CHAPTER 10
The Basics of Capital Budgeting
Should we
build this
plant?
10-1
What is capital budgeting?



Investment decision: Analysis of
potential cost-benefit of fixed assets.
Replacement decision: Analysis of costbenefit of the new machine in
comparison to the old machine.
Project launching: Complete cost-benefit
analysis of the project taking under the
whole life of the project under
consideration .
10-2
Challenges of capital budgeting




To forecast the long term cash flows.
To assess the riskiness of the future cash
flow.
To select the right cost of capital
To select the right method of capital
budgeting
10-3
Difference between independent
and mutually exclusive projects


Independent projects – if the cash flows of
one are unaffected by the acceptance of
the other.
Mutually exclusive projects – if the cash
flows of one can be adversely impacted by
the acceptance of the other.
10-4
Methods of capital budgeting

Accounting Technique:


Accounting Rate of Return
Financial Techniques:





1.
2.
3.
4.
5.
Payback Period
Discounted payback period
Net Present Value (NPV) Method
Internal Rate of Return (IRR)
Profitability Index (PI)
10-5
Problem defined

Both project L and project S are $100 projects. The
investments have zero salvage value at the end of the 3
year project. Revenue and expenses (including
depreciation) are as following. Tax rate is 30%. Cost of
capital is 10%. Evaluate the potentiality of the projects.
Project L
Project S
Year 1 Year 2 Year 3 Year 1 Year 2 Year 3
Revenue
Expenses
50
83
194
113
132
123
103
50
104
80
57
90
10-6
AAR Vs. Cash Flow
Project L
Year 1
Year 2
Project S
Year 3
Year 1 Year 2
Year 3
Revenue
50
194
132
103
104
57
Expenses (Incl. depreciation)
83
113
123
50
80
90
Taxable income
-33
81
9
53
24
-33
Tax (30%)
-10
24
3
16
7
-10
Net income
-23
57
6
37
17
-23
Cash Flow (Net Inc+ Dep.)
10
90
40
70
50
10
Average Net Income
(-23+57+6)/3= 13.3
(37+17-23)/3=10.3
Average Investment
(100+0)/2= 50
(100+0)/2=50
13.3/50=26.6%
10.3/50=20.5%
AAR
10-7
What is the payback period?

The number of years required to
recover a project’s cost, or “How long
does it take to get our money back?” It
is not related to profitability as it defines
the time period needed to get the
original investment back. A project
would only make profit after the expiry
of the payback period.
10-8
1. Payback Period: Project L
Year
0
Cash Flow
(CFt)
-100
Cumulative
CF
-100
1
10
-90
2
90
0
3
40
40
Payback Period of Project L=2 years
10-9
Payback Period: Project S
Year
CFt
Cumulative Cash flow
0
-100
-100
1
70
-30
2
50
20
3
20
40
Project S=1 year+30/50 year=1.6 years
10-10
Decision

Project L has the payback period of 2
years and project S has a payback
period of 1.6 years. So project S is
better than project L. Project S should
be accepted.
10-11
Strengths and weaknesses
of Payback Period


Strengths
 An investor is primarily concerned of the
protection of original investment rather than
profit, and PBP aims to give such an idea.
 Easy to calculate and understand.
Weaknesses
 Ignores the time value of money.
 Ignores CFs occurring after the payback period.
 No yardstick to compare with
10-12
2.
Discounted Payback Period
Project L
Suppose, cost of capital is 10%
Year
0
1
2
3
Cash flow Discounted CF
at 10%
-100
-100
10
9.09
90
74.38
40
30.1
Cumulative
CF
-100
-90.9
-16.53
13.5
Discounted Payback Period
Project L=2+16.53/30.1=2.55 years
10-13
2.
Discounted Payback Period
Project S
Year
Cash flow
0
-100
Discounted CF Cumulative
at 10%
CF
-100
-100
1
70
63.64
-36.36
2
50
41.32
4.96
3
20
15.03
19.98
Discounted Payback Period
Project S=1+36.36/41.32=1.67 years
10-14
Decision based on
Discounted Payback Period

Project L has a Discounted Payback
Period of 2.55 years and Project S has a
Discounted Payback Period of 1.67 years.
So, project S is the better project.
10-15
3. Net Present Value (NPV)

Sum of the Present Values of all cash
inflows and outflows of a project:
CF3
CFn
CF1
CF2
NPV  CF0 


