Finance Management
Session 5- Capital Budgeting
SHL Specialist Diploma in Events, Sports & Leisure Management
Content page
Specific Learning objectives
 Capital Budgeting
 Investment Criteria
 Types of Project
 Capital budgeting methods
 Other factors to consider
 Dealing with risks & uncertainty
 Conclusion

Specific Learning Objectives





Explain capital budgeting.
Evaluate how an entity assesses an investment
project.
Explain the various criteria of an investment
appraisal.
Evaluate the use of the various appraisal
methods, i.e. Payback period / NPV / IRR /
Profitability index.
Describe the practical problems faced in using
the appraisal methods.
Content page
Specific Learning objectives
 Capital Budgeting
 Investment Criteria
 Types of Project
 Capital budgeting methods
 Other factors to consider
 Dealing with risks & uncertainty
 Conclusion

What is Capital budgeting?
How managers plan significant outlays on
projects that have long term implications.
 Typical examples:

◦ Expansion decisions
◦ Equipment selection decisions
◦ Cost reduction decisions

The decision to accept or reject a project
depends on an analysis of the cash flows
generated by the project and its cost
Capital budgeting programme
1.
Search for & discovery of investment
opportunities
2.
Collection of data
3.
Evaluation & decision-making
4.
Reevaluation & adjustment
Content page
Specific Learning objectives
 Capital Budgeting
 Investment Criteria
 Types of Project
 Capital budgeting methods
 Other factors to consider
 Dealing with risks & uncertainty
 Conclusion

Investment Criteria
Is a particular project a good
investment?
If more than 1 good project but can
only afford 1, which to choose?
Evaluation Methods and
Identify Relevant Cashflows
Payback
Period
Net Present
Value (NPV)
Internal Rate of
Return (IRR)
Profitability
Index (PI)
Chosen Methods Must Satisfy 3 Capital Budgeting Decision Rules:
1.Must consider all of the project’s cashflows
2.Must consider Time Value of Money
3.Must lead to correct decision when choosing mutually exclusive projects
Content page
Specific Learning objectives
 Capital Budgeting
 Investment Criteria
 Types of Project
 Capital budgeting methods
 Other factors to consider
 Dealing with risks & uncertainty
 Conclusion

Types of projects
Independent Projects


A Project whose cash
flows are not affected by
accept/reject decision
for other projects
Projects which meet
Capital Budgeting
criterion should be
accepted
Mutually Exclusive
Projects

A set of projects from
which at most one will
be accepted

Best project to be
accepted and provided
it meets the Capital
Budgeting criterion as
well
Determining cashflow
Types of Cashflows
Relevant Cashflows
Opportunity
Costs
Incremental
Costs and
Revenue
Irrelevant Cashflows
Sunk
Costs
Non-Incremental
Costs and
Revenue
Content page
Specific Learning objectives
 Capital Budgeting
 Investment Criteria
 Types of Project
 Capital budgeting methods
 Other factors to consider
 Dealing with risks & uncertainty
 Conclusion

Capital Budgeting Methods
1.
Payback Period
2.
Net Present Value
3.
Internal Rate of Return
4.
Profitability Index
Mtd 1: Payback Period
The time required to recoup the initial
investment
 Management will decide the maximum
payback period allowable
 Acceptance Criteria

