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Ihtisham JadoonFinancial Management

[email protected]: 0313-5937627

Project Classifications

Capital Budgeting projects are classified as either Independent Projectsor MutuallyExclusive Projects.

An Independent Projectis a project whose cash flows are not affected by theaccept/reject decision for other projects. Thus, all Independent Projectswhich meet theCapital Budgeting criterion should be accepted.

Mutually Exclusive Projectsare a set of projects from which at most one will beaccepted. For example, a set of projects which are to accomplish the same task. Thus,when choosing between "Mutually Exclusive Projects" more than one project may satisfythe Capital Budgeting criterion. However, only one, i.e.,the best project can be accepted.

Capital Budgeting is the process by which the firm decides which long-term investmentsto make. Capital Budgeting projects, i.e.,potential long-term investments, are expected to

generate cash flows over several years. The decision to accept or reject a CapitalBudgeting project depends on an analysis of the cash flows generated by the project andits cost

The following three Capital Budgeting decision rules will be presented:

Payback Period Net Present Value (NPV) Internal Rate of Return (IRR)

A Capital Budgeting decision rule should satisfy the following criteria:

Must consider all of the project's cash flows. Must consider theTime Value of Money Must always lead to the correct decision when choosing among Mutually

Exclusive Projects.

Payback Period

The Payback Period represents the amount of time that it takes for a CapitalBudgetingproject to recover its initial cost. The use of the Payback Period as a CapitalBudgeting decision rule specifies that all independentprojects with a Payback Period lessthan a specified number of years should be accepted. When choosing among mutuallyexclusiveprojects, the project with the quickest payback is preferred.
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Advantages:

Easy to calculateand understand Provides andindication of a project's risk and liquidity

Disadvantages:

Ignores time value of money - to correct for this disadvantage the discountedpayback periodcan be used. The discounted payback periodis an improvementover the regular payback method because the present value (discounted) of theproject's cash flows is used to calculate the payback period. The discountedpayback method considers the time value of money.

Does not consider cash flows occurring after the payback period

Net Present Value

The Net Present Value (NPV) of aCapital Budgetingproject indicates the expectedimpact of the project on the value of the firm. Projects with a positive NPV are expectedto increase the value of the firm. Thus, the NPV decision rule specifies thatall independent projects with a positive NPV should be accepted. When choosingamong mutually exclusive projects, the project with the largest (positive) NPV should be

selected.

The NPV is calculated as the present value of the project's cash inflows minus the presentvalue of the project's cash outflows. This relationship is expressed by the followingformula:

Where

CFt= the cash flow at time t and r = the cost of capital.

The example below illustrates the calculation of Net Present Value. Consider CapitalBudgeting projects Aand B which yield the following cash flows over their five yearlives. The cost of capital for the project is 10%.
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Project A Project B

YearCash

FlowCash

Flow

0 $-1000 $-1000

1 500 100

2 400 200

3 200 200

4 200 400

5 100 700

Net Present Value

Project A:

Project B:

Advantages:

Considers time value of money Considers all cash flows NPV is the value the project will add to the firm Consideredto be the best decision criteria

Disadvantages:

NPV will be erroneous if cash flow estimates are incorrect (requires accurate cashflow estimations)

NPV is a dollar return but percent returns are easier to communicateandunderstand

Internal Rate of Return

The Internal Rate of Return (IRR) of aCapital Budgetingproject is the discount rate atwhich theNet Present Value (NPV) of a project equals zero. The IRR decision rulespecifies that all independent projects with an IRR greater than the cost of capital should
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be accepted. When choosing among mutually exclusive projects, the project with thehighest IRR should be selected (as long as the IRR is greater than the cost of capital).

For a given project, the NPV and IRR will give the same accept/reject decision. In

other words, if the NPV > 0, then IRR > k; or if the NPV = 0, then IRR = k; or if

NPV

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