Capital Budgeting

Kiran Thapa

Concept of Capital Budgeting

The process of planning investments in assets

whose cash flows are expected to extend beyond
one year
Term capital refers to long term assets used in
production, while budget is a plan which details
projected inflows and outflows during some
future period.
Capital budget is the planned expenditure on
long term assets and capital budgeting is the
process of evaluating and selecting long term
investments.

Importance

Irreversible decisions
Growth
Large amount of funds
Risk
Complex
National importance

Classification of capital projects

Independent projects

Contingent projects

Mutually exclusive projects

Replacement projects

Expansion of business

Diversification projects

Determination of cash flows

Cash flow is a process of income and expenditure of a

certain investment.

A series of income and expenditure over the life of the

investment project is known as cash flow stream.

Cash flow is of two types.

Cash inflows: Income, increase on an income, and

saving on expenditure.

Cash outflows: Expenditure, increase on an

expenditure, and investment.

Finding initial investment

Initial investment refers to the incremental

cash flows that occur only at the start of a
projects life.

Calculation of Initial investment

Installed cost of new asset
Change in working capital: Increase or decrease
Investment tax credit
Proceeds from sale of old asset
Tax liability from gain
Tax savings on loss
Initial Investment
=-

== - or +
=+
=+
==+

Finding the annual net cash flows

Annual after tax cash flows from a capital

expenditure project.
Calculation

Sales revenue
=..
Less: Cash expenses
= ..
EBDT Or savings
=
Less: Depreciation
=
Earnings before taxes
= .
Less: Income taxes
= .
Earnings after taxes
= .
Add: Depreciation
= .
Cash flow after taxes (CFAT) =..

Finding the final years net cash flow

Terminal cash flow (final year CFAT) is the net
cash flow that occurs at the end of the life of a
project.
Calculation
Differential Cash salvage value = ..
Tax on gain
= -.
Tax save on loss
= +.
Working capital release in 0 year = -
Terminal cash flow
=

Rules for estimating CFAT

Include only incremental costs
Disregard sunk costs
Include opportunity costs
Always adjust for taxes
Ignore financing cost

Capital Budgeting Decision Rules

Traditional Methods

Payback period

Accounting rate of return

Discounted Cash Flow Methods

Discounted Payback period

Net Present value

Profitability Index

Internal Rate of Return (IRR)

Modified Internal Rate of Return (MIRR)

Payback Period (PBP)

Time to recovered Initial Investment
Calculation of Payback period
Even Cash flows
PBP = Initial investment /Annual CFAT
Uneven Cash flows
PBP = Minimum year + Amount to recover/CFAT
of maximum year
Where, Amount to recover = Initial investment
Minimum years cumulative cash flow

Decision rules

If PBP > Target payback period Reject the project

If PBP < Target payback period Accept the project

For Independent projects: Lower PBP is better

For mutually exclusive projects: Lower PBP is better

Advantages of PBP
1.Simple and easy to understand.
2.Measure the liquidity.
3.Deals with the risk.

Payback period contd.

Disadvantages

1.Ignores the time value of money

2.Ignores cash inflows after the payback period.
3.Difficultives in determining target PBP.
4.Not consistent with wealth maximization goal.

Accounting rate of return (ARR)

ARR is the annualized net income earned on the
average funds invested in a project.

ARR = Average earning after tax /Initial outlay or

average initial outlay

Decision rule:
ARR > target ARR = Accept the project.
ARR< target ARR = Reject the project

ARR contd.
Advantages
1.Simple and easy to understand.
2.Consider the profitability.
3.Based on accounting data

Disadvantages
1.Ignores time value of money.
2.Based on accounting profits rather CFAT.

Discounted PBP (DPBP)

Same as regular PBP except that it discounts
cash flow at the projects cost of capital.
Calculation
PBP = Min. year + Amount to recover /PV of
CFAT of maximum year
Decision rule: Same as PBP

Net present value

NPV is the present value of all the cash inflows

less present value of all cash outflows.
NPV = TPV NCO Or CF0

Decision rule
NPV > 0 , Accept the project
NPV< 0, Reject the project
For independent projects: Positive NPV project
should be accepted.
For mutually exclusive projects: High positive
NPV project should be accepted.

NPV contd.
Advantages
1.Consider TVM
2.Uses Cash flows
3.Consistent with wealth maximization goal

Disadvantages
1.Involves difficult calculation
2.Difficult to determine required rate of return.

Profitability Index
Ratio of Total present value and net cash outlay
PI = TPV/NCO
Decision rule
PI > 1, Accepted
PI< 1, Rejected
Same accept and reject decision as NPV but
ranking may be different.
Merit and demerits are same as NPV method.

Internal Rate of return (IRR)

Discount rate that equates the present value of

cash inflows with the initial investment
associated with a project.
IRR formula is same as NPV formula except it
sets the NPV equal to zero and solves for the
discount rate.

