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CAPITAL BUDGETING AND ITS TECHNIQUES IN THE BANK

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 BANGLADESH RESEARCH PUBLICATIONS JOURNAL
ISSN: 1998-2003, Volume: 9, Issue: 4, Page: 249-259, March - April, 2014
Review Paper
CAPITAL BUDGETING AND ITS TECHNIQUES IN THE BANK

Sourav Paul Chowdhury1, Rony Kumar Datta3, *Md. Shamim Hossain2, Mahbuba Aktar3 and Jesmin Ara3

Sourav Paul Chowdhury, Rony Kumar Datta, Md. Shamim Hossain, Mahbuba Aktar and Jesmin Ara (2014)
Capital Budgeting and its Techniques in the Bank. Bangladesh Res. Pub. J. 9(4): 249-259. Retrieve from
http://www.bdresearchpublications.com/admin/journal/upload/1309134/1309134.pdf

Abstract
This study attempts to highlight the capital budgeting phenomena and capital
budgeting techniques on the cash flows of bank. Capital budgeting is the process
that requires planning for setting up budgets on projects expected to have long-
term implications, which is used as a standard for decision making for any
organization. The study exposes as well that if a market based cost of capital is
used to discount cash flows, the cash flows should be adjusted upwards to reflect
the effects of inflation in forthcoming periods. The researchers find that bank lends
its fund to the client at zero NPV that produces PI exactly 1. This study states that
inflation adjusted to the risk factor result in less NPV than not adjusting inflation to
the risk factor. The study finds the equality between the rate of cost of capital and
IRR. In addition to it, the researchers find the MIRR greater than the IRR.

Keywords: Capital budgeting, Bank, Cash flow, Cost of Capital, Investment, Inflation
and Discount Rate.
Introduction
Capital budgeting is an important aspect of decision-making in governments. Recent
years have witnessed significant developments in the use of capital budgeting techniques
which range from simple cost-benefit analysis to more complex decision-making models
(Aman Khan, 1987). Capital budgeting (or investment appraisal) is the planning process
used to determine whether a firm's long term investments such as new machinery,
replacement machinery, new plants, new products, and research development projects
are worth pursuing. It is budget for major capital, or investment, expenditures (Sullivan, et
al. 2003). Optimization can, at least intuitively, be seen as the method in assessing capital
allocation problems (Luenberger, 1998). The study of Abuzar Eljelly & Abubakr; Abuidris
(2001) surveys the capital budgeting practice in private and commercially-oriented
public sector enterprises in the Sudan, an African Less Developed Country (LDC). Their
study attempts to fill a gap in the existing literature by documenting the capital budgeting
practice in an LDC where the economic environment is different than the developed and
developing counterparts and where public sector still plays a major role in the economy.
Edward et al. (2001) focus that the early 1950s, the academic community has tried lo
convince corporate managers that there are sophisticated techniques that can improve
the capital budgeting decision-making process. Over the years, many studies have
documented a trend toward increasing business use of such sophisticated capital
budgeting techniques. The capital budgeting techniques are focused in this study. The
simple rate of return method is another capital budgeting technique that does not involve
discounted cash flows. The method is also known as the accounting rate of return, the
unadjusted rate of return, and the financial statement method. Unlike the other capital
budgeting methods that have been discussed in this paper, the simple rate of return
method does not focus on cash flows. Rather, it focuses on accounting net operating
income/income. The approach is to estimate the revenue that will be generated by a

*Corresponding Author: E-mail: hmd.shamim@gmail.com

1Dept. of Management, Hajee Mohammad Danesh Science and Technology University (HSTU), Dinajpur,
Bangladesh.
2 Dept. of Marketing, HSTU, Dinajpur, Bangladesh.
3 Dept. of Finance and Banking, HSTU, Dinajpur, Bangladesh.
Chowdhury et al. 250

