The Basics of Capital Budgeting
Should we
build this
plant?
10-1
What is capital budgeting?
Capital Budgeting is the process of evaluating
and selecting long term investments that are
consistent with the goal pf shareholders wealth
maximization.
It involves the following actions,
Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
10-2
Importance of Capital Budgeting
Capital budgeting decisions are of paramount
importance in financial decision making,
First of all, such decision affects the
profitability of a firm because of the fact that
they relate to fixed assets. The fixed assets
are the true earning assets of the firm. They
enable the firm to generate finished goods
that can ultimately be sold for profit. Thus
capital budgeting decisions determine the
future destiny of a firm.
10-3
Importance of Capital Budgeting
Secondly, capital expenditure decisions has its
effect over long time span and inevitably affect the
company's future cost structure. For example, if a
particular plant has been purchased by a company
to start a new product, the company commits itself
to a sizable amount of fixed cost, in terms of labor,
insurance, rent, salaries and so on. If the
investment turn-out to be unsuccessful in future,
the firm will have to bear the burden of fixed costs.
In short, future costs, break-even point, sales and
profits will all be determined by the selection
assets.
10-4
Importance of Capital Budgeting
Thirdly, Capital investment decisions, once
made are not easily reversible without much
financial loss to the firm because there may
be no market for second hand plant and
equipment and their conversion to other
users may not be financially viable.
10-5
Capital Budgeting Process & Its Types



Capital Budgeting process refers to the total
process of generating, evaluating, selecting
and following up on capital expenditure
alternatives.
There are 3 types of capital budgeting
decisions,
Accept/Reject decisions
The mutually exclusive choice decisions
The capital rationing decisions
10-6
Accept/Reject decisions
This is the fundamental decision in capital
budgeting. If the project is accepted, the firm
would invest in it; if the proposal is rejected,
the firm does not invest in it.
In general, all those proposals which yield a
rate of return greater than a certain required
rate of return or cost of capital are accepted
and the rest are the rejected.
By applying this criterion, all independent
projects are accepted.
10-7
The Mutually Exclusive choice decisions
The Mutually Exclusive projects are those
which competes with other project in such a
way that the acceptance of one will exclude
the acceptance of other projects. The
alternatives are mutually exclusive and only
one may be chosen. For example, a company
is intending to buy a folding machine. There
are 3 competing brands each with a different
initial investment and operating costs. The 3
machines represent mutually exclusive
alternatives and only one of these can be
selected.
10-8
The capital rationing decisions
It is the financial situation in which a firm has
only fixed amount to allocate among
competing capital expenditure. The firm
allocates funds to projects in a manner that it
maximizes long term return.
Thus capital rationing refers to a situation in
which a firm has more acceptable investments
than it can finance. It is concerned with
selection of group of investment proposals out
of many acceptable under the accept/reject
decision. Capital rationing employs ranking of
the acceptable investments projects.
10-9
Steps to capital budgeting
process
1.
2.
3.
4.
5.
6.
Identification of potential investment
opportunities
Assembling of investment proposals
Decision Making
Preparation of capital budget and
appropriations
Implementation
Performance Review
10-10
Investment Criteria
Investment Criteria
Discounting Criteria
NPV
Benefit Cost
Ratio
Non-discounting Criteria
IRR
Payback
Period
ARR
10-11
Net Present Value
The NPV (Net Present value) of a project is
the sum of the present values of all the cash
flows-positive as well as negative- that are
expected to occur over the life of the project.
The general formula of NPV is:
Ct
NPV of Project =

(1+r)t
initial
investment
10-12
Net Present Value
where,
Ct = Cash flow at the end of the year t
n= life of the project
r = Discount rate
Decision Rule:
NPV > Zero = Accepted
NPV < Zero = Rejected
10-13
Net Present Value
Year
Cash Flow
0
Taka(10,00,000)
1
200,000
2
200,000
3
300,000
4
3,00,000
5
350,000
If the cost of capital (r) = 10%. Calculate the NPV.
10-14
Net Present Value
NPV =
1000,000 -
300,000
200,000
+
1
(1.10)
200000
+
2
(1.10)
300,000
350000
+
(1.10)
3
+
(1.10)
4
(1.10)
5
10-15
Net Present Value: Different discount
rate
Year
Cash Flow
0
Taka(12000)
1
4000
2
5000
3
7000
4
6000
5
5000
If the cost of capital (r) = 14%,15%,16%,18%, &
20% respectively. Calculate the NPV.
10-16
Net Present Value: Different discount rate
C1= 4000 / 1.14
= 3,509

C2= 5000 / 1.14 x 1.15
= 3,814

C3= 7000 / 1.14 x 1.15 x 1.16 = 4,603

C4= 6000 / 1.14 x 1.15 x 1.16 x 1.18
=3,344
 PV of C5= 5000 / 1.14 x 1.15 x 1.16 x 1.18 x
1.20
= 2,322
NPV =3509+3814+4603+3344+2322 – 12,000
= 5,592

