Corporate Finance

Capital

Budgeting

Techniques
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 Capital Budgeting Techniques
 Capital Budgeting – A tool used to assess project acceptability and
ranking. A Process aimed at evaluating and selecting long term
investments that are consistent with the firm’s goal of maximizing owner’s
wealth

 Firms typically make a variety of long term investment which include

investment in fixed asset like property (land), plant and equipment –
“Earning Assets”, generally provide the basis for the firm’s earning power
and value.

 Capital Expenditure is an outlay of funds by the firm that is expected to

produce benefits over a period of time greater than 1 year. An operating
expenditure is an outlay resulting in benefits received within 1 year.

 The basic motives for capital expenditures are to expand operations, to

replace or renew fixed assets or to obtain some other, less tangible benefit
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over a long period.
 Process of Capital Budgeting
 Step-1 Proposal Generation : Proposal for new investment projects made at
all level within business organization. Proposals that require large cash
outlays are scrutinized more carefully.

 Step-2 Review and Analysis : Formal review and analysis to assess the
merits of proposal.

 Step-3 Decision Making : Firms typically delegate capital expenditure

decision making on the basis of financial availability.

 Step-4 Implementation : Following approval, expenditures are made and

projects are implemented.

 Step-5 Follow-up : Results are monitored and actual costs and benefits are
compared with those that were expected.
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 Capital Budgeting – Certain Terminology
 Independent vs. Mutually Exclusive Projects: Projects having cashflows
unrelated to one another are Independent Projects – acceptance of one does
not eliminate others. Mutually exclusive projects have same function and
compete with one another. E.g. To increase production capacity, Company
may (i) expand its plant; (ii) acquire another company; (iii) contract with
another company for production

 Unlimited Funds vs. Capital Rationing: If firm has unlimited funds, all
independent projects with acceptable return can be accepted. Generally, all
firms operate under capital rationing. This means limited funds available for
CaPex and numerous projects compete for funds.

 Accept-Reject vs. Ranking approaches: Former involves evaluating CaPex to

determine whether it meets minimum acceptance criterion. Later involves
ranking Capex proposals on the basis of say rate of return. Only acceptable
projects should be ranked. Proposals with highest return is ranked first.
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 Methods of Capital Budgeting

Three different methods for Capital Budgeting

Techniques :

1. Payback Period

2. NPV(Net Present Value)

3. IRR(Internal Rate of Return)

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 Payback Period

 Pay-back period is the amount of time required for the firm to recover its
initial investment in a project, as calculated from cash inflows.
 It is an unsophisticated capital budgeting technique, because it does not
explicitly consider the time value of money.
 Large firms sometimes use this method to evaluate small projects and small
firms use it to evaluate most projects.

 Decision Criteria
 If the Pay-back period is less than the maximum acceptable Pay-back
period, accept the project.
 If the Pay-back period is greater than the maximum acceptable Pay-back
period, reject the project.
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 Payback Period
 Pros :

 Useful to evaluate small projects.

 It is computationally simple.

 Implicit consideration to the timing of cash flows.

 Cons :

 It is not based on discounting cash flows to determine whether they add to firm’s
value. It is simply maximum acceptable period of time over which management
decides that a project’s cash flow must break even.

 It fails to take fully into account the time factor in the value of money.

 It fails to recognize cash flows that occur after the payback period.
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 Net Present Value (NPV)
 This method is used by most large companies to evaluate investment
projects.

 A firm should undertake an investment only when the value of cash flow
the investment generates is greater than the cost of making investment in
first place.

 NPV method takes into account the time value of money, it is more
sophisticated capital budgeting technique than payback rule.

 The NPV is found by subtracting a project’s initial investment (CF0) from the
present value of its cash inflows (CFt) discounted at a rate equal to firm’s
cost of capital(r) i.e. minimum return that must be earned on a project to
satisfy the firm’s investors.

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 Net Present Value (NPV)

 Formula :

 NPV = Present value of cash inflows – Initial Investment

𝑛
𝐶𝐹𝑡
𝑁𝑃𝑉 = 𝑡
− 𝐶𝐹0
(1 + 𝑟)
𝑡=1

 Decision Criteria :

 If the NPV is less than 0 (i.e. Negative), reject the project.

 If the NPV is greater than 0 (i.e. Positive), accept the project.

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 Net Present Value (NPV)

 Profitability Index (PI) - A variation of NPV rule

𝑛 𝐶𝐹𝑡
𝑡=1 (1 + 𝑟)𝑡
𝑃𝐼 =
𝐶𝐹0
 Decision Criteria :
 If the Profitability Index is less than 1.0, reject the project.
 If the Profitability Index is greater than 1.0, accept the project.
 NPV and PI :
 PI greater than 1 implies Positive NPV i.e. greater than zero and vice versa.
 PI and NPV always come to the same conclusion.

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 IRR (Internal Rate of Return)
 It is the discount rate that equates present value of cash inflow with initial
investment.
 It equates NPV to Zero.

 Formula:
𝑛
𝐶𝐹𝑡
$0 = 𝑡
− 𝐶𝐹0
(1 + 𝑟)
𝑡=1

𝑛
𝐶𝐹𝑡
𝑡
= 𝐶𝐹0
(1 + 𝑟)
𝑡=1

 Decision Criteria :
 If the IRR is less than Cost of Capital, reject the project.
 If the IRR is greater than Cost of Capital, accept the project. 11
 Comparing NPV & IRR Techniques
 NPV assumes that intermediate cash flows are reinvested at the cost of
capital, whereas IRR assumes that intermediate cash inflows are reinvested
at a rate equal to the project’s IRR.

 Conflicting rankings emerge using NPV & IRR result from differences in the
reinvestment rate assumption, timing of each project’s cash flows and the
magnitude of the initial investment.

 Theoritically, NPV is a better approach to capital budgeting as it measures

how much wealth a project creates for shareholders

 Despite this, Financial Managers use IRR approach just as often as the NPV
method.

 Edge of IRR approach is due to general disposition of business people to

think in terms of rates of return rather than actual returns in value.
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