proposed investment and then to deduct from these revenues all of the projected
expenses associated with the project. The net operating incomes then related to the initial
investment in the project. Accounting rate of return (ARR) measures profitability from the
conventional accounting standpoint by comparing the required investment (sometimes
average investment) to future annual earnings. Brijlal, Pradeep‘s (2008) paper revealed
that most businesses used the cost of bank loan as a basis in capital budgeting and more
than two thirds of respondents used non-quantitative techniques to consider risk when
making a decision on investing in fixed assets. Prather, et al. (2009) determine how small
rural firms apply capital budgeting techniques; they surveyed 281 members of the Durant,
Oklahoma Chamber of Commerce. Their goal is to determine whether these small rural
firms practice what academics teach. Their survey covered a variety of discounted cash
flow (DCF) and other traditional techniques and also examined the incidence and
treatment of capital rationing. The survey design permits us to partition results to examine
differences due to firm size, industry, form of business organization, firm age, age and
education level of the primary decision-maker, and whether operations are international
or domestic. They also examine the incidence and treatment of capital rationing. Finally,
they examine the methods used to determine the required return and the use of sensitivity
analysis, scenario analysis, and simulation. They also found that our sample firms operate
in a far less structured manner than optimal. More than 71% of the sample firms did not
have a written business plan. In addition, nearly 66% of the sample firms make capital
budgeting decisions based on managerial judgment or "gut instinct." Moreover, when
questioned about why sophisticated techniques are not used, more than 19% of
respondents were not familiar with the techniques; another 19% did not believe using the
techniques would affect profits, and 28% did not have the staff, time, or experience. Thus,
improving the process might require that additional training be available to these decision
makers. Rappaport and Taggart (1982) examined various methods for incorporating the
effect of inflation into capital budgeting. They provided an analysis which showed the
differential impact of using a gross profit per unit approach, a nominal cash flow
approach (where individual forecasts are incorporated into each component of cash
flow) and a real cash flow approach in which a general price deflator is used to deflate
nominal cash flows. They attempt to combine the simplicity of a gross profit per unit
methodology of adjusting for inflation with the more realistic nominal case flow and real
cash flow approaches. Fama (1975) demonstrates that short term rates accurately reflect
the expectations of future rates of inflation but his methodology and conclusions have
been disputed by several rebuttals. Cagan and Goldolfi (1969) have achieved similar
results for long term rates although they argue the results might not be applicable to short
term rates. It is reasonable to expect that the rate of interest will increase when there are
expectations of higher inflation, but there appears to be little evidence on the
measurement of the cost of capital under inflationary expectations. This is
understandable, given the difficulty in just measuring the cost of capital in a static sense.
Van Horne (1971) showed that to be consistent, inflation in forecasting cash flows must
also be reflected in a discount rate containing inflation; that is, a bias was introduced if
nominal cash flows were discounted at the real and not nominal cost of capital. Geoffrey
Mills (1996) has explored the question of the impact of inflation on the capital budgeting
process. It has shown that it is reasonable to expect that the cost of capital will increase at
the same rate as the rate of inflation on an ex ante basis, and that this increase will be a
multiplicative relationship. The IRR method gives the rate of return result. This is especially
important in our current economic climate, where businesses are trying to cut costs and
only invest in those projects which will yield a higher rate of return (Gitman, 2009). The
internal rate is the discount rate that equates the present value of cash inflows with initial
investment associated with a project their by causing NPV= 0 (Khan & Jain 2007-08). The
internal rate of return (IRR) is the rate of return promised by an investment project over its
useful life. It is some time referred to simply as yield on project. Generally speaking, the
higher a project's internal rate of return, the more desirable it is to undertake the project.
Recent studies (Pradeep Brijlal, 2008)) highlight that financial managers worldwide favor
methods such as the internal rate of return (IRR) over the net present value (NPV), which is
the model academics consider superior. Despite the emergence of new methods, the
traditional ones, NPV and IRR are still the most popular (Remer and Nieto, 1995). However,
it can be argued that a shift from IRR methods towards the NPV methods has occurred

