Capital budgeting- Chapter 8 & 9:
What questions do we need to ask?
[Do not learn the below definitions, they are merely for interest sake]
WACC
Introduction:
Should a project be accepted or not?
Benefits (consists of?) > Cost (consist of?) → accept
BUT also consider?
o If the IRR > WACC, then accept
o Comparing and ranking different projects
Definition:
What does capital budgeting entail?
Analyzing and evaluating
of investment projects
that normally provides benefits
over a number of years
Critical decision:
Why is it such an important decision?
, Over investment results in: Under investment results in:
Higher cost Quality
Flexibility limited Capacity limited
Other factors we need to consider when deciding to invest:
o Long term decision
o Large capital outlay
o Cash flow forecasts
o Strategic considerations
o Revision of budgets
Classification/ types of investment projects:
Replacement or expansion
o Replacement refers to the acquisition of an asset to maintain existing
production. The new machine may result in cost savings due to increased
efficiencies.
o Expansion refers to the expansion of existing product lines to new markets or
to the introduction of new product lines. The effect of globalization has
resulted in more competition which reduces the lives of existing products. But
those that are able to compete internationally, are able to grow their sales
revenues significantly
Independent vs. mutually exclusive projects
o Independent projects are such that the acceptance of one does not affect the
acceptance of another. Both can be accepted if certain criteria are met.
o Mutually exclusive projects are alternatives. Either one or the other can be
accepted, but not both.
Divisible vs. indivisible projects
o A divisible project may be split into a number of separate parts, each capable
of being undertaken on its own.
o If the project is indivisible, then entire project must be undertaken.
Capital budgeting techniques:
1. Net present value (NPV)
a. NB!!
2. Internal rate of return (IRR)
a. NB!!
3. Payback method
4. Accounting rate of return
a. Focuses on accounting figures and profit or loss
b. The rest are based on cash flow
5. Discounted payback
6. Profitability index
7. Modified internal rate of return
8. Economic value added (EVA)
1. Net present value (NPV):
, Principle → time value of money
1. Calculate future cash flows
2. Discount these cash flows at a company’s required rate of return (usually WACC)
3. If Positive, this indicates that the project results in the PV of cash flows being
greater than the cost. Therefore accept.
If negative, this indicates that the project results in the PV of cash flows being
smaller than the cost. Therefore do not accept.
Example 8.1:
Project X cash flow stream:
Yr 0 Yr 1 Yr 2
-10 000 8 000 6 000
Initial investment = R10 000
Company WACC is 14%
Should we accept the project?
CF0 -10 000
CF1 8 000
CF2 6 000
I/YR 14
nd 1
2 func p/yr
nd 1,634
2 func
NPV
Yes, we should accept the project because the NPV is positive. The shareholders’ wealth will
be increased by the NPV amount.
Example 8.2:
Project T has got a cost of R40m and will result in equal cash flows of R20m for a period of 3
years. The company’s cost of capital is 18%.
Should the project be accepted?
CF0 -40 000 000
CF1 20 000 000
CF2 20 000 000
CF3 20 000 000
I/YR 18
2nd func p/yr 1
2nd func NPV 3,485,459
Yes, we should accept the project
2. Internal rate of return:
, The IRR is the discount rate that causes present value of net future cash flows to equal
the cost of the investment (Rate at which NPV = 0).
At a discount rate of 14%, the NPV = R1,634. To find the IRR, we have to reduce the
NPV to 0.
CF0 -10 000
CF1 8 000
CF2 6 000
IRR/YR 27.18%
To decide whether or not to accept the project, the IRR must be compared to a firm’s
cost of capital.
Use of IRR:
When do we accept / reject a project?
o If a project’s IRR > than company’s required rate of return (WACC) →
ACCEPT the project as it offers a higher return than the cost of financing the
project.
In practice, firms use spreadsheets to set out and determine the NPV and IRR of a
project.
If we are evaluating mutually exclusive projects, then we would select the project
with the highest IRR, provided this exceeds the cost of capital.
A disadvantage associated with the use of IRR is that it is a percentage which results
in the ignoring of the size of the project.
An advantage is that we do not need to know what the company’s WACC is. BUT,
we must compare it to something.
NPV vs. IRR:
In mutually exclusive projects, there is a conflict in rankings between the IRR and
NPV methods. The correct approach is to base the investment decision on the NPV
method because
Cost outlays are different:
AZ Limited has the opportunity of investing in either of the following one year
projects:
Projec Cost CF1 IRR NPV
t
A -100 000 120 20% 9 090
000
B -60 000 75 000 25% 8 182
C -1 1.75 75% 59c
The cost of capital is 10%. The IRR method suggests that Project B should be selected
in preference to Project A. However, the NPV method states that A should be selected
as it has the higher NPV. A situation may arise where these two methods are in
conflict. An extreme example would be to compare Project A with another mutually
exclusive Project C. Project C has a cost of R1 but it results in a cash inflow one year
later of R1.75. The IRR is 75% but the NPV at 10% is only 59c. The IRR method
What questions do we need to ask?
