The project C has 6 years of life, and the project F has 3
years of life, now we assume that the project F is repeated
after 3 years to make its life equal to 6 years.
 Our assumptions for the project F would be that i) Project F’s
cost and annual cash inflows will not change if the project is
repeated in 3 years and ii) the cost of the project will also
remain same, that is, 12%.
 Now the NPV of this extended project F is $8,824 and it is
now higher than project C’s NPV of $6,491. So, on the basis
of common life the project F is selected.
 Alternatively, the NPV of project F with 3 years of life is
$5,155. Now if after 3 years NPV is also $5,155, finds its PV
at time t = 0, and add it back to $5,155.
Working of the Replacement Chains.
Second Method: Equivalent Annual
Annuities (EAA)
 In

  annual annuities method, we find the constant cash flows
that may emanate from the projects over their respective
lives.
 We first find the constant payment for the project C over the 6
years. The NPV of the project is $6,491, the cost of the
project is 12% and number of payments are 6. Using the
following formula for the constant payment.

 Using the above information for the formula, the constant

payment becomes $1579 for the project C. For project F this
constant payment is $2,146.
 The project F, therefore produce higher cash flows in 6 years.
Conclusion about Unequal Lives.
 Again unequal lives of the projects only matter if they are
mutually exclusive and their lives significantly differ.
 Even for the mutually exclusive projects, it is not always
appropriate to extend the analysis for the common life, till
the time there is no high probability that projects will be
extended by the end of their initial lives.
 The issues that are encountered when the projects are
intended to be extended are, inflation, the replacement of
equipment with higher prices, sales prices and operating
prices would be changed, change in technology.
 Despite of the shortcoming cited above, the replacement
chains method is used, as it being easily implemented and
other modifications can be implemented using computer.
Economic Life versus Physical Life.
 It is always beneficial to evaluate the project before its
physical expiry, or well before its potential physical life.
 For instance, if the life of the project is 3 years then it can
be terminated at the end of any year and the assets are
sold at their salvation value.
 As, the intended life of the project is 3 years, therefore we
can find the NPV of this project for all 3 years.
 In the figure shown in the next slide, we find the PV of the
cash flows of the project for the three years, further the PV
of the salvage value of the project is also estimated.
 The project NPV is maximum if the project is terminated at
year 2, these type of analysis determine the project
economic life. That is the life that maximizes the NPV and
thus the value of the shareholders wealth.
Explanation of Economic Life of the
Project.
 Economic life versus Physical Life.
The Optimal Capital Budget.
 Optimal capital budget is the set of those projects that
maximizes the value of the firm.
 As firm only accepts those projects that add positive
value to the firm.
 However, in practice two complications arise such as,
 The cost of the capital might increase as the size of
the capital budget increases, making it hard to know
the proper discount rate to use when evaluating
projects.
 Sometimes firms set an upper limit on the size of their
capital budget, which is also known as capital
rationing.
An Increasing Cost of Capital
 The cost of the capital may increase as the capital
budget increase and it is known as marginal cost of the
capital.
 The cost of capital increases, if the firm has exhausted
all of its internally generated cash, and must sell
common shares and seek additional debt capital.
 It means that the project might be positive NPV when the
capital budget was $10 million, but it may turn out to be a
negative NPV, when the capital budget is $20 million.
 If the firm encounter such situation then the analysis
based on the Investment Opportunity Schedule (IOS)
and the Marginal Cost of Capital (MCC) has to be
conducted.
Continued….
 First of all the projects are to be ranked in terms of their
IRR (or MIRR), from higher IRR to lower IRR, these IRR
has to be placed in y-axis. Whereas, the cumulative cost
on the x-axis. This part is known as Investment
opportunity schedule, IOS.
 Secondly, we need to find the WACC associated with the
increasing cost. As WACC increases then we can
understand the size of budget when it becomes costly to
raise the capital for the execution of the project. This part
is known as Marginal Cost of Capital, MCC.
 The intersection of the IOS and MCC schedules
indicates the amount of capital the firm should raise and
invest.
IOS and MCC Schedules.
Capital Rationing
 The capital rationing is a strategy in which a firm let go
many positive NPV projects. This strategy obviously
goes against finance theory.
 Why the firms forgo value-added projects,
 Reluctance to issue new stock.
 Higher floating cost.
 Equity is overvalued (signal)
 Avoidance of sharing firm’s related information.
 Constraints on nonmonetary resources.
 Sometimes firms do not take positive NPV as they lack internal
capacity, such as, managerial, marketing and engineering.
 Controlling estimation bias.
 Managers tend to overestimate the cash flows, to control that the
firms limit the size of the capital budgets.