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Capital Budgeting and its Techniques 251

from the 1970s to 1990s. They suggest the process of implementing NPV in capital
budgeting problem being the following: determine the interest rate for the future cash
flows, estimate the economic useful life of the project, estimate the cash flows of the
project, calculate the net cash flows and calculate the present value (PV) of these net
cash flows. As many scholars agree, NPV is simple to calculate (Dixit and Pindyck, 1995).
Additionally, it holds no risk of ambiguous roots, as is in the case of IRR. On the other hand,
IRR depends only on the properties of the cash flow stream, having nothing to do with the
prevailing discount rate, which is sometimes troublesome to calculate. Considering these
factors, it seems that both methods have their place in investment appraisal, but in
different situations. Pandy (2005) states that the profitability index is the ratio of net present
value of cash inflows at required rate of return to the initial cash out flows of investment.
The profitability index, or PI, method compares the present value of future cash inflows
with the initial investment on a relative basis and payback period is defined as the
number of the years required to recover the original cash outlay invested in the project.
He states that the number of period taken in recovering the investment outlay on
presented value basis is the discounted payback period. Even though the payback
method has some cons associated with it, the simplicity of the method can allow it to be
used as a filter for those projects which should go on to a more in-depth method, if a
project is not recommended based on the payback method, then chances are pretty
high the project should not even be considered for the other method Gitman, (2009).The
real options approach embraces the concept of uncertainty. There must be uncertainty
in terms of future cash flows deriving from the investment, and management must have
flexibility to assess this uncertainty as it evolves (Gilbert, 2004). As uncertainty is in the core
of this approach, investments that can be described as 'cash cow' –investments are well
analyzed with existing (DCF-based) techniques.
Objectives
This study covers the following objectives in respect to capital budgeting and its
techniques in the bank.
(i) To know the meaning of capital budgeting and its techniques.
(ii) To find out the value of these techniques applied on bank cash flows.
(iii) To find out the comparisons from these results achieved.
Methodology
This research was the descriptive in nature and the primary information was used in it. The
researchers used the cash flows, here it was considered that monthly installments paid by
the client were cash inflows and the amount lent to the client was the cash outflow made
by the Prime Bank Ltd, Dinajpur Branch, Dinajpur. And the other cases the data had been
made on the assumed basis. The methods of capital budgeting had been applied on the
stated cash flows. The following equations of capital budgeting techniques had been set
to the cash flows and the numerical data. The economic variable inflation that has the
impact on the value of Net Present Value (NPV) was considered in the study.
N e t A n n u a l P ro fit
ARR= ..............................................1 .1
In v e stm e n t O u tla y

In c re m e n ta l n e t o p e ra tin g in c o m e
Or ARR= .....................1 .2
In itia l In v e stm e n t

A v e ra g e In c o m e
Or ARR= ..........................................1 .3
A v e ra g e I n v e stm e n t

In c re m e n ta l N e t O p e ra tin g In c o m e
Or ARR= ....................1 .4
In itia l In v e stm e n t

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Chowdhury et al. 252

-n m
  r  
1- 1+ m  
NPV =CI     
 r  I 0
.. ..... ..... ..... ...... ..... ..... ..... ...... ..2
 m 
 

-nm
  r  
 1-  1+  
m
PI=CI   
 /I 0
.....................................................3
 r
 m 
 

