Capital Budgeting

Capital-Budgeting Techniques
Learning Objectives
 Discuss the difficulty of finding

profitable projects in competitive
markets.
 Determine whether a new project
should be accepted using the
payback period.
 Determine whether a new project
should be accepted using the net
present value.
Learning Objectives
• Determine whether a new project

profitability index.
• Determine whether a new project
internal rate of return.
• Explain the importance of ethical
considerations in capital-budgeting
decisions.
• Discuss the trends in the use of
different capital-budgeting criteria.
Principles Used in this Chapter
• Principle 2: The Time Value of

Money – A Peso Received Today
is Worth More Than a Peso
Received in the Future.
• Principle 5: The Curse of
Competitive Markets – Why It’s
Hard to Find Exceptionally
Profitable Projects.
Capital Budgeting
• Investments in fixed assets

• An approach to source and
evaluate profitable projects
• Evaluating the profitability of
projects
• Often choosing between one or
more projects
R&D
• Typically, a firm has a research

& development department that
searches for ways of improving
existing products or finding new
projects.
Capital Budgeting
• Payback Period
• Net Present Value
• Profitability Index
• Internal Rate of Return
• Capital Rationing
Payback Period
• Number of years needed to

recover the initial cash outlay of
a capital budgeting project
• Deals with cash flows
• Ignores the time value of money
and does not discount these
free cash flows back to the
present.
Payback Period
Example:
Project with an initial cash outlay of
$10,000 with following free cash flows for
5 years.
YEAR CASH FLOW BALANCE
1 P 2,000 (P 8,000)
2 4,000 ( 4,000)
3 3,000 ( 1,000)
4 3,000 2,000
5 10,000 12,000
Payback is 3 1/2 years
Payback Period
• Ignores the time value of money

and does not discount these
free cash flows back to the
present.
Net Present Value or NPV
• Present value of the free cash

flows less the initial outlay
• Gives a measurement of the net
value of a project in today’s
peso
• If NPV > 0, accept
• If NPV < 0, reject
Net Present Value or NPV
Example: Project with an initial cash outlay

of P40,000 with following free cash flows
for 5 years.
Yr FCF Yr FCF
Initial outlay -40,000 3 13,000
1 14,000 4 12,000
2 13,000 5 11,000
The firm has a 12% required rate of return
and the present value of the FCF’s is
P47,678. Subtracting the initial cash outlay
of P40,000 leaves an NPV of P7,678.
NPV>0, therefore we accept.
NPV
• Examines cash flows, not profits

• Recognizes time value of money
• By accepting only positive NPV
projects, increases value of the
firm
Profitability Index
• Benefit-cost ratio
• Ratio of the present value of the
future free cash flows to the
initial outlay
• Generates same results as NPV
• PI = PV FCF/ Initial outlay
• PI > 1 = accept PI < 1 = reject
Profitability Index
A firm with a 10% required rate

of return is considering
investing in a new machine
with an expected life of six
years. The initial cash outlay
is P50,000.
Profitability Index
FCF PVF @ 10% PV
Initial -P50,000 1.000 -P50,000

Outlay
Year 1 15,000 0.909 13,635
Year 2 8,000 0.826 6,608
Year 3 10,000 0.751 7,510
Year 4 12,000 0.683 8,196
Year 5 14,000 0.621 8,694
Year 6 16,000 0.564 9,024
Profitability Index
PI = (P13,635 + P6,608+P7,510 + P8,196