 .... 
1
2
3
(1  k ) (1  k ) (1  k )
(1  k ) n
CFt
NPV  
t
t 0 ( 1  k )
n
10-16
NPV of Project L
Suppose, the cost of capital is 10%
Year CFt
0 -100
1
10
2
90
3
40
NPVL =
PV of CFt
-$100
9.09
74.38
30.1
13.5
=(10/1.1)
=(90/(1.1)2)
=(40/(1.1)3)
10-17
NPV of Project S
Year
0
1
2
3
CFt
-100
70
50
20
NPVs =
PV of CFt
-$100
63.64
41.32
15.02
$19.98
10-18
Decision making in NPV method



If projects are independent, accept the
project if the NPV is positive. Reject the
project if NPV is negative.
If projects are mutually exclusive, accept
projects with the highest positive NPV.
In this example, we would accept S if
mutually exclusive (NPVs > NPVL), and
would accept both if independent.
10-19
4. Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:
CFt
0
t
(
1

IRR
)
t 0
n
10-20
Short-cut method of IRR
Interpolation method for IRR
L1:Lower discount rate
L2: Higher discount rate
NPV1: NPV of lower discount rate
NPV2: NPV of higher discount rate
IRR=L1+ [NPV1/(NPV1-NPV2)] *(L2-L1)
10-21
IRR of project L
(under the short-cut method)

To use the short-cut method of IRR we need to know the NPVs
at two different discount rates. We know, NPV of the project L
was $13.52 when the discount rate is 10%. If the discount rate
was 15% then the NPV comes down to $3.05. So,

 13.52  
IRRL  10%  (15%  10%) * 


13.52  3.05 

13.52 

 10%   5% *
  10%  (5% *1.29)
10.47 

 10%  6.456%  16.46%

The IRR so calculated is close to the true IRR of 16.6%
10-22
IRR of Project S



For project S, at 10% discount rate the
NPV was $19.98. At 20% discount rate it
arrives at $4.63. Using the short cut
method:
IRRS= 10%+[(20%-10%)*(19.98/(19.98-4.63)]
= 23%
The true IRR however was 23.57%
10-23
Rational for the IRR method

If IRR > WACC, the project’s rate of
return is greater than its costs. There
is some return left over to boost
stockholders’ returns.
10-24
IRR Acceptance Criteria




If IRR > k, accept project.
If IRR < k, reject project.
If projects are independent, accept both
projects, as both IRR > k = 10%.
If projects are mutually exclusive,
accept S, because IRRs > IRRL.
10-25
5. Profitability Index (PI)
PV ( NCB )
PI 
PV ( NCO )
113.57
PI L 
 1.14
100
119.98
PIS 
 1. 2
100
Accept the projectif : PI 1, or higherPI.
10-26
Evaluation of the 2 projects
Techniques
Project L
Project S
Comment
Accounting Return
26.6%
20.5%
Project L
Payback Period
2 years
1.6 years
Project S
Discounted Pay Back
2.55
1.67
Project S
Net Present Value
13.5
19.98
Project S
IRR (ke=10%)
16.5%
23%
Project S
Profitability Index
1.14
1.2
Project S
10-27
Comments



Although Accounting Return of project L is better
than that of project S, but all other techniques show
superiority of project S over project L.
Project S has lower Payback Period and Discounted
Payback period. Its NPV is positive and higher than
Project L, its IRR is higher than the cost of capital
and higher than project L, and Profitability Index is
greater than one and higher than project L. So,
project S should be accepted if the projects are
mutually exclusive.
If the projects are independent, project L would also
be accepted (along with project S) since NPV is
positive, IRR is greater than the cost of capital, and
Profitability Index is greater than one.
10-28
Problem 2:
NPV vs. IRR: Project V & Project H
Year
Cash Flow V
Cash Flow H
0
-1200
-1200
1
1000
100
2
500
600
3
50
1050
NPV
160
176
IRR
20.7%
16.2%
10-29
NPV
Conflicting result: NPV vs. IRR
Project H
Project V
176
160
Discount Rate
10%
16%
21%
10-30
Comments: NPV vs. IRR

Given the cost of capital of 10%, project H has
higher NPV than Project V. If we take NPV as the
decision criteria then Project H should be accepted.
On the other hand, if we take IRR as the decision
criteria, then project V should be accepted. If we are
very confident of the cost of capital of 10% (or any
rate below the rate at cross over point), then project
H is better. If we are not sure of the cost of capital,
and there is possibility of increasing the cost of
capital, then project V is better. Of course, if there a
possibility that cost capital can be higher than 21%,
then no project should be accepted.
10-31
Tips of Capital Budgeting