n C Ft
IR R :   tk 0  N P V ......................4
t  0 1  I R R  t

TV
P V costs= n
....................................................5
1 +M IR R 
U
PBP= Y+ ......................................................................6
C
U
D PBP= Y+ .. .. .. .. .. .. .. .. .. .. .. .. .. ... .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ... 7
C
C F1 C F2 C F3 C Fn
D C F= 1
+ 2
+ 3
+..............+ n
...........8
1+r  1+r  1+r  1+r 
ARR denotes accounting rate of return, CI denotes cash inflows, r is the discount rate, m is
the frequency, n is the number of year, I 0 indicates initial investment, PI is the profitability
index, IRR states internal rate of return, CFt represents cash flows at time period t, PV is the
present value, TV is the terminal value, MIRR is the modified internal rate of return, PBP is
the payback period, Y denotes year before full recovery, U is the unrecovered cost and C
is the cash flow during recovery period, DPBP states discounted payback period and DCF
is the discounted cash flow.
Result and Discussion
Terminologies to Capital Budgeting
Time Value of Money: Investments commonly involve returns that extend over fairly long
period of time. Therefore, in approaching capital budgeting decisions, it is necessary to
employ techniques that recognize the time value of money. “A dollar today is worth more
than a dollar a year from now” Cash out flows and Cash inflow: Cash outflow is the initial
investment (including installation costs). It entails increased working capital needs for
project and repairs and maintenance as well As incremental operating cost. Cash inflows
include Incremental revenues reduction in costs, salvage value, release of working
capital. Cost of capital: it is the required rate of return of different types of financings.
Weighted average cost of capital is the composite cost of capital of financing or it is the
total cost of capital. Present value and future value: Present value is the discounted value
of the future receipt and future value is the compound interest rate of present receipt. F1
= P ( 1 + r ) and P = Fn / (1 + r )n where: F1 = the balance at the end of one period, P =
the amount invested now, and r = the rate of interest per period. n = number of year.
Terminal Cash flow: It includes the net cash generated from the sale of the assets, tax
effects from the termination of the asset and the release of net working capital. Free Cash
Flow: A measure of financial performance calculated as operating cash flow minus
capital expenditures. Free cash flow (FCF) represents the cash that a company is able to
generate after laying out the money required to maintain or expand its asset base.
Techniques used in Capital Budgeting
The accounting rate of return that does not involve discounted cash flows. The method is
also the unadjusted rate of return, and the financial statement method. Accounting rate
of return (ARR) measures profitability from the conventional accounting standpoint by
comparing the required investment (sometimes average investment) to future annual
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Capital Budgeting and its Techniques 253

earnings. Each potential project's value should be estimated using a discounted cash flow
(DCF) valuation, to find its net present value (NPV). This valuation requires estimating the
size and timing of all of the incremental cash flows from the project. The profitability index,
by definition, is the ratio of the present value of the benefits (PVB) to the present value of
the cost (PVC). This simple benefits-to-costs ratio will remove the scale effect's bias. We
obviously prefer to invest in the asset that has the higher value for the profitability index.
The internal rate of return (IRR) is defined as the discount rate that gives a net present
value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR
method will result in the same decision as the NPV method for (non-mutually exclusive)
projects in an unconstrained environment, in the usual cases where a negative cash flow
occurs at the start of the project, followed by all positive cash flows. The IRR equation
generally cannot be solved analytically but only via iterations. One shortcoming of the IRR
method is that it is commonly misunderstood to convey the actual annual profitability of
an investment. The cost of capital is a screening tool, in case of the Net Present Value
Method and the cost of capital is used as the discount rate when computing the net
present value of a project. Any project with a negative net present value is rejected
unless other factors dictate its acceptance and in case of the Internal Rate of Return
Method, the cost of capital is compared to the internal rate of return promised by a
project. However, this is not the case because intermediate cash flows are almost never
reinvested at the project's IRR and therefore, the actual rate of return is almost certainly
going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR)
is often used. The payback is another method to evaluate an investment project. The
payback method focuses on the payback period. Payback is often used as a "first
screening method". By this, it is meant that when a capital investment project is being
considered, the first question to ask is: 'How long will it take to pay back its cost?' The bank
/ company might have a target payback, and so it would reject a capital project unless
its payback period was less than a certain number of years. The payback period is the
length of time that it takes for a project to recoup its initial cost out of the cash receipts
that it generates. This period is sometimes referred to as" the time that it takes for an
investment to pay for itself." The basic premise of the payback method is that the more
quickly the cost of an investment can be recovered, the more desirable is the investment.
A valuation method used to estimate the attractiveness of an investment opportunity.
Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts
them (most often using the weighted average cost of capital) to arrive at a present value,
which is used to evaluate the potential for investment. If the value arrived at through DCF
analysis is higher than the current cost of the investment, the opportunity may be a good
one. Certainty Equivalent Technique is the common procedure for dealing with in capital
budgeting is to reduce the forecast of cash flows to some conservative level. Risk adjusted
discount rate states that if the time preference of money is to be recognized by
discounting estimated future cash flows at some risk free rate to their present value, then
to allow for the riskiness of those future cash flows at risk premium rate may be added to
risk free discount rate such composite discount rate. The study reveals that that the bank
use capital budgeting techniques in their capital investment decisions as well as the
majority of private sector companies that these methods.
Capital Budgeting Decisions and its Importance
Business decisions that require capital budgeting analysis are decisions that involve in
outlay now in order to obtain some return in the future. This return may be in the form of
increased revenue or reduced costs. Capital budgeting decisions include: cost reduction
decisions, expansion decisions, equipment selection decision, lease or buy decisions and
equipment replacement decisions. Besides capital budgeting as a least cost decisions
reveals that revenues are not directly involved in some decisions. The success of a business
depends on the capital budgeting decisions taken by the management. The
management of a company should analyze various factors before taking on a large
project. Firstly, management should always keep in mind that capital expenditures require
large outlays of funds. Secondly, firms should find modes to ascertain the best way to raise
and repay the funds. The management should also keep in mind that capital budgeting
requires a long-term commitment. The requirement for relevant information and analysis
of capital budgeting has paved the way for a series of models to assist firms in amassing

