The

The Basics
Basics of
of Capital
Capital
Budgeting
Budgeting
Should we
build this
plant?
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What is capital budgeting?

• Horngreen, “Capital budgeting is long term planning for making

and financing proposed capital outlays”.
• G.C.Philippatos, “ Capital budgeting is concerned with the
allocation of the firm’s scarce financial resources among the
available market opportunities. The consideration of investment
opportunities involves the comparison of the expected future
streams of earnings from a project with the immediate and
subsequent streams of earning from a project, with the
immediate and subsequent streams of expenditures for it.”
• Analysis of potential additions to fixed assets.
• Long-term decisions; involve large expenditures.
• Very important to firm’s future.
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Need and Importance of Capital

Budgeting

• Large investments
• Long-term commitment of funds
• Irreversible nature
• Long term effect on profitability
• Difficulties of investment decisions
• National importance
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Steps to capital budgeting

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine the appropriate cost of
capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR >
WACC.
The investment decision-
5

making process
Stage 1 Determine investment funds available

Stage 2 Identify profitable project opportunities

Stage 3 Appraise and classify proposed projects

Stage 4 Evaluate the proposed project(s)

Stage 5 Approve and implement the

project(s)

Stage 6 Monitor and control the project(s)

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Methods of investment appraisal

Accounting rate of return (ARR)

Payback period (PP)

Net present value (NPV)

Internal rate of return (IRR)

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Methods of Capital Budgeting

Methods of capital
Budgeting

Traditional Methods Discounted Methods

Pay back period Accounting rate of Net Present Value Internal Rate of
Profitability Index
method return Method Return
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Payback period
• The number of years required to recover a
project’s cost, or “How long does it take to
get our money back?”
• Calculated by adding project’s cash inflows
to its cost until the cumulative cash flow for
the project turns positive.
• Annual cash inflows (Net profit before
depreciation and after tax) are taken.
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Calculating payback
0 1 2 2.4 3
Project L
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

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Strengths and weaknesses of

payback
• Strengths
– Provides an indication of a project’s risk and
liquidity.
– Easy to calculate and understand.
• Weaknesses
– Ignores the time value of money.
– Ignores CFs occurring after the payback period.
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Accounting rate of return

ARR = Average annual profit after tax x 100

Average investment in the project

 Also known as return on investment or

return on capital employed.
 The ARR method distorts all cash flows by
averaging them over time.
 It ignores the time value of money.
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Net Present Value (NPV)

• Considers the time value of money .

• NPV discounts all cash inflows and outflows
attributable to a capital investment project by a
chosen percentage eg. Weighted average cost of
capiatl.
• It takes sum of the PVs of all cash inflows and
deducts it from outflows of a project. If the
yield is positive the project is acceptable.

n
CFt
NPV = ∑
t =0 ( 1 + k )
t
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Present value of Re1 receivable at various times in the
future, assuming an annual financing cost of 20%
Present value Year
of Re.1
1 2 3 4 5

(1 + 0.2)0 1.000

(1 + 0.2)1 0.833

(1 + 0.2)2 0.694

(1 + 0.2)3 0.579

(1 + 0.2)4 0.482

(1 + 0.2)5 0.402
Rationale for the NPV
14

method
NPV = PV of inflows – Cost
= Net gain in wealth

• If projects are independent, accept if

the project NPV > 0.

• If projects are mutually exclusive,

accept projects with the highest
positive NPV, those that add the most
value.
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Why NPV is superior to ARR

NPV is a better method of appraising

investment opportunities than ARR because it
fully addresses each of the following:

The timing of the cash flows

The whole of the relevant cash flows

The objectives of the business

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Internal Rate of Return (IRR)

• IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:
n
CFt
0=∑
t =0 ( 1 + IRR ) t

• It is the percentage rate of return, based

upon incremental time-weighted cash flows.
• Solving for IRR :
– Trial and Error approach
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Profitability Index

PV of Future Cash Inflows

PI =
Initial Investment
NPV
=1 +
Initial Investment

Decision Rule:
Undertake the project if PI > 1.0
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Profitability Index

• PI measures the NPV per rupee invested.

• For independent projects, the PI method yields
conclusions identical to the NPV method.
• For mutually exclusive projects, differences in
project size can lead to conflicting conclusions.
– Use the NPV method.
• PI is useful when there is capital rationing.
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The factors influencing the

discount rate to be applied
to a project

Interest Discount Inflation

forgone rate

Risk premium
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Inflation

• Inflation effects can be complex because

asset value is a function of both the
required return and the expected future
cash flows.

• The changes can cancel each other out,

leaving the project’s NPV unchanged.
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Inflation
• Inflation affects the cash flows from a project.
– Effect on revenues
– Effect on expenses
• Inflation also affects the cost of capital.
– The higher the expected inflation, the higher the return
required by investors.

