Capital Budgeting

Dr. Bulent Aybar

Professor of International Finance
 Capital Budgeting Agenda

• Define the capital budgeting process, explain the

administrative steps of the process and categorize the capital
projects which can be evaluated
• Summarize and explain the principles of capital budgeting,
including the choice of the proper cash flows and the
identification of the proper discount rate.
• Explain the implications of:
– (1) independent versus mutually exclusive projects,
– (2) project sequencing, and
– (3) unlimited funds versus capital rationing

© Dr. C. Bulent Aybar

• Explore widely used capital budgeting techniques such as
– Net Present Value (NPV),
– Internal Rate of Return (IRR),
– Payback Period,
– Discounted Payback Period,
– Average Accounting Rate of Return (AAR), and
– Profitability Index (PI)

• Explain the NPV profile, compare and contrast the NPV

and IRR methods when evaluating more than one capital
project, and describe the multiple IRR problem and no-IRR
problems that can arise when calculating an IRR.
© Dr. C. Bulent Aybar
• Describe the relative popularity of the various capital
budgeting methods and explain the importance of the NPV
in estimating the value of a stock price.

© Dr. C. Bulent Aybar

 Capital Budgeting Process

• Generating ideas—the most important part of the process.

• Analyzing individual proposals—including forecasting cash
flows and evaluating the project.
• Planning the capital budget—this will take into account a
firm’s financial and real resource constraints; it will decide
which projects fit into the firm’s strategies.
• Monitoring and post-auditing—comparing actual results
with predicted results and explaining the differences. This is
very important; it helps improve the forecasting process and
focuses attention on costs or revenues that are not meeting
expectations.
© Dr. C. Bulent Aybar
 Capital Budgeting Process

Review Implementation
Proposal Decision
& and
Generation Making
Analysis Follow-up

is the formal process of Decision making is the Implementation of the project

Proposal Generation
assessing the step where the proposal is begins after the project has
is the origination of proposed
appropriateness and compared against been accepted and funding is
capital projects for the firm by
economic viability of the predetermined criteria and made available.
individuals at various levels of
project in light of the either accepted or Follow-up is the post-
the organization. firm’s overall objectives. rejected. implementation audit of
This is done by expected and actual costs and
estimating cash flows revenues generated from the
arising from the project project to determine if the
and evaluating them return on the proposal meets
through capital budgeting pre-implementation projections
techniques. Risk factors
are also incorporated into
the analysis phase.
 Project Classifications
• Replacement, when the maintenance of business requires the
replacement of equipment or when cost savings are possible if out-of-
date equipment is replaced. These replacement decisions are often
amenable to very detailed analysis, and you might have a lot of
confidence in the final decision.
• Expansion of existing products or markets- expansion decisions may
involve more uncertainties than replacement decisions, and they should
be more carefully considered.
• New products and services- these decisions are more complex and will
involve more people in the decision - making process.
• Regulatory, safety and/or environmental projects, in many cases these
are mandatory projects.
• Others-pet projects or high risk projects such as major R&D efforts
which may be difficult to analyze by using standard techniques
© Dr. C. Bulent Aybar
 Basic Assumptions in Capital Budgeting
• Decisions are based on cash flows and not accounting profits. Intangibles
are often ignored since it is assumed that the benefits or costs will
eventually be reflected in cash flows.
• Timing of cash flows is critical.
• Cash flows incorporate opportunity costs. We use incremental cash
flows; these are the total cash flows that occur as a direct result of taking
on a specific project.
• Cash flows are on an after-tax basis; taxes should be incorporated in the
analysis
• In the analysis we use cash flows that accrue to the project that is used to
pay the capital providers to the project.
• Financing costs are ignored in the cash flows as they are accounted for in
the weighted-average cost of capital being used to discount the cash
flows.
© Dr. C. Bulent Aybar
 Important Capital Budgeting Concepts

• Sunk costs
– These refer to costs that have already been paid or been committed to, regardless of whether a
project is taken on or not. For instance, consulting fees paid to prepare a report on the feasibility of
a project is a sunk cost! These should not to be included as a cost.

• Opportunity costs
– These refer to the cash flows that could be generated from an asset if it was not used in the project.
For example, if a project is going to use premises that could be used for other purposes by the
company. Opportunity costs should be taken into account in the cash flows used.