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Chowdhury et al. 254

the best of the allocated resources. One of the oldest methods used is the payback
model; the process determines the length of time required for a business to recover its
cash outlay. Another model, known as return on investment, evaluates the project based
on standard historical cost accounting estimates. Popular methods of capital budgeting
include net present value (NPV), discounted cash flow (DCF), internal rate of return (IRR),
and payback period. While working with capital budgeting, a firm is involved in valuation
of its business. By valuation, cash flow is identified and discounted at the present market
value. In capital budgeting, valuation techniques are undertaken to analyze the impact
of assets instead of financial assets. The importance of capital budgeting is not the
mechanics used, such as NPV and IRR, but is the varying key involved in forecasting cash
flow. William et al. (2001) state that capital budgeting decisions are crucial to a firm's
success for several reasons first, capital expenditures typically require large outlays of
funds. Second, firms must ascertain the best way to raise and repay these funds. Third,
most capital budgeting decisions require a long-term commitment. Finally, the timing of
capital budgeting decisions is important. When large amounts of funds are raised, firms
must pay close attention to the financial markets because the cost of capital is directly
related to the current interest rate.
Inflation Involvement in cash flow term of Bank
The effect of inflation is considered on the appraisal of capital investment proposals.
Discounted cash flow techniques, such as the net present value method, consider the
timing and amount of cash flows. To use the net present value method, you will need to
know the cash inflows, the cash outflows, and the company's required rate of return on its
investments. The required rate of return becomes the discount rate used in the net present
value calculation. NPV compares the value of a dollar today to the value of that same
dollar in the future, taking inflation and returns into account Inflation is particularly
important in developing countries like Bangladesh, as the rate of inflation tends to be
rather high. As inflation rate increases, so will the minimum return required by an investor.
For example, one might be happy with a return of 10% with zero inflation, but if inflation
was 20%, one would expect a much greater return. A hypothetical example is provided
below- Suppose X bank is considering in investing by giving loan to the account holder
return backed within three year having the following uneven installments basis of Tk
1,00,000 investments.
Table 1 Cash outflow and inflows
Investment consideration of Bank Taka
Time period (year) at 0 (1,00,000)
,, 1 90,000
,, 2 80,000
,, 3 70,000

The Bank requires a minimum return of 40% under the present conditions. Inflation
(assumed) is currently running at 30% a year and this is expected to continue indefinitely.
Should The Bank go ahead with the investment? Let us take a look at the Bank’s required
rate of return, if it invested Tk10,000 for one year on 1 January, then on 31 December it
would require a minimum return of Tk 4,000. With the initial investment of Tk10,000, the total
value of the investment by 31 December must increase to Tk 14,000. During the year, the
purchasing value of the dollar would fall due to inflation. It can be restated the amount
received on 31 December in terms of the purchasing power of the taka at 1 January as
follows:
Amount received on 31 December in terms of the value of the taka at 1 January:
= Tk 14,000/ (1+ 30%) 1
= Tk 10,769
In terms of the value of the taka at 1 January, Bank would make a profit of Tk 769 which
represents a rate of return of 7.69% in "today's money" terms. This is known as the real rate
of return. The required rate of 40% is a money rate of return (sometimes known as a
nominal rate of return). The money rate measures the return in terms of the dollar, which is

