Corporate

Finance
[Capital Budgeting
Techniques]

Dr. Sawkat Hossain

1
Acknowledgement Ross et al, 2011, Essentials of Corporate Finance, 7th Ed, McGraw-Hill Companies, Inc..
Learning Outcome
 Critical evaluation and application of
various capital budgeting techniques.

 Review the recent and relevant

finance literature.
 INVESTMENT APPRAISAL TECHNIQUES:
UNDERLYING REASONS & APPLICATIONS
Expansion – capacity and revenues of firm.

Diversification – Reducing risk.

Cost saving – new technological projects

Replacement –

Safety / legal issue –

Lease or buy decisions –

 Rationale of investment
appraisal
Investment Concept?
Objective of investment appraisal ?
Financial resources are expensive and may be
limited and so must be used in the most
efficient and effective way possible.
The effect on revenues is uncertain and may
persist for many years.
The decision may not be reversible.
 Concept and Steps of Capital Budgeting
The process of allocating firm resources for major capital investment, & expenditures.
Capital Budgeting Procedure
Stowe and Gagne (2018) Model
Types of Basic Techniques
 There are two groups of basic
investment appraisal techniques:
 1. Non-discounted methods
ROCE, & PB method
 2. Discounted methods
DPB, NPV, IRR, EACF, P.I methods.
 Return on Capital Employed
ROCE/ROI/ARR/AAR: EX- A
* Gains to costs ratio & accounting-based method.
Example: Cofla Ltd, Project A with 4 years maturity:
Given, initial capital investment = 250,000
Total Revenues Streams
(70,000+110,000+100,000+40,000) …………..
Average Annual Cash Flows (320,000/4)
Less: average depreciation (250,000/4)
Average Annual Net Profits ………………
Average capital Investment (250,000/2)

ROCE/ROI/ARR 17,500/125,000 ………%

* Q. Evaluate the project if Index rate is 11.5%
ROCE/ROI/ARR: EXAMPLE B
Cofla Ltd, Project B with 6 years maturity
Given, initial capital investment is same of Project A
Total In-flows from Revenues
(80000 + 80000 + 80000+ 90000 + 80000 +30000) =
Average Annual Cash Flows (440,000/6)
Less: average depreciation (250,000/6)
Average Annual Net Profits ……………..
Average capital Investment (???)
ROCE/ROI/ARR:
* Q. Evaluate the project if Index rate is 11.5%
*Q. Between A and B, which one is recommended?
* Q. Critically evaluate the appraisal technique.
 Activity-0:
Return on Investment /
Accounting Rate of Return

 Let us assume, a project has an installation

cost of $4.0 million. If the plant has
projected net income of $1735000;
$2105,000; $1945,000; and $1342,000 over
these four years, following the straight-line
depreciation, what is the project's average
accounting return (AAR)?
 Provide your comment if the market hurdle
rate is 15.5%. Critically evaluate AAR.
 Non-discounted method
PAYBACK TECHNIQUE
Calculates the length of time that the estimated cash
flows take to pay the original cost of the investment.
Example: Cofla Ltd, Project A: £
Initial investment in project A 250,000
Accumulating cash inflows:
year 1 70,000
year 2 110,000
year 3 70,000

• The payback period or the project is repaid

investment within:…..

* Provide your comment.

Payback-Period:
Example: Cofla Ltd, Project B: £
Initial investment in project B 250,000
Accumulating cash inflows:
year 1 80,000
year 2 80,000
year 3 80,000
year 4 90,000
Total:
The project is therefore repaid the initial cap.: ………….

* Provide your comment.

Payback
 Therefore, based on payback time,
project A is the most favourable

 Note: To resolve the issue of time

value of money discounted payback is
normally applied in practice.
Payback
Advantages:
 It is simple to understand and apply
 Companies with cash flow problems will
want a quick payback
 The longer the project lasts the greater
the risk of error in forecast estimates
 Real life applications
 Any other issue?
Payback
Disadvantages
 Risk evaluation.
 Time value of money.
 Ignores cash flows
B. Discounted Payback Method
Example: Cofla Ltd, Project C:
Assume interest rate is 5%
Initial investment in project B 250,000
Accumulating cash inflows:
year 1 80,000
year 2 80,000
year 3 80,000
year 4 60,000
year 5 50,000
**Under discounted payback period, project payback period
changes due to ..……….. method.
** Between traditional & discounted payback method, which
payback period w/b relatively higher?
 NPV AND IRR Methods
Discounted Cash Flow Techniques continues…..

Based on the principle of the TVM.