• Externalities
– The impact of a project on other parts of a firm should be taken into account, whether positive or
negative. This includes cannibalization, when sales of another side of the firm will be switched to
the new area if a new project goes ahead.

• Conventional versus nonconventional cash flows

– A conventional cash flow pattern is when you see negative cash flows for the first year (or longer)
representing initial outlays, followed by a series of cash inflows. Unconventional cash flows occur
when inflows change to outflows again, or vice versa, if this happens two or more times it is
unconventional.
© Dr. C. Bulent Aybar
Incremental Cash Flow Concept and Replacement Decisions
Conventional & Non-Conventional Cash Flows
Conventional Cash Flows

Non-Conventional Cash Flows

 Independent and Mutually Exclusive Projects

• Independent projects are projects whose cash flows are

independent of each other. If projects meet the set criteria,
they can be implemented provided that they are within the
resource constraints of the firm.
• Mutually exclusive projects compete directly with each
other. For example, if Projects A and B are mutually
exclusive, you can choose A or B, but you cannot choose
both.
• Sometimes there are several mutually exclusive projects, and
you can choose only one from the group.

© Dr. C. Bulent Aybar

 Project Sequencing

• Many projects are sequenced through time so that investing

in a project creates the option to invest in future projects.
• For example, you might invest in a project today and then in
one year invest in a second project if the financial results of
the first project or new economic conditions are favorable.
• If the results of the first project or new economic conditions
are not favorable, investment in the second project is
avoided.

© Dr. C. Bulent Aybar

 Capital Rationing

• If the firm has unlimited funds for making investments, then

all independent projects that provide returns greater than
some specified level can be accepted and implemented.
– The accept-reject approach involves the evaluation of capital
expenditure proposals to determine whether they meet the firm’s
minimum acceptance criteria.

• However, in most cases firms face capital rationing

restrictions since they only have a given amount of funds to
invest in potential investment projects at any given time.
– The ranking approach involves the ranking of capital expenditures
on the basis of some predetermined measure, such as the rate of
return. The funds must be allocated to achieve the maximum
shareholder value subject to the funding constraints.
© Dr. C. Bulent Aybar
 Capital Budgeting Methods

• Net Present Value (NPV),

• Internal Rate of Return (IRR),
• Payback Period,
• Discounted Payback Period,
• Average Accounting Rate of Return (AAR), and
• Profitability Index (PI)

© Dr. C. Bulent Aybar

 NPV Method

• For a simple project with one investment outlay, made

initially, the net present value (NPV) is the present value of
the future after - tax cash flows minus the investment outlay,
or :

INVESTMENT RULE: Invest if NPV>0 //Do not invest if NPV<0

© Dr. C. Bulent Aybar

 A more general model for NPV

• Many investments have cash flow patterns in which outflows

may occur not only at time 0, but also at future dates. It is
useful to consider the NPV to be the present value of all cash
flows:

© Dr. C. Bulent Aybar

 Characteristics of NPV

• NPV measures present value of a project’s expected cash-

flow stream at its cost of capital.
– PV of cash flows essentially estimate how much the project would
sell for if a market existed for it

• NPV of an investment project represents the immediate

change in the wealth of the firm’s owners if the project is
accepted
– If positive, the project creates value for the firm’s owners; if
negative, it destroys value

• The NPV rule takes into consideration the timing of the

expected future cash flows. The method attributes higher
value to earlier cash flows.
© Dr. C. Bulent Aybar
Timing Matters : Projects with Equal Total Cash Inflows

• Assume that both projects require $1m cash outflow at time

T=0. Do projects A and B worth the same?

Year Project A Project-B

0 (1,000,000) (1,000,000)
1 800,000 100,000
2 600,000 200,000
3 400,000 400,000
4 200,000 600,000
5 100,000 800,000
Total Cash Inflows 2,100,000 2,100,000

© Dr. C. Bulent Aybar

Mutually Exclusive Projects with Equal Total Cash Inflows

Year Project A Project-B

0 (1,000,000) (1,000,000)
1 800,000 100,000
2 600,000 200,000
3 400,000 400,000
4 200,000 600,000
5 100,000 800,000
Total Cash Inflows 2,100,000 2,100,000
Cost of Capital 10% 10%
Project NPV $722,361.24 $463,269.40

