CAPITAL BUDGETING

Financial Management

LEARNING OBJECTIVES
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the following:
Payback Period
Discounted Payback Period
Net Present Value (NPV)
Average Rate of Return
Profitability Index
Internal Rate of Return (IRR)

Calculate the depreciation tax shield, and explain why

depreciation is important in investment analysis.

CAPITAL BUDGETING WHAT

IS IT?

Long-term investments represent sizable outlays of funds that

commit a firm to some course of action. Consequently, the
firm needs procedures to analyze and select its long-term
investments.
Capital budgeting is the process of evaluating and selecting
long-term investments that are consistent with the firms goal
of maximizing owners wealth. Firms typically make a variety
of long-term investments, but the most common is in fixed
assets, which include property (land), plant, and equipment.
These assets, often referred to as earning assets, generally
provide the basis for the firms earning power and value

CAPITAL EXPENDITURE
A capital expenditure is an outlay of funds by the firm that is
expected to produce benefits over a period of time greater
than 1 year.
Companies make capital expenditures for many reasons. Some
reasons for capital expenditures are to:

New products or expansion of existing products

Replacement of existing equipment or buildings

Research and development

Exploration

CAPITAL BUDGETING
PROCESS
The capital budgeting process consists of five distinct but
interrelated steps:
a.
Proposal generation. Proposals for new investment projects are
made at all levels within a business organization and are
reviewed by finance personnel.
b.
Review and analysis. Financial Managers perform formal
review and analysis to assess the merits of investment
proposals.
c.
Decision making. Firms typically delegate capital expenditure
decision making on the basis of dollar limits.
d.
Implementation. Following approval, expenditures are made
and projects implemented.
e.
Follow-up. Results are monitored, and actual costs and benefits
are compared with those that were expected.

BASIC TERMINOLOGY
IN CAPITAL BUDGETING
Independent projects

Projects whose cash flows are unrelated to

(or independent of) one another; the
acceptance of one does not eliminate the
others from further consideration

Mutually exclusive projects

Projects that compete with one

another, so that the acceptance of
one eliminates from further
consideration all other projects
that serve a similar function.

BASIC TERMINOLOGY
IN CAPITAL BUDGETING
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 available for capital
expenditures, and numerous
projects compete for these dollars.

BASIC TERMINOLOGY
IN CAPITAL BUDGETING
Acceptreject approach

The evaluation of capital expenditure

proposals to determine whether they meet
the firms minimum acceptance Criterion.

Ranking approach

The ranking of capital

expenditure projects on the basis
of some predetermined measure,
such as the rate of return.

PRINCIPLES OF CAPITAL BUDGETING

Capital budgeting has five principles that play a crucial role in
the allocation of money and the process of capital budgeting.
The five principles are:
(1) Decisions are based on cash flows, not accounting
income,
(2) Cash flows are based on opportunity cost,
(3) The timing of cash flows are important,
(4) Cash flows are analyzed on an after tax basis,
(5) Financing costs are reflected on projects required rate of
return.

CAPITAL BUDGETING
TECHNIQUES - PAYBACK
The payback period is the amount
of time required for the firm to
recover its initial investment in a
project, as calculated from cash
inflows
For example, if an investment
costs $15,000 and generates
returns of $5,000 per year, it has a
payback period of 3 years.
Question 1
Investment Cost $120,000
generates annual cash flows of
$35,000. What is the payback
period?

There are 2 serious limitations with

this method.
It does not consider cash inflows in
years beyond the payback year (e. g.
years, 4, 5 and 6 in the example
above.
It does not consider the time value of
money.

Question 2
Investment Cost $120,000 generates
the following cash inflows Yr 1
$35,000, Yr 2 $30,000, Yr 3 30,000
and Yr 4 $45,000. What is the
payback period?

CAPITAL BUDGETING TECHNIQUES

DISCOUNTED PAYBACK
Discounted payback period is
a variation of payback period
which accounts for time value
of money by discounting the
cash inflows from a project.

Question
Using the information above
calculate the payback period
and discounted payback period
for projects A and B . The initial
investment is $50,000 and the
discount rate is 5%

Year

Cash
Flow
A

Cash
Flow
B

10,000

47,000

10,000

2,000

30,000

1,000

5,000

5,000

5,000

5,000

TECHNIQUES - ACCOUNTING
RATE OF RETURN
Accounting rate of return (ARR, also known as average rate of return) is
used to estimate the rate of return for an investment project. The higher
the ARR, the more attractive the project is.
ARR = Average Net Income
Average Investment
Example :
An investment of $600,000 is expected to give returns as follows: Year 1 ($50,000), Year
2 ($150,000), Year 3 ($80,000), Year 4 ($20,000).Calculate the average rate of return.
Solution:
Total returns over the four years
= 50,000 + 150,000 + 80,000 + 20,000 = $300,000
Average returns per annum = 300,000 / 4 = $75,000
ARR = 75,000 / 600,000 = 12.5%

CAPITAL BUDGETING TECHNIQUES NET

PRESENT VALUE

The method used by most large companies to evaluate

investment projects is called net present value (NPV).
When firms make investments, they are spending money that
they obtained, in one form or another, from investors.
Investors expect a return on the money that they give to
firms, so a firm should undertake an investment only if the
present value of the cash flows that the investment generates
is greater than the cost of making the investment in the first
place

NPV is the present value of net cash inflows generated by a

project including salvage value, if any, less the initial investment
on the project. It is one of the most reliable measures used in
capital budgeting because it accounts for time value of money.

