Capital Budgeting

AAMIR AIJAZ SYED

What is Capital Budgeting

Capital Budgeting is the process of determining which

real investment projects should be accepted and given an allocation of funds from the firm. To evaluate capital budgeting processes, their consistency with the goal of shareholder wealth maximization is of utmost importance.

The Flows of funds and decisions important to the financial manager

Investment Decision Reinvestment Real Assets Financial Manager

Financing Decision Refinancing Financial Markets

Returns from Investment

Returns to Security Holders

Capital Budgeting is used to make the Investment Decision

Capital Budgeting process

1.Estimate the cash flows. 2. Assess the riskiness of the cash flows. 3. Determine the appropriate discount rate. 4. Find the PV of the expected cash flows. 5. Accept the project if PV of inflows > costs.

Techniques
The main techniques for capital budgeting include:

Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI) and Payback

Each requires estimates of expected cash flows (and their timing) for the project.
Including

cash outflows (costs) and inflows (revenues or savings)

Each requires an estimate of the projects risk so that an appropriate discount rate (opportunity cost of capital) can be determined.

Sometimes the above data is difficult to obtain this

is the main weakness of all techniques.

Net Present Value(NPV)

Discount cash inflows to their present value and then

compare with capital outlay required by the investment Discount rate (hurdle rate or required rate of return) required minimum rate of return given riskiness of investment Proposal is acceptable when NPV is zero The higher the NPV, the more attractive the investment

Example:
Project X cost Rs 2500 now and is expected to generate year-end cash flows of Rs

900,Rs 800,Rs 700,Rs 600 and Rs 500 in year 1 through 5.The opportunity cost assumed to be 10%. Formula= R=Cash Inflows T=Time Period I=Opportunity Cost Step 1) Calculate the Present Value of the cash flows =2725 Step 2) Subtract the Sum of PVFs with initial cash outlay i.e.2725-2500 This will give the NPV =275 As NPV is positive Project we can accept the project X.

Strength Weakness of NPV method

Strength: Resulting number is easy to interpret: shows how wealth will change if the project is accepted. Acceptance criteria is consistent with shareholder wealth maximization. Relatively straightforward to calculate Weakness: Cash Flow Estimation Discount Rate

Internal Rate of Return (IRR)

IRR is the rate of return that a project generates. Algebraically,

IRR can be determined by setting up an NPV equation and solving for a discount rate that makes the NPV = 0. Equivalently, IRR is solved by determining the rate that equates the PV of cash inflows to the PV of cash outflows. Method: Use your financial calculator or a spreadsheet; IRR usually cannot be solved manually. If IRR opportunity cost of capital (or hurdle rate), then accept the project; otherwise reject it.

Example:
A project cost Rs 16000 and expected to generate expected cash flows of Rs 8000,Rs 7000,Rs 6000 at the end of each year for the next 3 year. Calculate IRR? First step try with a arbitrary discount rate say 20% and try to bring NPV to zero. As when we take 20 % IRR NPV will come to Rs -1004. Negative NPV will indicate project IRR is lower than 20% then we take IRR to 16% ,In this case NPV will come to Rs -57.Here again it shows that NPV is negative and IRR should be below 16% If we take 15% NPV will come to Rs 200.This shows that IRR should be between !5% to 16% and by interpolation we find that IRR is 15.8%. Hence if the opportunity cost is lower than IRR we will take the project.

1)
2) 3)

4)

Strength and Weakness of IRR

Strength:
Time Value
Profitability measure Acceptance Rule Shareholder value

Weakness:
Mutually exclusive project Based on hit and trail method

Difficult to calculate manually

Profitability Index (PI)

Profitability index is the ratio of present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment
Method: PI=PV cash flow after the initial investment Initial investment

Note: PI should always be expressed as a positive number.

If PI 1, then accept the real investment project; otherwise, reject it.

Example:
Calculate profitability index if Initial outlay of project is Rs 100000 and generate cash inflows of Rs 40000,Rs30000,Rs 50000 and Rs 20000 .Assume 10% rare of discount.
1) 2) 3) 4)

Step 1 Calculate the present value of cash flows at 10% rate of discount Divide the summation by initial outlay. Present value of each cash flows will come to Rs 112350 and as initial outlay is Rs 100000 therefore profitability index will be 1.1235 As it is more than one we will accept the project.

Strength and Weakness of Profitability index

Strength:

PI number is easy to interpret Acceptance criteria is generally consistent with shareholder wealth maximization. Relatively straightforward to calculate.
Requires knowledge of finance to use. Method needs to be adjusted when there are mutually exclusive projects

Weaknesses

Payback period
FORMULA:For a project with equal annual receipts:

Where: I= initial investment C =net annual cash inflow

Example :

Years Project A

2 250,000

3 250,000

4 250,000

5 250,000

1,000,000 250,000

= 4 years

Example:
Payback for uneven Cash flows:
Project cash outlay is Rs 20000,and generate cash inflows of Rs 8000, Rs 7000, Rs 4000, Rs 3000 during 1 to 4 years. What is project pay back?

Steps:
When we add the project inflows of first three years Rs 19000 of original outlay is recovered. In the fourth year cash inflow generate Rs 3000 and only 1000 of initial outlay is to be recovered Time required to recover 1 thousand will be(Rs 1000/Rs 3000)*12 months=4 months Hence payback period is 3 years and 4 months.

Strength and weakness of Payback

Strength:
Simple
Cost effective Risk shield Liquidity

Weakness
Cash flow ignored Cash flow pattern

Conclusion
The DCF techniques, NPV, IRR, and PI, are all good

techniques for capital budgeting and allow us to accept or reject investment projects consistent with the goal of shareholder wealth maximization. Beware, however, there are times when one techniques output is better for some decisions or when a technique has to be modified given certain circumstances . Among the various technique of capital budgeting, payback technique is the mostly followed technique due to its simplicity.

Thank you