+ P8,694 + P9,024) / P50,000
=P3,667/P50,000
= 1.0733
Project PI > 1
• Therefore, accept.
NPV and PI
• When the present value of a

project’s cash flows are greater
than the initial cash outlay, the
project NPV will be positive.
• PI will also be greater than 1.
• NPV and PI will always yield the
same decision
Internal Rate of Return or IRR
• Discount rate that equates the

present value of a project’s
future net cash flows with the
project’s initial cash outlay
• If IRR > Required rate of return,
accept
• IF IRR < Required rate of return,
reject
IRR and NPV
• If NPV is positive, IRR will be

greater than the required rate of
return
• If NPV is negative, IRR will be
less than required rate of return
• If NPV = 0, IRR is the required
rate of return.
IRR
Purchase P3,817
Cash flows Yr.1=P1,000, Yr. 2=P2,000,
Yr. 3=P3,000
Discount rate NPV
15% P4,356
20% P3,958
22% P3,817
IRR is between 22% because the NPV
equals the initial cash outlay
Modified IRR
• Primary drawback of the IRR relative

to the net present value is the
reinvestment rate assumption made
by the internal rate of return
• Modified IRR allows the decision
maker to directly specify the
appropriate reinvestment rate
• MIRR> required rate of return: Accept
• MIRR< required rate of return: Reject
Calculating the MIRR
• Project having a 3yr. Life and a

required rate of return of 10%
with the following cash flows:
FCF’s FCF’s
Initial -P6,000 Year 2 P3,000
Outlay
Year 1 2,000 Year 3 4,000
Calculating the MIRR
• Step 1: Determine the PV of the project’s cash

outflows. P6,000 is already at present.
• Step 2: Determine the terminal value of the project’s

free cash flows. To do this use the project’s
required rate of return to calculate the FV of the
project’s three cash flows of the project’s cash
outflows. They turn out to be P2,420 +P3,300 +
P4,000 = P9,720 for the terminal value
• Step 3: Determine the discount rate that equates to

the PV of the terminal value and the PV of the
project’s cash outflows. MIRR= 17.446% > required
rate of return: Accept
Capital Rationing
• Limit on the dollar size of the

capital budget
• Often a firm may select a set of
projects with the highest NPV–
subject to the capital constraint
• May preclude accepting the
highest ranked project in terms
of PI or IRR
Ranking Problems
• Size Disparity
• Time Disparity
• Unequal Life
Ethics in Capital Budgeting
• Ethics do play a role in capital

budgeting
• Any actions that violate ethical
standards can cause a loss of
trust which can have a negative
and long lasting effect on the
firm
Popularity of Capital
Budgeting Techniques
Percent of Firms Using Each

Method used Primary Secondary Total
Method Method Firms
IRR 88% 11% 99%
NPV 63% 22% 85%
Payback 24% 59% 83%
PI 15% 18% 33%
Source: Harold Bierman, Jr.,”Capital Budgeting in 1992: A Survey,”
Financial Management (Autumn 1993):24.
The Multinational Firm:
Capital Budgeting
• The key to success in capital

budgeting is finding good projects
• Often these projects are overseas in
today’s global environment
• Joint ventures and strategic
alliances are current trends
• Some companies have > 50% of their
revenues from sales abroad
How Do Financial Managers
Use this Material?
• If you don’t take on new projects, a

company couldn’t continue to exist
• Finding new projects and correctly
evaluating them are key
• Whatever decision made results in an
investment in fixed assets
• Process often called “strategic
planning” but involves the Capital
Budgeting Process

Capital Budgeting

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Capital-Budgeting Techniques

 Discuss the difficulty of finding

• Determine whether a new project

• Principle 2: The Time Value of

• Investments in fixed assets

• Typically, a firm has a research

• Number of years needed to

• Ignores the time value of money

• Present value of the free cash

Example: Project with an initial cash outlay

• Examines cash flows, not profits

A firm with a 10% required rate

FCF PVF @ 10% PV

Initial -P50,000 1.000 -P50,000

PI = (P13,635 + P6,608+P7,510 + P8,196

• When the present value of a

• Discount rate that equates the

• If NPV is positive, IRR will be

• Primary drawback of the IRR relative

• Project having a 3yr. Life and a

• Step 1: Determine the PV of the project’s cash

• Step 2: Determine the terminal value of the project’s

• Step 3: Determine the discount rate that equates to

• Limit on the dollar size of the

• Ethics do play a role in capital

Percent of Firms Using Each

• The key to success in capital

• If you don’t take on new projects, a

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