Incremental Cash flow: The change in a firm’s net
cash flow attributable to an investment project. This
must be taken under consideration. For example,
Consider TQC Co. at present without the project A;
versus, TQC Co. with the project A. If cost increases
in the second case then the increasing amount is the
cost of the project A. If cost decreases in the second
case then that is the benefit of project A.
Sunk Cost: A cash outlay that has already been
incurred and can not be recovered regardless
whether the project is accepted or not. Like the cost
of feasibility study. This must not be taken under
consideration.
10-32
Tips of Capital Budgeting (Contd.)


Opportunity cost: The return of the best alternative
foregone must be taken under consideration even
if it does not have an impact on cash flow.
Example, rental value of the land owned by the
firm should be a cost even though the firm does
not pay that.
Externalities: The effect accepting a project will
have on the cash flows of other project. Example,
opening a new branch may cause a loss of sale of
an existing branch. That loss must be considered
as the cost of the new branch.
10-33
Tips of Capital Budgeting (Contd.)

Terminal Cash Flow: The value of the
project or any part of it that would arrive
at the end of the project must be
considered as a cash inflow in its after
tax form. Example, net salvage value,
net working capital, etc.
10-34
Problem 3: Net salvage value

Example: (a) The price of machine is $1000.
The machine has a life of 10 years. The life of
the project is 4 years. It is estimated that the
machine would be sold at $900 at the end of
the project. Find the net salvage value. (b) The
building requires an investment of $200. It has
a life of 20 years. The selling price of the
building at the end of the 4 year project is
$100. Find the salvage value.
10-35
Calculation of Net Salvage
Value
Machine
Building
Annual Depreciation
(cost/Life)
Depreciation for 4 years
1000/10=100
200/20=10
100*4=400
10*4=40
Book value (Cost-Depr)
1000-400=600
200-40=160
Market value
900
100
Profit (Loss)
900-600=300
100-160=(60)
Tax effect
(120)
24
Net salvage value
900-120=780
100+24=124
10-36
Problem 3:

A fast food shop has a 4 year life that needs
the investment in machine of $1000 and
building of $200. Annual sales $300 and the
cost is 40% of sales. The feasibility study
needed $500 and the rental value of the land
(owned by the firm) is $20 per year. Cost of
capital is 8% and the corporate tax rate is
40%.
10-37
Solution of Problem 3
Source
Investment
Sales
Cost
Land Rent
Depreciation
EBIT
Year 0 Year 1 Year 2 Year 3 Year 4
(1200)
300
300
300
300
(120) (120) (120) (120)
(20)
(20)
(20)
(20)
(110) (110) (110) (110)
50
50
50
50
10-38
Solution (Contd.)
Source
EBIT
Tax 40%
Net income
Add back
Depreciation
Net salvage value
Cash Flow
Year 0
Year 1 Year 2 Year 3 Year 4
50
(20)
30
110
(1200) 140
50
(20)
30
110
140
50
(20)
30
110
50
(20)
30
110
140
904
1044
10-39
Solution (Contd.)
Source
Year 0 Year1
Year2
Year3
Year4
Cash Flow
(1200) 140
140
140
1044
Present Value
of Cash Flow
(1200) 129.6
120.0
111.1
767.4
NPV=-$71.8
Since the NPV is negative, so do not
accept the project.
10-40
Other methods of capital budgeting




Payback Period=3.75 years
Discounted Payback= The project does not have a
discounted payback period in the project life with
8% cost of equity.
IRR=6.03% (Trial & Error method)
IRR (Shortcut method)
=5%+(8%-5%)/(40.456/40.456+71.83)
=6.06%
Comment: NPV is negative, IRR is less than ke,
DPBP is negative, PBP is inconclusive. So, do not
accept the project.
10-41
Problem 3a: Sensitivity Analysis

