Inflation and Capital Budgeting Options in Capital Budgeting Strategy and Analysis in Using Net Present Value Cost of Capital, and Capital Budgeting Capital Budgeting for Levered Firm Risk and Capital Budgeting – Absolute measure and relative measure of risk, certainty equivalent method and risk adjusted discount rate method.

1. Course F-611:CAPITAL INVESTMENT
DECISION OR
CAPITAL BUDGETING
Prof. Shabbir Ahmad
Introduction Definition, types of projects, techniques of CID etc.
Cash Flow Estimation – Determination of cash out flow and cash
inflows
Techniques of Capital Budgeting – Discounted (NPV, IRR, MIRR, PI,
and DPB) and non-discounted (PB & AAR) cash flow techniques,
decision criteria, advantages and disadvantages of each technique.
Special Issues in Capital Budgeting –Projection evaluation, cost-
cutting projects, bid price setting, projects with different lives.
Project Analysis and Evaluation – Forecasting risk, sensitivity and
scenario analysis, break-even analysis, operating leverage and capital
budgeting.

2. Course F-611:CAPITAL INVESTMENT
DECISION OR
CAPITAL BUDGETING
Inflation and Capital Budgeting
Options in Capital Budgeting
Strategy and Analysis in Using Net Present Value
Cost of Capital, and Capital Budgeting
Capital Budgeting for Levered Firm
Risk and Capital Budgeting – Absolute measure and relative measure
of risk, certainty equivalent method and risk adjusted discount rate
method.
Text Books
Fundamentals of Corporate Finance by Ross, Westerfield, JORDAN
Corporate Finance by Ross, Westerfield, JAFFE
Capital Budgeting & Long-term Finance by Neil Seitz
Managerial Finance by Lawrence J GITMAN
Essentials of Managerial Finance by Eugene F. Brigham

3. Course F-611:CAPITAL INVESTMENT
DECISION OR
CAPITAL BUDGETING
Course Evaluation
Class Attendance ----- 10
Mid-term – I -----------15
Mid-term – II ----------15
Class Test/Quiz --------10
Term Paper/Pres.------10
Final Exam -------------40
Total --------------------100

4. CAPITAL BUDGETING OR
CAPITAL INVESTMENT DECISION
Goal of Firm
Maximization of the owner’s wealth, which is attained
through maximization of the current market price of the
outstanding shares.

5. CAPITAL BUDGETING OR
CAPITAL INVESTMENT DECISION
Capital Investment Decisions or Capital Budgeting
involves company’s long term investment decision. It
includes evaluation of the firm’s expenditure decisions
that involve current outlays but are likely to produce
benefits or returns over a long period of time.
Capital Budgeting is the process of evaluating and
selecting long-term investments in fixed or capital
assets that are consistent with the firm’s goal of
maximizing owner’s wealth.

6. CAPITAL BUDGETING OR
CAPITAL INVESTMENT DECISION
The process of identifying, analyzing, and selecting
investment projects whose returns (i.e. cash inflows) are
expected to extend beyond one year.
Example: Suppose a firm must decide whether to purchase a
new plastic moulding machine for $125,000. How it should
decide?
Will the machine be profitable?
Will our firm earn a high rate of return on the
investment?

7. CAPITAL BUDGETING OR
CAPITAL INVESTMENT DECISION
Why a firm makes capital investment?
In order to secure a stream of benefits in future years
that add value to the firm through cash inflows over
future times.

8. CAPITAL BUDGETING OR
CAPITAL INVESTMENT DECISION
Applications
Purchase of fixed assets
Mechanization of production method
Selection from alternative equipments
Introduction of new products
Expansion of business
Modernization and replacement

9. FEATURES/CHARACTERISTICS
OF CID (IMPORTANCE)
Long term investment decision (future profitability of
firm).
Returns or benefits are expected over number of years
Investment involves huge amount of cash outflow
(determines the destiny of the firm)
Investment decision is generally irreversible (once
made can not be changed)
Relatively high degree of risk
Relatively long time period between the initial outlay
and the anticipated return

10. CLASSIFICATION OF PROJECTS
By Size:
Major Project.
Minor Project.
By Benefit:
Cost Reduction Project.
Market Expansion Project.
Project for new products.