Both project A and B generate total cash inflows of $2.1m and cost $1m.
However, project A generates larger inflows at the early stages of project
as compared project B. NPV method favors project A over project B.
 NPV ignores embedded options in the project

• A project that can adjust easily and at a low cost to

significant changes such as:
– Marketability of the product
– Selling price
– Risk of obsolescence
– Manufacturing technology
– Economic, regulatory, and tax environments
• Flexibility is likely to contribute more to the firm value, but
NPV method does not account for managerial options that
can be exercised during the useful life of the project. In
other words, NPV underestimates the value of projects with
significant flexibility options.
© Dr. C. Bulent Aybar
 Internal Rate of Return

• The internal rate of return (IRR) is one of the most

frequently used techniques in capital budgeting and in
security analysis. The IRR is the rate of return that makes
the present value of the future after - tax cash flows equal to
investment outlay.
• In other words, the IRR is the solution to the following
equation:

© Dr. C. Bulent Aybar

 IRR for Projects A and B

Year Project A Project-B

0 (1,000,000) (1,000,000)
1 800,000 100,000
2 600,000 200,000
3 400,000 400,000
4 200,000 600,000
5 100,000 800,000

IRR for project A will be the rate of return that satisfies the
following equation:.

800, 000 600, 000 400, 000 200, 000 100, 000
1, 000, 000 0
(1 IRR) (1 IRR) 2 (1 IRR)3 (1 IRR) 4 (1 IRR)5

Note that algebraically, this equation would be very difficult to solve. We

normally resort to trial and error, systematically choosing various
discount rates until we find one, the IRR, that satisfies the equation.
 IRR Solution by Using Excel
• We can solve the IRR by using Excel in a
number of ways. One easy solution is to
use IRR function.
• Simply type @IRR in excel and select the
input variables:
• @IRR(Cash Flow Range, rate)
• Rate can be an arbitrary rate of return, any
number will work
• Cash Flow range should include all the
cash flows of the project. Cash outflows
should have a negative sign, and inflows
should have a positive sign.
• IRR has a built in algorithm which starts
with the rate you enter and reaches to
IRR.
© Dr. C. Bulent Aybar
• We can also solve for IRR by using NPV function and Goal
Seek. We can calculate the NPV in a sell by using cost of
capital as rate of return.
• Then ask Goal Seek to set the NPV function to value zero by
changing cost of capital/rate of return.
• Goal seek produces the rate of return that equates the NPV
of the project to zero which is by definition the IRR of the
project.

© Dr. C. Bulent Aybar

 IRR for Project A

Net Present Value vs Rate of Return

$1,000,000.00

$800,000.00

$600,000.00
Net Present Value

IRR=47% , Discount rate when NPV=0

$400,000.00

$200,000.00

$0.00
0.325

0.75
0.05

0.15

0.25

0.35

0.45

0.55

0.65

0.85
0.075
0.1
0.125

0.175
0.2
0.225

0.275
0.3

0.375
0.4
0.425

0.475
0.5
0.525

0.575
0.6
0.625

0.675
0.7
0.725

0.775
0.8
0.825

0.875
0.9
($200,000.00)

($400,000.00)
Expected Rate of Return/Discount Rate

Graphically IRR is the rate of return at the point the line crosses the
horizontal axis. At this point NPV=0  INVESMENT RULE: Invest
when IRR>Cost of Capital
 The IRR Rule

• An investment should be accepted if its IRR is higher than

its cost of capital and rejected if it is lower
• If a project’s IRR is lower than its cost of capital, the project
does not earn its cost of capital and should be rejected

© Dr. C. Bulent Aybar

 Is IRR a good investment decision Rule?

• Adjustment for the timing of cash flows?

– Considers the time value of money

• Consider investments A and B

– Investment A is preferable to B because its largest cash flow occurs
earlier
– IRR rule indicates the same preference as NPV because the IRR of
investment A (47% percent) is higher than the IRR of investment B
(22 percent)

• An important limitation of IRR is the assumed re-investment

rate. IRR assumes that cash inflows can be reinvested at the
IRR. This may overstate the viability of the project!
© Dr. C. Bulent Aybar
IRR like NPV accounts for the timing of the cash flows

