Capital Budgeting

Capital Budgeting

Capital Budgeting is employed to evaluate expenditure decisions which involve current outlays but are likely to produce benefits over
a period of time longer than one year.

Capital Budgeting is the process of evaluating & selecting long term investments that are consistent with the firm's goal of owner
wealth maximization.

Expenditure

Capital Expenditure: An outlay of funds by the firm that is expected to produce benefits over a period of time greater than one year.

Current Expenditure: An outlay of funds by the firm resulting in benefits received within one year.

Key Motives for Making Capital Expenditure

1)

Expansion

2)

Replacement

3)

Renewal

4)

Other purposes

Steps in Capital Budgeting Process

1)

Proposal generation

2)

Review &analysis

3)

Decision making

4)

Implementation

5)

Follow-up
Independent Projects

Projects whose cash flows are unrelated or independent of one another ; the acceptance of one does not eliminates the others from
future consideration.

Mutually Exclusive Projects : Projects that compete with one another, so that acceptance of one eliminates the others from further
consideration.

Unlimited Funds : The financial situation in which a firm is able to accept all independent projects that provide an acceptable return.

Capital Rationing: The financial situation in which a firm has only a fixed number of dollars to allocate among competing capital
expenditure.

Ranking Approach : The ranking of capital expenditure projects on the basis of some predetermined measures such as the rate of
return.

Capital Budgeting Techniques

1)

Payback Period

Payback Periods are a commonly used criterion for evaluating proposed investments.

The Payback Period is the exact amount of time required for the firm to recover its initial investment in a project as
calculated from cash inflows.

In the case of an annuity, the Payback Period can be found by dividing the initial investment by the annual cash inflow .

For a mixed stream, the yearly cash inflows must be accumulated until the initial investment is recovered.

Capital Budgeting
(Original Investment- CCF YFR)

Payback = [ YFR 1] + ----------------------------------------------CF YFR

Where ,
YFR
= Year of full recovery
CCF YFR = Cumulative CF at the start of year of full recovery
CF YFR = Cash flow during YFR

Payback Period is generally viewed as an unsophisticated capital budgeting technique, because it does not explicitly consider the time
value of money by discounting cash flows to find the present value. Payback period also ignores cash flows beyond payback period.

2)

Net Present Value (NPV)

A sophisticated capital budgeting technique; found by subtracting a projects initial investment from the present value of its
cash inflows discounted at a rate equal to the firms cost of capital.

NPV= Present value of cash inflow Initial Investment

NPV = CF0 + CF1 + CF2 + CF3 ..+ CFN
(1+k)1 (1+k)2 (1+k)3

(1+k)n

CF = Present Value of Cash Inflows

CF0 = Cash flow in zero year / Initial Investment
K = Discount Rate / Required Return/ Cost of Capital
The Decision Criterion: The decision criterion when NPV is used to make accept- reject decisions is as follows :

3)

If NPV is greater than $ 0, accept the project, if NVP is less than $ 0 ,reject the project.

If NPV is greater than $ 0, the firm will earn a return greater than its cost of capital. Such action should enhance the market
value of the firm & therefore wealth of its owner

Internal Rate of Return (IRR)

IRR is defined as the discount rate that equates the present value of cash inflows with the initial investment associated with
a project, thereby causing NPV = 0.

The IRR, in other words, the discount rate that equates the net present value of an investment opportunity with $0 .
0 = CFo + CF1____ + CF2____ + + CFN____
(1+ IRR)1 (1+ IRR)2
(1+ IRR)n
Where,

4)

5)

CF0 = Cash outflow at zero year

CFN = Present Value of Cash Inflows

The Decision Criterion:

If IRR is greater than the cost of capital, accept the project

If IRR is less than the cost of capital, reject the project

This criterion guarantees that the firm earns at least its required return. Such an outcome should enhance the market value
of the firm & therefore the wealth of its owner.

Interpolation:
IRR = L + A X (H - L)

B
L= Lower discounting rate, H = Higher discounting rate
A= NPV at lower discount rate
B = Difference between the PV of all net cash benefits at lower
discounting rate and higher rate , OR
NPV at lower discount rate NVP at higher discount rate

Capital Budgeting

Problem 1
Capital Budgeting : Replacement Decision
A machine purchased six years ago for $ 150000 has been depreciated to a book value of $ 90000. It originally had a projected life of
15 years and zero salvage value. A new machine will cost $ 250000 and result in a reduced operating cost of $ 30000 per year for the
next nine years. The older machine could be sold for $ 50000. The cost of capital is 10%. The new machine will be depreciated on a
straight line basis over nine years life with $ 25000 salvage value. The company tax rate is 55%. Determine whether the old machine
should be replaced ?

Replacement Decision:
Whether to purchase capital assets to take the place of existing assets to maintain or improve existing operations.

Expansion Decisions :
Whether to purchase capital projects and add them to existing assets to increase existing operations

Independent Projects :
Projects whose cash flows are not affected by decision made about other projects.

Mutually Exclusive Projects:

A set of projects in which the acceptance of one project means the other cannot be accepted.