MODULE 11
BUDGETING AND LONG
TERM PLANNING
ADB Private Sector Development Initiative
Corporate and Financial Governance Training
Solomon Islands
Originally by
Dr Judy Taylor
Acknowledgement
These materials were produced by Dr Judy Taylor from La Trobe University, through the Asian
Development Bank’s Pacific Private Sector Development Initiative (PSDI). PSDI is a regional technical
assistance facility co-financed by the Asian Development Bank, Australian Aid and the New Zealand Aid
Programme.
Module 11 Outline



What is Capital budgeting
Steps in capital budgeting
Capital budgeting techniques explained
 Payback
 Net
present value
 Internal rate of return
 Accounting return

How do I choose which project to implement
Capital Budgeting


Capital budgeting is the formal term for planning
long-term investment decisions. These projects are
different from normal budgeting decisions due to
their size and the time taken to implement them.
The problem for the business is threefold,
how to evaluate a project,
 when they have a number of such projects they can
undertake how do they evaluate them and then
 how to compare them.

Capital Budgeting

Techniques can be used to help a company to assess if the
capital budgeting proposals will yield a return and deliver
an economic value to the company.



usually focus on the cash flows of the investment choices rather than
accounting profit.
Module 8, we constructed a budget for our business. Capital
budgeting decisions require the company to complete similar
forecasts of costs as well as cash flows in and out when
evaluating a business proposal.
These projects should be found in the long term business
plan, but they will be planned for and evaluated
separately.
Capital Budgeting

If there is more than one project that the company is
considering the company should evaluate all the
projects in the same manner. Firstly estimating the
costs then the cash flow. Taking care to allocate
each of these to the correct period.
Capital Budgeting

Once the capital budgeting is undertaken for all the
proposed projects the company must make a decision of
which project they will undertake.
companies usually have access to limited resources and are
unable to take up every opportunity that presents itself.
 companies that grow too quickly often fail or suffer loss for
a period of time because they

stretch their management resources too thinly and
 it takes resources to integrate new business into the old business
structure.
 So even if it is possible to undertake a number of projects it is
often not wise to do so.

Capital Budgeting
Steps involved in capital budgeting.
1.
Identify long-term goals of the individual or business.
2.
Identify potential investment proposals
3.
Estimate and analyse the relevant cash flows of the
investment
4.
Determine financial feasibility of each of the
investment proposals using the capital budgeting
methods.
5.
Choose the projects to implement
6.
Implement the projects chosen
7.
Monitor the projects implemented.
Capital Budgeting



Different projects have different timings of cash outflows
and inflows.
There are a number of techniques that a company can
use to evaluate the projects. Each potential project
needs to be evaluated.
This can be done either calculating
the amount of time it takes to have your investment funds
returned, or
 converting the cash inflows and outflows into current dollars.


Assume the following 4 projects are available for your
company to undertake.
4 different projects
Project 1
Project 2
4 different projects
Project 3
Project 4
4 different projects



Which project is better?
Why?
How do you evaluate the different timing of the
cash inflows and outflows?
Capital budgeting decisions

Understanding how the different methods for
assessing capital investments are calculated, is
critical to making a sound responsible choice (even
though staff will usually do it for the board).

Understanding discount rates and the time value of
money is central to this solid understanding
A
dollar received in a year from today is not as
valuable as a dollar received today, its value is
discounted by time - I year
Capital budgeting decisions







If the dollar received today could be invested and earn 10%,
then in a year it will be worth $1.10,
But, the dollar we receive is a year will just that $1.
To find the value of a dollar that will be received in the future
we discount it by the rate it could have earned, 10%.
So 1/1.10 =$.909.
And $ .909 invested at 10% for I year will grow to $1.
That shows us that in todays terms a dollar received today is
worth $1 but a dollar received in in year is worth only $.909
cents today
This is why we prefer a dollar today and why discounting
future cash flows to todays value helps us make sound
responsible financial investment decisions.
Capital budgeting decisions


If we discount by a set amount say 10% to find the
value of a dollar received in the future to a present
value $, the dollar value of the discounted sums is
called the net present value, NPV
If we discount so that the NPV = 0 this is called the
internal rate of return.
Capital Budgeting

