The Islamia University of Bahawalpur

Department of Finance- IBMAS

Capital Budgeting
Techniques
Dr. AMNA NOOR
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

• Independent projects are projects whose cash flows are

unrelated to (or independent of) one another; the acceptance
of one does not eliminate the others from further
consideration.

• Mutually exclusive projects are projects that compete with

one another, so that the acceptance of one eliminates from
further consideration all other projects that serve a similar
function.
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

Payback Period (PBP)

PBP is the period of time required for the cumulative
expected cash flows from an investment project to
equal the initial cash outflow.
0 1 2 3 4 5

–40 K 10 K 12 K 15 K 10 K 7K
10 K 22 K 37 K 47 K 54 K

Cumulative
Inflows
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

Strengths: Weaknesses:
• Easy to use and • Does not account
understand. for time value of
• Can be used as a money.
measure of • Does not consider cash
liquidity. flows beyond the Pay
• Easier to forecast ST than back period.
LT flows. • Cutoff period is
subjective.
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

Net Present Value (NPV)

NPV is the present value of an investment project’s net
cash flows minus the project’s initial cash outflow.

Decision criteria:
– If the NPV is greater than $0, accept the project.
– If the NPV is less than $0, reject the project.
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

Example:

A project has an initial cost of $52,125, expected net cash inflows

of $12,000 per year for 8 years, and a cost of capital of 12%.
What is the project’s NPV?
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

Strengths: Weaknesses:
• Cash flows • May not include
assumed to be managerial
reinvested at the options embedded
hurdle rate. in the project.
• Accounts for time value
of money.
• Considers all
cash flows.
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

Internal Rate of Return (IRR)

IRR is the discount rate that equates the present value
of the future net cash flows from an investment
project with the project’s initial cash outflow.

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.
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

Example:
• PV of cash flows = $ 59,612
• Initial cash flow = $ 52,125
• NPV = $ 7486
The Islamia University of Bahawalpur
Department of Finance- IBMAS

Strengths: Weaknesses:
• Accounts for time • Assumes all cash
value of money. flows reinvested at
• Considers all the IRR.
cash flows. • Difficulties with
• Less subjectivity project rankings and
Multiple IRRs.
The Islamia University of Bahawalpur
Department of Finance- IBMAS

Profitability Index (PI)

PI is the ratio of the present value of a project’s future
net cash flows to the project’s initial cash outflow.
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

Potential Problems Under Mutual Exclusivity

1.Cash Flow Pattern
END OF YEAR Project D Project I
0 -$1,200 -$1,200
1 1,000 100
2 500 600
3 100 1,080
IRR NPV@10% PI
D 23% $198 1.17
I 17% $198 1.17
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

2. Project life Differences

NET CASH FLOWS
END OF YEAR Project X Project Y
0 -$1,000 -$1,000
1 0 2,000
2 0
3 3,375
IRR NPV@10% PI
X 50% $1536 2.54
Y 100% $818 1.82
 The Islamia University of Bahawalpur
Department of Finance- IBMAS

Capital Rationing
Capital Rationing occurs when a constraint (or
budget ceiling) is placed on the total size of
capital expenditures during a particular period.

Example: Julie Miller Corporation must determine

what investment opportunities to undertake. The
capital budget is limited to a maximum expenditure
of $32,500 only.
The Islamia University of Bahawalpur
Department of Finance- IBMAS

Project ICO IRR NPV PI

A 500 18% $ 50 1.10
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
E 12,500 26 500 1.04
F 15,000 28 21,000 2.40
G 17,500 19 7,500 1.43
H 25,000 15 6,000 1.24