Decision rule:
IRR> cost of capital = Accept
IRR< cost of capital = Reject

IRR contd
Merits
1.Consider the time value of money.
2.Consider the all cash flows
3.Consistent with wealth maximization goal.
Demerits
1.Involves tedious and complicated calculation
2.Produces multiple IRR
3.Future cash inflows are reinvested at IRR rate.

Modified IRR (MIRR)

The discount rate at which the present value of
a projects cost is equal to the present value of
its terminal value.
Calculation
PV costs = Future value / (1 + MIRR)n
Decision rule
MIRR> cost of capital = Accepted
MIRR < cost of capital = Rejected

MIRR contd
Merits
1.MIRR gives single correct answer
2.Cash flows are reinvested at cost of capital.
3.Consider the TVM.
Demerits
1.It involves difficult calculations
2.MIRR suffer from some other drawbacks of
IRR.

Any queries?

?
Thank You

NPV vs IRR

IRR and NPV give same accept and reject

decisions
IRR and NPV methods may rank projects
differently if the projects are of different costs,
timing of cash flows differ, or have unequal
lives.
NPV gives clear cut decision, while IRR may
give multiple results.
NPV gives better ranking as compared to the
IRR

NPV vs IRR contd.

If two projects are independent, then the NPV

and IRR criteria always lead to the same accept
and reject decision
When IRR and NPV methods give conflicting
results, the NPV method should be relied upon
since it gives the incremental addition to the
value of the firm.

Projects with unequal lives

If a company is choosing between two mutually

exclusive alternatives with significantly
different lives, an adjustment may be necessary.
Equivalent Annual Annuity (EAA) method
Step 1: Calculate each projects NPV at
projects required rate of return
Step 2: Find out the equivalent annual annuity
(EAA)
EAA = NPV/PVIFAk,n

Unequal lives contd

Step 3: Find out the infinite horizon NPVs
Infinite horizon NPV = EAA/k
Step 4: Decision
Select the project with higher infinite horizon
NPV.

Problems
ABC company needs a car. There are two car
options. Each type of car will cost Rs 50,000.
The life of first car is 10 years and provide an
after tax cash flow of Rs 9,500 per year. The
second car will last for 15 years, and their
annual after tax cash flow is estimated as Rs
8,140. The required rate of return of the
company is 10 percent. Which car is better
buy?
Ans: Infinity horizon NPV1 = Rs 13,630 and NPV 2 = 15,660

Problems contd.

Janak Products, Inc., is considering purchasing new machine

which costs Rs 300,000 including installation and shipping. The
machine is expected to generate Rs 100,000 sales revenue for 10
years and its operating cost will be Rs 50,000. At the end of 10
years, the book value of machine will be Rs 0, and it is anticipated
that the machine will be sold for Rs 100,000. The investment tax
credit is 10 percent Company will follow straight line depreciation.
If the machine is undertaken, company will have to increase its net
working capital by Rs 75,000. Janak requires a 12 percent annual
return on this type of project and its margin tax rate is 40 percent.
a. Calculate the initial investment outlay.
b. Calculate annual depreciation.
c. Calculate the operating cash flows.
d. Calculate the terminal cash flow.
e. Is the project acceptable?

Contd.

Ans:
a. - 345,000
b. 30,000;
c. 42,000;
d. 135,000;
e. 64,221.6

A firm is considering purchasing a replacement machine. The existing machine can

run for 5 more years producing annual revenues of Rs 60,000 with cash expenses of
Rs 30,000. Its current book value is Rs 20,000 and it is being depreciated at Rs
4,000 per year down to a zero book value. The machine could be sold today to net
Rs 8,000 it could be sold in 5 years to net Rs 5,000. The replacement machine will
cost Rs 50,000 plus an additional Rs 20,000 to transport it to the factory and install
it. It will generate revenues of Rs 90,000 but will have cash expenses of Rs 40,000. It
will be depreciated using the straight-line method over a 5-year period at which
time it will have a book value of Rs 20,000 and cash salvage value of Rs 25,000. The
replacement machine will require additional working capital of Rs 5,000 to be
permanently tied up. The firm decides to finance the cost of the machine by taking
loans and the cost of transportation and installation, and the working capital by
using its equity. The loan is available from the bank at 15% interest rate. The cost
of equity of the firm at present is 18%. The firm uses its weighted average cost of
capital to evaluate the investment proposals. The firm is in 40% tax bracket. The
tax on capital gain/ loss is the same as in the case of ordinary income. Should the
firm make the replacement? Base your answer on the payback period, NPV and
IRR.

Ans:

Ans:
NCO = - 62,200
Diff. Dep = 6,000
CFAT = 14,400 for 4 years
5th year = 14,400 + 20,000 + 5000 = 39,400
K = 11.97% or 12%
NPV = 3,894.12
PBP = 4.12 years
IRR = 14.116%

Problems