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CAPITAL BUDGETING TECHNIQUES

Introduction
Capital Budgeting is the process of determining which real investment

projects should be accepted and given an allocation of funds from the


firm.
To evaluate capital budgeting processes, their consistency with the go
al of shareholder wealth maximization is of utmost importance.
Wealth =

C0
C1
C2
C

........

(1 r ) 0 (1 r )1 (1 r ) 2
(1 r )

Capital Budgeting Techniques can be Traditional and Modern.

Traditional Capital Budgeting Techniques


Pay Back Period: It refers to the period in which the project will gene
rate the necessary cash to recover the initial investment. It does not t
ake the effect of the time value of money. It emphasizes more on ann
ual cash inflows, economic life of the project and original investment.
Payback period = A+
,
B
where A= the last periodC with a negative cash flow;
B= the absolute value of cumulative cash flow at the end of the p
eriod A;
C= the total cash flow during the period after A

Payback Period: Example


Company C is planning to undertake another project requiring initial inv
estment of $50 million and is expected to generate $10 million in Year 1
, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $
22 million in Year 5. Calculate the payback value of the project.
Year

Cash Flow

Cumulative Cash
Flow

(50)

(50)

10

(40)

13

(27)

16

(11)

19

22

30

Payback Period,
= 3+ (-11)/ 19
= 3+ 0.58
= 3.58 years

Payback Period (Cons)


It is based on principle of rule of thumb.
Does not recognize time value of money.
Does not consider profitability of economic life of the project.
Does not recognize patterns of cash flows.

Accounting Rate of Return Method


The assets expected accounting rate of return (ARR) is computed by d
ividing the expected incremental net operating income by the initial inve
stment and then compared to the managements desired rate of return t
o accept or reject a proposal. If the assets expected accounting rate of
return is greater than or equal to the managements desired rate of retu
rn, the proposal is accepted. Otherwise, it is rejected.
Accounting Rate of Return = Incremental Accounting Income/Initial Inve
stment.
Example: The Fine Clothing Factory wants to replace an old machine
with a new one. The old machine can be sold to a small factory for $10,
000. The new machine would increase annual revenue by $150,000 an
d annual operating expenses by $60,000. The new machine would cost
$360,000. The estimated useful life of the machine is 12 years with zer
o salvage value

Discounted Cash Flow (DCF) Techniques


The main DCF techniques for capital budgeting include: Net Present

Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI)
.
Each requires estimates of expected cash flows (and their timing) f

or the project.
Including cash outflows (costs) and inflows (revenues or saving
s) normally tax effects are also considered.
Each requires an estimate of the projects risk so that an appropriat
e discount rate (opportunity cost of capital) can be determined.
Sometimes the above data is difficult to obtain this is the main weak

ness of all DCF techniques.

Net Present Value (NPV)


Forecast cash flow (C1, C2, Ct) generated by a project over it
s economic life;
Determine the appropriate opportunity cost of capital (r);
Use the opportunity cost of capital (r) to discount the projects f
uture cash flows, and sum them up (PV);
Calculate the net present value (NPV) by subtracting the initial i
nvestment cost (C0);
The NPV rule for investment decision:
Accept a project if the NPV is greater the zero (NPV>0)
Reject a project if the NPV is less than zero (NPV<0)

Net Present Value (NPV)


Net present value formula:

NPV C0

C1
C2
C

......

(1 r ) (1 r ) 2
(1 r )

Time value of money:


A dollar today is worth more than a dollar tomorrow
Opportunity cost of capital:
A safe dollar is worth more than a risky one
Additively of present values:
Risk-adjusted present values are comparable quantities.

NPV: Example
Examples: Details of two projects investments and returns are given
below:
Particulars
Project A
Project B
C0
tk. 40,000
tk. 40,000
C1
14,000
22,000
C2
16,000
20,000
C3
18,000
18,000
C4
20,000
16,000
C5
25,000
17,000
If discount rate is 10%, the PV factors for (1-5) years are .909,.826,.75
1,.683 and .621 respectively.

