Capital Budgeting is about allocating resources to competing uses
* Why resource allocation is important:
 Because resources are scarce
 Because a misallocation of resources can be fatal
* Range of decisions:
 Independent versus mutually exclusive projects
 Costminimizing versus profitmaximizing projects
* Sensible resource allocation requires an understanding of:
 Risk and how it affects project choice
 How returns from the project will be measured (earnings versus
cash flows)
What is a project?
Any decision that requires the use of resources (financial or
otherwise) is a project. This can range from:
* Broad strategic decisions
 Entering new areas of business
 Entering new markets
 Acquiring other companies
* Tactical decisions
 Opening a new branch
 Expanding an existing branch
* Management decisions
 The product mix to carry in a business
 The level of inventory to maintain
* Decisions on delivering a needed service
 Lease or buy a distribution system
 Creating and delivering a management information system
 Providing a training program to educate employees
Approaches to Investment Decision Making
Equity Approach: One approach focuses on the equity investor in the project and asks the question ñ Are the returns to equity investors high enough to justify taking this project?.
Firm Approach: The second approach expands the analysis to cover all investors in the firm  equity investors, lenders and preferred stockholders, if any. It asks a broader question  Are the total returns made by this project for all the investor groups high enough to justify taking this project?.
Approach Hurdle Rate Returns
Equity Approach Cost of Equity Returns to Equity Investors
Firm Approach Cost of Capital Returns to All Investors
Cost of Equity: What Equity Investors require as a rate of return
for investing ...
Cost of Capital: What all investors (Equity Investors, Lenders)
require as a rate of return for investing ...
Alternative Decision Rules
* Net income versus Cash Flow Based Rules
* Net Income versus Cash Flows
 Net income is based upon accounting rules; cash flows are based
upon cash inflows and cash outflows.
 Net income is easier to manipulate than cash flows.
 There are cases where net income and cash flows give very different
pictures of a project.
 When net income and cash flows conflict, cash flows are much
more likely to reflect reality.
* Why net income is different from cash flows:
 Because depreciation, which reduces net income, is a noncash
charge.
 Because capital expenditures, which reduce cash flows, do not
affect net income.
 Because working capital needs, which do not affect net income,
can affect cash flows.
1. You have written a bestselling book, which Paramount Communications
is planning to turn into a movie. You are negotiating your contract
with Paramount, and they offer you two choices. Which of the two
would you choose?
* 10% of net income on the movie
* 1% of the gross revenue on the movie
I. Accounting Measures
Return on Investment (ROI): This is the ratio of the firm's income to the book value of
its assets. In project terms, this is the ratio of average aftertax
income brought in by the project to the average investment in
the project.
ROI = Average Income / Average Investment
Average Income = Average Net Profit after taxes from investment
Average Investment = (Beginning Investment + Ending Salvage Value)/
2
Decision Rule: ROI > Cut off ROI
Limitations:
(a) Accounting Income can be fudged using accounting techniques
(b) Book Value is often an unreliable measure of the true investment
in the project.
Two Variants on ROI
Return on Equity (ROE) = Average Net Income / Average BV of Equity
Return on Assets (ROA) = Average EBIT (1tax rate)/Average BV
of Assets
2. You are the divisional manager of a company that evaluates
divisional managers on the basis of their return on investment
(defined to be net income divided by the book value of the assets
in the division). Last year you made $ 3 million and had a return
on investment of 30%. You know that your machines are old and
inefficient. If replaced, your profits will jump to $ 5 million.
It will cost you $ 10 million to do the upgrade. Would you?
* Yes, I would
* No, I would not.
II. Cash flow Measures
Payback: This is the measure of the number of years before the initial