Year Project A Project-B

0 (1,000,000) (1,000,000)
1 800,000 100,000
2 600,000 200,000
3 400,000 400,000
4 200,000 600,000
5 100,000 800,000
Cash Inflows 2,100,000 2,100,000
Cost of Capital 10% 10%
Project NPV $722,361.24 $463,269.40
IRR 47% 22%
 The Payback Period

• A project’s payback period is the number of periods required

for the project’s cash flows to recover its initial cash outlay
• According to this rule, a project is acceptable if its payback
period is shorter than or equal to the cutoff period
• For mutually exclusive projects, the one with the shortest
payback period should be accepted.
• Payback period is usually measured in years

© Dr. C. Bulent Aybar

Expected and Cumulative Cash Flows for Investment A

A’s cash outlay

was $1,000,000.
This amount is
fully recovered
at the end of
year 3.

Payback Period= 3 years

It takes three years for the project cash flows to fully
recover the initial outlay!
 Another Example

0 1 2 3 4 5

(1,000,000) 325,000 325,000 325,000 325,000 325,000

Cumulative Cash Flows 325,000 650,000 975,000 1,300,000 1,625,000

In the above example, the initial investment is recovered somewhere between

3rd and 4th year. 975,000 of 1m initial outlay is recovered in year 3. Only 25,000
Is recovered in year 4. The total cash inflows in year 4 is 325,000. This means
that it takes about 25,000/325,000 =0.076 yrs to recover the remaining amount.
The payback period then is expressed as 3+0.076=3.076 yrs.
 The Payback Period Rule

• Does the payback period rule meet the conditions of a good

investment decision?
– Adjustment for the timing of cash flows?

• Ignores the time value of money ;

• Timing of cash flows are not considered; projects with
early large cash flows are favored
– Adjustment for risk?

• Ignores risk! Low risk and high risk projects may

have equal payback periods

© Dr. C. Bulent Aybar

 Maximization of the firm’s equity value?

• No objective reason to believe that there exists a particular

cutoff period that is consistent with the maximization of the
market value of the firm’s equity
– The choice of a cutoff period is always arbitrary
– The rule is biased against long-term projects

© Dr. C. Bulent Aybar

 Flaws of PB Period: Payback Period and NPV

Note that payback period favors project A, which is a negative NPV

project! It also favors Project D over Project E, which has much
larger NPV.
Why Do Managers Use the Payback Period Rule?

– Simple and easy to apply for small, repetitive investments

– Favors projects that ―pay back quickly‖ ; Contribute to the firm’s
overall liquidity (Can be particularly important for small firms)
– Makes sense to apply the payback period rule to two investments that
have the same NPV
– Because it favors short-term investments, the rule is often employed
when future events are difficult to quantify such as for projects
subject to political risk

© Dr. C. Bulent Aybar

 The Discounted Payback Period
• The discounted payback period, or economic payback period is the
number of periods required for the sum of the present values of the
project’s expected cash flows to equal its initial cash outlay
• Compared to ordinary payback periods discounted payback periods are
longer . It may result in a different project ranking
• The discounted payback period rule says that a project is acceptable if its
discounted payback period is shorter or equal to the cutoff period
• Among several projects, the one with the shortest period should be
accepted

© Dr. C. Bulent Aybar

 The Discounted Payback Rule

• Does the discounted payback period rule meet the conditions

of a good investment decision?
– Adjustment for the timing of cash flows?

• The rule considers the time value of money

– Adjustment for risk?

• The rule considers risk

© Dr. C. Bulent Aybar

• The discounted payback does account for the time value of money and
risk within the discounted payback period, but it ignores cash flows after
the discounted payback period is reached.
• This drawback has two consequences.
– First, the discounted payback period is not a good measure of profitability (like the
NPV or IRR) because it ignores these cash flows.
– A second idiosyncrasy of the discounted payback period comes from the possibility of
negative cash flows after the discounted payback period is reached. It is possible for a
project to have a negative NPV but to have a positive cumulative discounted cash flow
in the middle of its life and thus a reasonable discounted payback period.

• The NPV and IRR, which consider all of a project ’ s cash flows, do not
suffer from this problem.

© Dr. C. Bulent Aybar

 Maximization of the firm’s equity value?