These techniques include:
 Payback
Period
 Discounted Payback
 Net Present value
 Internal rate of return
 Modified internal rate of return
 Accounting rate of Return

How do I do this, Which one should I use, and Why?
Payback Period
The payback period calculates how long it takes to have your
investment returned to you in years, or months.
 This is the simplest method for assessing a projects return.
Using Project 1 above

Year
0
1
2
3
Cash Flow
-$40,000
-$40,000
$110,000
$130,000
Cumulative cash flows
-$40,000
-$80,000
$30,000
$160,0000
It took 2. 72 years to receive cash flows sufficient to return the capital
invested.
Decision Rule
 The project that pays back in shortest time is most desirable.
Discounted Payback Period
The payback does not distinguish the future dollars from todays dollars. A dollar
received in 4 years hence is worth less than a dollar received today. We can discount
the future values by a discount rate, say 10% and recalculate the payback based on the
more realistic values.



Year
Cash Flow
Discount rate
Discounted value
Cumulative
Cash Flows
0
-$40,000
0
-40000
-$40,000
1
-$40,000
1.1
-36,366
-$76,366
2
2
$110,000
(1.1)
90909.9
+$14543
3
3
$130,000
(1.1)
This gives a payback in 2.84 years as opposed to 2.72. Usually the discounted
payback takes longer.
Decision Rule
 The project that pays back in shortest time is most desirable.
Net Present Value (NPV)





This technique estimates the present value of a stream of
cash inflows and outflows over different time periods.
If the NPV is greater than zero then the project is viable.
It discounts cash inflows and outflows using a discount
rate, to find its NPV.
This technique was first used in 1951.
Today it is the most common method used in financial
textbooks and by companies.
To undertake a NPV calculation an estimate of the size
and timing of all the cash flows as well as an estimate
of a discount rate is required.
Net Present Value (NPV)
Value of NPV Interpretation
NPV > 0
the project would add
value to the firm
the project would not
add value to the firm
the project would neither
add nor lose value
for the firm
Action
the project
may be accepted
NPV < 0
the project
should be rejected
NPV = 0
as the project neither
adds nor subtracts from
the value we are
indifferent to the project
The decision to proceed or reject the project will be based on
availability of other projects or other criteria.
Net Present Value (NPV)


Selecting the proper discount rate is critical to the
correct calculation.
The NPV is determined by the discount rate, also
called the hurdle rate—is crucial to making the right
decision. The hurdle rate is the minimum acceptable
rate of return on an investment.
Net Present Value (NPV)

The formula to discount one future cash flow to its
present value is:
PV = FV/(1+r)n
 PV= Present value
 FV = Future value
 r = discount rate
 n = number of years
Net Present Value (NPV)
However where there is more than one future cash flow you use
the following formula
Or
-C0 = Initial Investment
C = Cash Flow
r = discount rate
1,2,3, n = time
Net Present Value (NPV)
Looking at project 1.
The project incurs cost of $40000 in each of the 4 years, but
In year 2 the project earns a net cash inflows for the first time of $110000.
In year 3 the project earns a net cash inflow of $1300000.
Year
0
1
2
3
Cash Flow
-$40,000
-$40,000
$110,000
$130,000
Total costs$160,000
Discount rate
0
1.1
(1.1)2
(1.1)3
Present Value
-$40,000
-$36,363.64
$90,909.09
$97,670.92
+$112,216.37
Net Present Value (NPV)
Net Present Value = $112,216.37
Net Present Value (NPV)
Decision Rule.
If at the end the NPV is greater than zero then the
project is viable.
Discount Rate



The discount rate is the rate used to convert the cash
flows into todays value, the present value.
The rate used should reflect the riskiness of the
investment, as well as the volatility of the cash flows.
It must also take into account the financing mix,
internal, raising capital from owners plus outside
financing from banks or bond issuing.
Net Present Value (NPV)
Different discount rates
 If the company produces across a number of
industry types and the cost of capital is different in
each,
a
different hurdle rate should be used for each project
that reflects the risk of each project.