[Do not learn the below definitions, they are merely for interest sake]
WACC
Introduction:
Should a project be accepted or not?
Benefits (consists of?) > Cost (consist of?) → accept
BUT also consider?
o If the IRR > WACC, then accept
o Comparing and ranking different projects
Definition:
What does capital budgeting entail?
Analyzing and evaluating
of investment projects
that normally provides benefits
over a number of years
Critical decision:
Why is it such an important decision?
, Over investment results in: Under investment results in:
Higher cost Quality
Flexibility limited Capacity limited
Other factors we need to consider when deciding to invest:
o Long term decision
o Large capital outlay
o Cash flow forecasts
o Strategic considerations
o Revision of budgets
Classification/ types of investment projects:
Replacement or expansion
o Replacement refers to the acquisition of an asset to maintain existing
production. The new machine may result in cost savings due to increased
efficiencies.
o Expansion refers to the expansion of existing product lines to new markets or
to the introduction of new product lines. The effect of globalization has
resulted in more competition which reduces the lives of existing products. But
those that are able to compete internationally, are able to grow their sales
revenues significantly
Independent vs. mutually exclusive projects
o Independent projects are such that the acceptance of one does not affect the
acceptance of another. Both can be accepted if certain criteria are met.
o Mutually exclusive projects are alternatives. Either one or the other can be
accepted, but not both.
Divisible vs. indivisible projects
o A divisible project may be split into a number of separate parts, each capable
of being undertaken on its own.
o If the project is indivisible, then entire project must be undertaken.
Capital budgeting techniques:
1. Net present value (NPV)
a. NB!!
2. Internal rate of return (IRR)
a. NB!!
3. Payback method
4. Accounting rate of return
a. Focuses on accounting figures and profit or loss
b. The rest are based on cash flow
5. Discounted payback
6. Profitability index
7. Modified internal rate of return
8. Economic value added (EVA)
1. Net present value (NPV):
, Principle → time value of money
1. Calculate future cash flows
2. Discount these cash flows at a company’s required rate of return (usually WACC)
3. If Positive, this indicates that the project results in the PV of cash flows being
greater than the cost. Therefore accept.
If negative, this indicates that the project results in the PV of cash flows being
smaller than the cost. Therefore do not accept.
Example 8.1:
Project X cash flow stream:
Yr 0 Yr 1 Yr 2
-10 000 8 000 6 000
Initial investment = R10 000
Company WACC is 14%
Should we accept the project?
CF0 -10 000
CF1 8 000
CF2 6 000
I/YR 14
nd 1
2 func p/yr
nd 1,634
2 func
NPV
Yes, we should accept the project because the NPV is positive. The shareholders’ wealth will
be increased by the NPV amount.
Example 8.2:
Project T has got a cost of R40m and will result in equal cash flows of R20m for a period of 3
years. The company’s cost of capital is 18%.
Should the project be accepted?
CF0 -40 000 000
CF1 20 000 000
CF2 20 000 000
CF3 20 000 000
I/YR 18
2nd func p/yr 1
2nd func NPV 3,485,459
Yes, we should accept the project
2. Internal rate of return:
, The IRR is the discount rate that causes present value of net future cash flows to equal
the cost of the investment (Rate at which NPV = 0).
At a discount rate of 14%, the NPV = R1,634. To find the IRR, we have to reduce the
NPV to 0.
CF0 -10 000
CF1 8 000
CF2 6 000
IRR/YR 27.18%
To decide whether or not to accept the project, the IRR must be compared to a firm’s
cost of capital.
Use of IRR:
When do we accept / reject a project?
o If a project’s IRR > than company’s required rate of return (WACC) →
ACCEPT the project as it offers a higher return than the cost of financing the
project.
In practice, firms use spreadsheets to set out and determine the NPV and IRR of a
project.
If we are evaluating mutually exclusive projects, then we would select the project
with the highest IRR, provided this exceeds the cost of capital.
A disadvantage associated with the use of IRR is that it is a percentage which results
in the ignoring of the size of the project.
An advantage is that we do not need to know what the company’s WACC is. BUT,
we must compare it to something.
NPV vs. IRR:
In mutually exclusive projects, there is a conflict in rankings between the IRR and
NPV methods. The correct approach is to base the investment decision on the NPV
method because
Cost outlays are different:
AZ Limited has the opportunity of investing in either of the following one year
projects:
Projec Cost CF1 IRR NPV
t
A -100 000 120 20% 9 090
000
B -60 000 75 000 25% 8 182
C -1 1.75 75% 59c
The cost of capital is 10%. The IRR method suggests that Project B should be selected
in preference to Project A. However, the NPV method states that A should be selected
as it has the higher NPV. A situation may arise where these two methods are in
conflict. An extreme example would be to compare Project A with another mutually
exclusive Project C. Project C has a cost of R1 but it results in a cash inflow one year
later of R1.75. The IRR is 75% but the NPV at 10% is only 59c. The IRR method
