CAPITAL BUDGETING Capital Budgeting refers to the methods that managers use to determine which projects should be selected

and which projects should be rejected. Imagine a manager has been presented with the following projects. The first is for a new drink called Sugar Soda and the second is for a drink called Lime Soda. Lets call these projects Project S and Project L. Both drinks will cost $1000 to create and market, Sugar Soda is expected to have high initial sales followed by a decline as parents find out what the drink does to their children (they will bounce off the walls). Lime Soda on the other hand is an acquired taste and sales are expected to increase as consumers begin to acquire a taste for the product. After year 5 the formula for the drinks will be obsolete and the drinks will no longer be marketed or sold. The cash flows for these two projects are shown below:
Project S Cash Flows
1000 500 0 $ -500 -1000 -1500 1 2 3 Tim e 4 5
$ 800 600 400 200 0 -200 -400 -600 -800 -1000 -1200 1 2 3 Time 4 5

Project L Cash Flows

When considering two projects a manager must know whether the projects are mutually exclusive projects or independent projects. Mutually exclusive projects when accepting one implies rejected the other. For example if the company only has the capacity to manufacture one new soda. Independent projects when the company can accept either or both projects based only on the projects expected cash flows. For example if the firm has the capacity to invest in both beverages. The following six methods are used to evaluate projects: 1. Net present value (NPV) 2. Internal Rate of Return (IRR) 3. Modified Internal Rate of Return (MIRR) 4. Profitability Index (PI) 5. Payback Period 6. Discounted Payback

Capital Budgeting

1. Net Present Value is also known as the discounted cash flow technique. NPV is the amount the shareholders wealth would increase if the firm selected the project if this number is positive then the firm should select the project. 1 Using the following formula we can find the NPV of the two projects. (Assume a cost of capital (r) of 5%).

NPV =
t =0

(1+ r )

CFt

NPVS = 1000 + NPVL = 1000 +

500

( 1 + 5% )
100

+ 1 + 1

400

( 1 + 5% )
300

+ 2 + 2

300

( 1+ 5% )
400

+ 3 + 3

100

( 1+ 5% )
600

= $180.42 = $206.50

( 1 + 5% )

( 1 + 5% )

( 1+ 5% )

( 1+ 5% )

Conclusion: Based on NPV, and if the projects are mutually exclusive (i.e. only one project can be selected) then the firm should go with Project L (the Lime Soda). 2. Internal Rate of Return (IRR) the IRR is the discount rate that makes the net present value of the project equal to zero.2 A projects IRR should be compared to the companys cost of capital or hurdle rate. The hurdle rate is the rate that the project must exceed to create positive shareholder wealth effects. (Assume the hurdle rate (r) is 5%).

NPV =
t =0

( 1 + IRR )

CFt

=0
+ 400

NPVS = 1000 + IRRS = 14.5% NPVL = 1000 + IRRL = 11.8%

500

( 1 + IRR )
100

( 1 + IRR )
300

300

( 1 + IRR )
400

100

( 1 + IRR )
600

= $0

( 1 + IRR )

+ 1

( 1 + IRR )

( 1 + IRR )

( 1 + IRR )

= $0

Conclusion: Based on IRR, and if the projects are mutually exclusive (i.e. only one project can be selected) then the firm should go with Project S (the Sugar Soda). Question: Why do the NPV and IRR methods offer different decisions in this example? Answer: Because NPV rankings depend on the cost of capital and the timing of the cash flows impacts their present values. Project S has higher short-term cash
1 2

Key Assumption: All cash flows are reinvested at the companys cost of capital. Key Assumption: All cash flows are reinvested at the projects IRR.

Capital Budgeting

flows while Project L has higher long-term cash flows. Note: Long-term cash flows are much more sensitive to interest rates. The tables below shows NPVs for the two projects at various interest rates. Notice that at 5% Project L offers a higher NPV while at 10% Project S offers a higher NPV.
NPV Sensitivity Analysis
500 400 300 200 100 0 (100) (200) 0% 5% 10% 15% Cost of Capital (r) Project S Project L 500 400 300 200 100 0 (100) (200) 0% 5% 10% 15% Cost of Capital (r) Project S Project L Net Present Value

NPV Sensitivity Analysis

Question: At what rate would we be indifferent between these two projects? Answer: At the crossover rate. The crossover rate is the rate below which, the two methods offer different accept / reject solutions. To calculate the crossover rate for two projects subtract the cash flows at each time and then solve for the rate at which the NPV equals zero.

Net Present Value

NPV = 1000 ( 1000 ) + = 0+ 400

500 ( 100 )

( 1 + rc )
+

400 ( 300 )

( 1 + rc )
500
4

300 ( 400 ) 100 ( 600 ) + = $0 3 4 ( 1 + rc ) (1 + rc )

( 1 + rc )

100

100

( 1 + rc )

( 1 + rc )

(1 + rc )

rc = 7.17%
This is calculated easily by using the cash flow register in your financial calculator. For the TI BAII Plus Enter: CF (CF0) = 0; (C01) = 400; ENTER (F01) = 1; ENTER (C02) = 100; ENTER (F02) = 1; ENTER (C03) = -100; ENTER (F03) = 1; ENTER (C04) = -500; ENTER; IRR; CPT Answer: 7.1673%