A higher discount rate would be used if
a
project's risk is higher than the risk of the firm as a
whole.
Net Present Value (NPV)
How do you estimate the discount rate?
 To estimate the cost of the financing mix Managers often use
models such as the Capital Asset Pricing Model, (CAPM) to
estimate the appropriate discount rate for each particular
project.
 CAPM uses the cost of the financing mix - debt plus equity,
weighted by their respective share of the total.
 This is called the weighted average cost of capital (WACC),
when it is used as the discount rate to calculate the NPV it is
referred to as the hurdle rate. This is because each project
must earn a return greater than the cost of capital. If not
there is no financial/economic reason to proceed with the
project.
Net Present Value (NPV)
Problems with the NPV Calculations
 Choosing the discount rate
 Choosing the correct premium to add as a risk factor to the
discount rate. If this is simply based on a bank premium it
may be incorrect and result in a misleading indicator of
economic value.
 Depending upon the industry, cash flows at the end of the
life of the project may become negative (e.g. if large
remediation of the site is required), in areas such as mining.
This can be catered for by explicitly allowing for financing
the losses- negative cash outflows.
 The NPV shows you whether your return is above your
required return but it does not give you an actual return. In
order to calculate this you need to do an IRR calculation.
Internal Rate of return
The IRR is the rate of return such that the present
value equals zero.
Internal rate of return and net present value
 IRR uses a similar technique to the one used in NPV
(to convert the future cash flows into present day
dollars) except a different discount rate is used. The
IRR is the discount rate that gives a NPV of zero.
 IRR is used as a measure of investment efficiency.

Internal Rate of return



The IRR method will result in the same decision as the
NPV method, (see table below).
In the usual cases where a negative cash flow occurs at
the start of the project, followed by all positive cash
flows projects that have a higher IRR higher than the
hurdle rate should be accepted.
Nevertheless, for mutually exclusive projects, it is
possible that if a company’s decision rule requires them
to choose the project with the highest IRR - which is
often used – they may be selecting a project with a
lower NPV.
Internal Rate of return
Value of NPV
Value of IRR
Interpretation/Action
NPV > 0
IRR> NPV
NPV < 0
IRR<NPV
NPV = 0
IRR= NPV
the project would add value to the
firm the project may be accepted
the project would not add value to the
firm the project should be rejected
The project would neither
add nor lose value for the firm As the
project neither adds nor subtracts
from the value so we are indifferent to
the project.
The decision to proceed or reject the
project will be based on availability of
other projects or other criteria.
Internal Rate of return




To find the IRR we use the same formula as used in
NPV but insert a new value for the discount rate.
This discount rate is found by trial and error.
In our example above we found that the NPV of our
project is $112,216 when a hurdle rate of 10% is
used.
We know the project cost $160,000 and earned
$320, 000, so we might start with a discount rate of
45%
Internal Rate of return
In 2015 the project costs $40000
In 2016 the project costs another $40000
In 2017 the project earns a net cash inflows for the first time of
$110000.
In 2018 the project earns a net cash inflow of $1300000.
Year
0
1
2
3
Total costs
Cash Flow
-$40,000
-$40,000
$110,000
$130,000
$160,000
Present Value - IRR at 45%
-$40,000
-$27,586.21
$52,318.67
$42,642.18
$27,374.64
Internal Rate of return
𝑁𝑃𝑉 = −$40,000 +
−$40000
$110000
$130000
+
+
1.45
1.452
1.453
Net Present Value = $27,374.64 and an IRR above 45%. Because the NPV is greater
than zero dollars we have not found the true IRR. We then keep trying to find the IRR
through trial and error.
Year
0
1
2
3
Cash Flow
-$40,000
-$40,000
$110,000
$130,000
total
$160,000
𝑁𝑃𝑉 = −$40,000 +
Present Value - IRR at 65%
-$40,000
-$24,242
$40,404
$28,940
$5,101
−$40000
$110000
$130000
+
+
1.65
1.652
1.653
This is still not zero. It is also a bit misleading. The IRR is unique if one or more years of
net investment (negative cash flow) are followed by years of net revenues. However if
the signs of the cash flows change more than once, there may be several IRRs.
Internal Rate of return
Decision Rule
 If the IRR is greater than the hurdle rate, the
required rate of return by your company, then the
project is Viable.
Internal Rate of return
Problems with IRR Calculation
 Understanding how to interpret the IRR can be problematic. The IRR
does not calculate the actual annual profitability of an investment.



