The document discusses capital budgeting, which is the process of planning and evaluating long-term investments. It covers key concepts like net present value (NPV), internal rate of return (IRR), payback period, and profitability index. The steps to capital budgeting are outlined as estimating cash flows, assessing risk, determining the cost of capital, and using methods like NPV and IRR to evaluate whether projects should be accepted. Examples are provided to illustrate how to calculate these metrics and address issues that can arise like mutually exclusive projects.

1. Capital Budgeting
Course No: IPE 4111
Online Lecture No: 06-07
Md. Rakibul Islam
Assistant Professor
Department of IPE, RUET

2. What is capital budgeting?
 Process of planning and evaluating expenditures on asset whose cash
flows are beyond 1 year.
 Decide which are acceptable investments
 Decide which actually should be purchased (or invested)
 Long-term decisions; involve large expenditures.
 Very important to firm’s future.
 Examples:
 Build a new refinery
 Modify a process unit within an existing refinery
 Modify an Apple factory production line to make new product
 Open a new Target store location
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3. Good Decision Criteria
 We need to ask ourselves the following questions when
evaluating capital budgeting decision rules
 Does the decision rule adjust for the time value of money?
 Does the decision rule adjust for risk?
 Does the decision rule provide information on whether we are
creating value for the firm?
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4. Steps to Capital Budgeting
1. Estimate all expected after-tax cash flows (CFs), including when they will
occur.
 Positive cash flows are money received and called “inflows”
 Negative cash flows are expenditures and are called “outflows”
2. Assess the risk of the project
 Some projects will be riskier than the company’s normal business, some will be about
the same risk, and others may be less risky.
3. Determine the appropriate cost of capital.
 For projects that have the same risk level as the company’s normal business, use the
weighted-average cost of capital (WACC).
 For riskier projects, adjust WACC up; less risky projects, adjust WACC down.
4. Calculate NPV and/or IRR. Accept project if NPV > 0 and/or IRR >
WACC.
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5. Key Criteria
The Payback
The Discounted Payback
Net Present Value
The Internal Rate of Return
The Profitability Index
The Average Accounting Return
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6. Payback Period
The number of years required to recover a project’s cost,
or how long does it take to get the business’s money
back?
 Example: Payback for Franchise L (Long: Most CFs in out years)
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7. Payback Period
 Franchise S (Short: CFs come quickly)
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8. Payback Period
Computation
 Estimate the cash flows
 Subtract the future cash flows from the initial cost until the
initial investment has been recovered
Decision Rule – Accept if the payback period is less
than some preset limit
If the cut-off point is 2 years, which project should be
accepted, which should be rejected?
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9. Strengths and Weaknesses of PB Period
Strengths
Provides an indication of a project’s risk and liquidity.
Easy to calculate and understand.
Weaknesses
Ignores the time value of money.
Ignores CFs occurring after the payback period.
requires an arbitrary cut-off point
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10. Discounted Payback Period
Compute the present value of each cash flow and then
determine how long it takes to payback on a discounted
basis
Compare to a specified required period
Decision Rule - Accept the project if it pays back on a
discounted basis within the specified time
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11. Discounted Payback
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 Uses discounted rather than raw CFs. Project L