The technique is based on calculating
the Present Value of any future
receipts.
This is the exact reverse of compound
interest.
There are two types of DCF techniques:
1. NPV method
2. IRR method
NET PRESENT VALUE (NPV)
 NPV recommends project if worth is more
than cost.
 Thus managers should accept all projects with
positive NPV.
 The NPV method uses DCF technique where
project cash flows are discounted at
appropriate rate.
 This rate a firm use to take account of time
value of money is called cost of capital or
discount rate or required return.
 Cost of capital or discount rate or required
return?
NET PRESENT VALUE
 NPV = PVCF – investment outlay
C1 C2 C3 Cn
NPV = C0 + + + +
1 + r (1 + r ) (1 + r ) (1 + r ) n
2 3

Co = initial investment outlay-this is a ---------figure

Cn = future investment cash flows
r = cost of capital
n = time period of investment
 ACTIVITY-1:
NET PRESENT VALUE
 Cofla plc is considering expansion of their
production site due to a three-year contract
signed by a customer to produce new
product line. The total cost of construction
would cost £365,000.This is expected to save
the company £16,500 fixed annual rent for
three years and the building could be sold for
£435,000 at expire. Putting the money in
stock market investments will produce 7.5%
rate of return; this is what Cofla is given up
by not investing in comparable securities.
 Calculate the NPV for this project and
provide your comment.
NET PRESENT VALUE
Example: Cofla Ltd, Project A

cash inflow factor Present value

Year 1 70,000 .909 63,630
2 110,000 .826 90,860
3 100,000 .751 75,100
4 40,000 .683 27,320
256,910
Cost of investment 250,000
Net Present Value (NPV) +6,910
NET PRESENT VALUE
Cofla Ltd, Project B

cash inflow factor Present value

Year 1 80,000 .909 72,720
2 80,000 .826 66,080
3 80,000 .751 60,080
4 90,000 .683 61,470
5 80,000 .621 49,680
6 30,000 .564 16,920
326,950
Cost of investment 250,000
Net Present Value (NPV) 76,950
NET PRESENT VALUE
The decision rule
 Projects with a positive NPV are
worthwhile.
 Those with a negative NPV should be
rejected.
 Therefore, on this basis BOTH projects A
and B are financially worthwhile
 However, the company would invest in the
project giving the highest NPV
 Hence project B would be selected
 NET PRESENT VALUE
Remark: If the present value of the cash flows
is greater than the cost of the investment (The
NPV is positive) then the calculation answers 2
questions:
1. …………………….?
2. ………………………?

It is therefore financially safe to proceed with the

investment.
The NPV represents the surplus funds earned on
the project
The NPV gives impact on shareholder wealth.
NET PRESENT VALUE
Advantages:
 recognises the time value of money
 enables alternative proposals to be ranked.
 Others?

Disadvantages:
 requires the calculation of a discount rate,
usually the cost of capital
 appropriate discount rate used
 Anymore, please?
EXAM TYPE ACTIVITY-1:
MSH Manufacturing imposes a payback cutoff of three years for its international
investment projects. If the company has the following two projects available, should it
accept either of them?
Evaluate the projects by payback; discounted payback and net present value method if the
required rate of return is 10%. Which project (s) should we accept if both projects are i)
mutually exclusive and ii) independent?
Year Cashflow (TK) A Cashflow (TK) B
0 -45,000 -90,000
1 17,000 19,000
2 23,000 24,000
3 19,000 35,000
4 100,000 55,000
EXAM TYPE ACTIVITY-2:
ABC evaluates all of its projects by applying the NPV rule. If the required return is 11 percent,
should the firm accept the following project?

Year Cashflow (TK)

0 -4,500
1 1,750
2 2,550
3 940
 Comprehensive Review: 1

 Beximco is exploring a new manufacturing plant having

the expected maturity of five years. The company’s
required rate of return is 10%. The total initial capital
outlay of the project is expected to be tk100,000. This
will generate tk40,000 annual cashflow stream for the
first & second years; and afterwards this will increase
by 10% in the subsequent years.
 Required: Evaluate the projects on the basis of:
1. Payback; 2. Discounted payback; 3. Net Present Value.
CAPITAL INVESTMENT THEORY

