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Name: Mirza Maaz Bin Shahid

Roll no. 44(m)


Seat no. B-0697044

Capital Budgeting and its Techniques


Capital budgeting (definitions):
The process of identifying, analyzing and selecting investment projects whose
returns (cash flows) are expected to extend beyond one year. [1]

The process of evaluating and selecting long-term investments that are consistent
with the firm’s goal of maximizing owner wealth. [2]

Capital budgeting (or investment appraisal) is the planning process used to


determine whether a firm's long term investments such as new machinery,
replacement machinery, new plants, new products, and research and
development projects are worth pursuing. [3]

Capital Expenditure:
A capital expenditure is an outlay of cash for a project that is expected to
produce a cash inflow over a period of time exceeding one year. [4]

Expenditures that may provide benefits into the future and therefore are treated
as capital outlays and not as expenses of the period in which they were incurred.
[5]

An outlay of funds by the firm that is expected to produce benefits over a period
of time greater than one year. [6]

Capital Budgeting Process:


There are five steps in process.
 Proposal Generation
Proposals are made at all levels within a business organization and are
reviewed by Finance personnel. [7]

Investment project proposals can stem from a variety of sources. For


purposes of analysis, projects may be classified into five categories.

1. New products or expansion of existing products.


2. Replacement of equipment or buildings.
3. Research and development.
4. Exploration
5. Others (for e.g., safety-related or pollution–control devices) [8]
In this step people from every field of the corporation like Marketing,
Operations, and Finance develop proposals mostly looking into their own
department first.

 Review and Analysis


Formal review and analysis is performed to assess the appropriateness of
proposals and evaluate their economic viability. Once the analysis is complete, a
summary report is submitted to decision makers. [9]

One of the most important tasks in capital budgeting is estimating future


cash flows for a project. The final results we obtain from our analysis are no
better than the accuracy of our cash flow estimates. Because cash, not accounting
income, is central to all decisions of the firm, we express whatever benefits we
expect from a project in terms of cash flows rather than income flows. [10]

In this step the proposals go through serious analysis about being beneficial to
what extent for the firm.

 Decision Making
Firms typically delegate capital decision making on the basis of dollar
limits. Generally, the board of directors must authorized expenditures beyond a
certain amount. Often plant mangers are given authority to make decisions
necessary to keep the production line moving. [11]

Selecting project based on a value-maximizing acceptance criterion. [12]

 Implementation
Following approval, expenditures are made and projects implemented.
Expenditures for a large project often occur in phases. [13]

 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. [14]

Capital Budgeting Techniques


Following techniques are used for capital budgeting:

1. Payback Period
2. Internal rate of return
3. Net present value
4. Profitability index [15]
5. EAC (Equivalent Annual Cost) [16]
The first method is a simple additive method for assessing the worth of a project.
The remaining are more complicated discounted cash flow (DCF) techniques. [17]

Payback Period
The period of time required for the cumulative expected cash flows from an
investment project to equal the initial cash outflow.
The payback period (PBP) of an investment project tells us the number of years
required to recover our initial cash investment based on the project’s expected
flows. [18]

STEPS (FOR PBP)

1. Accumulate the cash flows occurring after the initial outlay in a cumulative
inflows column.
2. Look at the cumulative inflows column and note the last year for which the
cumulative total does not exceed the initial outlay.
3. Compute the fraction of the following year’s cash inflows to payback the
initial cash outlay as follows:
Take the initial outlay minus the cumulative total from step 2; divide this
amount by the following year’s cash inflow.
4. To get the payback period in years, take the whole figure determined in step
2 and add to it the fraction of a year determined in step 3.