This is because the intermediate cash flows are not reinvested at the
project's IRR, therefore, the actual rate of return will be lower than the
IRR calculated. For this reason a Modified Internal Rate of Return (MIRR)
is often used.
Despite a strong academic preference for NPV, surveys indicate that
executives prefer IRR over NPV, although when they are used
together they produce the strongest information. In a budgetconstrained environment, efficiency measures should be used to
maximize the overall NPV of the firm.
Some managers find it intuitively more appealing to evaluate
investments in terms of percentage rates of return than dollars of
NPV.
Modified Internal Rate of Return


The MIRR assumes a different finance rate to the IRR
For instance in our project the finance rate on our
$40,000 investment in years 1 and 2 would be
different from our discount or hurdle rate in years 3
and 4. This is intuitively sensible as we expect to
earn more on our project than the costs of finance.
Modified Internal Rate of Return






In our above example we found an IRR above 71%.
This is not intuitively realistic.
To calculate the MIRR we begin by setting a cost of
finance at 10% and a reinvestment rate at 15%
We then do our calculating in 3 steps.
Step 1. calculate the present value of the negative cash
flows (discounted at the finance rate):
Step 2. Calculate the future value of positive cash flows
Step 3. Calculate MIRR.
Modified Internal Rate of Return
Year
Cash Flow
0
1
2
3
-$40,000
-$40,000
$110,000
$130,000
total costs $160,000
Present Value Future Value
at 10% discount at 15% discount
-$40,000
-$36,364
$126,500
$130,000
- $76,364
$256,500
Modified Internal Rate of Return
Step 1. Present Value of investment
Step 2.
(110,000*1.15) +130000 = 256,500
Step 3. Calculate the MIRR:
= 49.75%
this formula can be done in excel or in steps
In steps –
calculator
Step 1 divide 256500/76364 = 3.359
Step 2 use cubic square root function on
Step 3 subtract 1
Modified Internal Rate of Return
Using the MIRR we get a return of approximately
50%, less than the estimated 71% using IRR, it is a
more realistic estimate of our return.
Decision Rule
 If the MIRR is greater than the hurdle rate, the
required rate of return by your company, then the
project is viable.

Accounting Rate of return


The ARR, often also referred to as the average rate
of return, calculates the accounting profit amount of
an investment made. It is calculated by dividing the
average profit by the initial investment to get the
ratio or return that can be expected. This allows the
company to then compare the outcome of this
project to other projects.
ARR does not take into account the time value of
money and for this reason considered to lack the
sophistication of NPV or IRR.
Accounting Rate of return



ARR = Average return during period/ average
investment
Average Investment = Book value at beginning of
year 1 less book value at end/divided by 2
Average return = incremental revenue less
incremental expense.
Accounting Rate of return


Using Project 1 An initial investment of $40,000 in year 1 and 2 is
expected to generate cash inflow of $110000 in year 3 and
$130000 in year 4.
We assume that at the end of the 4 years the machine will be worth
$20,000 and we can sell it for this amount. During the projects life
we can depreciate the equipment using the straight line basis. We
can calculate ARR assuming that there are no other expenses on the
project.
Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in
Years
Annual Depreciation = ($160,000 − $20,000) ÷ 4 ≈ $35000
Average Accounting Income = (110000 +130000)/4 )− 35000 =
$25,000
Accounting Rate of Return = $25000÷ $160,000 ≈ 15.6%
Accounting Rate of return

