FNC 345 – Unit II – Ch.

11
Capital Budgeting

Capital Budgeting – the process of selecting the best capital projects for long-term fixed assets
based on economic theory; the analysis of choosing the best investment
projects for a firm based on the likelihood that the project will add to
stockholder’s wealth and be profitable.

I. Decision Making Process

Capital budgeting appraisal methods are techniques in order to evaluate investment proposals
that will help a company make investment decision on long-term fixed asset. These methods
provide insight on various aspects of an investment proposal such as looking at relative income
generating capacity, discount cash flows, rates of returns, and payback periods that may allow
for a ranking of these investment proposal in order of their desirability. These method helps a
company accept or reject investment proposals.

Steps involved with capital budgeting:

1. Identify projects: Project investment proposals are the first step in capital budgeting. New
project can occur for several reasons: replacement (to continue and/or to obtain a more cost
efficient product line), expansions of existing product line, expansion into new product lines,
and/or to support corporate operations (i.e. building a new headquarter location or support
structure for production).

2. Evaluate the project: Gathering all the information to determine a project's need and
impact (i.e. estimating the costs and benefits) in order to maximize market value of the firm.
Weigh the pros and cons associated with the investment process such as risks involved with
the total cash inflows and outflows.

3. Select a project: There is no defined technique for selecting a project as each business has
its own requirements. A project's approval is based on your company's objectives. Factors
may include funds acquisition, viability, profitability and market conditions.

4. Implementation: Once the project is selected, the company should build out the project
within the budget and timeline projected in the initial investment projection.

5. Performance review: The company needs to actively monitor the projects performance
against the initial forecast and make any necessary adjustments. Any problems need to be
identified and resolved. Reports need to be generate for uses by decision makers at the
company.

Orzechowski – FNC 345 Notes

1
II. Five Appraisal Methods

Listed below are five type of analysis or appraisal methods that may help a company
decide if a long-term capital investment proposal is desirable (i.e. adding to
stockholder’s wealth and profitable). Each method provides a different insight about
the economics of a project. Each method has their own pros and cons or unique
insight and subsequent limitations. Decision makers may want to reference several
methods in order to make a final decisions.

A. Net Present Value (NPV)

The NPV takes into consideration the time value of money. The cash flows of
different years are valued differently and made comparable in terms of present values.
To analyze an investment project the net cash inflows of various future period are
discounted using the required rate of return (or discount rate) minus the present value
of the cost of the initial investment.

In other words, NPV is the difference between the present value of cash inflows of a
project and the initial cost of the project. According to the NPV analysis, only project
with a positive NPV should be selected.

1. NPV formula

The formula for NPV is the present value of cash inflows minus the investment costs
or:
𝑛
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑ − 𝑖𝑛𝑣𝑒𝑠𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡𝑠
(1 + 𝑟)𝑡
𝑡=0

where, CF is cash flows, r is the required rate of return (or discount rate), n is a
positive integer, and t is the respective time period(s).

Or can be expressed by consolidating the investment costs into the appropriate CFt
arrangement (i.e. as a negative CF input) as:
𝑛
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑
(1 + 𝑟)𝑡
𝑡=1

Orzechowski – FNC 345 Notes

2
2. Organizing the NPV decisions process:
1. Forecast the project’s incremental free cash flow in each future time period;
2. Determine the appropriate cost of capital or discount rate to use;
3. Discount all incremental free cash flows to time zero by the cost of capital or discount
rate;
4. Net out all investments costs;
5. If NPV > 0, accept the project, If NPV < 0, reject the project.
The firm should usually accept all positive NPV projects because they give shareholders more
value than their required rate of return.

3. Pros and cons of the NPV method:

Pros:
1. NPV uses the time value of money approach (i.e. it discounts future money values);
2. NPV uses the entire cash flow stream generated during the useful life of the asset;
3. NPV uses a methodology that maximizes the wealth of the owners;
4. NPV method allows the ranking of projects by dollar amount size of NPV.

Cons:
1. May be complex to understand and use (use of computers helps; what is the best
discount rate to use?, ect.);
2. It does not allow easy comparisons of projects with different amounts of
investment and time periods.

4. MS Excel:
=NPV(rate, CF1:CFn) + CF0
CF0 is usually negative value and represents the initial investment costs.

5. Example:

Cost: $100,000
Projected Free Cash Flow: $25,000/yr. - first year; then $30,000/yr. for the next 4 years;
WACC: 6%

NPV = -$100,000 + 25,000 + 30,000 + 30,000 + 30,000 + 30,000

1.06 (1.06)2 (1.06)3 (1.06)4 (1.06)5
= -$100,000 + 23,585 + 26,700 + 25,189 + 23,763 + 22,418
= -$100,000 + $121,653.93
= +$21,653.93

The investment project increases the (present) value of the company by $21,653.93, so the project should
be accepted.

