1. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Capital budgeting - A process of evaluating and planning expenditure on assets that will provide future cash flow(s).
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

2. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Payback period
The number of years required to recover a project’s cost,
or how long does it take to recover the investment?
Pros:
Provides an indication of a project’s risk and liquidity.
Easy to calculate and understand.
Cons:
Ignores the TVM.
Ignores CFs occurring after the payback period.
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

3. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Net Present Value
Sum of the PVs of inflows and outflows
CFt Period t Cash Flow, positive for inflows, negative for outflows.
r discount rate
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

4. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
NPV Decision rule.
NPV = PV Inflows –
PV Outflows (Cost)
= Net gain in wealth.
Accept project if NPV > 0
Reject project if NPV < 0
Choose between mutually
exclusive projects on basis of
higher NPV. Adds most value.
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

5. IRR:Internal rate of Return
IRR is the discount rate that forces
PV inflows = PC outflow .
This is the same
as forcing NPV = 0.
IRR is the rate that solve the equation.
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

6. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
IRR Decision Rule
r Discount rate
If IRR > r, accept project.
If IRR < r, reject project.
Consistent with NPV
If IRR > r  NPV >0
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

7. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
NPV vs IRR
NPV assumes reinvest at r (opportunity cost of capital).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

8. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
NPV vs IRR
For mutually exclusive projects, IRR does not consider project scale.
Multiple outflow periods lead to multiple IRR.
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

9. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Project Cash Flow
Consider only incremental cash flows.
Disregard sunken cost (sunken cost has no impact on future cash flows: it is irrelevant to shareholders)
Opportunity cost of resources as project cost.
Consider effect on other projects (externalities).
Beware of inflation.
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

10. Depreciation and Cash Flows
It is important to remember that when making financial decisions only timed cash flows are used
depreciation is an expense, but is not a cash expense, and must be excluded
the tax benefit of depreciation, however, is a cash flow, and must be included
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

11. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Proposed Project A
Capital equipment initial cost $240,000, all depreciable.
Economic life = 4 years
Salvage value = 25,000
Depreciable using 3 year class MACRS.
Sales: 100,000 $2.
Variable cost = 60% of sales.
Tax rate = 40%.
Discount rate = 10%.
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

12. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Proposed Project A
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

13. Working Capital & Cash Flows
Some cash flows do not occur on the income statement, but involve timing
working capital additions and reductions are cash flows
at the end of a project, the sum of the nominal changes in working capital is zero
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

14. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Proposed Project A.1
Working Capital – The difference between current assets and current liabilities.
In capital budgeting Working capital is committed to the project and is fully recovered by the end of the project.
Project requires $50,000 working capital in the initial year. The working capital is recovered when the project is terminated.
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

15. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Proposed Project A.1
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

16. Inflation and Capital Budgeting
Assume annual inflation (π ) rate affect all project cash flow.
We can:
Use nominal rate to discount nominal cash flows
Use real rate to discount real cash flow.
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

17. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Proposed Project A.2
Assume Project A faces inflation π = 5%
Inflate cash flow by inflation rate (after period 1).
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

18. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Proposed Project A.2
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

19. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Sensitivity Analysis
Will the project still be economical if some of the underlying variables are incorrect?
We can check the effect on the project of different variable and how sensitive is the project NPV to them
For Example:
Sales Units
Sales Price
Variable Cost
Life of the Project
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg

20. Bus 512- Capital Budgeting | Dr. Menahem Rosenberg
Sensitivity Analysis
Project A, with $10,000 sales increments.
NPV Breakeven occurs at $187,985
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Bus 512- Capital Budgeting | Dr. Menahem Rosenberg