ACCEPTANCE CRITERION

If the payback period calculated is less than some maximum acceptable payback
period, the proposal is accepted; if not, it is rejected. [19]

PROS AND CONS OF PAYBACK PERIOD

The payback period is widely used by large firms to evaluate small projects and
by small firms to evaluate most projects. Its popularity results from its
computational simplicity and intuitive appeal. It is also appealing that it
considers cash flows rather than accounting profits. By measuring how quickly
the firm recovers its initial investments, the payback period also gives implicit
consideration to the timing of cash flows and therefore to the time value of
money. Because it can be viewed as a measure of risk exposure, many firms use
the playback period as a decision criterion or as a supplement to other decision
techniques. The longer the firm must wait to recover its invested funds, the
greater the possibility of a calamity. Therefore, the shorter the payback period,
the lower the firm’s exposure to such risk. [20]

The major weakness of the pay back period is that the appropriate payback
period is merely a subjectively determined number. It cannot be specified in light
of the wealth maximization goal because it is not based on discounting cash flows
to determine whether they add to the firm’s value.
A second weakness is that this approach fails to take fully into account the time
factor in the value of money.
A third weakness of payback period is its failure to recognize cash flows that
occur after the payback period. [21]

This technique gives a simple and clear cut idea about the recovery of firm’s
investment in a project.
Net Present Value (NPV)

Net present value (NPV) is a standard method for the financial appraisal of long-
term projects. Used for capital budgeting, and widely throughout economics, it
measures the excess or shortfall of cash flows, in present value (PV) terms, once
financing charges are met. It is also called net present worth (NPW). [22]

Formula
Each cash inflow/outflow is discounted back to its present value (PV). Then they
are summed. Therefore

Where
t - The time of the cash flow
N - The total time of the project
r - The discount rate (the rate of return that could be earned on an investment in
the financial markets with similar risk.)
Ct - the net cash flow (the amount of cash) at time t (for educational purposes,
C0 is commonly placed to the left of the sum to emphasize its role as the initial
investment). [23]

The present value of an investment project’s net cash flow minus the project’s
initial cash outflow. [24]
The net present value method is a discounted cash flow approach to capital
budgeting. [25]

In formula we have
Where, “k” is the required rate of return. [26]

Because, net present value (NPV) gives explicit consideration to the time value of
money, it is considered a sophisticated capital budgeting technique. All such
techniques in one way or another discount the firm’s cash flows at a specified
rate. This rate – often called discount rate, required rate, cost of capital, or
opportunity cost – is the minimum return that must be earned on a project to
leave the firm’s market value unchanged.
The net present value is found by subtracting a project’s initial investment (CF 0)
from the present value of its cash inflows (CFt) discounted at a rate equal to the
firm’s cost of capital (k).

NPV=Present value of cash inflows-Initial investment

When NPV is used, both inflows and outflows are measured in terms of present
dollars Because we are dealing only with investments that have conventional
cash flows patterns, the initial investment is automatically stated in terms of
today’s dollars. If it were not, the present value of a project would be found by
subtracting the present value of outflows from the present value of inflows. [27]

ACCEPTANCE CRITERION

If an investment project’s net present value is zero or more the project is


accepted; if not, it is rejected. Another way to express the acceptance criterion is
to say that the project will be accepted if the present value of cash inflows
exceeds the present value of cash outflows. [28]

In this technique we determine the net value of cash inflows and cash outflows, if
the value is zero or more than zero projects can be accepted but if less than zero,
projects are rejected.

Internal Rate of Return

The internal rate of return (IRR) for an investment proposal is the discount rate
that equates the present value of the expected net cash flow (CFs) with the initial
cash outflow (ICO). If the initial cash outflow or cost occurs at time 0, it is
represented by that rate IRR, such that

Thus, IRR is the interested rate that discounts the stream of future net cash flow
– CFt through CFn – to equal in present value the initial cash outflow (ICO) at
time 0. [29]

The internal rate of return (IRR) is probably the most widely used sophisticated
capital budgeting technique. However, it is considerably more difficult than NPV
to calculate at hand. The internal rate of return (IRR) is 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 compound annual rate of
return that the firm will earn if it invests in the project and receives the given
cash inflows.
Mathematically, the IRR is the value of k that causes NPV to equal $0.