A market promotion firm assures that
sales of the firm could be doubled every
year provided that firm takes care of
market expansion. The firm would
charge 20% as the sales commission.
What would be the effects in capital
budgeting?
10-42
The statement of cost-benefit
Source
Year 1
Year 2
Year 3
Year 4
600
600
600
600
Cost
(240)
(240)
(240)
(240)
Land Rent
Sales
Commission
Depreciation
(20)
(120)
(20)
(120)
(20)
(120)
(20)
(120)
(110)
(110)
(110)
(110)
110
110
110
110
Investment
Sales
EBIT
Year 0
(1200)
10-43
Calculation of Cash-Flow
Source
Year 0
Year 1 Year 2 Year 3 Year 4
EBIT
110
110
110
110
Tax 40%
(44)
(44)
(44)
(44)
66
66
66
66
110
110
110
110
Net income
Add back Depreciation
Net salvage value
Cash Flow
904
(1200)
176
176
176
1080
10-44
Calculation of NPV & IRR
Source
Year 0
Cash Flow
Present Value
of Cash Flow
NPV=$47.4
IRR=9.3%
Year1
Year2
Year3
Year 4
(1200) 176
176
176
1080
(1200) 163
150.9 139.7 793.8
The NPV is positive and IRR  ke, so
accept the project. The offer of the
marketing firm should be
accepted.
10-45
Problem 4



A Gulshan based fast food shop contemplates to introduce a branch
at Kamal Ataturk Road. The firm has expended Tk.2 million for the
feasibility of the project, and found the project feasible.
The initial investment requires Tk.50 million in machineries, Tk.30
million for building and Tk.10 million for permanent working capital.
There would be a cost of installation of machineries to an extent of
Tk.10 million. The working capital would be required through out the
whole life of the 4 year project and expected to be fully recovered at
the end. The machine would have a 10 year life and the building
would have a 15 year life. It is expected that both the machine and
the building would be sold at Tk.25 million each at the end of the
project.
It has been known that the project would not require any investment
for land as the land is already owned by the firm (cost price Tk.50
million) and presently brings a rent of Tk.2 million per year.
10-46
Problem 4 (Contd.)



The annual sales from the project would be Tk.100 million in the next year
and it is expected to increase annually by 10%.
The fixed cost is estimated Tk.25 million per year and the variable cost is
estimated 25% of the sales for the first 2 years and 30% for the last 2 years.
The fixed cost of the project includes the salaries for engineers that can be
used for the Gulshan branch saving the branch to an amount of Tk.5 million
per year. The marketing department of the firm says that there should be a
billboard investment of Tk.1 million per year through out the project to
maintain the sales. The Gulshan branch says the sale of the branch would
be affected by an extent of Tk.20 million for the first year and Tk.10 million
for the second year in consequence of the introduction of the new branch.
The corporate tax rate is 40%. Due to the growing nature of fast food shop
in and around the location of the project, the cost of equity is estimated to
be as high as 20%. You have to evaluate the profitability of the project and
comment on that.
10-47
Solution: Problem 4
Sources
Total Investment
Year 0
Year 1
Year 2
Year 3
Year 4
-100
Sales Revenue
100
110
121
133.1
Fixed Costs
-25
-25
-25
-25
Variable Costs
-25
-27.5
-36.3
-39.9
Depreciation
-7
-7
-7
-7
Land
-2
-2
-2
-2
Bill board expenses
-1
-1
-1
-1
-20
-10
5
5
5
5
25
42.5
54.7
63.17
Loss of existing sales
Cost saving of engineers
Taxable income
-100
10-48
Solution: Problem 4 (Contd.)
0
1
2
3
Taxable income
25
42.5
54.7
63.17
Tax
-10
-17
-21.9
-25.3
Net Income
15
25.5
32.8
37.9
7
7
7
7
Add back depreciation
Net Working capital
4 Total
10
Net salvage value
50.8
Net cash flow
-100
22
32.5
39.8
105.7
PV (Cash Flow) Ke=20%
-100
18.3
22.6
23.0
51.0
14.9
PV (Cash Flow) i=25%
-100
17.6
20.8
20.4
43.3
2.1
25.80% Since NPV is positive and IRR > k
e
Tk.14.9m So the project should be accepted.
10-49
IRR (Short cut method)
NPV (Ke=20%)
Notes of solution of Problem 4
Notes:
1. Tk.2 million expended for feasibility is the sunk cost and so excluded.
2. Calculation of Net Salvage Value:
Cost Price
Annual Depreciation
Accumulated Depreciation
Book Value at the end of the project
Market Value
Profit (loss)
Tax Effect (40%)
Net Salvage Value
3. Total Investment
Machineries
Building
Installation
Permanent Working Capital
Total
50
30
10
10
100
Machineries
50
5
20
30
25
-5
2
27
Building
30
2
8
22
25
3
-1.2
23.8
10-50