• Thus, the effects of inflation must be properly

incorporated in the NPV analysis.
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Effect of Inflation on the

Cost of Capital
• Notation:
rr = cost of capital in real terms
rn = cost of capital in nominal terms
i = expected annual inflation rate
• (1 + rn) = (1 + rr) (1 + i)
• rn = rr + i + i rr
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Inflation and NPV Analysis

• The NPV of the project is unchanged as long
as the cash flows and the cost of capital are
expressed in consistent terms.
– Both in real terms
– Both in nominal terms

• If inflation is expected to affect revenues

and expenses differently, these differences
must be incorporated in the analysis.
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Risk Analysis in Capital Budgeting

• Risk relates to uncertainty about a project’s
future profitability.
• Techniques:
– Certainity equivalent method
– Risk Adjusted discount rate
– Sensitivity analysis
– Scenario analysis
– Decision tree analysis
– Standard deviation method
– Co-efficient of Variation
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The Certainty Equivalent

Approach
• The project is adjusted for risk by
converting the expected cash flows
to certain amounts then discounting
at the risk-free rate.
• The NPV is computed as:

α t × CFAT t
n n
NPV = ∑ CECF t
=∑
t =0 ( 1 + k RF ) t =0 ( 1 + k RF )
t t
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The Risk-Adjusted Discount

Rate Approach

• Use CAPM to get relevant rate:

k project = k RF + ( k m − k RF ) × b project

• Establish risk classes and assign

RADR
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Graphical Representation of
the SML
ri = rf + β i ( RM − rf )

ri = rf + 2( RM − rf )
Risk
Premium
M for a stock
rM twice as
Market
1 risky as
ri = rf + ( RM − rf ) Risk
2 Premium the market
rf
Risk Premium for a
Riskless
stock half as risky
return
as the market
β
0.5 1.0 2.0
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What is sensitivity analysis?

• Shows how changes in a variable such

as unit sales affect NPV or IRR.
• Each variable is fixed except one.
Change this one variable to see the
effect on NPV or IRR.
• Answers “what if” questions, e.g.
“What if sales decline by 30%?”
Factors affecting the
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sensitivity of NPV calculations

for a new machine

Sales Annual sales Project

price volume life

Project
NPV

Financing Operating Initial

cost costs outlay
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Sensitivity Analysis
• Change the value of an independent
variable by X%
• Calculate the resulting value of the
dependent variable
• Calculate the % ∆ in the dependent
variable; compare!
• If % ∆ > X%, then dependent variable
is sensitive to changes in the
independent variable
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What are the weaknesses of

sensitivity analysis?

• Does not reflect diversification.

• Says nothing about the likelihood
of change in a variable, i.e., a
steep sales line is not a problem if
sales won’t fall.
• Ignores relationships among
variables.
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Why is sensitivity analysis

useful?

• Gives some idea of stand-alone

risk.
• Identifies potentially
dangerous variables.
• Gives some breakeven
information.
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What is scenario analysis?

• Examines several possible

situations, usually worst case,
most likely case, and best case.
• Provides a range of possible
outcomes.
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Decision Tree

• A decision tree is diagramatic representation of

the relationships among decision states of nature
and outcomes (pay-offs).
• Decision trees are constructed left to right.
• The branches represents the possible alternative
decisions which could b made and the various
possible outcomes which may arise.
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Decision tree diagram showing

different possible project
Cash
outcomes
flow Probability
Rs.

Year 1 (0.6) 8,000

Outcome 1 0.6 x 0.6 = 0.36
Year 2 (0.6) 8,000

Year 1 (0.4) 12,000

Outcome 2 0.4 x 0.4 = 0.16
Year 2 (0.4) 12,000
(Rs.6,000)
Outlay

Year 1 (0.4) 12,000

Outcome 3 0.4 x 0.6 = 0.24
Year 2 (0.6) 8,000

Year 1 (0.6) 8,000

Outcome 4 0.6 x 0.4 = 0.24
Year 2 (0.4) 12,000 Total 1.00
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Standard Deviation

σ NPV = Σ fd2
n

Coefficient of Variation

Σ σ NP $30.3
CVNPV = = = 2.0.
$15
V

Mean
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What is a simulation analysis?

• A computerized version of scenario

analysis which uses continuous probability
distributions of input variables.
• Computer selects values for each variable
based on given probability distributions.
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What is a simulation analysis?

• NPV and IRR are calculated.

• Process is repeated many times
(1,000 or more).
• End result: Probability
distribution of NPV and IRR based
on sample of simulated values.
• Generally shown graphically.
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The main steps in simulation

Step 1 Identify the key variables and their

interrelations

Step 2 Specify the possible values for each

variable

Step 3 Carry out repeated trials using a selected

value for each key variable and obtain a
probability distribution of the cash flows of
the project
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Independent Variable A Independent

Independent
Variable B
Variable C
Value = $Z, fixed

60%
-1σ µ 40% Independent
Variable D
+1σ Value = Y%, fixed
Value 1 Value 2

Dependent Variable--100 iterations

-1σ µ +1σ
What are the advantages of
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simulation analysis?
• Reflects the probability distributions of each input.
• Shows range of NPVs, the expected NPV, σ NPV , and
CVNPV .
• The model building process can provide valuable
insights about the interdependencies of the input
parameters.
• The model can describe a complex situation that
cannot be described in simple terms.
• Gives an intuitive graph of the risk situation.
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What are the disadvantages

of simulation?

• Difficult to specify the

interrelationships, probability
distributions, and correlations.
• If inputs are bad, output will be bad:
“Garbage in, garbage out.”
• The model may be too complex.
• May look more accurate than it really
is. (Just a scientific guess!)
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Summary
• Sensitivity, scenario, and simulation
analyses do not provide a decision
rule. They do not indicate whether a
project’s expected return is
sufficient to compensate for its risk.
• Sensitivity, scenario, and simulation
analyses all ignore diversification.
Thus they measure only stand-alone
risk, which may not be the most
relevant risk in capital budgeting.
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Risk preference of investors

Investors may display three possible attitudes

towards risk. They may be:

Risk-seeking investors

Risk-neutral investors

Risk-averse investors