11. CLASSIFICATION OF PROJECTS
By Degree of Dependence:
Mutually Exclusive Projects.
Independent Projects.
By Cash Flow pattern:
Conventional Project.( - + + + + + i.e. outflow
followed by a series of inflow).
Non Conventional Projects ( - + + - + - + i.e. if the
project inflows & outflows are mixed & zigzag
pattern).

12. End of Year
0 1 2 3 4 5
10,000 Cash outflow
2000 2000 2000 2000 2000 Cash Inflows
Conventional Cash Flow Pattern: This consists of an
initial outflow followed only by a series of inflows.

13. End of Year
10,000 8000 Cash outflow
2000 2000 2000 2000 Cash Inflows
0 1 2 3 4 5
Non-conventional Cash Flow Pattern: This consists of
an initial outflow followed by a series of inflows and
outflows.

14. CAPITAL INVESTMENT
DECISION
►Determination of Cash Outflow or
Investment
► Projection or Forecast or Estimation of
Future Cash Inflows
► Determination of Appropriate Discount Rate
(i.e. Cost of Capital)

15. CASH FLOW DETERMINATION
A project should be evaluated on the basis of
Incremental After Tax Cash Flows.
Incremental After Tax Cash Flows for project
evaluation consist of any and all changes in the
firm’s future cash flows that are a direct
consequence of taking the project or the
difference between a firm’s future cash flows
with a project and those without the project.

16. CASH FLOW
DETERMINATION
Only the relevant cash flows should be taken under
consideration in determining the cash flows (i.e.
inflows or outflows) for making capital investment
decision.
Relevant cash flows should be included in a capital
budgeting analysis. These cash flows will only occur if
the project is accepted
Relevant cash flows are those which influence the
firm’s decision regarding accepting or rejecting a
project.

17. CASH FLOW
DETERMINATION
Irrelevant cash flows are those which do not
affect the firm’s decision regarding accepting or
rejecting a project i.e. they exist if the firms
accepts a project or if rejects a project.
Irrelevant cash flows should NOT be included
in capital budgeting analysis.

18. CASH FLOW
DETERMINATION
Asking the Right Question
Will this cash flow occur ONLY if we accept the
project?”
If the answer is “yes”, it should be included in the
analysis because it is incremental
If the answer is “no”, it should not be included in
the analysis because it will occur anyway
If the answer is “part of it”, then we should include
the part that occurs because of the project

19. CASH OUTFLOW OR
INVESTMENT DETERMINATION
Cost of new asset or project
Add installation cost (if any)
Add transportation cost (if any)
Add removal cost of old asset (only if borne
by the company)
Less selling price of old asset (if new asset replaces
old asset)
+ / - Tax on sale of old asset
Less Amount of investment tax credit (AITC)

20. Depreciation
Depreciation is a non-cash expense,
consequently, it is relevant because it affects
taxes.
Depreciation tax shield i.e. amount of annual tax
savings from depreciation expense = D x T
D = depreciation expense
T = tax rate

21. Computing Depreciation
Straight-line depreciation
Annual Dep. = Installed cost / number of useful years
MACRS
Need to know which asset class is appropriate for tax
purposes
Multiply percentage given in table by the installed
cost

22. Example: Depreciation
You purchase equipment for $100,000 and it
costs $10,000 to have it installed. The company’s
tax rate is 40%. What is the depreciation expense
each year?

