Lecture 8:

Capital Budgeting

By: Sana Tauseef

 Outline
 What are capital projects?
 Fundamentals of capital budgeting
 Estimating project cash flows
 Investment decision rules
• Payback period
• Net present value
• Internal rate of return

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What is Capital Budgeting???
The process of analyzing, and selecting
investment projects whose returns (cash
flows) are expected to extend beyond one
year.

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Thorough evaluation is done before making
investment in long-term projects…

 Capital Projects affect long-term profitability

of firms.
 Purchasing fixed assets requires huge
investment.
 Capital decisions are irreversible.

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Types of Capital projects include…

Expansionary Projects:
New products or expansion of existing products

Replacement Projects:
Replacement of existing equipment or buildings

Regulatory Projects:
Projects to control pollution or provide safety of employees

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Types of Capital projects include…

Independent Projects:
The decision to accept/reject one project does not affect
the decision to accept/reject another project.

Mutually Exclusive Projects:

The decision to accept/reject one project affects the
decision to accept/reject another project.

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Some important points to remember!!!
 Projects are evaluated on stand-alone basis.
 Evaluation is done based on incremental cash flows and
only the relevant cash flows are included in analysis.
 Cash flows are computed on after-tax basis.
 Sunk costs are ignored in the analysis.
 Opportunity costs are included in the analysis.
 Project-driven changes in working capital is considered.
 Financing costs are not included in cash flows.

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Capital evaluation involves…
1. Estimating the cash flows (inflows and
outflows) during project’s useful life.
i. Initial Investment
ii. Operating Cash flows
iii. Terminal Cash flows

2. Estimating the cost of capital (WACC) to be

used as discount rate.

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Initial Cash Investment (t=0) includes the
following…

– Cost of new assets

– Capitalized expenditures
– Increased NWC
Only for replacement projects:
+ Net proceeds from sale of old asset
–/+ Taxes (savings) on gain/loss on the sale of
old asset

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Practice Question 1
Arnold Inc. is considering a project which requires use of an existing
warehouse which the firm acquired three years back for $1 million and
which it currently rents out for $138,000 per year. the project will require
an upfront investment of $1.5 million which can be fully depreciated
straight-line over next 10 years. Firm expects to terminate and sell
machine for $491,000 at the end of 8 years. The project requires an
investment into net working capital equal to 10 percent of first year’s
predicted sales. Sales are expected to be $4.6 million each year and
manufacturing and operating expenses (excluding depreciation) are 80
percent of sales and profits are taxed at 30 percent.

Compute the initial cash flow.

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Practice Question 2
Top Star Company is considering replacing its old machine
with the remaining book value of $200,000 with a new one
costing $5,500,000. The salvage value of the old machine is
$100,000 and the tax rate is 20%. If the new machine is
purchased, an additional working capital of $40,000 would
be needed. Compute the initial cash outflow for this
replacement project.

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Operating Cash flows (t=1-n) include the
following…

Cash Revenues
– Cash Expenses
= Net Cash Proceeds
– Taxes
= After-tax cash proceeds
+ Tax saving on Depreciation
= Incremental OCF from new asset

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Alternate method to calculate Operating Cash
flows…

Cash Revenues
– Expenses (including depreciation)
= Before-tax income
– Taxes
= After-tax income
+ Depreciation expense
= Incremental OCF from new asset

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Operating Cash flows (t=1-n) for
replacement projects…

Operating cash flows from new asset

Less: Operating cash flows from old asset
Incremental operating cash flows

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Practice Question 3
Refer to information given in practice question 1. Compute the operating
cash flow for each year when the machine will be used.

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Practice Question 4
Top Star Company is considering replacing its old machine
with the remaining book value of $200,000 with a new one
costing $5,500,000. The company can continue to use its old
machine for next 5 years in which case it will generate cash
proceeds of $50,000 each year and will have zero salvage
value in 5 years. The salvage value of the new machine after
5 years is expected to be $1,500,000 and it is expected to
generate cash proceeds of $800,000 for each of the first 2
years and 1,400,000 for each of the next 3 years. The tax
rate is 20%. Compute the operating cash outflow for each
year for this replacement project.

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Terminal Cash Flows (t=n) include the
following…

+/– Salvage value (disposal costs) of new

asset
–/+ Taxes (tax savings) on gain/loss on sale or
disposal of new assets
+ Release/ recovery of net working capital

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Practice Question 5
Refer to information given in practice question 1
and 2. Compute the terminal cash flow in each
case.

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Capital evaluation techniques include…
 Payback Period (simple and discounted)
 Net Present Value (NPV)
 Internal Rate of Return (IRR)

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Payback period gives the number of years required
to recover a project’s cost…
• Project is acceptable if the payback period is lesser than some
pre-specified no. of years.
• Simple payback ignores the time value of money. Discounted
payback considers the discounted cash flows.
• Payback period can be used as a measure of liquidity but
doesn’t indicate anything about profitability or value addition
of the project.
• Payback method does not consider the cash flows beyond the
payback period.

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NPV is the sum of the PVs of all cash inflows and outflows of a project…

 NPV is the amount by which value of the firm will

increase if the new project is taken
 If projects are independent, accept if the project NPV is
greater than 0
 If projects are mutually exclusive, accept projects with
the highest positive NPV, because that asset adds the
most value

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The NPV profile and IRR
 NPV profile is a graph of the project’s NPV over a range
of discount rates
 NPV of a project depends on the appropriate cost of
capital
 Often there is uncertainty regarding the project’s COC and
therefore helpful to consider an NPV profile

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IRR is the discount rate that forces PV of inflows
equal to cost, and the NPV to equal 0…
 If projects are independent, accept if the project IRR >
WACC
 If IRR > WACC, the project’s return exceeds its costs
and there is some return left over to boost stockholders’
returns
 Difference between COC and IRR is the maximum
estimation error in estimation of COC that can exist
without altering the original decision
 Don’t use IRR for mutually exclusive projects or for
projects with non-conventional cash flows

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References
 Fundamentals of Corporate Finance. Stephen A. Ross,
Randolph W. Westerfield & Bradford D. Jordan, 8 th
edition. Chapter 10.

 Fundamentals of Corporate Finance, Brealey Myers

Marcus, 4th edition.

 Financial Management: Theory and Practice. Eugene F.

Brigham & Michael C. Ehrhardt, 11 th edition.

 Corporate Finance. CFA-II Program Curriculum.

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