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04 Capital Budgeting Decisions

Corporations face multiple decisions, but have to pick wisely due to limited capital.

Capital Budgeting

Process of evaluating firm’s long-term investment opportunities

Large investments usually consist of smaller investment decisions.

Framework

  1. Generation of investment idea
  2. Estimation of cash flows
  3. Select the appropriate opportunity cost of capital
  4. Selection of ideas based on acceptance criteria
  5. Re-evaluation

Types of Investments

  • Revenue-enhancement
  • Cost-reduction
  • Mandatory [government] investments to meet regulations

Net Present Value (Primary)

It is in currency

One of

\[ \text{NPV} = \text{PV(Inflows)} - \text{PV(Outflows)} \]
NPV Meaning Decision
\(>0\) Actual returns > Minimum required return Accept
\(<0\) Actual returns < Minimum required return Reject
\(0\) Actual returns = Minimum required return Doesn’t matter

IRR (Primary)

Internal Rate of Return

\[ \text{IRR} = \text{Rate @ which NPV is 0} \]

Actual return of your project

We only know cashflows; no interest rates

Calculating

  1. Derive an equation in terms of
\[ \text{NPV} = 0 \\ \implies \sum \text{Discounted Cashflows} = 0 \\ \]
  1. Solve for \(r\)

Disadvantages

  • multiple solutions can be found for the same project
  • assumes that positive cash flows are reinvested at the IRR, which is considered impractical in practice

MIRR

Modified Internal Rate of Return

The modified internal rate of return (MIRR) is a measure of the profitability of a project or other investment.

It assumes that positive cash flows are reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's financing cost. The MIRR, therefore, more accurately reflects the cost and profitability of a project

$$ \begin{aligned} \text{MIRR} &= \Bigg( \dfrac{\text{FV}(\text{Positive cash flows} \times \text{Cost of capital})}{\text{PV}(\text{Initial outlays} \times \text{Financing cost})} \Bigg) ^{1/n} - 1 \ \textbf{where }

\text{FVCF}© &= \text{the future value of positive cash flows at the cost of capital} \ \text{PVCF}(fc) &= \text{the present value of negative cash flows at the financing cost} \ n &= \text{number of periods} \end{aligned} $$

Profitability Index (Secondary)

\[ \text{PI} = \frac{ \text{PV(Inflows)} }{ \text{PV(Outflows)} } \]

For every 1 unit of investment

\[ \begin{aligned} &\text{Additional value generated after taking minimum returns} \\ &= (\text{PI} - 1) \times \text{Original Investment} \end{aligned} \]
NPV Meaning Decision
\(>1\) Actual returns > Minimum required return Accept
\(<1\) Actual returns < Minimum required return Reject
\(1\) Actual returns = Minimum required return Doesn’t matter

Payback Period (Secondary)

  • Simplest explanation
  • If you have low DPP, that means the investement is less risky

Discounted Payback Period (Secondary)

\[ \text{DPP} = \]

Disadvantages

  • Subjective payback period
  • Only focusing on short-term gains

Required Rate of Return

\[ \text{RRR} = R_f + \beta \cdot \text{RP} \]

where

  • \(R_f=\) Risk Free Return
  • \(\text{RP} =\) Risk Premium
Last Updated: 2025-07-26 ; Contributors: AhmedThahir, web-flow

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