NPV: Strengths and Weaknesses


Strengths
Resulting number is easy to interpret: shows how wealth will chang
e if the project is accepted.
Acceptance criteria is consistent with shareholder wealth maximiza
tion.
Relatively straightforward to calculate
Weaknesses
Requires knowledge of finance to use.
An improper NPV analysis may lead to the wrong choices of projec
ts when the firm has capital rationing.
cash flow, the future cash flow may be difficult to measure

Ross (1995) on NPV rule


The Good:
Rejecting an investment when it should be rejected

The Bad:
Rejecting an investment when it should be accepted

The Ugly:
Accepting an investment when it should be rejected

Internal Rate of Return


IRR is the discount rate that equates the present value of the future n
et cash flows from an investment project with the projects initial cash
outflow.
If IRR opportunity cost of capital (or hurdle rate), then accept the pr
oject; otherwise reject it.

C1
C2
C
0 C0

........
1
2
(1 irr ) (1 irr )
(1 irr )

IRR: Example
Example: A project costs tk. 36,000 and is expected to generate cash i
nflows of tk. 11,200 annually for 5 years. Calculate the IRR of the proje
ct.
The payback period is (tk. 36,000/tk. 11,200) 3.214.
According to factor tables, the factors closest to 3.214 for 5 years are 3
.274 (16% ) and 3.199 (17%).
So, PV (16%) tk. 11,200*3.274 = tk. 36,668.8
PV (17%). Tk.11,200 *3.199= tk. 35,828.8
So, IRR = 16 36668.8 36000 *1

36668.8 35828.8

= 16.8%

IRR: Strengths and Weaknesses


Strengths
IRR number is easy to interpret: shows the return the project gener
ates.
Acceptance criteria is generally consistent with shareholder wealth
maximization.
Weaknesses
Unrealistic Assumption
For calculating IRR we create one assumption : if we invest out mone
y on this IRR, after receiving profit, we can easily reinvest our investm
ents profit on same IRR.
Multiple IRR or no IRR at all:
If the cash flow stream changes sign more than once ( Unconventi
onal cash flows
Mutually exclusive projects case
May lead to incorrect decision in comparison of mutually exclusive i
nvestment

IRR: Weakness
Multiple rates of return: Helmsley Iron is proposing to develop a new
strip mine in Western Australia. The project has the following payoffs.
Cash Flows ( Billions of Australian Dollars)
C0

C1

C9

C10

-3

-6.5

The Projects IRR and NPV are as follows:


IRR (%)

NPV at 10%

3.50 and 19.54

$ A 253 Million

IRR :Weakness
Mutually Exclusive Projects: Helmsley Iron is proposing to develop a
new strip mine in Western Australia. The project has the following payoff
s.
Cash Flows ($)
Project

C0

C1

IRR (%)

NPV at 10%

-10000

+20000

100

+ 8182

-20000

+35000

75

+ 11,818

Perhaps project D is a manually controlled machine tool and project E


is the same tool with the addition of computer control. Both are good in
vestments, but E has the higher NPV and is, therefore, better. However
, D has the highest IRR.

Profitability Index (PI)


Profitability Index (PI)is the ratio of the present value of future cash flow
s and the initial cost of a project.

PVFCIFs
PI
CF0
Decision Criterion Using PI
For independent projects: Accept all projects with PI greater than one (this is i
dentical to the NPV rule).
For mutually exclusive projects: Among the projects with PI greater than one,
accept the one with the highest PI.

Profitability Index (PI): Example


Examples: Details of two projects investments and returns are given
below:
Particulars
Project A
Project B
C0
tk. 40,000
tk. 40,000
C1
14,000
22,000
C2
16,000
20,000
C3
18,000
18,000
C4
20,000
16,000
C5
25,000
17,000
If discount rate is 10%, the PV factors for (1-5) years are .909,.826,.75
1,.683 and .621 respectively.

PI: Strengths and Weaknesses


Strengths
PI number is easy to interpret: shows how many $ (in PV terms) yo
u get back per $ invested.
Acceptance criteria is generally consistent with shareholder wealth
maximization.
Relatively straightforward to calculate.
Useful when there is capital rationing.

Weaknesses
Requires knowledge of finance to use.
It is possible that PI cannot be used if the initial cash flow is an inflo
w.
Method needs to be adjusted when there are mutually exclusive pr
ojects.

Capital Rationing and Profitability Index

Project

Investment
($ Million)

NPV
($ Million)

Profitability
Index

10

21

2.1

16

3.2

12

2.4