• If a project’s discounted payback period is shorter than the

cutoff period, the project’s NPV, when estimated with cash
flows up to the cutoff period, is always positive
• If the project’s NPV is negative, it will not have a discounted
payback period!
• The rule is biased against long-term projects

© Dr. C. Bulent Aybar

 The Discounted PPR Versus the Ordinary PPR

• The discounted payback period rule is superior to the

ordinary payback period rule
– Considers the time value of money
– Considers the risk of the investment’s expected cash flows

• However, the discounted payback period rule is more

difficult to apply
– Requires the same inputs as the NPV rule
– Used less than the ordinary payback period rule

© Dr. C. Bulent Aybar

 Average Accounting Rate of Return
• AAR calculated by using average net income and average book value during the life of the
project,

• Unlike the other capital budgeting criteria AAR is based on accounting numbers, not on
cash flows. This is an important conceptual and practical limitation.
• The AAR also does not account for the time value of money, and there is no conceptually
sound cutoff for the AAR that distinguishes between profitable and unprofitable
investments.
• The AAR is frequently calculated in different ways, so the analyst should verify the
formula behind any AAR numbers that are supplied by someone else.
• Analysts should know the AAR and its potential limitations in practice, but they should
rely on more economically sound methods like the NPV and IRR.

© Dr. C. Bulent Aybar

 Profitability Index

• The profitability index (PI) is the present value of a project’s future cash
flows divided by the initial investment.

• PI is closely related to the NPV. The PI is the ratio of the PV of future

cash flows to the initial investment, while an NPV is the difference
between the PV of future cash-flows and the initial investment.
• Whenever the NPV is positive, the PI will be greater than 1.0, and
conversely, whenever the NPV is negative, the PI will be less than 1.0
• Investment Rule:
– Invest if PI >1.0
– Do not invest if PI <1.0

© Dr. C. Bulent Aybar

 NPV Profile and IRR

Project E Project H
-1,000,000 -1,000,000
325,000 100,000
325,000 100,000
325,000 100,000
325,000 150,000
325,000 1,500,000

NPV $232,005.70 $282,519.20

IRR 18.72% 16.59%

Note that Project E has higher IRR than Project H. However, project H higher
NPV when cost of capital is below 12.94%. If the cost of capital is below 12.94%
as in this example, NPV and IRR rules conflict!
The NPV Profiles of Investments E and H.
Investment E is better than H only
Low IRR High NPV if the cost of capital (assumed to be
the same for both projects) is
higher than the value of the
discount rate at which the NPV
profiles of E and H intersect
(Fisher’s intersection).

If the cost of capital is

lower than the
discount rate at the
Fisher’s intersection,
choosing the project
with the highest IRR
means selecting the
project which
contributes the least
to the firm’s equity
value.

IRR rule may lead to suboptimal decisions

 NPV and IRR Conflict

• As in the previous example, differing cash flow patterns can

cause two projects to rank differently with the NPV and IRR.
• When two rules are in conflict, one should rely on NPV rule
simply because of the assumed opportunity cost or more
realistic reinvestment rates.
• Another circumstance that frequently causes mutually
exclusive projects to be ranked differently by NPV and IRR
criteria is project scale — the sizes of the projects. Would
you rather have a small project with a higher rate of return or
a large project with a lower rate of return? Sometimes, the
larger, low rate of return project has the better NPV.

© Dr. C. Bulent Aybar

Project Scale and IRR-NPV Conflict

As the NPV profile

Shows, project B has
higher NPV for discount
rates between 0 and
21.83%
 Multiple IRR Problem

Unconventional cash flows where the sign of cash flows change more
than once, produce multiple IRRs. For instance the following cash flow
pattern leads and IRR of 100% and 200%.

In this case NPV profile of the project intersects the horizontal line twice:
at discount rate 100% and discount rate 200%.

© Dr. C. Bulent Aybar

 Multiple IRR Problem

100% 200%
 No IRR Problem

In some cases, NPV profile may never cross the horizontal axis.
 Survey Evidence

• A Survey of CFOs who belong to Financial Executives

International revealed the following:
• 75% of CFOs report using IRR and 75% NPV.
– On a scale of 0 to 4, where 4 is very important, mean responses
associated with both were 3.1.

• 57% of CFOs reported using the payback rule.

– Used by older, longer-tenure CEOs without MBAs.
– Payback most intuitive, NPV least intuitive.

© Dr. C. Bulent Aybar

Duke-FEI Survey Results
International Preferences-Mean Responses
4=Used very frequently 0=Never used