CAPITAL BUDGETING

Capital Budgeting: The total process of generating, evaluating, selecting and following
up on capital expenditure alternatives.
Capital Expenditure: An outlay made by a firm for a fixed or an intangible asset from
which benefits are expected to be received over a period greater than a year.
Independent Projects: Capital expenditure alternatives that compete with each other, but
in such a way that the acceptance of one project does not eliminate the other projects
from further consideration.
Mutually Exclusive Projects: A group of capital budgeting projects that compete with
one another in such a way that the acceptance of one eliminates all other in the group
from further consideration.
Capital Rationing: The allocation of limited,.bn amount of funds to a group of
competing capital budgeting process.
Ranking Approach: Evaluating the relative attractiveness of capital projects on the basis
of some predetermined criterion.
Present Value: The value of a future sum or stream of dollars discounted at a specified
rate. The process of finding present value is actually the inverse of the compounding
process.
Future value: The value of a single sum or an annuity compounded at a given interest
rate for a specified time period.
Importance of Capital Budgeting:
1. To achieve long-term goal of firm.
2. Huge Capital Investment.
3. Long Term Investment.
4. Risky Investment.
5. Balancing amomg liquidity, profitability and value of the firm.
6. Searching for alternative investment opportunities.
7. Ranking of projects and best use of limited capital.
Types of Investment Decision
1. Accept-Reject Decision
2. Mutually Exclusive Projects Decision
3. Capital Rationing Decision
Steps in Capital Budgeting:
1. Identification of investment projects
2. Evaluation of alternative investment projects
3. Selection of the best investment projects
4. Implementation of the projects
5. Continuous evaluation of the selected projects.

Application of Capital Budgeting:

1. Purchase of Fixed assets
2. Mechanisation of production method
3. Selection from alternative equipments
4. Introduction of new product
5. Expansion of business
6. Modernization and replacement
7. Make or buy decision.
Related Issues in Capital Budgeting:
Prospective Investment porposals
1. Cost of the projects
2. Life of the projects
3. Cash inflows and outflows
4. Salvage value of the projects
5. Dsicounting rate
6. Techniques of evaluation

Capital Budgeting Methods

1. Average/Accounting Rate of Return Methods of Capital Budgeting
Formula 1: Based on original investment
ARR = Annual Net Profit After Tax
Original Investment

X 100

Formula 2: Based on Average investment

ARR = Net Profit After Tax
Average Investment

X 100

*Average investment
= Original Investment Salvage value
2

+ Salvage value

2. Pay Back Period Methods of Capital Budgeting

Formula 1: When Annual Cash Flows are uniform
PBP = Investment
Cash flow after tax

Formula 1: When Annual Cash Flows are uniform

PBP = A + NCO - C
D
Where, A = Year in which the accumulated cash flows are nearer to NCO
NCO = Net Cash Outlay
C = Accumulated cash outlay of the year A
D = Cash flow of the succeeding year of the year A
Formula : NPV
Where there is one single investment in the beginning
n
NPV = t 1

CFt
Sn Wn

COo
t
(1 K ) n
(1 K )
n
CFt
COo
Or, NPV = t 1
(1 K ) t

Or, NPV = PV of NCB PV of NCO

Here,
NPV = Net Present Value
CFt= Cash flow at different time period.
Sn= Salvage value at N year.
Wn= Working capital structure
Coo= Initial cash out flow
K = Cost of capital.
Where there is a number of investment at interval
n
NPV = t 1

CFt
Sn Wn
COt

t
1
t
n
(1 K )
(1 K )
(1 K ) t
n

Or, NPV = PV of NCB PV of NCO

Here,
Cot= Cash out flow at different times.

Decision Rule at a glance

1. NPV>0 Accepted
2. TPV> NCO Accepted
3. NPV = O May accepted or rejected.
4. NPV < O Rejected
5. TPV < NCO Rejected

FORMULA : IRR
IRR = A + (B-A)
Where,
IRR = Internal Rate of Return
A = Lower Discount Rate.
B = Higher Discount Rate.
C = NPV of Lower Discount Rate.
D = NPV of Higher Discount Rate
ILLUSTRATION (NPV)
ABC co. has two projects for consideration

Year

EBDT
Project A
(50,000)
10,000
15,000
12,000
20,000
10,000
5,000

0
1
2
3
4
5
Salvage value

Project B
(50,000)
12,000
10,000
15,000
25,000
9,500
2,500

If the tax rate is 40% and the discount rate is 12%, which of the two projects will be
accepted ?

SOLUTION:
Depreciation = = = 9,000.
Year
1
2
3
4
5
S.V

EBDT
10,000
15,000
12,000
20,000
10,000
5,000

Dep.
9,000
9,000
9,000
9,000
9,000
---

EBT
1,000
6,000
3,000
11,000
1,000
5,000

Tax 40%
400
2,400
1,200
4,400
400
---

EAT
600
3,600
1,800
6,600
600
5,000

NCF
9,600
12,600
10,800
15,600
9,600
5,000

Factor 12%
.892
.797
.712
.635
.567
.567

PV
8,563
10,042
7,690
9,906
5,443
2,835
44,479

Tax 40%
1,000
200
2,200
15,500
0

EAT
1,500
300
3,300
9,300
0

CFAT
11,000
9,800
12,800
18,800
9,500

Factor 12%
.892
.797
.712
.635
.567

PV
9,812
7,811
9,101
11,938
5,387
44,049

NPV = PV of NCB PV of NCO

= 44,479 50,000
= (5,521)
Depreciation = = 9,500
Year
1
2
3
4
5

CFBT
12,000
10,000
15,000
25,000
9,500

Dep.
9,500
9,500
9,500
9,500
9,500

EBT
2,500
500
5,500
15,500
0

NPV = PV of NCB PV of NCO

= 44,049 50,000
= (5,951)
Decision: Both the companies have a negative NPV. So none of them would be
considered for investment.
FORMULA : IRR
IRR = A + (B-A)
Where,
IRR = Internal Rate of Return
A = Lower Discount Rate.
B = Higher Discount Rate.
C = NPV of Lower Discount Rate.
D = NPV of Higher Discount Rate
ILLUSTRATION: (IRR)
The cost of a 3 year project is estimated as tk. 20,000. The estimated inflows for three
years have been estimated as tk. 8,000 per year. If the cost of capital is 7% whether
investment in the project is worthy or not?

Year
1-3
Less : NCO

CFAT
8,000

Calculation of IRR
Factor 7%
PV
2,624
20,992
20,000
992

Factor 10%
2,486

PV
19,888
20,000
-112

IRR = A + (B-A)
= 7% + (10-7)%
= 7% + 3%
= 7% + 2.695%
= 9.695%
Illustration 1 : ARR and PBP
Nishat Enterprise wants to buy a machine costing tk. 1,50,000 for an expected life of
5 years. The projected net profit after tax is follows:
Years
Net Profit After Tax
1
Tk. 20,000
2
Tk. 18,000
3
Tk. 15,000
4
Tk.17,000
5
Tk. 15,000
Calculate the average rate of return (ARR) of Nishat Enterprise
Illustration 2 : NPV
A Company is considering an investment proposal to install new milling controls at a
cost of tk. 50,000. The facility has a life expectancy of five years and no salvage
value. The tax rate is 35 per cent. Assume the firm uses straight-line depreciation. The
cost of capital is 10%. The Earnings before depreciation and taxes from the
investment proposal are as follows.
Years
EBDT
1
Tk. 10,000
2
Tk. 10,692
3
Tk. 12,769
4
Tk.13,462
5
Tk. 20,385
Compute the following and suggest whether the proposal is to be accepted or not