 ADVANCED ISSUES
 Dealing inflation in NPV
 Two types of inflation rate need to
be dealt with under nominal method.
1. Specific inflation rate – impacts all
the individual cash flows, each cash
flow is affected by specific rate.
2. General inflation rate– which
investors need compensation for loss
of purchasing a basket of all
goods/cashflows rather than specific
one seperately.
 ACTIVITY-2:
ILLUSTRATION
 Let us consider, the three year’s project of Cofla
Ltd, where initial investment requires 7000. Due
to this investment, the firm contains some
economies of scale, such as wage savings (1,000)
and mat savings (400) that would be inflated by
inflation rates of 10% and 5% respectively. The
market interest rate is 15%. Evaluate the project by
Net profit valuation method.
 Is the project worthwhile?
 Also evaluate if general rate of inflation is 11%.
ILLUSTRATION
Items & Illustrations T0 T1 T2 T3
£ £ £ £
 Initial investment
 Wages savings@10%
 Mat savings @5% infl.
 Cash flow (year wise)
 PVIF@15%
 PV of cash flow
 Therefore NPV =

 Note: the general rate of inflation has not been used in

this calculation and therefore irrelevant in this situation.
 INTERNAL RATE OF RETURN
(IRR METHOD)
 Also based on Discounted Cash Flow but
calculates the discount rate that will give a
Net Present Value of ?.
 This also represents the return that the
project is giving on the original investment,
expressed in DCF terms.
 The simplest way is to use trial and error -
trying different rates until the correct rate is
found. But this is laborious.
 There is a linear interpolation formula?
 Projects should be accepted if………..
IRR using Linear Interpolation
 It involves two steps:
1. Calculate two NPVs for the project at
two different costs of capital
2. Use the following formula to find the
IRR:

IRR = L+ NL (H-L)
NL - NH
ILLUSTRATION
Cofla Ltd.
 Remember, at 10%, project A has a
positive NPV of £6,910.
 Now, recalculate NPV at (say) 14%
ILLUSTRATION
cash inflow factor Present value
Year 1 70,000 .877 61,390
2 110,000 .769 84,590
3 100,000 .675 67,500
4 40,000 .592 23,680
237,160
Cost of investment 250,000
Net Present Value (NPV) -12,840
ILLUSTRATION
 At 10%, the NPV is £6,910
 At 14% the NPV is -£12,840
 Therefore the IRR is somewhere in-
between these 2 rates
 This can be estimated or calculated
ILLUSTRATION

IRR = L+ NL (H-L)
N L – NH

Where: L is the lowest discount rate

H is the highest discount rate
NL is the NPV of the lower rate
NH is the NPV of the higher rate
ILLUSTRATION
Calculation of IRR using interpolation formulae.

IRR = L+ NL (H-L)
NL - NH

= 10% + 6,910 (14% - 10%)

6,910 + 12,840

= 10% + 1.4%
= 11.4%
ILLUSTRATION
 Now calculate the IRR for Cofla Ltd,
project B
 Remember, at 10%, project B has a
positive NPV of £76,950
 Now, recalculate NPV at (say) 25%
ILLUSTRATION
cash inflow factor Present value
Year 1 80,000 .800 64,000
2 80,000 .640 51,200
3 80,000 .512 40,960
4 90,000 .410 36,900
5 80,000 .328 26,240
6 30,000 .262 7,860
227,160
Cost of investment 250,000
Net Present Value (NPV) -22,840
 ILLUSTRATION-X
Based on first two steps of Linear
Interpolation, the findings are as follows:
 At 10%, the NPV is £76,950
 At 25% the NPV is -£22,840
 Therefore, the IRR is:…………….
 This can be estimated or calculated.
 Interpret result if cost of capital is 18.5%.
 ILLUSTRATION-X
IRR = L+ NL (H-L)
NL - NH

 IRR=?
 Evaluate the project, if cost of capital
is 18.5%.
 Perpetuity IRR
 IRR for Investment where the cash
flows are perpetuities is calculated
as:

 IRR perpetuity = Annual inflow x 100

Initial investment
 ACTIVITY-3
ILLUSTRATION
 A) Find the IRR of an investment that
costs £20,000 and generates cash-
flow £1,650 for an indefinitely long
period.
 B) Find the IRR if investment costs
£55,000 with £5,000 inflow of cash in
perpetuity?
 Evaluate the projects if the market
interest rate is 8.75%.
 Multiple IRRs
 If we are trying to decide whether a
single project is worthwhile, then NPV
and IRR will give the same answer (Yes
or No) so long as
◼ all the positive cash flows are grouped
together and
◼ all the negative cash flows are grouped
together e.g. all at the beginning or all at
the end
◼ This pattern is called ------ cash flow pattern

Week 9 46
Multiple IRRs (2)

 There can be two or more IRRs,

however, if we have “-------” cash
flows:
◼ For example, a power station might have
negative cash flows at the beginning to pay
for construction, followed by positive cash
flows while it operates.
◼ There might be negative cash flows again
at the end, to pay to close the power
station and dispose of the waste.
Week 9 47
Multiple IRRs (3)
 “---------------” cash flows arise when
either the positive cash flows or the
negative cash flows are not grouped
together
◼ For the previous example, there is at
least one negative cash flow at the
beginning and at least one at the end,
with positive cash flows in between.