investment in the project is made back (in cash flows).
Decision Rule: Payback < Cutoff Payback period
Limitations:
(a) It does not consider cash flows after the payback period
(b) It is difficult to compare payback periods.
Using the payback in decision making
* Payback is more a measure of risk than return. A project with
a lower payback is generally considered to be less risky than
one with a higher payback.
* Payback is much more important for firms with cash flow problems.
For instance, highly leveraged firms are more likely to use payback
than firms with significant cash flows.
* Payback is much more important in businesses where there is
significant uncertainty about the life of the project (because
of technological or other changes).
3. You are comparing two projects on the basis of payback  one
has a payback of 3 years and the other has a payback of 5 years.
Which of the following statements do you most agree with ñ
* The project with the lower payback is the better project
* The project with the lower payback is the less risky project
* it is difficult to draw any conclusion based purely on the payback
III. Discounted Cash flow Measures
Net Present Value (NPV): The net present value is the sum of the present values of all
cash flows from the project (including initial investment)
NPV = Sum of CFt /(1+r)t  Initial Investment
Decision Rule: Accept if NPV > 0
Internal Rate of Return (IRR): The internal rate of return is the discount rate that sets the
net present value equal to zero.
Decision Rule: Accept if IRR > Discount rate
4. One of the arguments for using IRR is that you do not need
a discount rate (whereas you do for the NPV). Do you agree with
this statement?
* Yes
* No
Discounted Payback: This is a measure of the number of years before the initial investment
is made back (in discounted cashflows)
Decision Rule: Accept if discounted payback < Cutoff payback
Assumptions Of NPV Rule
a. The Reinvestment rate assumption: The NPV rule assumes that shareholders can invest their money
at the opportunity cost of capital. Since this is market determined
this is the correct assumption.
b. The Value Additivity Principle:
NPV(A+B+C)= NPVA + NPVB + NPVC
The implication is that the value of a firm is the sum of the
net present values of all its projects. No other decision rule
has this property.
5. A firm with a value of $ 100 million takes a project with a
net present value of $5 million. What should the value of this
firm be after the project is taken?
c. Term structure of interest rates
If interest rates are expected to change and such expectations
can be quantified the NPV rule is flexible enough to allow it
NPV = CF1/ (1+r1) + CF2/(1+r1)(1+r2)
where rn = Oneyear interest rate in year n
NPV Profiles
A NPV profile estimates the NPV at various discount rates. It
is useful because it illustrates the sensitivity of the net present
value to the discount rate. Consider the following example:
Time Cash flow
0 12337
1 +10000
2 + 5000
The NPV profile looks as follows:
MULTIPLE IRRs
Consider the following investments:
Investment  CF  Year 0  CF  Year 1  Cf  Year 2  IRR 
R  100  30  130  30% 
S  0  280  350  25% 
I  100  310  220  10% OR 100% 
* Which of the IRRs would you choose to use in your decision?
IRR vs. NPV: SCALE OF CASHFLOWS
Project X  Project Y  Project Z  
Initial Investment  100,000  1,000,000  100 
Cashflow in Year 1  +140,000  +1,250,000  +150 
NPV (@15%  21,739  86,957  30 
IRR  40%  25%  50% 
Year  Project A  Project B 
0  1,000,000  1,000,000 
1  800,000  100,000 
2  300,000  400,000 
3  200,000  500,000 
4  100,000  800,000 
NPV  81,154  116,781 
IRR  22.99%  21.46% 
A Solution to the Reinvestment Rate Problem: The Modified Internal Rate of Return
One solution that has been suggested for the reinvestment rate
assumption is to assume that intermediate cash flows get reinvested
at the hurdle rate and to calculate the internal rate of return
from the initial investment and the terminal value. This approach
yields what is called the modified internal rate of return (MIRR).
Modified Internal Rate of Return = ($2160/$1000)^{1/4} 1 = 21.23%
What Do Firms Do?
A Survey in 1976
Primary  Secondary  
TECHNIQUE  Number  Percent  Number  Percent 
Internal Rate of Return  60  53.60%  13  14.00% 
Rate of return  28  25.00%  13  14.00% 