This method like the payback is simple to calculate,
however it ignores the real (time) value of money. It
is also common to find it calculated differently and
as such consistency can be a problem.
Decision Rule
 Accept project if ARR is equal to, or greater than
the required rate of return
Capital budgeting decisions
technique
Accept
Reject
Not sure
Payback
Shortest number
of years
Longest number mid range and strong
of years
NPV with IRR > NPV
Discounted payback
Shortest number
of years
Longest number mid range and strong
of years
NPV with IRR > NPV
Net Present value
NPV>0
NPV<0
NPV=0 project neither
adds value nor costs the
firm
Internal rate of return
NPV>0 and
IRR>NPV
NPV<0
IRR<NPV
NPV=0
IRR+NPV
Modified internal rate
of return
NPV>0 and
MRR>NPV
NPV<0
MRR<NPV
NPV=0
MRR+NPV
Accounting rate of
return
ARR> required
rate of return
ARR< required
rate of return
ARR=required rate of
return
How do we choose the correct project?
Payback
Discounted
payback
NPV
IRR
MIRR
ARR
Payback
Discounted
payback
NPV
IRR
MIRR
ARR
Return
2.73years
2.84 years
Return
3.64 years
3.97 years
Return
2.78 years
2.92 year
Project 4
Return
2.9 years
3.1years
$112,216
71%
50%
28.1%
$30,353
11%
11%
6.75%
$140,120
52%
40%
30.9%
$115,326
40%
34%
35.16%
Rank
1
1
Rank
4
4
Rank
2
2
3
1
1
3
4
4
4
4
1
2
2
2
Project 4
Rank
3
3
2
2
3
1
Capital budgeting decisions

Project 1
 Ranks
1 on 4 methods
 Payback,

Project 2
 Ranks

4 under every technique
Project 3
 Ranks

discounted payback, IRR and MIRR
1using NPV only
Project 4

Ranks 1 using Accounting rate of return
Capital budgeting decisions



1.
2.
3.
Project 1 is overwhelmingly the best project using these
techniques.
It pays back our investment in the shortest time as well
as having the highest internal rate of return
However this number crunching is only the first step in
our review.
Does this business sit well with our other businesses?
We have used the same hurdle rate on each
investment, was this appropriate?
What is the actual risk of each of these businesses
Risk – Questions Directors Need to Ask
4.
How well do the proposed businesses fit with our
present business, risk appetite and ethics?
5.
What are the main risks we need to consider of
the alternate projects
Strategic Risk:
A possible source of loss that might arise from the pursuit
of an unsuccessful business plan
Financial Risk:
is an umbrella term for multiple types of risk associated
with financing, including financial transactions that
include company loans in risk of default.
Risk – Questions Directors Need to Ask
Regulatory Risk2.
is the risk of a change in regulations and law that might
affect an industry or a business.
Systematic Risk
risk of collapse of an entire financial system or entire
market, as opposed to risk associated with any one
individual entity, or group.
Process Risk:
Probability of loss inherent in business processes. The risk
that a manufacturing company might produce
contaminated food.
2. The definitions for the risk have been taken from Wikipedia, unless stated otherwise
Risk – Questions Directors Need to Ask
Legal Risk
The risk of financial or reputational loss arising from:
 regulatory or legal action;
 disputes for or against the company;
 failure to correctly document, enforce or adhere to
contractual arrangements;
 inadequate management of non-contractual rights; or
 failure to meet non-contractual obligations
 changes to laws affecting your business2
 the cost and loss of income caused by legal uncertainty,
multiplied by possibility of the individual event or legal
environment as a whole.3
2. Kevin Johnson and Zane Swanson "Legal Risk in the Financial Markets" Management Accounting Quarterly, Full 2007
3.Tat Chee Tsui. "Experience from the Anti-Monopoly Law Decision in China (Cost and Benefit of Rule of Law)." The Network:
Business at Berkeley Law (Apr/ May 2013)
Risk – Questions Directors Need to Ask
Operational Risk is "the risk of a change in
value caused by the fact that actual losses,
incurred for inadequate or failed internal
processes, people and systems, or from
external events (including legal risk), differ
from the expected losses".
Basel II: Revised international capital framework". Bis.org. Retrieved 2013-06-06.
Risk – Questions Directors Need to Ask
Reputational Risk:
is a risk of loss resulting from damages to a
firm's reputation, in lost revenue; increased
operating, capital or regulatory costs; or
destruction of shareholder value consequent
to an adverse or potentially criminal event
even if the company is not found guilty.
Adverse events typically associated with
reputation risk include ethics, safety, security,
sustainability, quality, and innovation.
Reputational risk can be a matter of
corporate trust.
(Wikipedia)
Risk – Questions Directors Need to Ask
6. What are we doing to measure and assess these?
7. What can we learn from the experience of others?
A report by the financial subcommittee on capital
budgeting will include a discussion of each of these
areas as well as capital budgeting techniques.
Only when the returns and risks are reviewed together
can the company make a decision.