Capital Budgeting

3. Modified Internal Rate of Return (MIRR) the modified IRR assumes that cash flows are reinvested at the companys cost of capital.3 The cash flows are first brought forward to their future values at the companys cost of capital. Next the terminal value is calculated by summing all of the future value cash flows. Finally the terminal value is brought to the present vale of the initial investment at the MIRR rate. (Assume a cost of capital of 5%).

t =0

Cash Outflowt

( 1+ r )

= t =0

Cash Inflow ( 1 + r )
( 1 + MIRR )
N N

N 1

PV of costs =

Terminal value

( 1 + MIRR )
4 1

= PV of terminal value

( 500 ) ( 1 + 5% ) $1000 =
$1000 = $1, 434.81

+ ( 400 ) ( 1 + 5% )

3 1

( 1 + MIRRS )

+ ( 300 ) ( 1 + 5% )
4

2 1

+ ( 100 ) ( 1 + 5% )

11

( 1 + MIRRS )
4

( 1 + MIRRs )

$1, 434.81 = 1.4348 $1000

1/4

1 + MIRRs = ( 1.4348 ) MIRRS = 9.45%

= 1.0945

( 100 ) ( 1 + 5% ) $1000 =
$1000 = $1, 466.51

4 1

+ ( 300 ) ( 1 + 5% )

31

( 1 + MIRRL )

+ ( 400 ) ( 1 + 5% )
4

2 1

+ ( 600 ) ( 1 + 5% )

11

( 1 + MIRRL )
4

( 1 + MIRRL )

$1, 466.51 = 1.4665 $1000

1/4

1 + MIRRL = ( 1.4665 ) MIRRL = 10.05%

= 1.1005

Conclusion: Based on MIRR, and if the projects are mutually exclusive (i.e. only one project can be selected) then the firm should go with Project L (the Lime Soda). Note: At a 10% cost of capital Project S would be superior based on the MIRR calculation.
3

IRR assumes that cash flows are invested at the IRR rate.

Capital Budgeting

4. Profitability Index (PI) The profitability index is the present value of the projects cash flows divided by the cost. (Assume a 5% cost of capital) PI tells us how much profit we can earn for each dollar invested.

PV of future cash flows t = 0 PI = = Initial cost CF 0

500 PI S

( 1+ r )
100

CFt

( 1 + 5% ) =
=

400

( 1 + 5% )

300

(1 + 5% )

(1 + 5% )

1000

$1180.42 = 1.18 $1000 100 300 400 600 + + + 1 2 3 4 ( 1 + 5% ) ( 1 + 5% ) ( 1 + 5% ) ( 1 + 5% ) PI L = 1000 $1206.50 = = 1.21 1000 Conclusion: Based on PI, and if the projects are mutually exclusive (i.e. only one project can be selected) then the firm should go with Project L (the Lime Soda). According to the Profitability Index calculation at a 5% cost of capital Project L will yield $1.21 for every dollar invested in the project. Note: At a 10% cost of capital Project S would be superior based on the PI calculation. 5. Payback Period The payback period is the expected number of years required to recover the original investment. The payback period method has three main flaws: 1) dollars received in different years are all given the same weight 2) cash flows beyond the payback year are not considered 3) payback period analysis does not provide an indication of how much shareholder wealth should increase (like NPV) and 4) payback period analysis does not indicate how much the project will yield over the cost of capital (like IRR).

Payback = Number of years prior to full recovery + Unrecovered cost at start of year Cash flow during full recovery year $100 = 2.33 years $300

Payback S = 2 +

Capital Budgeting

Payback L = 3 +

$200 = 3.33 years $600

Cumulative CFs -$1000 -500 -100 200 300 Project L Cash Flows Year 0 = -$1000 Year 1 = 100 Year 2 = 300 Year 3 = 400 Year 4 = 600 Cumulative CFs -$1000 -900 -600 -200 400

Project S Cash Flows Year 0 = -$1000 Year 1 = 500 Year 2 = 400 Year 3 = 300 Year 4 = 100

Conclusion: Based on the payback method, and if the projects are mutually exclusive then the firm should go with Project S (the Sugar Soda). 6. Discounted Payback This method is similar to the payback period method except the cash flows are discounted by the projects cost of capital. The discounted payback period is the number of years required to recover the investment from the discounted net cash flows. (Assume a cost of capital of 5%)

Discounted Payback = Number of years prior to ful l recovery* Unrecovered cost at start of year* Cash flow during full recovery year * *considers discounted cash flows +
Project S Cash Flows Year 0 = -$1000 Year 1 = 500 Year 2 = 400 Year 3 = 300 Year 4 = 100 Discounted CFs Cumulative CFs 0 -1000/(1.05) = -$1000.00 -$1000.00 500/(1.05)1 = 476.19 -523.81 400/(1.05)2 = 362.81 -161.00 3 300/(1.05) = 259.15 98.15 100/(1.05)4 = 82.27 180.42

Payback S = 2 +

$161.00 = 2.62 years $259.15

Discounted CFs Cumulative CFs 0 -1000/(1.05) = -$1000.00 -$1000.00 100/(1.05)1 = 95.83 -904.76 2 300/(1.05) = 272.11 -632.65 400/(1.05)3 = 345.54 -287.12 4 600/(1.05) = 493.62 206.50

Project L Cash Flows Year 0 = -$1000 Year 1 = 100 Year 2 = 300 Year 3 = 400 Year 4 = 600

Payback L = 3 +

$287 = 3.58 years $493

Conclusion: Based on the discounted payback method, and if the projects are mutually exclusive then the firm should go with Project S (the Sugar Soda).

Capital Budgeting