capital budgeting

1. CAPITAL BUDGETING/
INVESTMENT DECISIONS
Instructor: Liban Ali Abdinur
Capital budgeting is the process of analyzing potential
projects.
Capital budgeting decisions are probably the most
important ones that managers must make

2. Typical Capital Budgeting Decisions
Plant expansion
Equipment selection Equipment replacement
Lease or buy Cost reduction

3. Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad categories.
1. Screening decisions. Does a proposed project meet
some preset standard of acceptance?
2. Preference decisions. Selecting from among several
competing courses of action.

4. Cash Flows versus Operating Income
• Payback Method
• Net Present Value
• Internal Rate of Return
These methods focus on analyzing the cash flows associated
with capital investment projects:
The simple rate of return method focuses on incremental net
operating income.

5. Typical Cash Outflows
Repairs and maintenance
Incremental
operating
costs
Initial
investment
Working
capital

6. Typical Cash Inflows
Reduction
of costs
Salvage value
Incremental
revenues
Release of
working
capital

7. Time Value of Money
A dollar today is worth
more than a dollar a
year from now.
Therefore, projects that
promise earlier returns
are preferable to those
that promise later
returns.

8. Time Value of Money
The capital budgeting
techniques that best
recognize the time value of
money are those that
involve discounted cash
flows.

9. Learning Objective 1
Determine the payback
period for an
investment.

10. The payback method
focuses on the
payback period,
which is the length of
time that it takes for
a project to recoup
its initial cost out of
the cash receipts
that it generates.
The Payback Method

11. The payback method analyzes cash flows;
however, it does not consider the time value of
money.
When the annual net cash inflow is the same
each year, this formula can be used to compute
the payback period:
The Payback Method
Payback period =
Investment required
Annual net cash inflow

12. The Payback Method
Management at the Daily Grind wants to install an
espresso bar in its restaurant that
1. Costs $140,000 and has a 10-year life.
2. Will generate annual net cash inflows of
$35,000.
Management requires a payback period of 5 years
or less on all investments.
What is the payback period for the espresso bar?

13. The Payback Method
Payback period = Investment required
Annual net cash inflow
Payback period =
$140,000
$35,000
Payback period = 4.0 years
According to the company’s criterion,
management would invest in the espresso bar
because its payback period is less than 5 years.

14. Quick Check 
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined

15. Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
Quick Check 
• Project X has a payback period of 2 years.
• Project Y has a payback period of slightly more than 2 years.
• Which project do you think is better?

16. Evaluation of the Payback Method
Ignores the
time value
of money.
Ignores cash
flows after
the payback
period.
Short-comings
of the payback
method.
Shorter payback
period does not
always mean a
more desirable
investment.

17. Evaluation of the Payback Method
Serves as
screening
tool.
Identifies
investments that
recoup cash
investments
quickly.
Identifies
products that
recoup initial
investment
quickly.
Strengths
of the payback
period.

18. Payback and Uneven Cash Flows
1 2 3 4 5
$1,000 $0 $2,000 $1,000 $500
When the cash flows associated with an
investment project change from year to year,
the payback formula introduced earlier cannot
be used.
Instead, the un-recovered investment must be
tracked year by year.

19. Payback and Uneven Cash Flows
1 2 3 4 5
$1,000 $0 $2,000 $1,000 $500
For example, if a project requires an initial
investment of $4,000 and provides uneven net
cash inflows in years 1-5 as shown, the
investment would be fully recovered in year 4.

20. PAYBACK PERIOD
 NPV and IRR are the most commonly used methods today, but historically the first selection
criterion was the payback period,
 defined as the number of years required to recover the funds invested in a project from its
operating cash flows.
 Equation 10-4 is used for the calculation, and the process is diagrammed in Figure 10-9.
 We start with the project’s cost, a negative number, and then add the cash inflow for each year
until the cumulative cash flow turns positive.
 The payback year is the year prior to full recovery, plus a fraction equal to the shortfall at the
end of the prior year divided by the cash flow during the year when full recovery occurs

21. Exercise
 A project has an initial cost of $52,125, expected net
cash inflows of $12,000 per year for 8 years, and a
cost of capital of 12%.
 What is the project’s payback period?
 What is the project’s discounted payback period?

22. Exercise
 You are a financial analyst for the Lasanod Company. The director of capital budgeting has
asked you to analyze two proposed capital investments, Projects X and Y. Each project has a cost
of $10,000, and the cost of capital for each is 12%. The projects’ expected net cash flows are as
follows:
 A. Calculate each project’s payback period,
net present value (NPV), internal rate of
return (IRR)
 B. Which project or projects should be
accepted if they are independent?
 C. Which project should be accepted if they
are mutually exclusive?

23. Learning Objective 2
Evaluate the
acceptability of an
investment project using
the net present value
method.

24. The Net Present Value Method
The net present value method compares the present value of a project’s
cash inflows with the present value of its cash outflows. The difference
between these two streams of cash flows is called the net present value.
The net present value (NPV), defined as the present value of a
project’s cash inflows minus the present value of its costs, tells us how
much the project contributes to shareholder wealth—the larger the
NPV, the more value the project adds and thus the higher the stock’s
price.

25. The Net Present Value Method
Two Simplifying Assumptions
• All cash flows other than the initial investment occur at
the end of periods.
• All cash flows generated by an investment project are
immediately reinvested at a rate of return equal to the
discount rate.

26. NET PRESENT VALUE (NPV)
 We can find the NPVs as follows.
 1. Calculate the present value of each cash flow discounted at the
project’s risk adjusted cost of capital, which is r = 10% in our
example.
 2. The sum of the discounted cash flows is defined as the project’s
NPV.
 The equation for the NPV, set up with input data for Project S,

27. If the Net Present
Value is . . . Then the Project is . . .
Positive . . .
Acceptable because it promises
a return greater than the
required rate of return.
Zero . . .
Acceptable because it promises
a return equal to the required
rate of return.
Negative . . .
Not acceptable because it
promises a return less than the
required rate of return.
The Net Present Value Method

28. Exercise
 A project has an initial cost of $52,125, expected net cash
inflows of $12,000 per year for 8 years, and a cost of capital of
12%.
 What is the project’s NPV? (Hint: Begin by constructing a time
line.)

29. Learning Objective 3
Evaluate the
acceptability of an
investment project using
the internal rate of
return method.

30. Internal Rate of Return Method
 The internal rate of return is the rate of return promised by an
investment project over its useful life. It is computed by
finding the discount rate that will cause the net present value
of a project to be zero.
 It works very well if a project’s cash flows are identical every
year. If the annual cash flows are not identical, a trial-and-
error process must be used to find the internal rate of return.

31. Internal Rate of Return Method
General decision rule . . .
If the Internal Rate of Return is . . . Then the Project is . . .
Equal to or greater than the minimum
required rate of return . . .
Acceptable.
Less than the minimum required rate
of return . . .
Rejected.
When using the internal rate of return, the cost
of capital acts as a hurdle rate that a project
must clear for acceptance.

32. INTERNAL RATE OF RETURN (IRR)

33. Exercise
 A project has an initial cost of $52,125, expected net
cash inflows of $12,000 per year for 8 years, and a
cost of capital of 12%.
 What is the Projects IRR?