CAPITAL BUDGETING

Objective of financial management: to maximise the current market value of the firm’s shares. The single most
important decision that a firm’s managers will make in pursuit of this objective is the capital budgeting decision.
It is all about choosing projects that return more than what they cost. If managers do this badly, shareholder
value will be destroyed (by projects that cost more than they return).

What Projects?
Of course, these are not obvious. Managers must dream them up: new products, new markets, take-overs,
mergers, new plant, or equipment and so on. We make this point because otherwise it seems as though all
you need to do is analyse projects. But the ideas must come from somewhere.

Assume You Have the Project Idea…How Do You Know It’s Worth Doing?
An investment should be accepted (and will increase the market value of the firm) if the net present value is
positive and rejected if it is negative. Net present value is simply the present value of the (net) cash flows
associated with a project minus the cost of the project. This is a straightforward idea, but many managers do
not really understand it.1 So if you do understand it (and it is easy!) you will hit the ground running…

Net Present Value: An Easy Case

All we need to be able to compute NPV is the net cash flows and the cost of the project. Because projects
may involve a combination of cash inflows and outflows, setting up for the final calculation may require some
careful work. We will start with an easy case.

BHP Ltd will invest $100,000,000 to develop a new oil reserve in the North Sea. The cost of extracting the oil
is $10 per barrel. The oil will be sold for $45 per barrel. The reserve will produce 250,000 barrels each year
and will be exhausted in 20 years. The discount rate is 15%.

Step One: Determine the Initial Investment

In this case, it’s easy: $100,000,000.

Step Two: Determine the Free Cash Flows Each Year

In this simple case, it’s also easy because there’s no further information about working capital, depreciation
etc. It’s just cash in minus cash out: (250,000 x $45) – (250,000 x $10) = $8,750,000 each year.

Step Three: Determine the Time Period

20 years.

1
This has been determined by surveys/research with business managers.

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Step Four: Determine the Discount Rate

It is given to us: 15%

Step Five: Set Up and Solve

8,750,000 8,750,000 8,750,000

𝑁𝑃𝑉 = −$100,000,000 + (1+0.15)1 + (1+0.15)2 +. . . + (1+0.15)20

Rather than do 20 calculations, we can simply work out the

value of the annuity using the PVAF… Just multiply $8,750,000
by PVAF.

1 − [1/(1 + 𝑟)𝑡 ]
𝑁𝑃𝑉 = −$100,000,000 + $8,750,000 ×
𝑟
1 − [1/(1 + 0.15)20 ]
𝑁𝑃𝑉 = −$100,000,000 + $8,750,000 ×
0.15
𝑁𝑃𝑉 = −$100,000,000 + $8,750,000 × 6.2593
𝑁𝑃𝑉 = −$100,000,000 + $54,768,875.00
𝑁𝑃𝑉 = −$45,231,125

Step Six: Conclude

Negative NPV means we should reject this project.

Net Present Value: When Computing Cash Flows Requires a Little More Work
The cash flows in the example above were very simple. In reality, we will have data on sales, variable costs,
fixed costs and so on to include. BUT… our approach is the same easy approach: all we need is the initial
investment and the net cash flows that result from the project:

Note #1: The Components of the Initial Investment

• Capital costs of the investment +

• Working capital (money the firm must invest in accounts receivable, inventory and cash to support
the sales and production of its products and services).2

2
This will be freed once the project concludes, and we normally add it as a positive cash flow in the last period
of the project.

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Note #2: The Free Cash Flows
The cash flows we refer to are free cash flows, which as we know are cash flows leftover out of operating
cash flow once capital spending and working capital have been considered. For each year we must find the
PV of the project’s free cash flows. We first find the operating cash flows:

• EBIT –
• Taxes +
• Depreciation (and any other non-cash charges).

IBM is considering an investment of $6,000,000 in plant and equipment to manufacture a new form of
microprocessor. The microprocessors will sell for $10 each. 1,600,000 microprocessors will ship each year
for five years. At the end of the fifth year, the plant and equipment will be sold at a book value of $1,000,000.
The other information concerning the project is:

• Variable cost: $6.50 per unit

• Fixed cost: $1,700,000 per year
• Depreciation: $1,000,000 per year
• Taxes: 30%
• Working capital required: $1,200,000
• Discount rate is 10%

No matter how detailed the scenario, we follow our process:

Step One: Initial Investment

This is equal to the $6,000,000 capital investment + $1,200,000 in working capital = $7,200,000.