Week 9 48
 Multiple IRRs (4)

 When there are two (or more) IRRs the

IRR rule (the project is worthwhile if the
IRR>appropriate discount rate) is
impossible to apply
◼ In these cases we would also need to examine
the NPV, so it is better to use NPV the first
place
 There can be as many IRRs as there are
changes in sign of the cash flow
 ‘-----------’ cash flows only have one sign
change, so only one WeekIRR
9 49
 Activity 3.5: Multiple IRR:
Power Station Cash Flows
Year Cash flow
0 -800000
1 450000
2 450000 Market
interest
3 450000 rate 10%
4 450000
5 450000
6 -1500000
 Is it a conventional/non-conventional cash flow stream?
Calculate NPV by using discount rates of: 2.68%, 12%,
16%, 27.74%.
 Draw a hypothetical graph based on your calculations.
 Provide your comment for evaluating the project based
on NPV versus IRR.

MSH-JU
IRR-advantage-disadvantage
Advantages:
1. Risk exposure
2. Time value of money
3. Whole life of the project
Disadvantages:
1. IRR is not a measure of absolute
profitability
2. Interpolation only provides an estimate.
3. It is fairly complicated to calculate
 Modified IRR (MIRR)-1
 MIRR assumes that positive cash flows are reinvested at the
firm's cost of capital and that the initial outlays are financed at firm's
financing cost.
 TIRR assumes cash flows are reinvested at IRR itself.
 The MIRR, therefore, more accurately reflects cost and
profitability.
 MIRR eliminates the issue of multiple IRRs.
 MIRR is used to rank investments or projects of Unequal size.
 TIRR gives an overly optimistic picture while the MIRR gives a
more realistic evaluation of the project.
 MIRR-2: IllUSTRATION

Example: Assume that a two-year project with an

initial outlay of $195; and a cost of capital of 12% will
return $121 in the first year and $131 in the second
year.
 Estimate TIRR of the project.
 Estimate MIRR of the project.
LIMITATION OF MIRR-3
 MIRR requires to compute an estimate of the cost of
capital in order to make a decision, a calculation that can be
subjective and vary depending on the assumptions made.
 NPV often provides a more effective theoretical basis than
IRR for selecting investments that are mutually exclusive.
 MIRR can also be difficult to understand for people who
do not have a financial background. Moreover, the theoretical
basis for MIRR is also disputed among academics.
MIRR VERSUS FMRR-5

 The financial management rate of return (FMRR) is a metric most often used
to evaluate the performance of a real estate investment projects.
 MIR improves on the traditional internal rate of return (TIRR) value by
adjusting reinvestment rates with subsequent cash inflows.
 FMRR takes things a step further by specifying cash outflows and cash
inflows at two different rates known as the “safe rate” and the “reinvestment
rate.”
 Safe rate assumes that funds required to cover negative cash flows are
earning interest at a rate easily attainable and can be withdrawn when needed at a
moment’s notice (i.e., within a day of account deposit).
 The reinvestment rate includes intermediate or long-term investment with
comparable risk. The reinvestment rate is higher than the safe rate.
MIRR VERSUS FMRR-6

 Assume that a two-year project with an initial outlay of

$195 following safe rate (earning interest) 7.5% in the first
year. The project generates cashflow stream $121 in the first
year and $131 in the second year following reinvestment rate
of 12% . To find the traditional IRR of the project so that the
net present value (NPV) = 0 when IRR = 18.66%.
 Estimate financial management rate of return (FMRR).
 NPV vs IRR-: CRITIQUE-1
 Both NPV and IRR use DCF techniques
 However, only NPV can distinguish
between two mutually-exclusive
projects.
 The advantage of NPV is that ….
 The IRR simply states that……….
 NPV vs IRR-: CRITIQUE-2
Cashflow Sensitivity to Discount Rate•
(NPV Profile)