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Capital Budgeting and its Techniques 255

falling in value. The real rate measures the return in constant price level terms. The two
rates of return and the inflation rate are linked by the equation:
(1 + MR) = (1 + real rate) x (1 +IR) Where, MR: Money Rate, RR: Real Rate
and IR: Inflation rate
(1 + 0.40) = (1 + 0.0769) x (1 + 0.3)
= 1.40
Which rate is used in discounting? As a rule of thumb: a) If the cash flows are expressed in
terms of actual taka that will be received or paid in the future, the money rate for
discounting should be used. b) If the cash flows are expressed in terms of the value of the
taka at time 0 (i.e. in constant price level terms), the real rate of discounting should be
used. In the Bank’s case, the cash flows are expressed in terms of the actual taka that will
be received or paid at the relevant dates. Therefore, we should discount them using the
money rate of return.
Table 2. Present value from cash flows
Time Cash Flow PV at 40% rate PV at 30% inflation rate PV at 7.69% real rate
Taka Discount PV Discount PV Discount PV
Factor (Taka) Factor (Taka) Factor (Taka)
1 2 3 4=2x3 5 6=2x5 7 8=6x7
0 ( 1,00,000) 1.000 (1,00,000) 1.000 (1,00,000) 1.000 (1,00,000)
1 90,000 .714 64,260 .769 69210 1.0769 -1 64268
2 80,000 .510 40,800 .592 47360 1.0769 -2 40838
3 70,000 .364 25,480 .455 31850 1.0769 -3 25502
NPV 30,540 30,608

The NPV is greater at 30% inflation rate plus 7.69% real rate that is 30,608>30,540. The
investment has a positive net present value of Tk 30,540, so Bank should go ahead with
the this investment of loan to client.
Inflation and Tax Effect on Capital Budgeting in Bank
Much research has been published examining the impact of inflation on the capital
budgeting decision making process, and, although inflation is not currently the serious
problem, rapid prices increases, coupled with the potential of future inflation, argue for
continued research in this field. Inflation of the national economy is one of the important
drives to influence the capital budgeting decision in the banking sectors in this country.
The inflation rate is adjusted with interest rate having for the maintenance of real/ actual
cash flows. Many organizations do not pay income taxes. Not-for-profit organizations, such
as hospitals and charitable foundations, and government agencies are exempt from
income taxes. The organizations that earn profit are not exempted from income tax the
Bank as the profit organizations is responsible to pay tax to the state government at the
given percent on income. Interest rate of the bank is the required rate of return/ hurdle
rate. The empirical evidence with respect to whether or not interest rates would perfectly
reflect expected inflation is strong but also controversial. Cooley, et al (1975) revealed the
mechanics by which inflation adjustments can be incorporated into the capital
budgeting process. At the same time, Nelson (1976) demonstrated the theoretical impact
of inflation on capital budgeting and showed how inflation would shift the entire NPV
schedule of a capital budget downward for a set or projects. Baily and Jensen (1977)
have analyzed how price level adjustments affect the process in detail and specifically
how various price level adjustments might change the ranking of projects. It is assumed
that Prime Bank Limited wants to purchase generator to supply electricity that cost Tk
40,000. The generator would provide annual cost savings of Tk 30,000, and it would have a
three-year life with no salvage value. The Real cost of capital is 12%. For each of the next
three years, Prime Bank Limited expects a 10% inflation rate in the cash flows associated
with the new generator. If Prime Bank Limited’s cost of capital is 23.2%, should the new
generator be purchased? To answer this question, it is important to know how the cost of
capital was derived. Ordinarily, it is based on the market rates of return on the Bank's
various sources of financing - both debt and equity. This market rate of return includes
expected inflation; the higher the expected rate of inflation, the higher the market rate of
return on debt and equity. When the inflationary effect is removed from the market rate
of return, the result is called a real rate of return. For example if the inflation rate of 10% is
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Chowdhury et al. 256