Step Two: Determine Operating Cash Flows Each Year

A little more complicated than last time (but still easy!):

Sales $16,000,000

Variable costs $10,400,000

Fixed cost $1,700,000

Depreciation $1,000,000

EBIT $2,900,000

Taxes $870,000

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Operating Cash Flow (years 1 to 5):

EBIT $2,900,000

Depreciation $1,000,000

Taxes $870,000

OCF $3,030,000

Free Cash Flow will be equal to OCF in years 1 to 4 because there are no further additions or subtractions
relating to capital spending or working capital. In year 5, though, free cash flow is equal to OCF plus the
returned working capital sum:

EBIT $2,900,000

Depreciation $1,000,000

Taxes $870,000

OCF $3,030,000

+ Sale of plant $1,000,000

+ Recovery of working capital $1,200,000

FCF $5,230,000

Step Three:
Time period is five years.

Step Four:
Discount rate is 10%.

Step Five: Set Up and Solve

$3,030,000 $3,030,000 $3,030,000 $3,030,000 5,230,000

𝑁𝑃𝑉 = −$7,200,000 + + + + +
(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3 (1 + 0.10)4 (1 + 0.10)5

1 − [1/(1 + 0.10)4 ] $5,230,000

𝑁𝑃𝑉 = −$7,200,000 + $3,030,000 × +
0.10 (1 + 0.10)5
𝑁𝑃𝑉 = −$7,200,000 + $9,604,692.30 + $3,247,418.52
𝑁𝑃𝑉 = $5,652,110.82

Step Six: Conclude

Positive NPV means we accept!

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What Else Do You Need to Know?
Again, like everything, there are lots of details and different cases that you could learn about. Given the
importance of capital budgeting, reading a few extra books about it sometime in your career certainly will not
hurt. But we should always be careful of clouding key concepts with less important details. So here are the
essentials (in addition to our NPV calculation):

• Sunk costs don’t figure in our calculations

• Neither do financing costs
• Opportunity costs do figure in our calculations
• So do erosion or cannibalisation costs
• There are several other tools that can be used in place of NPV: IRR, payback rule, accounting rate of
return, profitability index. Most managers use NPV. The other methods have problems and are suited,
if anything, to special cases.
• The components of cash flows, like sales revenues, must be forecast. Like anything that occurs in
the future, cash flows associated with projects are uncertain.
• Because of this, the NPV calculations will be sensitive to the data you have. Therefore, managers use
tools like “what if analysis” and “sensitivity analysis”.
• And, ALWAYS REMEMBER, investment ideas must be dreamed up. They do not just present
themselves. So a lot of the important stuff behind the numbers involves corporate strategy and
entrepreneurship.

A Note on IRR
The internal rate of return for a project is the discount rate that makes the NPV equal to zero. So, if we had
our previous example:

8,750,000 8,750,000 8,750,000

𝑁𝑃𝑉 = −$100,000,000 + + +. . . +
(1 + 0.15)1 (1 + 0.15)2 (1 + 0.15)20

The IRR would be the discount rate, R, that solves this:

8,750,000 8,750,000 8,750,000

$0 = −$100,000,000 + + +. . . +
(1 + 𝑅)1 (1 + 𝑅)2 (1 + 𝑅)20

• You can only solve for this by trial and error3 or, more likely, with a spreadsheet or financial calculator.

• If the IRR is greater than the discount rate, we should accept the project.

• This is so because any project yielding more than the discount rate would have a positive NPV.

3
Actually, this is just like the YTM for a bond!

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 • Whilst NPV is a better method, managers seem to understand IRR better. So, if you report the results
of an analysis to your CEO, he or she might prefer to hear about the IRR of the potential project
rather than the NPV.

For this example, we use EXCEL (see below) and find that the IRR = 6%. Given that our discount rate was
15%, we reject! If you enter 6% into the formula above as the discount rate, of course, the NPV will equal
$0.

Simply a matter of entering the

cash flows and using the IRR
function!

Selected Readings:
1. Kester, C.W. 1984, “Today’s Options for Tomorrow’s Growth,” Harvard Business Review, March-April, pp.153-
160.

This reading outlines the link between capital budgeting and corporate strategy. It also points out another key
aspect: you will have to engage in political battles to get projects accepted by management and boards.

2. Hall, W.K. 1980, “Survival Strategies in a Hostile Environment,” Harvard Business Review, September-
October, pp.75-85.

This reading outlines the key to business success: low cost and/or product differentiation. Whilst not directly
related to capital budgeting, we should be looking for projects that initiate or foster these factors.
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3. Porter, M.E. 1979, “How Competitive Forces Shape Strategy,” Harvard Business Review, March-April,
pp.137-145.

In a similar vein to the second reading, this paper highlights the importance of coping with competition. Of
course, projects that generate lower costs, differentiated products and barriers to entry will be critical.

There are many good books on strategy, capital budgeting and corporate finance. This is the most critical
area for corporate survival and growth…Read!