Net Present Value  11  9.80%  24  25.80% 
Payback period  10  8.90%  41  44.00% 
Benefit/Cost Ratio  3  2.70%  2  2.20% 
Total Responses  112  100.00%  93  100.00% 
Primary  Secondary  
TECHNIQUE  Number  Percent  Number  Percent 
Internal Rate of Return  288  49.00%  70  15.00% 
Rate of return  47  8.00%  89  19.00% 
Net Present Value  123  21.00%  113  24.00% 
Payback period  112  19.00%  164  35.00% 
Benefit/Cost Ratio  17  3.00%  33  7.00% 
Total Responses  587  100.00%  469  100.00% 
STRUCTURING CASHFLOWS FOR CAPITAL BUDGETING
PROBLEM 1: Structuring Cashflows (Solution on next page )
Cost of project investment = $50000 Salvage value = $10000
Life expectancy for project = 5 years Tax rate = 40%
Investment tax credit = 10% Revenues/ year = $40000
Depreciation method = Straight line Expenses/year = $20000
Financing: The project will be financed with owner's equity. The
discount rate is 10%.
PROBLEM 2: WORKING CAPITAL AND OPPORTUNITY COSTS
Cost of project investment = $50000 Salvage value = $10000
Life expectancy for project = 5 years Income Tax rate = 40% *CG
rate = 20%
Investment tax credit = 10% Revenues/ year = $40000 *Growth =10%
*Depreciation method =DDB Expenses/year = $20000 *Growth = 10%
* Working capital needs: $10000 initially and maintained at 25%
of revenues over time.
* The project will use equipment already owned by the company.
If the project is not taken this equipment would have been sold
for $10000. It has a book value of $5000.
Financing: The project will be financed with owner's equity. The
discount rate is 10%.
* The Effects Of Depreciation On NPV
Straight line Depreciation:
Year  Depreciation  Tax Savings  PV 
1  8000  3200  2909 
2  8000  3200  2645 
3  8000  3200  2405 
4  8000  3200  2186 
5  8000  3200  1987 
Year  Depreciation  Tax Savings  PV 
1  20000  8000  7273 
2  12000  4800  3967 
3  7200  2880  2164 
4  800  320  219 
5  0  0  0 
7. You have invested $100 million in an item, which can be expensed
or depreciated. Which of the following choices will have the most
favorable impact on current net income?
* Depreciate the item using straight line depreciation.
* Depreciate the item using accelerated depreciation
* Expense the item.
8. Which of the choices above will have the most favorable impact
on current cash flows?
* Depreciate the item using straight line depreciation.
* Depreciate the item using accelerated depreciation
* Expense the item.
Proposition 1: Generally speaking, the net present value of a project will increase
if we shift from straight line depreciation to accelerated depreciation,
and the more accelerated the depreciation, the greater the net
present value.
Question: There are two exceptions to this proposition. What are they?
* The Effects Of Changes In Working Capital
WORKING CAPITAL = NONCASH CURRENT ASSETS  CURRENT LIABILITIES
Why working capital affects cash flows
Funds invested in working capital cannot be used elsewhere. Any
increase in working capital will reduce cash flows available for
other uses, and any decrease in working capital will increase
cash flows.
Questions On Working Capital
1. To start this project, do I need any initial working capital?
2. After the project is under way, are there any changes in working
capital?
Increase in working capital > Decrease in cashflow
Decrease in working capital > Increase in cashflow
3. At the end of the project lifetime, how much can be salvaged
from working capital?
9. You are looking at a project analysis, which yields a net present
value of $ 18,829. The project analyst, however, failed to consider
working capital requirements in calculating the net present value.
(The working capital investment needed is $ 10,000 initially,
and will increase by $ 4,641 over the next five years, but the
entire amount of $14,641 will be salvaged at the end of the fifth
year. The entire amount will be salvaged at the end of the project
life, and the discount rate is 10%). What effect will considering
working capital have on the net present value?
* It will increase the net present value.
* It will not affect the net present value.
* It will decrease the net present value.
Ignoring working capital will lead to 
a. overestimation of NPV
b. failure to plan for cashflow needs
In this project, the effects of working capital are as follows