◦ Independent Projects – Accept all projects with
Payback Period < Predetermined period
◦ Mutually Exclusive Projects – Accept projects with
fastest payback and provided it is less than
the predetermined period
Example 1: Payback Period
Assume Project A and B has the following
cash inflows for $10,000 invested.
Year
Project A
Project B
1
$5,000
$1,500
2
$5,000
$2,000
3
$3,000
$2,500
4
$8,000
$5,000
Example 1: Payback Period
Year
Project
A
Cumulative
Cash flow
Project
B
1
$5,000
$1,500
2
$5,000
$2,000
3
$3,000
$2,500
4
$8,000
$5,000
Cumulative
Cash flow
Payback Period
Based on payback period,
Project ____ is better. Really?
Example 1: Payback Period
Choice: Project __ – _____payback period.
If the company policy is to have projects
that have payback period of not more
than 1.5 years, is your choice still the
same?
____________________________
More about Payback Period
Strengths
Weaknesses
1.Simple to use
1.Ignore Time Value of
money
2.Bias towards liquidity as
it is bias towards ST
projects
2.Ignore Cashflows after
payback period
3.No Objective basis for
right payback period
4.Bias against LT project
Activity 1: Payback Period
Assume a $100,000 investment and the
following cash flows for two alternatives.
Which of the following alternatives would
you select under the payback method?
Year
1
2
3
4
5
Investment A
$30,000
$50,000
$30,000
$60,000
-
Investment B
$40,000
$30,000
$20,000
$20,000
$50,000
Activity 1: Payback Period (Soln)
Year Investment
A
1
$30,000
2
$50,000
3
$30,000
4
$60,000
5
-
Cumulative
Cash flow
Investment
B
$40,000
$30,000
$20,000
$20,000
$50,000
Cumulative
Cash flow
Payback period of A =
Payback period of B =
Based on payback period, investment ____should be
chosen since it pays back earlier.
Mtd 2: Net Present Value (NPV)
Sum of Present Value of Inflows and
Outflows ie discounting back the inflows
over the life of the investment to
determine whether they equal or exceed
the required investment.
 Acceptance criteria

◦ Independent Projects – accept any project
whose NPV > 0
◦ Mutually Exclusive projects – choose projects
with highest NPV and it must be >0
Mtd 2: Net Present Value (NPV)
Net Present Value
= Present Value of future cashflows
–
Initial investment
Recap from session 4:
Present & Future Value
Total value at the
end of the n period
(Future Value)
= Principal (1+i)n
Can be rewritten:
FV = PV (1+i)n
Where FV = Future Value
PV = Present Value for Sum of Money
i
= Interest Rate (per period)
n = No. of periods
= No. of Years x No. of compounding per year)
Example 2: NPV
Assume Project A and B has the following
cash inflows for $10,000 invested.
Assuming the cost of capital is 10% pa.
Year
Project A
Project B
1
$5,000
$1,500
2
$5,000
$2,000
3
$3,000
$2,500
4
$8,000
$5,000
Example 2: NPV
Year
Project A
1
$5,000
2
$5,000
3
$3,000
4
$8,000
Present Value
Net Present value
Year
Project B
1
$1,500
2
$2,000
3
$2,500
4
$5,000
Net Present Value
Present Value
More about NPV
Strengths
Weaknesses
1.Take into account all
cashflows
1.Estimates for cashflows
and discount rate difficult
to apply
2.Take into account time
value of money (hence
more superior than
payback period)
3.Calculation quite
straightforward
Activity 2: NPV
Skyline Corp will invest $60,000 in a temporary
project that will generate the following cash
inflows for the next 3 years. Calculate the net
present value assuming interest rate of 5% pa and
decide if this project should be undertaken.
Year
1
2
3
Cash flow
$15,000
$25,000
$40,000
Activity 2: NPV (Solution)
Year
Cash flow
1
$15,000
2
$25,000
3
$40,000
Net present value
PV of cash flow
As the NPV is _________this project
should be _____________.
Mtd 3: Internal Rate of return(IRR)
It is the discount rate that equates cash
outflows (cost) of an investment with the
subsequent cash inflows.
 The discount rate that gives the project
NPV = 0 (zero)
 Aka the discounted cash flow (DCF) rate
of return.