23. Example: Three-year MACRS
Year MACRS
percent
D
1 .3333 .3333(110,000) =
36,663
2 .4444 .4444(110,000) =
48,884
3 .1482 .1482(110,000) =
16,302
4 .0741 .0741(110,000) = 8,151
BV in year 6 =
110,000 – 36,663 –
48,884 – 16,302 –
8,151 = 0

24. CASH OUTFLOW OR INVESTMENT
DETERMINATION
Example
The Sprint Inc. is trying to estimate the net cash outflow required to
replace an old machine with a new one. The new machine’s purchase
price is $270,000. An additional $7,000 will be required for transportation
and $5,000 will be required to install the machine. As the new machine
has greater capacity to produce, there will be an additional investment of
$20,000 in raw material inventory in the initial year. The new machine
will be depreciated on straight-line basis over five years of useful life.
The old machine was purchased two years ago at a cost of $70,000 has a
remaining useful life of five years. It is also subject to straight-line
depreciation. The company is entitled to investment tax allowance of
25%. The corporate tax rate is 55% and the capital gain tax rate is 30%.
Find the net cash outflow considering separately each of the following
scenarios:
i) If the old machine is sold for $40,000
ii) If the old machine is sold for $50,00. NCO.xls
iii) If the old machine is sold for $60,000.
iv) If the old machine is sold for $90,000.

25. CASH INFLOW DETERMINATION
Operating Cash Flow (OCF)
Operating Cash Flow (OCF) = EBIT + depreciation – taxes
OCF = Net income + depreciation when there is no interest
expense
OCF = Sales – Costs – Taxes (Don’t subtract non-cash
deductions)
OCF = (Sales – Costs)(1 – T) + Depreciation*T
Opportunity Cost
Sunk Cost
Erosion or Side Effects
Financing Cost
Change in Net Working Capital

26. Common Types of Cash Flows
Sunk costs – costs that have accrued in the past and should
not be included capital budgeting analysis
Opportunity costs – costs of lost options and should be
included in capital budgeting analysis
Side effects
Positive side effects – benefits to other projects
Negative side effects – costs to other projects
and should be included in capital budgeting analysis
Changes in net working capital (should be included in
capital budgeting analysis)
Financing costs (should not be included in capital budgeting
analysis)
Taxes should be considered

27. PROJECTCASH FLOW
DETERMINATION
Year
0 1 2 3
OCF
Change in NWC
Opportunity Cost
Capital Spending/CO ATSV
PCF

28. After-tax Salvage
If the salvage value is different from the book
value of the asset, then there is a tax effect
Book value = installed cost – accumulated (i.e.
total ) depreciation
After-tax salvage value (ATSV) = salvage –
Tc(salvage – book value)

29. TECHNIQUES OF CAPITAL BUDGETING
The techniques of capital budgeting are divided
into two broad groups
A) Non discounted cash flow techniques i.e.
techniques that do not consider time value of
money as such do not discount the future cash
flows
B) Discount cash flow (DCF) techniques i.e.
techniques that do not consider time value of
money as such do not discount the future cash
flows

30. TECHNIQUES OF CAPITAL BUDGETING
A) Non-DCF techniques include the following:
i) Payback Period Method
ii) Average Accounting Return or Accounting Rate
of Return
B) DCF techniques include the following:
i) Net Present Value (NPV)
ii) Internal Rate of Return (IRR)
iii) Profitability Index (PI) or Benefit-Cost
Ratio (BCR)
iv) Discounted Payback Period Method

31. The Payback Period Rule
How long does it take the project to “pay back”
its initial investment?
Payback Period = number of years to recover
initial costs
Minimum Acceptance Criteria:
set by management

32. The Payback Period Rule (continued)
Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback criteria may
not have a positive NPV
Advantages:
Easy to understand
Biased toward liquidity

33. The Discounted Payback
Period Rule
How long does it take the project to “pay back”
its initial investment taking the time value of
money into account?