[30]

The internal rate of return (IRR) is a capital budgeting metric used by firms to
decide whether they should make investments. It is an indicator of the efficiency
of an investment, as opposed to net present value (NPV), which indicates value or
magnitude.
The IRR is the annualized effective compounded return rate which can be
earned on the invested capital, i.e., the yield on the investment.

A project is a good investment proposition if its IRR is greater than the rate of
return that could be earned by alternate investments (investing in other projects,
buying bonds, even putting the money in a bank account). Thus, the IRR should
be compared to any alternate costs of capital including an appropriate risk
premium. [31]

ACCEPTANCE CRITERION

The acceptance criterion generally employed with the internal rate of return
method is to compare the internal rate of return to a required rate of return,
known as the cutoff of hurdle rate. We assume for now that the required rate of
return is given. If the internal return of rate exceeds the required rate, the
projects accepted; if not, the project is rejected. [32]

Profitability Index

The ratio of the present value of a project’s future net cash value to the project’s
initial cash outflow.
The profitability index (PI), or benefit-cost ratio, of a project is the ratio of the
present value of future net cash flows to the initial cash out flow.
It can be expressed as:

[33]

Profitability index identifies the relationship of investment to payoff of a


proposed project. The ratio is calculated as follows:

(PV of future cash flows) / (PV Initial investment) = Profitability Index

Profitability Index is also known as Profit Investment Ratio, abbreviated to P.I.


and Value Investment Ratio (V.I.R.). Profitability index is a good tool for ranking
projects because it allows you to clearly identify the amount of value created per
unit of investment, thus if you are capital constrained you wish to invest in those
projects which create value most efficiently first. [34]

ACCEPTANCE CRITERION

As long as the profitability index is 1.0 or greater, the investment proposal is


acceptable. For any given project, the net present value and the profitability
index methods give the same accept-reject signals. [35]

This technique is used to find out aspects of profitability by comparing returns


gained with the cost of a project.

Equivalent Annual Cost (EAC)

In finance the equivalent annual cost (EAC) is the cost per year of owning and
operating an asset over its entire lifespan.

EAC is often used as a decision making tool in capital budgeting when


comparing investment projects of unequal life spans.

EAC is calculated by dividing the NPV of a project by the present value of an


annuity factor. Equivalently, the NPV of the project may be multiplied by the
loan repayment factor.

EAC=

[36]

This technique is used when the two projects of unequal lifespan are under
consideration. They are compared by this technique by looking into the year by
year expenses of the two projects. Project with greater EAC will be rejected.

References
1. James Van Horne and John Wachowicz “Fundamentals of Financial
Management” (FFM) Pg 316
2. Lawrence Gitman “Principles of Managerial Finance” (PMF) Pg 356
3. www.en.wkipedia.org/wiki/Capital_budgeting
4. www.netmba.com/finance/capital/budgeting
5. FFM Pg 320
6. PMF Pg 356
7. PMF Pg 356
8. FFM Pg 316-317
9. PMF Pg 356
10. FFM Pg 317
11. PMF Pg 357
12. FFM Pg 316
13. PMF Pg 357
14. PMF Pg 357
15. FFM Pg 334
16. www.en.wikipedia.org/wiki/Capital_budgeting
17. FFM Pg 334
18. FFM Pg 334
19. FFM Pg 334-335
20. PMF Pg 398
21. PMF Pg 399
22. www.en.wikipedia.org/wiki/Net_present_value Lin, Grier C.I ; Nagalingam,
San V. (2000) CIM Justification London: Taylor Francis 36
23. www.en.wikipedia.org/wiki/Net_present_value#formula
24. FFM Pg 337
25. FFM Pg 337
26. FFM Pg 338
27. PMF Pg 401
28. FFM Pg 338
29. FFM Pg 335-336
30. PMF Pg 403
31. www.en.wikipedia.org/wiki/Internal_rate_return
32. FFM Pg 337
33. FFM Pg 340
34. www.en.wikipedia.org/wiki/Profitability_index
35. FFM Pg 340
36. www.en.wikipedia.org/wiki/Equivalent_Annual_Cost