Capital Budgeting

Nature & Types of Investment

Decisions

Nature
An investment/capital budgeting decision
is the firms decision to invest current
funds in long term assets in anticipation
of an expected flow of benefits over a
series of years. Its features are
Exchange of current funds for future
benefits
Investment of funds in long term assets
Future benefit will accrue over a period of
time

Importance of Investment
Decisions
They influence the firms long-run
growth
They affect the risk the firm faces
They involve commitment of large funds
They are irreversible decisions; if
reversible, only at substantial loss
They are among the most difficult
business decisions because of their
complexity

Types of Investment
Decisions
Expansion & Diversification (capacity;
new)
Replacement & Modernisation
(technology)
Mutually exclusive investments
(alternatives)
Independent investments (additions)
Contingent investments
(complementary)

Capital Budgeting Process

Identification of investment
opportunities (idea generation)
Forecasting (cost-benefit analysis)
Project evaluation (net benefits using
IRR, NPV, ARR, Payback, Cut-off Rate,
Risk Assessment, Sensitivity
Analysis, Capital Rationing)
Authorisation for capital expenditure
Control & Monitoring

Time Value of Money

Annual Compounding: F = P(1+ i)n where F is
the future value of todays investment P at the
interest rate i for n years
Semi-annual compounding: F = P(1 + ) nx2
Compound value of annuity: F = A[(1+i)n-1]
2
A=10,000; n=5; i=12% then F = A(CVFA,12%,5)
=
10,000x6.353
= 63,530

Discounting/Present Value
P = F[1/(1 + i)n
Present Value of an annuity: P = A[1-1/
(1+i)n]
i

The reciprocal of the present value

annuity factor is called the capital
recovery factor (CRF)

Investment Valuation
Estimation of cash flows
Estimation of required rate of return:
opportunity cost of capital
Application of decision rule:
objective, ordinal, choice criteria
DCF: NPV, IRR, PI
Non-DCF: Payback Period, Discounted
payback period, ARR

Net Present Value Method

Forecast cash flows realistically
Use appropriate discount rate:
opportunity cost of capital=required rate
of return on investments of equivalent
risk
Calculate PV using opportunity cost of
capital as discount rate
Calculate NPV=PV(inflows)-PV(outflows)
Accept if NPV > 0

Why NPV

Time value of money

Assesses true profitability
Value additive
Shareholder value
But: CF estimation difficult; deciding
DR tough; different project lives;
project ranking

IRR
Similar to DCF; not value additive;
multiple rates possible; may not
evaluate mutually exclusive projects
correctly
Easy for even cash flows
Accept if r>k
Reject when r<k
Accept/reject when r=k

Profitability Index
Ratio of PV of cash inflow at the required
rate of return to the initial cash outflow
PI = PV of Cash Inflows/Initial Cash
Outlay
= PV(Ct) = nt=1Ct
C0
C0
(1+k)t
Accept if PI>1
Reject if PI<1
Accept/Reject if PI=1

Payback
The number of years required to recover
the initial cash outlay
Payback = Initial Investment = Co
Annual Cash Inflow C
Popular because of simplicity
Cost effective
Short term effect
Risk shield
Liquidity
Cash flows after payback

Payback Reciprocal & Rate of

Return
The reciprocal of the payback is a
close approximation of IRR if
Life of project large/at least twice
payback period
Project generates equal annual cash
inflows

Discounted Payback Period

Calculated after discounting annual
cash inflows

Accounting Rate of Return

ARR = ROI = Avg.Income
Avg. Investment
On an after tax basis:
n

ARR = [t=1 EBITt(1-T)]n

(Io+In)2
where T = tax rate; Io=book value;
In=book value of investment after n
number of years