Capital budgeting is the process of evaluating long-term investments to maximize shareholder wealth. It involves 5 steps: proposal generation, review and analysis, decision making, implementation, and follow-up. Techniques for evaluation include non-discounting methods like payback period and accounting rate of return that ignore time value of money, and discounting methods like net present value, internal rate of return, and profitability index that consider time value of money. Payback period is the number of years to recover initial investment from cumulative cash inflows, and is used as a decision criterion. Net present value discounts future cash flows at the required rate of return and compares to initial investment, accepting projects with positive NPV. Internal rate of

1. Capital Budgeting

2. Capital budgeting is the process of evaluating and selecting
long-term investments that are consistent with the firm’s goal
of maximizing owner wealth.

3. The capital budgeting process consists of five steps:
1. Proposal generation. Proposals for new investment projects
are made at all levels within a business organization and are
reviewed by finance personnel.
2. Review and analysis. Financial managers perform formal
review and analysis to assess the merits of investment
proposals
3. Decision making. Firms typically delegate capital
expenditure decision making on the basis of dollar limits.
4. Implementation. Following approval, expenditures are made
and projects implemented. Expenditures for a large project
often occur in phases.
5. Follow-up. Results are monitored and actual costs and
benefits are compared with those that were expected. Action
may be required if actual outcomes differ from projected
ones.

4. Types of Investment Decision
 Accept – Reject Decision
 Mutually Exclusive Project Decision
 Capital Rationing Decision

5. Capital Budgeting Evaluation Techniques
Non –discounting techniques
Ignores the time value of money
1) Average Rate Return /Accounting
rate of return (ARR)
2) Pay back period (PBP)
Discounting techniques
Considers the time value of money
1) Net present value (NPV)
2) Internal Rate of Return (IRR)
3) Profit index or Benefit –cost
Ratio (BCR)

6. Pay Back Period
Pay Back Period (PBP): It refers to the number of years required to
recover the initial investment in the form of cumulative cash inflows.
Decision Criterion:
If actual PBP is less than standard PBP accept the project and vice versa.

7. 1. PBP = Net Cash Outflow / Net Cash Inflow
2. PBP = A + (NCO – C)/D

8. A company is interested to invest Tk 50,000 in a project. It is expected that the
project would have a life five years. The cash flows from the project in
different years would be as follows-
Year Cash flows (TK)
1 20,000
2 18,000
3 25000
4 27000
5 28000
Calculate Pay back Period.

9. Discounting Techniques :
Under discounted cash flow techniques, the future net cash flows generated by
a capital project are discounted to ascertain their present values .
NPV: Net Present Value
Under NPV method future cash flows are discounted at minimum required rate
of return of the project and then deduct it from initial out lay to arrive at the
NPV of the project .
NPV = PV (Benefits) – Initial investment
Decision criteria:
1) Accept if NPV > 0
2) Reject if NPV < 0
3) May accept or Reject if NPV = 0

10. The Internal Rate of Return (IRR) is a sophisticated
capital budgeting technique; the discount rate that
equates the NPV of an investment opportunity with $0
(because the present value of cash inflows equals the
initial investment); it is the rate of return that the firm
will earn if it invests in the project and receives the given
cash inflows.
Decision criteria:
If the IRR is greater than the cost of capital, accept the project.
If the IRR is less than the cost of capital, reject the project.

11. A company is interested to invest Tk 50,000 in a project. It is expected that the project would
have a life five years. The cash flows from the project in different years would be as
follows-
Year Cash flows (TK)
1 20,000
2 18,000
3 25000
4 27000
5 28000
Depreciation should be charged on a straight line basis and salvage value TK 5000. The cost
of capital is 10%. The company’s tax rate is 40%. Calculate NPV.

12. Problem:
Bonna Co. considering the following project at the beginning of 2007.. The particulars of expected
net profit before tax are given below-
. The company cost of capital @10%. The rates of Tax @45%. The project
will be depreciated on a straight line method. Calculate NPV
Particulars Project-A
Initial Investment TK 1,00,000
EBIT
2007 26,000
2008 30,000
2009 32,000
2010 35,000
2011 40,000
Salvage value 10,000

13. A company ltd is considering the purchase of a new machine. Two alternative machines
have been suggested, each having an initial cost of TK 4,00,000, estimated salvage
value TK 50,000. Earnings before tax are expected to be as follows. The company has a
required rate of return of 10%.Which machine would be bought. Use NPV and IRR
method
 Year Project-A Project-B
 1 80,000 1,20,000
 2 1,20,000 1,60,000
 3 1,60,000 2,00,000
 4 2,40,000 1,20,000
 5 1,60,000 80,000
Company uses straight line method, tax rate 50%. Calculate NPV, ARR, PI, PBP.