Chapter 12
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CHAPTER 12. THE CAPITAL BUDGETING DECISION. Capital Expenditures Decision. CE usually require initial cash outflows in hope of future benefits or cash inflows Examples: new plant construction, acquisition of business, purchase of new machine, etc. Projects often last for more than a year

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Capital Expenditures Decision

  • CE usually require initial cash outflows in hope of future benefits or cash inflows

  • Examples: new plant construction, acquisition of business, purchase of new machine, etc.

  • Projects often last for more than a year

  • The longer the time horizon, the greater the uncertainty

Areas of Uncertainty in CE Decision

  • Expected cash flows

  • Product life

  • Interest rates

  • Economic conditions

  • Technological change

Capital Budgeting

  • To see if the CE is economically acceptable - if it creates or adds value to the firm

  • To examine the CE from an investment perspective

  • The basic concept is to determine if it makes sense to commit to an initial cash outflows in order to receive future cash inflows

Example - Project A

Project A cont’

Project Evaluation

  • Discount Rate = Cost of Capital

  • Positive NPV indicates that the yield or rate of return on the project exceeds the cost of capital (thus add value to the firm)

  • Project is financially acceptable when the PV of the total cash inflows greater than the PV of the total cash outflows ( +ve NPV)

Example - Project B

Project B cont’

Project B cont’

  • Both projects A and B require an initial capital outflow of $10000

  • Both of them will generate a total return of $12000 in the next three years

  • However, project A has a positive NPV while project B has a negative NPV

  • Why?

Project A

Yr 0-$10,000

Yr 1$5,000

Yr 2$5,000

Yr 3$2,000

Project B

Yr 0-$10,000

Yr 1$2,000

Yr 2$5,000

Yr 3$5,000

Cash Flows of Project A & B


  • For Project A, the cash inflows mainly occur at the first two years

  • For Project B, the cash inflows mainly come in at the last two years

  • Due to the time value of money, money received earlier has higher value than that received later

  • Hence, Project B is not acceptable -(negative NPV)

Flexibility of NPV - Using various discount rates across time

  • The longer the time horizon, the higher the risk

  • Sometimes, we may have to use a higher discount rate for income in the latest year

  • Instead of 10%, we may use 12% to discount the latest cash inflow at the end of third year

  • NPV method provides such a flexibility

Flexibility of NPV – allow reversal of cash flows

  • NPV method can be applied to any type of cash flows even cash flows with reversal

  • Cash flows with reversal means that there are more than one cash outflows

  • Example: a 2-year project with cash flows:

  • Yr 0 – Initial cash outflow – (-$1000)

  • Yr 1 – Cash inflow – (+$5000)

  • Yr 2 – Another cash outflow – (-$3000)

Profitability Index

  • It is a variation of the NPV method

  • Profitability index (PI)

    = PV of cash inflows/PV of cash outflows

  • If PI > 1, PV of cash inflows is greater than PV of cash outflows. That is NPV > 0

  • Hence project with PI > 1 is financially viable

Another method - IRR

  • IRR = Internal Rate of Return

  • The IRR is the discount rate at which the PV of cash inflows = PV of the cash outflows

  • I.E., IRR is the discount rate which makes the NPV = 0

  • Project is financially acceptable when the IRR is greater than the cost of capital

IRR of Project A

IRR of Project B

Project Evaluation

  • Project A has an IRR of 11.16% which is higher than the cost of capital, 10%. Hence project A is financially acceptable.

  • Project B has an IRR of 8.53% which is lower than the cost of capital, 10%. Hence project B is financially not acceptable.

Why bother to use IRR?

  • Since both NPV and IRR generate similar results, why bother to use IRR

  • Yield derived from IRR may be more comprehensible than the absolute value derived from NPV

  • In fact, we use IRR when we cannot use the cost of capital (the risk of the project differs from the risk of the firm)

Limitations of IRR method

  • A single discount rate (the IRR) throughout the project life – inability to account for cash flows of different risk levels

  • Possibly unrealistic to assume reinvestment of the generated cash inflow at the IRR

  • Inapplicable when more than one reversal of cash flows exists – will generate multiple IRRs in that case

Graphical Illustration of NPV and IRR

See Examples Below

Investment A

Yr 0-10000

Yr 1 5000

Yr 2 5000

Yr 3 2000

Investment B

Yr 0-10000

Yr 1 1500

Yr 2 2000

Yr 3 2500

Yr 4 5000

Yr 5 5000

Cash Flows of Investment A&B





IRR= 14.33%





IRR= 11.16%

Discount Rate

NPV Profile – NPVs at different Discounting rate



Investment B

Yr 0-10000

Yr 1 1500

Yr 2 2000

Yr 3 2500

Yr 4 5000

Yr 5 5000

Investment C

Yr 0 -10000

Yr 19000

Yr 23000

Yr 31200

Cash Flows of Investment B & C

NPV Profile with crossover



Crossover point





IRR= 14.33%






IRR= 22.49%

Discount Rate

Where are we?

  • How to raise capital?

  • We have learned the three ways of raising long-term capital for a firm. What are they?

  • How to use the capital to generate more money?

  • Underlying principle – to generate an investment return that is greater than cost of capital

  • The lowest required rate of return = cost of capital

Project Valuation

  • Similar to the valuation of financial instruments, we must assess the fair market value for any capital expenditure project.

  • The highest price we pay is the present value of expected cash flows (derived from the project) discounted at the rate equivalent to the cost of capital

  • Basic concept – lowest rate of return = highest price to be paid

Cash Flows Determination

  • Net of tax i.e. after tax net cash flow

  • Gross of all financing costs (they have been reflected in the discount rate)

  • Shortfalls:

    - Future projection may base on extrapolation

    - Bias built into the cash flows estimation

    - Over/under estimate of the inflation

    - Neglect other qualitative factors such as better corporate image, fairer treatment of employee, etc

Capital Rationing

  • Management, for some reasons, may impose a dollar constraint in certain kind of investment

  • Projects become mutually exclusive

  • Project is selected based on the amount of benefit generated by the project

  • That is, projects with the greatest NPV or the highest IRR

Table 12-7Capital rationing


Total Present


  • CapitalA $2,000,000 400,000rationing B 2,000,000 380,000

  • solution C 1,000,000 $5M 150,000

  • Best D 1,000,000100,000

  • solution E 800,000 $6.8M40,000

  • F800,000(30,000.)

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