Orzechowski – FNC 345 Notes

3
 B. Internal Rate of Return (IRR)

The IRR is usually calculated as an estimated rate of return on an investment project. It is

computed in term of NPV whereas the IRR is the rate at which the project’s PV cash flow equal
its cost. In other words, the IRR is the discounted rate that makes the value of NPV = 0 for an
investment project, which equates the present value of cash inflows with the present value of
cash out flows of an investment.

1. IRR formula

The formula can be written as:

𝑛
𝐶𝐹𝑡
0 = 𝑁𝑃𝑉 = ∑
(1 + 𝐼𝑅𝑅)𝑡
𝑡=1

where, t = total number of periods, n = positive integer, CF = cash flow (negative or positive
value), and IRR = internal rate of return (or discounted rate).

The IRR is also known as the hurdle rate, or cutoff rate. When analyzing against the firm’s cost
of capital. Potential problems with IRR is that there can be more than one IRR such as in case of
a project that has an investment expenditure at the end of the project. These project are not
common.

2. Organizing the IRR decisions process:

1. Forecast the project’s incremental free cash flow in each future time period;
2. Estimate the cost of the investment project;
3. Calculate or solve for the IRR that brings the project’s NPV = 0;
4. Accept highest project by IRR and/or accept project where the IRR > firm’s WACC.

3. Pros and cons of the IRR method:

Pros:
1. IRR consider the time value of money;
2. IRR takes into account the cash flows over the entire project life of the asset;
3. The IRR allows comparisons with the firm’s WACC;
4. It allows for a ranking of project by IRR size.

Cons:
1. It is very difficult to understand and use (but computers make this easy).
2. It involves a very complicated computational work.
3. It may not give an unique answer in all situations ( i.e. multiple IRRs).

4. MS Excel:
=IRR(CF0:CFn,guess)
In most cases the guess rate can be ignored.
Orzechowski – FNC 345 Notes
4
5. Example:

Using the example from the above NPV method:

NPV = -$100,000 + 25,000 + 30,000 + 30,000 + 30,000 + 30,000 = 0

(1 + IRR)t

Solve for IRR.

C. 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 coast of capital. Reinvestment considerations are conducted
under the MIRR. Does not assume that project CF is invested at the project’s IRR, but uses the
firm’s WACC to calculate the MIRR. The MIRR method also avoids multiple IRR solutions.

1. MS Excel:

=MIRR(CF0:CFn,finance_rate,reinvestment_rate)

D. Payback Period (PBP)

The payback period defines the length of time necessary to earn back money that has been
invested in a project. In other words, the PBP method calculates by adding the project’s cash
inflows to its cost until the cumulative cash flow for the project turns positive. Payback periods
are less complex calculations than NPV and IRR methodologies. As with each method
mentioned so far, the payback period does have its limitations, such as not accounting for the
time value of money, risk factors, financing concerns or the opportunity cost of an investment.
Therefore, using the payback period in combination with other capital budgeting methods is far
more reliable.

1. Formula

𝐵𝐴
𝑃𝐵𝑃 = 𝐶𝐹𝑃𝑌 +
𝐶𝐹𝐹𝑌

where, PBP = Payback period, CFPY = Number of years prior to final year of recovery,
BA = Remaining balance amount to be recovered at start of final year, and CFFY = Cash
inflow during final recovery.

Orzechowski – FNC 345 Notes

5
2. Organizing the Payback Period decisions process:
1. Forecast the project’s incremental free cash flow in each future time period;
2. Estimate the cost of the investment project;
3. Calculate the time period (usually in years) to recover investment costs;
4. Projects acceptance is not clear cut in terms of impact, but methodology gives decision
makers an estimated time period in which investment cost will be recouped. Project with
quick recovery and longer life after recovery may be viewed as favorable.

3. Pros and cons of the Payback Period method:

Pros:
1. PBP method is one of the earliest methods of evaluating the investment projects;
2. PBP is simple to understand and to compute;
3. PBP provides an indication of a project’s risk and liquidity.;
4. PBP is one of the widely used methods in small scale industry sector;
5. PBP can be computed on the basis of accounting information available from the books.

Cons:
1. The PBP method fails to take into account the cash flows received by the company after
the payback period;
2. PBP doesn’t take into account the discount rate (or cost of capital) factor involved in an
investment project and the related cash flows;
3. PBP is not consistent with the objective of maximizing the market value of the company’s
wealth;
4. PBP fails to consider the pattern of cash inflows (i.e., the magnitude and timing of cash in
flows).

4. Example:

E. Discounted Payback Period (DPBP)

The length of time required for an investment’s cash flows, discounted at the investment’s cost
of capital, to recover its investment costs. Although the DPBP helps with accounting for the
time value of money the methodology still has the above mentioned cons in the PBP.

Orzechowski – FNC 345 Notes

6
1. Example:

III. Other concepts and definitions

Independent and Mutual Exclusive projects

Independent – Independent projects are projects whose cash flows are not affected by one
another.

Mutually Exclusive – Two or more events where the occurrence of one precludes the
occurrence of the others. When facing mutually exclusive decisions, you do not
always want to choose the project with the higher IRR.

Orzechowski – FNC 345 Notes

7