2. Capital Budgeting
• Capital refers to the long term investment made on fixed assets by
the firm for generating revenue.
• Budget refers to the end boundary of expenditure of a rational
consumer. And budgeting means the process of disbursing the total
amount of budget among different purpose.
• So Capital Budgeting is the process of evaluating and selecting long
term investments that are consistent with the firm’s goal of
maximizing owners wealth.
3. Steps in Capital Budgeting Process
The Capital Budgeting process consists of five distinct steps:
1. Proposal generation (reviewed by the finance personnel)
2. Review & analysis ( evaluate the economic viability)
3. Decision making ( BOD must authorize the expenditure)
4. Implementation (project is implemented)
5. Follow up.( results are monitored)
5. Cont.
• Cash flow pattern:
1. Conventional cash flow
2. Non conventional cash flow
• Basic Pattern of Cash flow:
1. Single amount
2. Annuity
3. Mixed steam
6. Capital Budgeting Techniques
1. Pay back period
2. Discounted Pay back period
3. Net Present value
4. Average Accounting Return
5. Internal rate of return
6. Profitability Index
7. Pay Back Period
• The amount of time required for an investment to generate cash
flows sufficient to recover its initial investment.
• Pay back period rules:
An investment is acceptable if its calculated payback period is less
than some prespecified number of years.
• Disadvantages of PBP:
1. It ignores the time value of money
2. Ignores the cash flows after the PBP.
8. Calculating PBP
Consider the two investments, Short & Long.
The PBP of long project is
2 years+ 50/100
= 2 yrs+0.5yrs
= 2.5 years
The PBP of Short project is
1 year+150/200
= 1 yr+o.75yrs
= 1.75yrs
Year Long Short
0 -250 -250
1 100 100
2 100 200
3 100 0
4 100 0
9. Cont.
• Now assume two situation:
1. If the cut off PBP is 3 years & if the project are independent then
both the projects will be accepted.
2. If they are mutually exclusive then short project will be accepted.
Because the rule is that “the sooner, the better”.
10. Discounted PPB
• The length of time period required for an investment’s discounted
cash flows to equal its initial cost.
• Rule:
An investment is acceptable if its discounted PBP is less than some
predetermined number of years.
Calculation of DPBP:
Suppose we require a 12.5% return on new investment that costs $350
and cash flows of $100 per year every year for five years. Calculate the
DPBP.
12. • DPPB for the project can be obtained as
4 years+ 50/55 yrs
= 4+.90
= 4.90 years
Decision: If the cut off DPBP is greater than 4.90 years then the project
will be accepted and vise versa.
13. Net Present Value (NPV)
The difference between an investment’s market value and its cost is called NPV.
The equation of NPV is,
NPV= PV of Cash inflows – PV of Cash outflow
= ∑ CFt /(1+i)n - CF0 {for unequal series of payment}
= CFt (PVIFA i%, n years) –CF0 {For annuity or equal series of payment}
Decision criteria:
An investment should be accepted if the NPV is positive and rejected if
the NPV is negative. If the NPV is zero then the decision is neutral.
NPV is one way of assessing the profitability of a proposed investment.
14. Internal Rate of Return (IRR)
IRR is the discount rate that makes the NPV of an investment zero.
We know that,
NPV= PV of Cash inflows – PV of Cash outflow
or, NPV = ∑ CFt /(1+i)n - CF0 {for unequal series of payment}
or, 0 = ∑ CFt /(1+IRR)n - CF0
or, CFO = ∑ CFt /(1+IRR)n
Based on IRR rule, an investment is acceptable if the IRR exceeds the required return.
i.e.,
IRR> Kd =Accept
IRR< kd = Reject
IRR=Kd = Neutral
15. Calculation of NPV & IRR
• Calculating NPV and IRR A project that provides annual cash flows of $24,000 for nine years costs
$110,000 today. Is this a good project if the required return is 8 percent? What if it’s 20 percent?
At what discount rate would you be indifferent between accepting the project and rejecting it?