0 IRR=? 1
Cashflows -100k
PV1
PV2
PV3
10k
2
3
Time
60k
80k
Mtd 3: Internal Rate of return(IRR)

Acceptance Criteria
◦ Independent Projects – Accept projects
where IRR > Cost of capital
◦ Mutually exclusive projects – Accept projects
with highest IRR and whose IRR > cost of
capital.
Example 3: IRR
Moon Pte Ltd is evaluating the Project Evergreen.
Calculate the rate of return of Project
Evergreen that will make the present value of all
cash flows equal to the initial outlay? (Hint:You
can use one of the functions in Excel)
Initial Outlay
Year 1
Year 2
Year 3
Project Evergreen
(10,000)
5,000
4,000
6,000
Example 3: IRR
Internal rate of return = _________
More on IRR
Strengths
Weaknesses
1.State in relative
percentages not absolute
value
1.More complicated
calculations
2.This can be compared
with cost of capital easily
to determine if the project
is viable.
2.When there are multiple
changes in the sign of the
cash flows, the IRR rule
does not work.
Activity 3: IRR
Moon Pte Ltd is evaluating Project Everbloom.
Calculate the rate of return that will make the
present value of all cash flows equal to the
initial outlay? (Hint:You can use one of the
functions in Excel)
Initial Outlay
Year 1
Year 2
Year 3
Project Everbloom
(15,000)
8,000
5,000
9,000
Activity 3: IRR (Solution)
Using Excel (instead of trial & error
method):
Internal rate of return = __________
Mtd 4: Profitability Index (PI)
It is the highest net present value per
dollar of investment.
 Acceptance criteria:

◦ Independent Projects – accept projects whose
PI >0
◦ Mutually exclusive projects – accept projects
with highest PI and whose PI > 0.
PV of Future Cashflows
Profitability Index (PI) 
PV of Initial Investment
Example 4: PI
There are three projects to be evaluated.
Based on the profitability index, which
project should be selected?
Project
PV of future
cashflows
Investment
NPV
X
$4,000
$3,000
$1,000
Y
$6,000
$5,000
$1,000
Z
$10,000
$7,000
$3,000
Example 4: PI
Project
PV
Investment
X
$4,000
$3,000
Y
$6,000
$5,000
Z
$10,000
$7,000
NPV
PI
Based on the PI, the project with the
highest PI should be selected first. For
every $1 invested, project ____ provides
the highest return ($______).
Profitability Index (PI) 
PV of Future Cashflows
PV of Initial Investment
More on PI
Strengths
Weaknesses
1.Take into account all
cash flows.
1.Size problems since it is
not in absolute figures.
2.Takes into account time
value of money
2.Estimates for cash flows
and discount rate is
difficult to apply
Activity 4: PI
Evaluate two projects for Adventurer Club
Pte Ltd using the profitability index
method. Project A and B requires
investment of $10,000 and $22,000
respectively. Assuming the current
interest rate is 3% pa.
Year
1
2
3
4
Cash flow for Project A
$4,000
$5,000
$4,200
$3,600
Cash flow for Project B
$10,800
$9,600
$6,000
$7,000
Activity 4: PI (Solution)
Year
1
2
3
4
Total PV
Outlay
Cash flow for
Project A
$4,000
$5,000
$4,200
$3,600
Cash flow for
Project B
$10,800
$9,600
$6,000
$7,000
PI
The PI of Project ____ is higher, so should
choose this.
Comparison of methods
Payback or Discounted
Payback Period
NPV
IRR
Criteria for
Independent Projects
Accept if Payback is less than a
specified no. of years
Accept any projects whose
NPV > 0
Accept any projects that IRR
> Costs of Capital (k)
Criteria for Mutually
Exclusive Projects
Choose projects that offers
Quickest Payback Period and if
the payback is less than
specified number of years
Choose the Highest NPV
Project and with NPV > 0
Choose the highest IRR
projects and with IRR>k
Weaknesses
1. Ignore Time Value*
2. Ignore risk differences
3. Ignore Cashflows after
payback period
4. No Objective basis for right
payback period
5. Bias against LT project
1. Estimates for cashflows
and discount rate difficult
to apply
1. More complicated
calculations
2. Unconventional
Cashflows may have
more than 1 IRR
3. Assumes reinvestment
at IRR which is less
realistic than NPV
4. Size problem since it is
not absolute figures
Strengths
1. Simple to use
2. Bias towards liquidity as it
bias towards ST projects
3. Cashflow towards end is
uncertain so ignoring it
seems to adjust for risk
1. Take into account all
cashflows
2. Take into account time
value of money
3. Calculation quite
straightforward
1. State in relative % not
absolute value
2. Can estimate IRR
without discount rate
Comparison of methods
Profitability Index (PI)
Criteria for Independent
Projects
Accept if PI > 1
Criteria for Mutually
Exclusive Projects
Choose projects PI > 1 and highest PI
Weaknesses
1. Size problems since it is not in absolute figures
2. Estimates for cashflows and discount rate difficult to apply
Strengths
1. Take into account all cashflows
2. Take into account time value of money
So which method?