removed from Prime Bank Limited’s cost of capital of 23.2% the real cost of capital is only
12% as shown below:
Table 3. Inflation and Capital Budgeting
Reconciliation of the Market-Based and Real Costs of Capital
The real cost of capital 12.0%
The inflation factor 10.0
The combined effect (12% x 10% = 1.2%) 1.2
The market based cost of capital 23.2%
While Inflation is not Considered
Particular Year(s) Amount of 12% Factor Present Value
Cash Flows of Cash Flows
Initial investment Now Tk (40000) 1.000 Tk (40,000)
Annual cost savings 1-3 30,000 2.402 72,060
Tk 32060*
Net present value
========
While Inflation is Considered
Particular Year(s) Amount of Price Price Adjusted 23.2% Present Value
Cash Index Cash Flows Factor*** of Cash Flows
Flows Number**
Initial investment Now Tk (40,000) 1.000 Tk (40,000) 1.000 Tk (40,000)
Annual cost
1 30,000 1.100 33,000 0.812 26,796
savings
,, 2 30,000 1.210 36,300 0.659 23,922
,, 3 30,000 1.331 39,390 0.535 21,074
Net present Tk 31,792*
value ========
*These amounts are different.
**Computation of the price index numbers, assuming a 10% inflation rate each year: Year 1, (1.10) = 1.10; Year
2, (1.10)2 = 1.21; Year 3, (1.10)3 = 1.331
***Discount formulas are computed using the formula 1/(1 + r)n, where r is the discount factor and n is the
number of years. The computations are 1/1.232 = 0.812 for year 1; 1/ (1.232)2 = 0.659 for year 2; and 1/(1.232)3 =
0.535 for year 3.

When performing a net present value analysis, one must be consistent. The market based
cost of capital reflects inflation. Therefore, if a market based cost of capital is used to
discount cash flows, then the cash flows should be adjusted upwards to reflect the effects
of inflation in forthcoming periods. Computations of Prime Bank Limited under this
approach are given above. On the other hand, there is no need to adjust the cash flows
upward if the "real cost of capital" is used in the analysis (Since the inflationary effects
have been taken out of the discount rat). The cash flows associated with the project are
affected in the same way by inflation. Several points should be noted where the effects of
inflation are explicitly taken into account, first, not that the annual cost savings are
adjusted for the effects of inflation by multiplying each year's cash savings by a price
index number that reflects a 10% inflation rate. Second, note that the net present value
obtained in where inflation is explicitly taken into account, is not the same that obtained
in where the inflation effects are ignored. This result may seem surprising, but it is logical.
The reason is that it has been adjusted both the cash flows and the discount rate so that
they are consistent, and these adjustments cancel each other out across the two results.
When there is inflation, the unadjusted cash flows can be used in the analysis if all of the
cash flows are affected identically by inflation and the real cost of capital is used to
discount the cash flows. Otherwise, the cash flows should be adjusted for inflation and the
market-based cost of capital should be used in the analysis.
Capital Budgeting Techniques to Bank’s cash flows
The ARR method (also called the return on capital employed (ROCE) or the return on
investment (ROI) method) of appraising a capital project is to estimate the accounting
rate of return that the project should yield. If it exceeds a target rate of return, the project
will be undertaken. It is a relative measure rather than an absolute measure and hence
takes no account of the size of the investment. Despite of limitation the ARR method of
capital budgeting is used due to simplicity in manner. To measure the as usual return this
method is used to take decision. The bank, easily and quickly estimating the ARR in
respect of investment, can reach in the quick decision. As it relative measure, the
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Capital Budgeting and its Techniques 257

