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# Presentation on Capital Budgeting

## What is Capital Budgeting

The total process of generating, evaluating, selecting and following up on capital expenditure alternatives Analysis of potential projects Very important to organizations future.

Overall Aim
To maximize shareholders wealth Project should give return over and above the weighted average cost of capital Project can be Independent Mutually exclusive

## Steps in Capital Budgeting

Identification of investment projects Evaluation of alternative investment projects Selection of the best investment projects Implementation of the projects Continuous evaluation of the selected projects

## Difference between independent and mutually exclusive project Projects are:

independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one would be adversely affected by the acceptance of the other

## Capital Budgeting Process

Estimating the cash flows Assessing the riskiness of cash flows Determining the appropriate discount rate Finding the PV of expected cash flows Accepting the project if PV of Inflows > Costs

Selection Methods

Average Rate of Return (ARR) Payback Period (PBP) Net Present Value (NPV) Internal Rate of Return (IRR)

## Average Rate of Return (ARR)

ARR = Net Profit After Tax Original Investment Year 1. 2. 3. 4. 5. Total = 15,000 = 3,000 taka/year 5 ARR

Net Profit After Tax (NPAT) (taka) 2000 3000 4000 3000 3000 15000

3000 taka/yr

## Pay Back Period

The number of years required to recover a projects cost PBP = Investment (cash flow uniform)
Cash flow after tax
(annual cash flow not uniform)

or PBP= A + NCO - C D

Where, A = Year in which the accumulated cash flows are nearer to NCO NCO = Net Cash Outlay C = Accumulated cash outlay of the year A D = Cash flow of the succeeding year of the year A

## Finding the payback period

NCO= 10,00,000 taka (annual cash flow not uniform)
Year 1. 2. 3. 4. 5. EDBT (tk) Cumulative cash flow 3,00,000 3,50,000 4,50,000 3,50,000 3,00,000 3,00,000 6,50,000, 11,00,000 14,50,000 17,50,000 Therefore, PBP = 2 + 10,00,000-6,50,000 4,50,000 = 2 + 7/9 = 2 year 9month 10days

The shorter is the PBP the more attractive the investment is.

## Or NPV= PV of cash inflow PV of NCO

Here CFt= cash flow at different period CFo=initial cash outflow K= cost of capital

## Decision Rule at a glance

1. NPV >O Accepted 2. NPV = O May accepted or rejected. 3. NPV < O Rejected

## Internal Rate or Return (IRR)

The IRR is the discount rate at which the NPV for a project .equals zero. This rate means that the present value of the cash inflows for the project would equal the present value of its outflows. The IRR is the break-even discount rate. The IRR is found by trial and error

IRR = A + C (B-A) C-D Where, IRR = Internal Rate of Return A = Lower Discount Rate. B = Higher Discount Rate. C = NPV of Lower Discount Rate. D = NPV of Higher Discount Rate

ABC company is considering and investment proposal to install new machine at a cost of tk 10,00,000. The machine has a life expectancy of five years with no salvage value. The company follows straight-line method for calculation of depreciation. The corporate tax rate is 40 percent. The company has a 10% cost of capital. Suggest whether the investment proposal would be financially viable under the method o,

Depreciation:
Year

## NPV and IRR or not EBDT (tk)

tk 10,00,000 5years
Dep (tk/yr)

= 2,00,000 tk/yr
Discnt factor (10%) .909 .826 .751 .683 .621 PV of inflow 236340 239540 262850 198070 161460 10,98,260

## EBT (tk) Tax (40%)EAT (tk) NCF

1. 2. 3. 4. 5. Total

## 260000 290000 350000 290000 260000

Calculation of NPV
Net Present Value (NPV) : PV of cash inflow PV of NCO = 10, 98,000 10, 00,000 = 98,260 Therefore NPV > 0

As we have found from calculation that the NPV is positive, so we can say that the investment proposal would be financially viable

Calculation of IRR
Year PV factors (10%) PV inflow NCF (tk) (NCF*PV factors, 10%) PV factors (14%) PVinflow (NCF* PV factors, 14%)

1. 2. 3. 4. 5. Total

## 2,36,340 2,39,540 2,62,850 1,98,070 1,61,460 10,98,260

2,60,000 .877 2,90,000 .769 3,50,000 .675 2,90,000 .592 2,60,000 .519

## 2,28,020 2,23,010 2,36,250 1,71,680 1,34,940 9,93,900

Calculation of IRR

So, NPV

= 9,93,900 10,00,000 = - 6100 IRR = A + C (B-A) C-D = 10% + 98,260 X (14-10) 98,260 (-6100) = 13.77 %

Here we can see that the IRR > Cost of Capital (10%); then the projects rate of return is greater than its cost. So, the investment proposal is viable

## Comparisons of Capital Budgeting Methods

Methods Strength Weakness

Payback

Easy

to understand Ignores profitability Based on cash flows and the time value of money Highlight risks

## NPV and IRR

Based on cash flows, Difficult to profitability & time determine discount rate value of money

Thank You