This document outlines capital budgeting concepts including projects, investment criteria, net present value (NPV) vs. internal rate of return (IRR). It defines projects and investment criteria like payback period, NPV, and IRR. NPV is the preferred method as it measures total discounted cash flows. While IRR and NPV typically agree for independent projects, they can differ for mutually exclusive projects due to reinvestment assumptions. The document also discusses sources of NPV and relevant cash flows to consider in capital budgeting analysis.

1. CAPITAL BUDETING
1

2. 2
OOuuttlliinnee
Projects
Investment Criteria
NPV v. IRR
Sources of NPV
Project Cash Flow Checklist

3. 3
PPrroojjeeccttss
A project is any potential real investment
opportunity
Distinguish real from financial
Mutually Exclusive - can do only one
Independent - decision about one does not
affect decision w/r/t the others
Replacement - special case

4. IInnvveessttmmeenntt CCrriitteerriiaa
Investment criteria are the rules by which we
decide whether or not to accept a particular
project; consider the following:
Y ear Project A Project B
0 (10,000) (10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
4

5. AAccccoouunnttiinngg RRaattee ooff RReettuurrnn
ARR = Avg. Income / Avg. Investment
Uses Income rather than Cash Flow
5
Ignores Time Value of Money

6. 6
PPaayybbaacckk
Years needed to recover initial investment
To Find: Calculate where cumulative cash
flows become positive
Project A: 2 1/6 years
Project B: 2 6/7 years

7. PPrroobblleemmss wwiitthh PPaayybbaacckk
Ignores Time Value of Money
Can use Discounted Payback; Why?
Ignores CF’s after payback
To see: Assume Project B’s cash flow in
year 4 is 1,000,000; how does this affect
payback
7

8. 8
NNeett PPrreesseenntt VVaalluuee
This rule is always consistent with
maximizing the value of the firm
Economically, take all projects for which
benefits costs (in PV dollars)
Mathematically, sum the present values of
all the cash flows

9. NNeett PPrreesseenntt VVaalluuee
= å -
R CF
NPV i 0
9
n CF
i
1 (1 )
i
= +

10. 10
NNPPVV eexxaammppllee
Year Project A Project B
0 (10,000) (10,000)
1 5,804 3.125
2 2,392 2.790
3 2,135 2,491
4 636 2,224
967 630

11. IInntteerrnnaall RRaattee ooff RReettuurrnn ((IIRRRR))
IRR - That rate which causes NPV to = 0.
11
0 = i CF
nå
i i=1 (1+IRR)
- 0 CF

12. 12
IIRRRR
Independent Projects - select all projects for
which IRR Cost of Capital
Mutually Exclusive - select project with
highest IRR
Use ‘well-designed’ spreadsheet

13. CCoommppaarriissoonn ooff NNPPVV IIRRRR
Business people are accustomed to thinking
in rates of return, so does it matter which of
NPV or IRR we use?
Independent - the two rules are equivalent
NPV 0 == IRR Cost of Capital
13

14. CCoommppaarriissoonn ooff NNPPVV IIRRRR
Mutually Exclusive Projects - can get
different answers
14
NPV Profile for Example
Reinvestment Assumption

15. NNPPVV vv.. IIRRRR EExxaammppllee
Project 1: (100,000) 125,000
Project 2: 1,000 2,000
NPV IRR
Project 1 13,636 25%
Project 2 818 100%
15

16. NNPPVV vv.. IIRRRR,, ccoonntt..
16
IRR == Do Project 2
NPV == Do Project 1
Problem: Reinvestment Assumption
What are you going to do with the other
$99,000?

17. PPrrooffiittaabbiilliittyy IInnddeexx
PV Cash Inflows / PV Cash Outflows
Independent: Choose all with PI 1
Mutually Exclusive: Choose highest PI
Project 1: 1.136
Project 2: 1.818
May be useful for capital rationing
17

18. OOtthheerr RReeaall OOppttiioonnss
18
Option to Expand
Option to Abandon
Strategic Options
Excluding biases NPV down
Decision Tree: Capital Budgeting should be
dynamic, not static

19. 19
SSoouurrccee ooff NNPPVV
Market Opportunities - ‘deviations from
equilibrium’
Economies of Scale
Cost Advantages
Product differentiation
Distribution Advantage
Regulatory Protection

20. RReelleevvaanntt CCaasshh FFlloowwss
20
We can always write:
EBIT
+ Depreciation
- Taxes (t x EBIT)
= Operating Cash Flow
- Δ NWC
- Capital Spending
= FCF

21. 21
CCaasshh FFlloowwss
1. Focus on Cash Flows; not accounting #’s
Depreciation
Not a cash flow
Affects Cash Flow through depreciation
Capital spending
Capitalized for accounting purposes
Cash outflow for finance purposes

22. PPrroojjeecctt CCaasshh FFlloowwss
2 Focus on Incremental Cash Flows
“What is different if project is accepted?”
Sunk Costs - those costs which have been
incurred and are not affected by project
decision
Opportunity Cost - highest value use of an
asset if not used in project
22

23. PPrroojjeecctt CCFF’’ss,, ccoonntt..
3 Externalities - less obvious costs/benefits
which should be included in analysis
4 Change in NWC - often a cash outflow
initially and cash inflow at end
5 Cash flows should be after tax
23
ΔRev/Exp x (1-t)
Depreciation x t
6 Do not include interest as a cash flow

24. PPrroojjeecctt CCFF’’ss,, ccoonntt..
Replacement problem - should you keep an
existing asset, or replace it with a new one
Δ in Cash Flows
Net of tax proceeds from disposal of
existing asset
24