12. Discounted Payback Period (Project S)
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13. Advantages and Disadvantages of DPB
 Advantages
 Includes time value of money
 Easy to understand
 Disadvantages
 Requires an arbitrary cutoff point
 Ignores cash flows beyond the cutoff point
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14. Net Present Value (NPV)
The difference between the market value of a project
and its cost
How much value is created from undertaking an
investment?
 The first step is to estimate the expected future cash flows.
 The second step is to estimate the required return for projects
of this risk level.
 The third step is to find the present value of the cash flows
and subtract the initial investment.
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15. NPV
 NPV: Sum of the PVs of inflows and outflows.
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16. NPV – Decision Rule
If the NPV is positive, accept the project
A positive NPV means that the project is expected to
add value to the firm and will therefore increase the
wealth of the owners.
Since our goal is to increase owner wealth, NPV is a
direct measure of how well this project will meet our
goal.
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17. What’s Franchise L’s NPV?
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18. What’s Franchise S’s NPV?
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19. Internal Rate of Return (IRR)
 The internal rate of return (IRR) is the discount rate that equates
the PV of a project’s net cash flows with its initial cash outlay.
 This is the most important alternative to NPV
 It is based entirely on the estimated cash flows and is
independent of interest rates found elsewhere
 Project A: cost $1000, PV of all future cash flows = $1500. What
is NPV of A?
 Project B: cost $1,000,000, PV of all future cash flows =
$1,500,000. What is NPV of B?
 We might need a rate of return in this case.
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20. IRR
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21. NPV vs IRR
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22. To Interpolate the IRR
 A project has an immediate cash outflow of $7,000, and then cash inflows of $4,000 in
years 1 and 2.
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23. IRR
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24. IRR
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25. Rationale for the IRR Method
If IRR > cost of capital (or required return), then the
project’s rate of return is greater than its cost-- some
return is left over to boost stockholders’ returns.
Example: required return = 10%, IRR = 15%. Profitable.
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26. Advantages of IRR
Knowing a return is intuitively appealing
It is a simple way to communicate the value of a project
to someone who doesn’t know all the estimation details
If the IRR is high enough, you may not need to estimate
a required return, which is often a difficult task
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27. NPV Vs. IRR
 NPV and IRR will generally give us the same decision
 Exceptions
 Non-conventional cash flows – cash flow signs change more than once
 Mutually exclusive projects
 Initial investments are substantially different
 Timing of cash flows is substantially different
 NPV>0 and IRR> required return
 NPV<0 and IRR< required return
 NPV=0 and IRR= required return
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28. IRR
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29. Example – Non-conventional Cash Flows
Suppose an investment will cost $90,000 initially and will
generate the following cash flows:
 Year 1: 132,000
 Year 2: 100,000
 Year 3: -150,000
The required return is 15%.
Should we accept or reject the project?
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30. Example – Non-conventional Cash Flows
 Calculator: CF0 = -90,000; C01 = 132,000; F01 = 1; C02 =
100,000; F02 = 1; C03 = -150,000; F03 = 1; I = 15; CPT NPV =
1769.54
 Solve for IRR
 0 = -90,000 + 132,000/(1+IRR)1 +100,000/(1+IRR)2 -
150,000/(1+IRR)3
 (IRR-0.101102)(IRR-0.426585) = 0
 IRR = 10.1102% and IRR = 42.6585%
 If you compute the IRR on the calculator, you get 10.1102%
because it is the first one that you come to.
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31. Summary of Decision Rules
The NPV is positive at a required return of 15%, so you
should Accept
If you use the financial calculator, you would get an IRR
of 10.11% which would tell you to Reject
You need to recognize that there are non-
conventional cash flows and look at the NPV profile
When you have conflict between NPV and IRR, go
with the NPV
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32. NPV Profile
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($10,000.00)
($8,000.00)
($6,000.00)
($4,000.00)
($2,000.00)
$0.00
$2,000.00
$4,000.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
Discount Rate
NPV

33. IRR and Mutually Exclusive Projects
 Independent and Mutually exclusive projects
 Independent: the decision to accept/reject one project does not affect
the decision to accept/reject another.
 Mutually exclusive: If you choose one, you can’t choose the other
 If L and S are independent, which project should we accept?
 IF L and S are mutually exclusive, which project should we accept?
 Intuitively you would use the following decision rules (if mutually
exclusive)
 NPV – choose the project with the higher NPV
 IRR – choose the project with the higher IRR
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34. Example With Mutually Exclusive Projects
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35. Example With Mutually Exclusive Projects
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36. NPV Profiles
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($40.00)
($20.00)
$0.00
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
$140.00
$160.00
0 0.05 0.1 0.15 0.2 0.25 0.3
Discount Rate
NPV
A
B

37. Profitability Index (PI)
PI = PV of future cash flows/ Initial cost
Measures the benefit per unit cost, based on the time
value of money
A profitability index of 1.1 implies that for every $1 of
investment, we create an additional $0.10 in value
Can have conflict with NPV in some mutually exclusive
projects
This measure can be very useful in situations in which
we have limited capital
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38. Profitability Index
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39. Example of PI
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40. More Examples
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41. Solution
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42. Solution
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43. Example
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44. Solution
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45. Solution
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46. Example
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47. Solution
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48. Solution
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49. Solution
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50. Example
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51. Solution
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52. Q&A
Thank You