CAPITAL BUDGETING TECHNIQUES NET PRESENT

VALUE
Steps to calculate NPV
1.
Identify the amount and time period of each cash flow associated with a
potential investment. Investment projects have both cash inflows and
cash outflows.
2.
Equate or discount the cash flows to their present values using a
required rate of return (cost of capital). This is the minimum return that
management will accept.
3.
Evaluate the net present value. This is the sum of all of the cash inflows
and cash outflows
Decision Criteria
. When NPV is used to make acceptreject decisions, the decision criteria
are as follows:
If the NPV is greater than $0, accept the project.
If the NPV is less than $0, reject the project.
. If the NPV is greater than $0, the firm will earn a return greater than its
cost of capital. Such action should increase the market value of the firm,
and therefore the wealth of its owners by an amount equal to the NPV.

CAPITAL BUDGETING TECHNIQUES

NET PRESENT VALUE
Class example
Using the information in the
table calculate the NPV for
projects A and B . The
initial investment is $50,000
and the discount rate is 5%
What is the profitability
index for each project?

Year

Cash
Flow
A

Cash
Flow
B

10,000

40,000

10,000

2,000

30,000

1,000

5,000

8,000

5,000

9,000

CAPITAL BUDGETING TECHNIQUES

PROFITABILITY INDEX
Profitability index is an investment appraisal technique calculated by
dividing the present value of future cash flows of a project by the
initial investment required for the project.
Formula:
Profitability Index = Present Value of Future Cash Flows
Initial Investment Required
=1+
Net Present Value
Initial Investment Required
Explanation:
Profitability index is actually a modification of the net present value
method. While present value is an absolute measure (i.e. it gives as the
total dollar figure for a project), the profitability index is a relative
measure (i.e. it gives as the figure as a ratio).

CAPITAL BUDGETING TECHNIQUES

INTERNAL RATE OF RETURN
Internal Rate of Return - the IRR of an investment is the
discount rate at which the present value of costs (negative
cash flows) of the investment is equal to the present value of
the benefits (positive cash flows) of the investment. It is the
rate of return at which the net present value of a project is
zero.
The IRR can be defined as the break-even interest rate that
equates the present value of project inflows with project
outflows.

CAPITAL BUDGETING TECHNIQUES

INTERNAL RATE OF RETURN
Example
Co. A wants to replace an old
machine with a new one. The new
machine will cost $8,475 and will
reduce the annual labor cost by
$1,500. The useful life of the
machine will be 10 years with no
salvage value. The minimum
required rate of return is 15%.
Required:
Should Co. A purchase the machine?
Use internal rate of return (IRR)
method for your conclusion.
.

Solution
To conclude whether the
proposal should be accepted or
not
the internal rate of return
promised by machine
would be found out first
and then compared to the
companys minimum
required rate of return

CAPITAL BUDGETING TECHNIQUES

INTERNAL RATE OF RETURN
Solution
The first step in finding out the internal rate
of return is to compute a discount factor
called internal rate of return factor. It is
computed by dividing the investment
required for the project by net annual cash
inflow to be generated by the project. The
formula is given below:
Formula of internal rate of return factor
=
Investment required
Net Annual cash Flow
After computing the internal rate of return
factor, the next step is to locate this
discount factor in present value of an
ordinary annuity table. This rate of return
will be based on the number of periods that
the investment generates cash flows.

Internal rate of return factor

= 8475 1500
=5.650

Nic\4ePresentValueOrdinaryAnnuityof1
_table4.pdf
Since the useful life of the machine is 10
years, the factor would be found in 10period line or row.
After finding this factor, see the rate of
return written at the top of the column in
which factor 5.650 is written. It is 12%. It
means the internal rate of return promised
by the project is 12%.
According to IRR method, the proposal is
not acceptable because the IRR promised by
the proposal (12%) is less than the minimum
required rate of return (15%).

PROJECT/INVESTMENT
CASH FLOWS
Basic characteristics of relevant cash flows
Cash (not accounting income) flows
Operating (not financing) flows
After-tax flows
Incremental flows

PROJECT/INVESTMENT
CASH FLOWS
Principles that must be adhered to in estimating the cash flows
Ignore sunk costs
Include opportunity costs
Include project-driven changes in working capital net of
spontaneous changes in current liabilities
Include effects of inflation

ESTIMATING CASH
FLOWS TAX AND DEPN
Cash Flow
Revenue $1000
Taxes @ 35% 350
After-Tax Income $650
Since there are no noncash expenditures included
above, after-tax revenue is
equal to cash flow.

Cash Flow
Revenue
$1000
Depreciation
200
Taxable Income $800
Taxes @ 35% 280
After-Tax Income $520
Plus Depreciation
200
Cash Flow
$720