Solution: Given Information
Initial Investment (CF0) = $110000
Annual cash flow (CFt) = $24000
Conversion period (n) =9 years
Cost of capital (i) =8%
We know that NPV= ∑ CFt /(1+i)n - CF0 {for unequal series of payment}
= CFt (PVIFA i%,n years) – CF0 {for equal cash flow}
= 24000 (PVIFA 8%,9years) – 110000
16. Cont.
NPV= (24000X6.2469)-110000 [Putting the values from Financial table]
= $39925.6 > 0
Decision : If the required return is 8% then the project will be accepted.
Again if the required rate of return is 20% then NPV= -$13256 which is less than zero. So the project
will be rejected if the required rate of return is 20%.
IRR Calculation
By using the trial & error method we can find out the value of IRR.
We know that,
CFO = ∑ CFt /(1+IRR)n
110000= 24000 (PVIFA IRR%,n years)
Now if IRR=10% then
110000= 24000 x5.7590
17. Cont.
or, $110000= $138216
Again If IRR=20% then,
$ 110000= 24000 (PVIFA 20%, 9 years)
or, $110000= 24000x4.0310
or, $110000= $96744
Now the expected IRR is in between 10% to 20% which can be find out by using the following
formula.
IRR= LR+ (CV at lower rate-GV)/(CV at lower rate-CV at higher rate) x(HR-LR)
Here, HR=20% , LR=10%
CV at HR= $96744, CV at LR= $ 138216
GV= $ 110000
18. Cont.
So that the IRR can be obtained at,
IRR=10%+(138216-110000)/(138216-96744) x (20-10)%
=10%+(28216/41472)x10%
= 10%+(o.6803x10)%
= 10% +6.803%
= 16.80%
At what discount rate would you be indifferent between accepting the project and rejecting it?
So at 16.80% discount rate we would be indifferent between accepting the project and rejecting it.
Because IRR indicates the discount rate that equals the NPV zero.
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19. Profitability Index
The present value of an investment’s future cash flows divided by its initial cost.
Also called the benefit–cost ratio.
Formula for PI,
PI = PV of cash inflows/ PV of cash outflow
= ∑ CFt /(1+i)n / CF0
Decision for PI: If
PI > 1, then project will be accepted.
PI < 1, then project will be rejected.
PI = 1, then the decision will be indifferent.
20. Calculating Profitability Index What is the profitability index for the following set of
cash flows if the relevant discount rate is 10 percent? What if the discount rate is
15 percent? If it is 22 percent?
Solution:
PI = PV of cash inflows/ PV of cash outflow
= ∑ CFt /(1+i)n / CF0
Year Cash flow
0
1
2
3
-$ 12000
6200
5600
3900
21. Cont.
Now if the discount rate is 10% then the PI will be obtained as,
PV of cash inflows:
= 6200/(1+0.10)1 +5600/(1+0.10)2 + 3900/(1+0.10)3
= $13194.59
Now the PI is,
PI = $13194.59/$12000
= 1.099
= 1.10 > 1
If the discount rate is 10% then the project will be accepted.
22. Cont.
• For Assignment:
Comparing Investment Criteria Consider the following two mutually exclusive projects:
Whichever project you choose, if any, you require a 15 percent return on your investment.
a. If you apply the payback criterion, which investment will you choose? Why?
b. If you apply the discounted payback criterion, which investment will you choose? Why?
Year Cash flow (A) Cash flow (B)
0
1
2
3
4
-$350000
25000
70000
70000
430000
-$350000
17000
11000
17000
11000
23. Cont.
c. If you apply the NPV criterion, which investment will you choose? Why?
d. If you apply the IRR criterion, which investment will you choose? Why?
e. If you apply the profitability index criterion, which investment will you choose? Why?
f. Based on your answers in (a) through (e), which project will you finally choose? Why?
For Practice:
Page: 443 ( ST9-1)
Page 444 (P9-1, 9-2, 9-3, 9-5, 9-6,9-12)
