2. CAPITAL BUDGETING
Capital Budgeting is employed to evaluate
expenditure decisions which involve current outlays
but are likely to produce benefits over a period of
time longer than one year.
Capital Budgeting is the process of evaluating &
selecting long term investments that are consistent
with the firm's goal of owner wealth maximization.
3. EXPENDITURE
Capital Expenditure : An outlay of funds by the firm
that is expected to produce benefits over a period
of time greater than one year.
Current Expenditure : An outlay of funds by the firm
resulting in benefits received within one year.
Key Motives for Making Capital Expenditure
1) Expansion
2) Replacement
3) Renewal
4) Other purposes
4. STEPS IN CAPITAL BUDGETING PROCESS
1) Proposal generation
2) Review &analysis
3) Decision making
4) Implementation
5) Follow-up
Independent Projects
Projects whose cash flows are unrelated or
independent of one another ; the acceptance of one
does not eliminates the others from future
consideration.
5. Mutually Exclusive Projects :
Projects that compete with one another, so that
acceptance of one eliminates the others from further
consideration.
Unlimited Funds :
The financial situation in which a firm is able to
accept all independent projects that provide an
acceptable return.
6. Capital Rationing:
The financial situation in which a firm has only a
fixed number of dollars to allocate among competing
capital expenditure.
Ranking Approach :
The ranking of capital expenditure projects on the
basis of some predetermined measures such as the
rate of return
7. CAPITAL BUDGETING TECHNIQUES
1) Payback Period
➢ Payback Periods are a commonly used criterion for
evaluating proposed investments.
➢ The Payback Period is the exact amount of time
required for the firm to recover its initial investment
in a project as calculated from cash inflows.
➢ In the case of an annuity, the Payback Period can be
found by dividing the initial investment by the annual
cash inflow .
➢ For a mixed stream, the yearly cash inflows must be
accumulated until the initial investment is recovered.
8. (Original Investment- CCF YFR)
➢ Payback = [ YFR – 1] -----------------------------------------------
CF YFR
Where ,
YFR = Year of full recovery
CCF YFR = Cumulative CF at the start of year of full recovery
CF YFR = Cash flow during YFR
➢ Payback Period is generally viewed as an unsophisticated
capital budgeting technique, because it does not explicitly
consider the time value of money by discounting cash flows to
find the present value. Payback period also ignores cash flows
beyond payback period.
9. CAPITAL BUDGETING TECHNIQUES
2) Net Present Value (NPV)
➢ A sophisticated capital budgeting technique; found by
subtracting a project’s initial investment from the present
value of its cash inflows discounted at a rate equal to the
firm’s cost of capital.
➢ NPV= Present value of cash inflow – Initial Investment
NPV = CF0 + CF1 + CF2 + CF3 …..+ CFN
(1+k)1 (1+k)2 (1+k)3 (1+k)n
CF = Present Value of Cash Inflows
CF0 = Cash flow in zero year / Initial Investment
K = Discount Rate / Required Return/ Cost of Capital
10. ➢ The Decision Criterion: The decision criterion when NPV
is used to make accept- reject decisions is as follows :
✓ If NPV is greater than $ 0, accept the project, if NVP is
less than $ 0 ,reject the project.
✓ If NPV is greater than $ 0, the firm will earn a return
greater than its cost of capital. Such action should
enhance the market value of the firm & therefore
wealth of its owner
11. CAPITAL BUDGETING TECHNIQUES
3) Internal Rate of Return (IRR)
➢ IRR is defined as the discount rate that equates the
present value of cash inflows with the initial investment
associated with a project, thereby causing NPV = 0.
➢ The IRR, in other words, the discount rate that equates the
net present value of an investment opportunity with $0 .
0 = CFo + CF1____ + CF2____ + …… + CFN____
(1+ IRR)1 (1+ IRR)2 (1+ IRR)n
Where,CF0 = Cash outflow at zero year
CFN = Present Value of Cash Inflows
12. ➢ The Decision Criterion:
✓ If IRR is greater than the cost of capital, accept the project
✓ If IRR is less than the cost of capital, reject the project
✓ This criterion guarantees that the firm earns at least its
required return. Such an outcome should enhance the
market value of the firm & therefore the wealth of its owner.
➢ Interpolation:
IRR = L + A X (H - L)
B
L= Lower discounting rate, H = Higher discounting rate
A= NPV at lower discount rate
B = Difference between the PV of all net cash benefits at lower
discounting rate and higher rate , OR
NPV at lower discount rate – NVP at higher discount rate
13. PROBLEM – 1
CAPITAL BUDGETING : REPLACEMENT DECISION
A MACHINE PURCHASED SIX YEARS AGO FOR $ 150000 HAS
BEEN DEPRECIATED TO A BOOK VALUE OF $ 90000. IT
ORIGINALLY HAD A PROJECTED LIFE OF 15 YEARS AND ZERO
SALVAGE VALUE. A NEW MACHINE WILL COST $ 250000 AND
RESULT IN A REDUCED OPERATING COST OF $ 30000 PER YEAR
FOR THE NEXT NINE YEARS. THE OLDER MACHINE COULD BE
SOLD FOR $ 50000. THE COST OF CAPITAL IS 10%. THE NEW
MACHINE WILL BE DEPRECIATED ON A STRAIGHT LINE BASIS
OVER NINE YEARS LIFE WITH $ 25000 SALVAGE VALUE. THE
COMPANY TAX RATE IS 55%. DETERMINE WHETHER THE OLD
MACHINE SHOULD BE REPLACED ?
14. REPLACEMENT DECISION:
WHETHER TO PURCHASE CAPITAL ASSETS TO TAKE THE PLACE OF
EXISTING ASSETS TO MAINTAIN OR IMPROVE EXISTING
OPERATIONS.
EXPANSION DECISIONS :
WHETHER TO PURCHASE CAPITAL PROJECTS AND ADD THEM TO
EXISTING ASSETS TO INCREASE EXISTING OPERATIONS
INDEPENDENT PROJECTS :
PROJECTS WHOSE CASH FLOWS ARE NOT AFFECTED BY DECISION
MADE ABOUT OTHER PROJECTS.
MUTUALLY EXCLUSIVE PROJECTS:
A SET OF PROJECTS IN WHICH THE ACCEPTANCE OF ONE PROJECT
MEANS THE OTHER CANNOT BE ACCEPTED.