Different capital budgeting methods may
yield different results.

So which is the preferred method?

Rule of the thumb is to follow the
recommendation by NPV method.
Other factors to consider

Certainty of cashflows

Availability of capital

Availability of financing

Whether cost of capital will remain the
same
Content page
Specific Learning objectives
 Capital Budgeting
 Investment Criteria
 Types of Project
 Capital budgeting methods
 Other factors to consider
 Dealing with risks & uncertainty
 Conclusion

Dealing with risks & uncertainty
Sensitivity Analysis – a technique that
indicates how much NPV will change in
response to a given change in an input
variable, other things held constant.
 Scenario Analysis - a risk analysis
technique in which bad and good sets of
financial circumstances are compared with
a most likely, or base case situation.

Dealing with risks & uncertainty
Monte Carlo Simulation - a risk analysis
technique in which probable future events are
simulated on a computer, generating estimated
rates of return and risk indexes.
 Decision Tree - a diagram that shows all
possible outcomes that result from a decision.
Each possible outcome is shown as a “branch”
on the tree. Decision trees are especially useful
to analyse the effects of real options in
investment decisions. Decision trees take into
consideration the probability of each outcome

Content page
Specific Learning objectives
 Capital Budgeting
 Investment Criteria
 Types of Project
 Capital budgeting methods
 Other factors to consider
 Dealing with risks & uncertainty
 Conclusion

Independent
Projects
Conclusion
Evaluating Projects
Types of
Cash Flows
Sunk Costs
Opportunity
Costs
Incremental
Costs
Cash Inflows
and Outflows
Time Value of
Cash Flows
Interest rate
Capital Budgeting
Methods
NPV
IRR
Timing of
cash flows
Standard Payback
Profitability Index
Mutually
Exclusive
Projects
Resources
Constraints and
Benchmarks
RESOURCES
Textbooks:
•
Block, Hirt, Danielsen; Foundations of Financial Management; 13th edition;
McGraw Hill; Chapter 12
•
Graham Peirson, Rob Brown, Steve Easton and Peter Howard; Business
Finance (8th Edition); Irwin/McGraw-Hill; 2003; Chapter 5 and 6.
•
Eugene F. Brigham and Joel F. Houston; Fundamentals of Financial
Management (Concise Fourth Edition); Thomson South-Western; 2004;
Chapter 10 and 11.
•
Lawrence J. Gitman; Principles of Managerial Finance (8th Edition); Addison
Wesley Longman, Inc; 1997; Chapter 8 and 9.
•
Jae K. Shim and Joel G. Siegel; Schaum’s Outline of Theory and Problems
of Financial Management (2nd Edition); Irwin/McGraw-Hill; 1998; Chapter 8
and 9.
•
William L. Megginson and Scott B. Smart; Introduction to Financial
Management (International Student Edition); Thomson South-Western;
2006; Chapter 8 and 9.