34. The Average Accounting Return Rule
Another attractive but fatally flawed approach.
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market values
Advantages:
The accounting information is usually available
Easy to calculate
Investent
of
Value
Book
Average
Income
Net
Average
AAR 

35. The Net Present Value (NPV) Rule
Net Present Value (NPV) =
Total PV of future CI’s - Initial Investment
∑PV of Cash Inflows – ∑PV of Cash Outflows
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV

36. Why Use Net Present Value?
Accepting positive NPV projects benefits
shareholders.
 NPV uses cash flows
 NPV uses all the cash flows of the project
 NPV discounts the cash flows properly

37. Good Attributes of the NPV Rule
1. Uses cash flows
2. Uses ALL cash flows of the project
Reinvestment assumption: the NPV rule assumes
that all cash flows can be reinvested at the
discount rate or cost of capital.

38. The Internal Rate of Return (IRR) Rule
IRR: the discount rate that sets NPV to zero or the rate
of return available from investing in a project.
Minimum Acceptance Criteria:
Accept if the IRR exceeds the required return.
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested at the IRR.
Disadvantages:
IRR may not exist or there may be multiple IRR
Problems with mutually exclusive investments
Advantages:
Easy to understand and communicate

39. The Internal Rate of Return: Example
Consider the following project:
0 1 2 3
$50 $100 $150
-$200
The internal rate of return for this project is 19.44%
3
2
)
1
(
150
$
)
1
(
100
$
)
1
(
50
$
0
IRR
IRR
IRR
NPV








40. Problems with the IRR Approach
Multiple IRRs.
The Scale Problem
The Timing Problem
Investing or Financing

41. The NPV Payoff Profile for This Example
Discount Rate NPV
0% $100.00
4% $71.04
8% $47.32
12% $27.79
16% $11.65
20% ($1.74)
24% ($12.88)
28% ($22.17)
32% ($29.93)
36% ($36.43)
40% ($41.86)
If we graph NPV versus discount rate, we can see the
IRR as the x-axis intercept.
IRR = 19.44%
($60.00)
($40.00)
($20.00)
$0.00
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
-1% 9% 19% 29% 39%
Discount rate
NPV

42. Multiple IRRs
There are two IRRs for this project:
0 1 2 3
$200 $800
-$200 - $800
($150.00)
($100.00)
($50.00)
$0.00
$50.00
$100.00
-50% 0% 50% 100% 150% 200%
Discount rate
NPV
100% = IRR2
0% = IRR1
Which one
should we use?

43. The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment
while the 50% return is on a $1,000 investment?

44. The Timing Problem
0 1 2 3
$10,000 $1,000 $1,000
-$10,000
Project A
0 1 2 3
$1,000 $1,000 $12,000
-$10,000
Project B
The preferred project in this case depends on the discount rate, not
the IRR.

45. The Timing Problem
..TimingProb.xls
($4,000.00)
($3,000.00)
($2,000.00)
($1,000.00)
$0.00
$1,000.00
$2,000.00
$3,000.00
$4,000.00
$5,000.00
0% 10% 20% 30% 40%
Discount rate
NPV
Project A
Project B
10.55% = crossover rate
16.04% = IRRA
12.94% = IRRB

46. Mutually Exclusive vs.
Independent Project
Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring an
accounting system.
RANK all alternatives and select the best one.
Independent Projects: accepting or rejecting one project
does not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria.

47. The Profitability Index (PI) Rule
Minimum Acceptance Criteria:
Accept if PI > 1
Ranking Criteria:
Select alternative with highest PI
Disadvantages:
Problems with mutually exclusive investments
Advantages:
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
Investent
Initial
Flows
Cash
Future
of
PV
Total
PI 

48. The Practice of Capital Budgeting
Varies by industry:
Some firms use payback, others use accounting rate of
return.
The most frequently used technique for large
corporations is IRR or NPV.

49. Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150

50. Example of Investment Rules
Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80
NPV = $41.92 $90.80
IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053

51. Example of Investment Rules
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?

52. Relationship Between NPV and IRR
Discount rate NPV for A NPV for B
-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52