Note: NPV profile shows the sensitivity of a project's NPV for different discount rates. It is
plotted on a graph where NPVs are on the y-axis with the discount rates on the x-axis.
 NPV vs IRR-: CRITIQUE-2
Cashflow Sensitivity to Discount Rate
❑ Exercise-A: Year Project A Project B
0 -500 -500
1 100 250
2 100 250
3 150 200
4 200 100
5 400 50
 A. Calculate IRR for projects A and B.
 B. Calculate NPVs of A & B for the interest rates of 2%, 8%
and 16%.
 C. Draw a hypothetical graph based on estimated trend of Q-B.
 D. Critically evaluate your finding based on your results, and
provide your comment with respect to cashflow sensitivity interest
rates.
 NPV vs IRR-: CRITIQUE-2
Cashflow Sensitivity to Discount Rate
Implication:
 Ceteris paribus, for lower discount rate than Fishers’ RR,
accept higher cash flow sensitivity project.
 Ceteris paribus, for higher discount rate than Fishers’
RR, accept lower cash flow sensitivity project.
Critique:
 Does not consider reinvestment rate.
 If reinvestment rate is lower than Fishers’ rate use NPV
 If reinvestment rate is greater than Fishers’ rate use IRR.
 NPV vs IRR-: CRITIQUE-3
Assumption for Reinvestment Rates
 The subject received extensive treatment more than fifty years ago in a number
of papers pertaining to capital budgeting. In this respect, we find that the choice
between net present value (NPV) or intemal rate of return (IRR) for selecting
among identical cost, mutually exclusive investment proposals has received
wide attention in the financial literature (Myer, 1979).
 None of the earlier studies considered any assumption about reinvestment rate
of return.
 Therefor, Dudley (1972) demonstrates that if the reinvestment rate of return is
greater than Fisher's rate of return-the IRR method will provide optimal
decisions while if it is less than Fisher's rate the NPV method will prove
optimal.
 Later on the problem, then, lies in determining the appropriate reinvestment
rate.
Fisher’s Rate of Return VS Fisher’s Equation

 Fisher's rate of return means the interest rate where the net
present values of two mutually exclusive projects become
equal.
 It is used in comparing two mutually exclusive projects which
have different cashflow sensitivity to interest rate.
 Fisher’s equation/Fisher hypothesis/ Fisher Effect is a concept
in economics that describes the relationship between nominal
and real interest rates under the effect of inflation. The equation
states that the nominal interest rate is equal to the sum of the
real interest rate plus inflation.
 ILLUSTRATION-X:
ESTIMATE FRR & INTERPRETATION

Revenues, expenditures and yields of the two mutually exclusive project

Project A Project B
Year
Expenditures Revenues Net Yields Expenditures Revenues Net Yield
0 350 0 -350 350 0 -350
1 552 557 5 771 1171 400
2 691 696 5 1017 1022 5
3 352 852 500 861.488 866 4.512
 Discounted Cashflow Method:
Equivalent Annuity Cash Flow
 Projects with Different Lifetimes
 We use EACF to compare mutually
exclusive projects with unequal/ uneven
lives.
 The EACF approach calculates the
average cashflow per year/ constant
annual cash flow generated by a project
over its lifespan if it was an annuity.

Week 9 64
 ILLUSTRATION-E
Cash Flows
Year Lorry A Lorry B
0 -£ 100,000.00 -£ 250,000.00
1 £ 150,000.00 £ 300,000.00
2 £ 150,000.00 £ 300,000.00
3 £ 150,000.00 £ 300,000.00
4 £ 150,000.00
5 £ 150,000.00
6 £ 150,000.00
Discount Rate 12%
 Evaluate the projects on the basis of
best fitted capital budgeting technique.
Week 9 65
 Capital Rationing
 Capital rationing –
Restrictions on investment projects.
 Two types of capital rationing:
 1. Soft : Internal sources
 2 Hard : External sources

 Solution: Profitability index method

Capital Rationing
 Soft capital rationing – ?
 Reasons for soft rationing may
include:
 Limited management skills
 Desire to maximise return of a limited
range of investments
 Encourages the acceptance of only
substantially profitable investments
Capital Rationing
 Hard capital rationing –?
 Reasons may include:
 1. Industry wide factors limiting funds
 2. Lack of or poor company track
record
 3. Lack of asset security
 4. Poor management team
Capital Rationing
 Profitability Index –
when face with multiple
projects with positive
 Profitability
NPVs but do not have the
funds to invest in all
index = ?
projects (limited
resources), profitability
index helps to choose the
project(s) that gives the
highest NPV per dollar of
investment.

 The profitability index is

the ratio of net present
value to initial
investment.
Capital Rationing
 Suppose that the opportunity cost of
capital is 10%,that the company has
a total resources of £20m and that it
is presented with the following
project proposals:
Example X:Capital Rationing

Proj. PV Co NPV P.I Rank

£m £m £m

J 4 3
K 6 5
L 10 7

M 8 6
N 5 4
Capital Rationing
 Project L offers the highest ratio of
NPV to investment(0.43) and thus L
is picked first. Projects J and M are
picked next with ratios of (0.33)
followed by N. These four projects
exactly use the £20 million budget.