Year  Revenues  Working Capital  Change in WC  Effect on Cash Flow 
0    10000  10000  10000 
1  40000  10000  0  0 
2  44000  11000  1000  1000 
3  48400  12100  1100  1100 
4  53240  13310  1210  1210 
5  58564  14641  1331  1331 
Total  14641 
Net Opportunity Costs = 10000  1000  1516 = 7484
10. Assume that, in the example of the van, instead of planning
to sell the van, you intended to rent it out for $ 2,000 a year
for the next 5 years, if you do not take the project. What is
the opportunity cost of the van?
* $ 10,000
* $ 7,581
* $ 4,549
* $ 6,065
* $ 3,033
THE EFFECTS OF UTILIZING EXCESS CAPACITY: IS THERE AN OPPORTUNITY
COST?
Framework for analysis:
1. If the new product is not taken, when will the firm run out
of capacity? Year n
2. If the new product is taken, when will the firm run out of
capacity? Year n  t
3. When the firm runs out of capacity, what will the firm do?
3.1. Cut back on production of less profitable product  Compare
contribution margins:
Cost = PV of lost cashflows on lost sales.
3.2. Build new capacity: Cost = PV of building capacity in nt
 PV of Building capacity in n
Choose Less Expensive Alternative In Present Value Terms
This Is Your Opportunity Cost
An example:
Existing Capacity = 100,000 units
Current Usage = 50,000 (50% of Capacity); 50% Excess Capacity;
New Product will use 30% of Capacity; Sales growth at 5% a year;
CM per unit = $5/unit
Should there be a cost attached with the usage of this capacity?
Book Value = $1,000,000 Cost of a building new capacity = $1,500,000
Current product sales are growing at 10% a year. CM per unit =
$4/unit
Year  Old  New  Old + New  Lost ATCF  PV(ATCF) 
1  50.00%  30.00%  80.00%  $0  
2  55.00%  31.50%  86.50%  $0  
3  60.50%  33.08%  93.58%  $0  
4  66.55%  34.73%  101.28%  $5,115  $3,251 
5  73.21%  36.47%  109.67%  $38,681  $21,948 
6  80.53%  38.29%  118.81%  $75,256  $38,127 
7  88.58%  40.20%  128.78%  $115,124  $52,076 
8  97.44%  42.21%  139.65%  $158,595  $64,054 
9  107.18%  44.32%  151.50%  
10  117.90%  46.54%  164.44%  
PV(LOST SALES)=  $179,456  
PV (Building Capacity In Year 3 Instead Of Year 8) =  
=  1,500,000/1.12^3 1,500,000/1.12^8=  $461,846 
12. The net present value for the project, assuming all equity
financing, is $ 17,678. Assume that you borrow $30,000 at 8% and
take the same project. (Everything else about the projects is
unchanged.) What will the effect on NPV be?
* The NPV will go up.
* The NPV will remain unchanged.
* The NPV will go down.
*There is insufficient information to answer the question.
PROBLEM 3: DEBT FINANCING
Cost of project investment = $50000 Salvage value = $10000
Life expectancy for project = 5 years Income Tax rate = 40% CG
rate = 20%
Investment tax credit = 10% Revenues/ year = $40000 Growth =10%
Depreciation method =DDB Expenses/year = $20000 Growth = 10% Working
capital needs: $10000 initially and maintained at 25% of revenues
over time.
The project will use equipment already owned by the company. If
the project is not taken this equipment would have been sold for
$10000. It has a book value of $5000.
Financing: Borrow $30000 at 8% using a term loan. Balance is owner's
equity
EFFECTS OF DEBT FINANCING ON EQUITY CASH FLOWS
Year  Cashflows without  Cashflows with 
Debt  Debt  
0  62484  32484 
1  20000  13446 
2  17000  10282 
3  16300  9406 
4  15082  7997 
5  16238  8497 
NPV  17678  21622 
THE GAINS FROM DEBT
APPROPRIATE COMPARISON  COST OF EQUITY  COST OF DEBT 
NAIVE  10%  8% (1.4) = 4.8% 
RISK ADJUSTED  10% + 2 % = 12%  8% (1.4) = 4.8% 
Debt is cheaper than equity, but it increases the cost of equity.
What determines this risk adjustment?
 The risk adjustment will be determined in large part by the
business risk that the firm has taken on.
 A more explicit analysis of this risk adjustment will follow
in the risk/return section.
ISSUES IN CASHFLOW ESTIMATION
I. SUNK COSTS
What are sunk costs? : Funds that have been spent already can be considered to be
sunk costs.
How should they be treated?: Sunk costs are irrelevant from the viewpoint of capital budgeting
since taking the project has no effect on these costs (They have
already been spent.)
What about test market expenses?
IB. Test Market Expenses
Are test market costs sunk?
At the time of the project, yes.
Before the project, no.
Can test market expenses be ignored?
At the time of the capital budgeting analysis, yes.
But who pays for the test market expenses?
Test market expenses have to covered with profits from successful
products.
To be successful, NPV of successful projects > Test Market costs
What about R&D Costs?
II. ALLOCATED COSTS
The allocation of existing costs to new products should not affect
cashflows.
However, any incremental effect of new products on allocated costs
should affect cashflows.
Example:
Total Administrative Costs before new project= $600,000 After
new project = $660,000
Number of Existing Divisions = 5 Administrative Costs/Division
= $120,000
Number of Divisions with new project=6 Administrative Costs/Division=
$110,000
III. COSTS IMPOSED ON OTHER PRODUCTS
Product Cannibalization
A new product's sales may come at the expense of other products
in the company's own line.
Should you consider this lost sales as part of the cost of the
new project?
A Real World Example: NPV from the Equity Investorsí Standpoint The Home Depot Store Analysis
I. Return on Equity
If $5 million of this initial investment comes from borrowing,
the book value of equity and the anticipated net income on the
store are estimated to be as follows ñ

