Capital Budgeting

Prepared By : Wael Shams EL-Din

Agenda
2

What is Capital Budgeting.
Why Capital Budgeting is so Important.
The Capital Budgeting Decisions.
Methods of Capital Budgeting
Payback
Discounted Payback
Net Present Value (NPV)
Internal rate of Return (IRR)
Modified Internal rate of Return (MIRR)
Profitability Index (PI)

What is Capital Budgeting ?
Capital budgeting is the process of analyzing
Potential Projects.
Capital budgeting can be defined as the
process of analyzing, evaluating, and
deciding whether resources should be
allocated to a project or not.
Process of Capital budgeting ensure optimal
allocation of resources and helps management
work towards the goal of shareholder wealth
maximization.
Why Capital Budgeting is so Important?
Involve Massive investment of Resources.
Have Long-term Implications for the Firm.
Involve uncertainty and risk for the Firm.
Due to the above factors, capital budgeting decisions
become critical and must be evaluated very
carefully. Any firm that does not follow the capital
budgeting process will not be able to Maximize
Shareholder Wealth and management will not be
acting in the best interests of shareholders.

The Capital Budgeting Decision
Types of Decisions
Expansion of Facilities
Replacement
Lease or Make or buy

Methods of Capital Budgeting

Payback
Discounted Payback
Net Present Value (NPV)
Internal rate of Return (IRR)
Modified Internal rate of Return (MIRR)
Profitability Index (PI)

Let us see how these methods Work

Payback Period Method

The payback Period defined as the expected
number of years required to recover the
original investment, it is the formal method
used to evaluate capital budgeting project.
0 1 2 3 4
* -----------* -----------* ----------* -------------*
-1000 500 400 300 100
-1000 + 500+400 = 100
100/300 = 0.33
Payback = 2.33 Years

Payback Period Pros &Cons
Advantage
1. Easy to calculate
2. Provide an indication
of a projects risk and liquidity

Disadvantage
Ignore cash flow after payback period
Doesnt consider time value of Money

Discounted Payback
It is a similar to the regular payback period except
that the expected cash flow is discounted by the
projects cost of capital. Thus the discounted
payback period is defined as the number of years
required to cover the investment from discounted net
cash flows.
0 1 2 3 4
* -----------* -----------* ----------* -------------*
-1000 500 400 300 100
455 330 225 68
- 1000 + 455 + 330 = 215/225 = 0.95
Discounted Payback Period = 2.95 Years

Discounted Payback Period Pros &Cons
Advantage
Consider Time value of Money
Disadvantage
Ignore cash flow after payback period

Ignores cash flows
after the payback
Period.

Net Present Value (NPV)

The net present value ( NPV) Method is based
upon the discounted cash flow (DCF) Technique ,
it is based on all discounted cash flows of the
project by using cost of capital rate and then sums
those cash flows, the project should be accepted if
NPV is positive or = Zero.


Calculation of NPV

0 1 2 3 4
* --------------------* -----------* -----------* -------------*
-1000 500 400 300 100
Cost of
Capital @
10%
+455
+330
+225
+ 68
====
+ 78

If Positive NPV we will accept the Project ()

Internal Rate of Return (IRR)

Internal rate of Return (IRR) is defined as the
discounted rate that forces a projects NPV to equal
zero. The project should be accepted if the IRR is
greater than cost of capital



-1000+ 500 + 400 + 300 + 100 = Zero
(1+IRR)
1
(1+IRR)
2
(1+IRR)
3
(1+IRR)
4

If IRR > WACC we will accept the project because the
projects rate of return is greater than its cost.
If IRR < WACC we will Reject the project because the
projects rate of return is less than its
0 1 2 3 4
* --------------------* -----------* -----------* -------------*
-1000 500 400 300 100

Modified Internal Rate of Return (MIRR)

Modified Internal rate of Return (MIRR) correct some of
the problem with regular IRR since MIRR involves finding
the terminal value (TV) of the cash inflows, compounded at
the firms cost of capital and then determining the discount
rate that forces the Present value of the TV to equal the PV
of the out flows.


330 +
484
665.50
======
TV 1579.50
0 1 2 3 4
* --------------------* -----------* -----------* -------------*
-1000 500 400 300 100
Calculation of MIRR
PV = FV (TV)
(1+MIRR)
4

1000 = 1579.50
(1+MIRR)
4

MIRR = 12.10%
If MIRR > WACC ,we Accept the project
If MIRR < WACC ,we Reject the project
Since 12.10%> 10% () Accept.


Profitability Index (PI )


0 1 2 3 4
* --------------------* -----------* -----------* -------------*
-1000 500 400 300 100
Cost of
Capital @
10%
+455
+330
+225
+ 68
====
+ 1078

Profitability index shows the
dollars of present value divided
by the initial cost, so it measure
relative profitability.
PI = 1078 = $ 1.08
1000
So the project is expected to produce $1.08 for each $ 1 of
investment, if we compare 2 projects we will select the project
with higher (PI) and must be greater than (1).
Which Approach is Better?
On a purely theoretical basis, NPV is considered the better
approach because:-
NPV measures how much wealth a project creates (or
destroys if the NPV is negative for shareholders.
Also NPV consider reinvestment of cash flow at cost of
capital which is more conservative.
Despite the fact most of the financial managers prefer to
use the IRR approach in addition to NPV method because
of the preference for rates of return.

Thank You