PV
PV
PV
PV
of
of
of
of
10-17
Benefit Cost Ratio
Benefit cost ratio = PVB / I
Where,
PVB = Present value of Benefits
I
= Initial Investment
Net Benefit Cost ration = BCR – 1
Where,
BCR = Benefit cost ration
Decision Rule:
When BCR
>1
<1
or NBCR
>0
<0
Rule
= Accepted
= Rejected
10-18
Benefit Cost Ratio
Problem: Let us consider a project which is being evaluated
by a firm that has a cost of capital of 12%
Initial Investment =
Tk. 100,000
Benefits
Year 1
25,000
Year 2
40,000
Year 3
40,000
Year 4
50,000
[1] Calculate the Benefit cost ratio
[2] Calculate Net Benefit cost ratio
10-19
Benefit Cost Ratio


BCR = [25000/1.12 + 40000/(1.12)2+
40000/(1.12)3+ 50000/(1.12)4] / 100000
= 1.145
NBCR = BCR – 1
= 1.145 – 1
= 0.145
10-20
Internal Rate of Return (IRR)
IRR is the discount rate that forces PV of inflows
equal to cost, and the NPV = 0
Put differently, it is the discount rate which
equates the present value of future cash flows
with the initial investment.
CFt
0
t
(
1

IRR
)
t 0
n
10-21
Internal Rate of Return (IRR)
In the NPV calculation we assume that the
discount rate (cost of capital) is known and
determine the NPV. In the IRR calculation,
we set the NPV equal to Zero and determine
the discount rate that satisfy this condition.
Decision rule
If the IRR is > Cost of Capital = Accept
If the IRR is < Cost of Capital = Rejected
10-22
Internal Rate of Return (IRR)
Problem:
year
0
1
2
3
4
Cash flow (100000) 30000 30000 40000 45000
The IRR is the value of r which satisfies the
following equations
100,000 = 30000/(1+r)1 + 30000/(1+r)2 +
40000/(1+r)3 + 45000/(1+r)4
The calculation of r involves a process of Trial
& Error method. We will try different values
of r till we find the right hand side of the
above equation is equal to left hand side.10-23
Internal Rate of Return (IRR)
Let us, to begin with, Try “r” = 15%
30000/(1.15)1 + 30000/(1.15)2 +
40000/(1.15)3 + 45000/(1.15)4
=100,802
This value is slightly higher than our initial
investment[left hand side]. So we will
increase the value of r from 15% to 16%.
(a higher r lowers and smaller r increases the
right hand side value)
10-24
Internal Rate of Return (IRR)
Try “r” = 16%
30000/(1.16)1 + 30000/(1.16)2 +
40000/(1.16)3 + 45000/(1.16)4
=98,641
As the value is now less than 100,000, we
may conclude that the value of “r” lies
between 15% & 16%.
If we need more refined estimate of “r”, then
use the following procedure
10-25
Internal Rate of Return (IRR)
[1] determine the Net present value of the
two closest rate of return
(100802 – 100000) = 802
(100000 – 98,641) = 1,359
[2] Find the sum of the absolute values of
the NPV obtained in step 1.
(802+1359) = 2,161.
[3] Calculate the ratio of the net present
value of the smaller discount rate,
10-26
Internal Rate of Return (IRR)
802/2161 = 0.37
[4] Add the number obtained in step 3 to the
smaller discount rate
15+0.37=15.37%.
10-27
Pay Back Period
Pay back period is the length of time required
to recover the initial cash outlay on the
project.
The number of years required to recover a
project’s cost, or “How long does it take to
get our money back?”
For Example, if a project involves in cash
outlay of Tk. 60000 and generate cash inflow
of Tk. 100000,Tk. 150,000 Tk. 150,000 and
Tk. 200000 in the 1st,2nd,3rd & 4th year
respectively. Its pay back period will be 4
10-28
years.
Pay Back Period
Because the sum of the cash inflows during 4
years is equal to the initial outlay.
When the annual cash inflow is a constant
sum the pay back period is simply the initial
outlay divided by the annual cash inflow.
For example, A project involves in a initial
cash outlay of Tk. 1000,000 and a constant
annual cash inflow of Tk. 300,000. Calculate
the payback period.
1000,000/300,000 = 3 1/3 years.
10-29
Pay Back Period

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.
It is a measure of Project’s capital recovery, not
profitability.
10-30
Accounting Rate of Return
It is also know as average rate of return.
Can be defined as
Profit after Tax
Book value of the investment


The numerator of this ratio may be measured as
the average annual post tax profit over the life of
the investment.
The Denominator is the average book value of
fixed assets committed to the project.
10-31
Accounting Rate of Return
Acceptance/Rejection Criteria
The higher the accounting rate of return, the better
the project.
In general, project’s which have an accounting rate
of return equal to or greater than a pre specified
cut-off rate of return – which is usually between
10% to 30% are accepted;others are rejected.
10-32
Accounting Rate of Return
Year
Book Value
of fixed Asset
1
2
3
4
5
90,000
80,000
70,000
60,000
50,000
Profit
after Tax
20,000
22,000
24,000
26,000
28,000
10-33
Accounting Rate of Return
The Accounting rate of Return is
(20,000+22,000+24,000+26,000+28,000)
5
(90,000+80,000+70,000+60,000+50,000)
5
= 34%
10-34
Problem: The expected cash flow of a project are as follows
Year
Cash Flow
0
Taka(100,000)
1
20,000
2
30,000
3
40,000
4
50,000
5
30,000
If the cost of capital (r) = 12%.
10-35





Calculate the NPV.
Benefit Cost ratio
Net Benefit cost ratio
Internal rate of Return
Payback Period
10-36