BV of Equity  Depreciation  Net Income  Return on Equity 

$7,500,000  

$6,000,000  $ 1,500,000  $ (250,000) 


$4,800,000  $ 1,200,000  $ 112,500 


$3,840,000  $ 960,000  $ 418,125 


$3,072,000  $ 768,000  $ 679,031 


$2,457,600  $ 614,400  $ 904,983 


$1,966,080  $ 491,520  $ 1,103,832 


$1,572,864  $ 393,216  $ 1,281,904 


$1,258,291  $ 314,573  $ 1,444,303 


$1,006,633  $ 251,658  $ 1,595,161 


$805,306  $ 201,327  $ 1,737,834 


$3,116,252  $ 902,767 

II. Estimating Cash Flows to Equity
The free cash flows to equity are estimated from the net income
for the store. It is expected that 40% of net capital expenditures
and working capital needs will be financed with debt.
Year 
Net Income  Equity Capital Investment 
Depreciation  Increase in Work. Cap. 
ATCF to Equity 
1  $ (250,000)  $ 1,500,000  $ 125,000  $ 1,125,000  
2  $ 112,500  $ 1,200,000  $ 131,250  $ 1,181,250  
3  $ 418,125  $ 960,000  $ 137,813  $ 1,240,313  
4  $ 679,031  $ 768,000  $ 144,703  $ 1,302,328  
5  $ 904,983  $ 720,000  $ 614,400  $ 151,938  $ 647,445 
6  $ 1,103,832  $ 491,520  $ 159,535  $ 1,435,817  
7  $ 1,281,904  $ 393,216  $ 167,512  $ 1,507,608  
8  $ 1,444,303  $ 314,573  $ 175,888  $ 1,582,988  
9  $ 1,595,161  $ 251,658  $ 184,682  $ 1,662,137  
10  $ 1,737,834  $ 201,327  $ 193,916  $ 4,122,787 
Free Cash Flows to Equity: The Home Depot ñ Store Analysis
Year 
FCFE  Cumulative CF 
Year 

Cumulative CF 






























5 

$ (2,003,665) 
Year  Net Income  Equity Investment  Depreciation  D WC  FCFE  PV of FCFE 
0  7500000  7500000  7500000  
1  250000  1500000  125000  1125000  978261  
2  112500  1200000  131250  1181250  893195  
3  418125  960000  137813  1240313  815526  
4  679031  768000  144703  1302328  744610  
5  904983  720000  614400  151938  647445  321894 
6  1103832  491520  159535  1435817  620743  
7  1281904  393216  167512  1507608  566766  
8  1444303  314573  175888  1582988  517482  
9  1595161  251658  184682  1662137  472483  
10  1737834  201327  193916  4122787  1019090  
NPV =  549951 
Illustration: The Boeing 777 Example
I. Estimating Operating Income and Return on Capital
Return on Capital_{t} = Operating Income*2 / (BV of Assets_{t1} + BV of Assets_{t})
Aftertax Return on Capital = Return on Capital (1  tax rate)
II. Calculating Net Present Value
The following table calculates the present value of the cash flows
to Boeing, as a firm, from the Boeing 777 project, using the cost
of capital of 12% as the discount rate on the cash flows. 15
Year  EBIT (1t)  Cap. Exp  Depreciation  D WC  FCFF  PV of FCFF 
0  4000  4000  4000  
1  929  82  1722  711  635  
2  1666  72  17  1755  1399  
3  1458  67  343  1868  1330  
4  1615  62  51  1626  1033  
5  1620  61  91  1772  1005  
6  1507  61  102  1466  742  
7  1647  61  42  1666  754  
8  1922  489  61  247  1247  504 
9  1658  102  212  1972  711  
10  922  98  431  588  189  
11  1718  90  376  1432  412  
12  1899  78  137  1840  472  
13  1640  500  75  389  826  189 
14  1172  73  604  641  131  
15  1895  52  119  5385  984  
NPV  5220 
This project has a net present value of $5220, suggesting that
it is a project that should be accepted, based upon the projected
cash flows, and the cost of capital of 12%.