performance can be measured by ARR method for different period of same bank, for
different periods of different bank / companies or for same period of the different banks.
So, this technique of capital budgeting is useful and bears importance.
Table 4. ARR Calculation
Year Investment Operating Profit ARR
2007 7550606492 2572192720 34.07%
2008 9031698884 3510266937 38.87%
Calculated values of Different Capital Budgeting Techniques
An NPV calculated using variable discount rates (if they are known for the duration of the
investment) better reflects the real situation than one calculated from a constant discount
rate for the entire investment duration. To find the NPV, the researchers used the equation
2. To find out PI, IRR, MIRR, PBP and DPBP, the equations stated in the researcher
methodology were used. Here, the researchers had used the transacted cash flows of
Prim Bank Limited, Dinajpur Branch, Dinajpur in where M/S New Sobhania Library,
Proprietor Mr. Sobhania who had the account in the Prime Bank Limited, Dinajpur Branch.
Mr Sobhania had taken loan from Prime Bank Limited Tk 80, 00,000 at 16% interest for two
year schedule payment. The Prime Bank imposed schedule number of payment 24
monthly basis in equal amount presented in the following table 5.
Table 5 Cash inflows and their calculation
Monthly
Monthly
installment
installment paid Discou
Date / paid by Discoun
by customer / nt DCF Date/ DCF
period customer / t Factor
Monthly Cash Factor period
Monthly Cash
Inflows
Inflows
12/27/08 Tk 391,704.88 0.987 386678.07 12/27/09 391,704.88 0.845 331158.72
1/27/09 391,704.88 0.974 381715.76 1/27/09 391,704.88 0.835 326908.9
2/27/09 391,704.88 0.962 376817.14 2/27/09 391,704.88 0.824 322713.63
3/27/09 391,704.88 0.95 371981.38 3/27/09 391,704.88 0.813 318572.19
4/27/09 391,704.88 0.937 367207.68 4/27/09 391,704.88 0.803 314483.9
5/27/09 391,704.88 0.925 362495.24 5/27/09 391,704.88 0.793 310448.07
6/27/09 391,704.88 0.914 357843.28 6/27/09 391,704.88 0.782 306464.04
7/27/09 391,704.88 0.902 353251.02 7/27/09 391,704.88 0.772 302531.13
8/27/09 391,704.88 0.89 348717.69 8/27/09 391,704.88 0.762 298648.7
9/27/09 391,704.88 0.879 344242.53 9/27/09 391,704.88 0.753 294816.09
10/27/09 391,704.88 0.868 339824.81 10/27/09 391,704.88 0.743 291032.67
11/27/09 391,704.88 0.856 335463.78 11/27/09 391,704.88 0.733 287297.8

1st Year 2nd Year 3705076

4,700,458.56 4326238 4,700,458.56
CI CI

-2 4
  .1 6  
 1-  1 +  
12 
N P V = tk 3 917 04.88     tk 8 000 000
 .16 
 12 
 
=Tk 0
-24
  .1 6  
1
  - 1 +  
12 
P I= tk 3 9 1 7 0 4 .8 8    / tk 8 0 0 0 0 0 0
 .1 6 
 12 
 
=1

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Chowdhury et al. 258

TV
P V c o sts= n
1 + M IR R 

T k10949979
T k 8000000=
1+M IR R  2

M IR R = T k 1 0 9 4 9 9 7 9 / 8 0 0 0 0 0 0   1
=16.993%

Tk 8000000-Tk 4700458.56
P BP= 1 Y ear +
Tk 4700458.56
= 1 Year +.70 Year
=1.70 Year

Tk 8000000-T k 4326238
D PBP= 1 Y ear +
Tk 3705076
= 1 Year +.99 Year
=1.99 Year
The results of this study were found that bank invested its fund at 0 NPV that is sum of the
present value of cash inflows equals to its initial cash outlay, PI is exactly 1, IRR equals to
the rate of cost of capital or required rate of return. MIRR > IRR, PBP< DPBP, when inflation
was considered, NPV was lower than that of when inflation was not considered. DCFs are
different in different periods.
Conclusion
The banks are the money sensitive organizations that deal their investment projects
verifying the positive value from them, so as the capital budgeting decision is strongly
supported by the researcher for decision making. Capital budgeting decision requires
planning for setting up budgets on projects expected to have long-term implication
having entailed its approaches/ techniques significantly is applied in banking sector. Now
a day, the techniques of capital budgeting are systematic. The banks or any organization
cannot control over the operation of them as per plan beyond the meaning full capital
budgeting decision and application of capital budgeting techniques. So, capital
budgeting decision and practice of capital budgeting techniques bear the significance
and importance for successful operation of banking business along with any other
business.
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