Chapter 7: Capital

Budgeting
What is capital budgeting?
Capital budgeting is defined as the firms
decision to invest its current funds most
efficiently in the long-term assets in
anticipation of an expected flow of benefits
over a series of years. It is long-term
expenditure decision. That is, the investment
decision that will provide benefits to the firm
for longer than one year and will help the firm
to maximize its long-term goal wealth
maximization.
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Chapter 7: Capital
Budgeting
Types of capital budgeting:
Investment decision: Analysis of potential
cost-benefit of fixed assets.
Replacement decision: Analysis of costbenefit of the new machine in comparison
to the old machine.
Project launching: Complete cost-benefit
analysis of the new project taking under
the whole life of the project under
consideration .
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Challenges of capital
budgeting

To forecast the long term cash flows.

To assess the riskiness of the future
cash flow.
To select the right cost of capital
To select the right method of capital
budgeting

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What is the difference between

independent and mutually exclusive
projects?

Independent projects if the cash flows

of one are unaffected by the acceptance
of the other.
Mutually exclusive projects if the cash
flows of one can be adversely impacted
by the acceptance of the other.

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Methods of capital
budgeting
1. Payback Period (PBP)
2. Average/Accounting Rate of Return
(ARR)
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)
5. Profitability Index (PI)
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1. Payback period
The number of years required
to recover a projects cost /
initial investment/ outflow, or
How long does it take to get
the money back?
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1.

Payback Period:
Project L: Investment Tk.100; Payback
Period=2
years Cumulative CF
Year
CashFlow
(CFt)
1

10

10

90

100

40

140

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Payback Period: Investment Tk.100

Project S=1 year+30/50 year=1.6
years
Year

CFt

70

Cumulative Cash
flow
70

50

120

20

140

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Decision
Project L has the payback period
of 2 years and project S has a
payback period of 1.6 years.
So project S is better than
project L. Project S should be
accepted.
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Strengths and weaknesses of

payback

Strengths

It aims to cover the investment rather than

making profit.
Easy to calculate and understand.

Weaknesses

Ignores the time value of money.

Ignores CFs occurring after the payback
period.
No yardstick to compare with.
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2. Average/Accounting Rate
of Return (ARR)
The accounting rate of return also known as
the return on investment, uses accounting
information as revealed by financial
statement to measure the profitability of an
investment. It is found by dividing the
average after tax profit by the average
investment. The average investment would
be equal to half of the original investment
if it is depreciated constantly.
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2. Average/Accounting Rate
of Return (ARR)
ARR = Average profit
Average investment
Average Profit = Sum of all Years Profit/
Number of Years considered
Average Investment = (Beginning Investment +
Ending investment)/2
= 10 + I n
2
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3. Net Present Value (NPV)

Sum of the PVs of all cash inflows and

outflows of a project:

CF3
CFn
CF1
CF2
NPV CF0

....
1
2
3
(1 k ) (1 k ) (1 k )
(1 k ) n

CFt
NPV
t
t0 ( 1 k )
n

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What is Project Ls NPV?

Suppose, the cost of capital is 10%
Year

CFt PV of CFt

0 -100
-$100
1 10
9.09
(=10/1.1)
2 90
74.38
=(90/(1.1)2)
3 40
30.1=(40/(1.1)3)
NPVL = 13.5
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NPV of Project S
Year
0
1
2
3

CFt
-100
70
50
20
NPVs =

PV of CFt
-$100
63.64
41.32
15.02
$19.98

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Decision making by NPV

method

If projects are independent, accept the

project if the NPV is positive. Reject the
project if NPV is negative.

If projects are mutually exclusive, accept

projects with the highest positive NPV.

In this example, we would accept S if

mutually exclusive (NPVs > NPVL), and
would accept both if independent.
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3. Internal Rate of Return

(IRR)

IRR is the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:

CFt
0
t
(
1

IRR
)
t0
n

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Short-cut method of IRR

Interpolation method for IRR
L1:Lower discount rate
L2: Higher discount rate
NPV1: NPV of lower discount rate
NPV2: NPV of higher discount rate
IRR=L1+ [NPV1/(NPV1-NPV2)] *(L2-L1)
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IRR of project L
(under the short-cut
method)
To use the short-cut method of IRR we need to know
the NPVs at two different discount rates. We know,
NPV of the project L was $13.52 when the discount
rate is 10%. If the discount rate was 15% then the NPV
comes down to $3.05. So,
IRRL=10%+(15%-10%)*(13.52/(13.52-3.05))
=10%+5%*13.52/10.47=10%+(5%*1.29)
=10%+6.456%=16.46%
The IRR so calculated is close to the true IRR of 16.6%
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IRR of Project S

For project S, at 10% discount rate

the NPV was $19.98. At 20% discount
rate it arrives at $4.63. Using the
short cut method:

IRRS= 10%+[(20%-10%)*(19.98/(19.984.63)]
= 23%
The true IRR however was 23.57%

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IRR Acceptance Criteria

If IRR > k, accept project.

If IRR < k, reject project.
If projects are independent,
accept both projects, as both IRR
> k = 10%.
If projects are mutually exclusive,
accept S, because IRRs > IRRL.
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4. Profitability Index (PI)

PV ( NCB )
PI
PV ( NCO )
113 .57
PI L
1.14
100
119 .98
PI S
1.2
100
Accept the project if : PI 1, or higher PI .
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Evaluation of the 2
projects
Techniques
Discounted Pay
Back
Net Present Value
IRR (ke=10%)
Profitability Index

Project L
2.55
13.5
16.5%
1.14

Project Commen
t
S
1.67
Project
S
19.98 Project
S
23%
Project
S
1.2
Project
S
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Factors of Capital
Budgeting

Incremental Cash flow: The change in a

firms net cash flow attributable to an
investment project. This must be taken
under consideration.
Sunk Cost: A cash outlay that has already
been incurred and can not be recovered
regardless whether the project is accepted
or not. Like the cost of feasibility study. This
must not be taken under consideration.
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Factors of Capital
Budgeting

Opportunity cost: The return of the best

alternative foregone must be taken under
consideration even if it does not have an impact
on cash flow. Example, rental value of the land
owned by the firm should be a cost even though
the firm does not pay that.
Externalities: The effect accepting a project will
have on the cash flows of other project.
Example, opening a new branch may cause a
loss of sale of an existing branch. That loss must
be considered as the cost of the new branch.
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Factors of Capital
Budgeting

Terminal Cash Flow: The value of the

project or any part of it that would
arrive at the end of the project must
be considered as a cash inflow in its
after tax form. Example, net salvage
value, net working capital, etc.

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