Chapter 5 CAPITALBUDGETING &

INVESTMENT DECISION

Dr Masharique Ahmad
Associate Professor - Accounting
MBA – II ND YEAR
SAMARAUNIVERSITY
COLLEGEOFBUSINESS& ECONOMICS

1-1
INVESTMENT DECISION
What
Means: is capital budgeting?
Capital Budgeting is the PROCESS of making decision
regarding capital Investment in Fixed Assets, such as
Machinery, Land and Building etc.
OR Determining which real investment projects should
be accepted and given an allocation of funds from the
firm.
Evaluation

Estimation of CashFlow Methods

 CBMETHODS
Methods:
i. Payback Period, discounted
payback
i. ARR[Average Rate of Return]
iii. NPV [Net Present Value]
iv. IRR, [Internal Rate of Return]
v. Profitability Index
 Steps in Capital Budgeting
• Estimate cash flows (inflows & outflows).
• Assess risk of cash flows.
• Determine r = WACCfor project.
• Evaluate cash flows.
What is the payback period?
The number of years required to
recover a project’s cost,
OR
How soon can we get back our
cash money from the business?
Exercise: 1

Initial Investment : 25,00000, the Annual Cash Inflow: 500000 for 8year,
Calculate the Pay Back Period ?

Solution: Initial Investment

Pay Back Period = ; 2500000 /500000 = 5 Year[Payback]
Cash Inflow
 The Effect of Initial Investment:
Cash Flow : Cumulative CashFlow
Investment
Decision
 Pay back Period
(Long: Most CFsin out years)
0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

 Franchise S (Short: CFscome
quickly)
0 1 1.6 2 3

CFt -100 70 100 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
Discounted Pay back Period: Uses
discounted rather than raw CFs.
0 1 2 3
10%
CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
= 2 + 41.32/60.11 = 2.7 yrs
payback
Recover invest. + cap. costs in 2.7 yrs.
 What’s
Project L:
Franchise L’s NPV?
0 1 2 3
10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
Exercise: At
Home
Calculate Net Present Value of two different Project, and suggest
which one of these two should be accepted assuming discounting
rate @10%.Other information is asfollows;
Project -X Project -Y
Initial Investment $40000 $60000
Estimated Life 5 Years 5 Year
Scrap Value $2000 $4000

CashInflow:
Years Project -X Project -Y
1 10000 40000
2 20000 20000
3 20000 10000
4 6000 6000
5 4000 4000
Rationale for the NPVMethod

NPV = PV inflows - Cost

= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually

exclusive projects on basis of
higher NPV. Adds most value.
 Using NPV method, which
franchise(s) should be
accepted?
• If Franchise Sand Lare mutually
exclusive, accept Sbecause NPVs>
NPVL.
• If S& Lare independent, accept
both; NPV > 0.
Capital Budgeting : All Methods in one
 Year -1 Year -2 Year -3 Year -4 Year -5
Profit before Dep. 10000 11000 14000 15000 25000
Less (Depreciation) (10000) (10000) (10000) (10000) (10000)

Net Profit before Tax NIL 1000 4000 5000 15000

Less Tax @ 35 % NIL 350 1400 1750 5250

NIL 650 2600 3250 9750
Add Depreciation 10000 10000 10000 10000 10000

Cash Inflow 10000 10650 12600 13250 19750

Pay Back Period Method
Average Rate of Return Method [ARR]
(iii) Net Present Value Method [NPV]:

Year Cash Flow PVF @10% Present Value

0 (50000) 1 (50000)

1 10000 0.909 9090

2 10650 0.825 8797

3 12600 0.751 9463

4 13250 0.683 9050

5 19750 0.621 12265

48665 – 50000
=- 1335 (Negative)
iv - Profitability Index Method
 Profitability Index (PI)
• Method: PI=
PVCash flows after the initial investment
Initial Investment
– Note: PI should always be expressed as a positive number.
• IfPI ≥ 1, then accept the real investment project;
otherwise, reject it.
 Example Project
• Initial investment Cash
required: $100,000 Revenues
Year
less Expenses
• Opportunity cost of after tax
capital: 15%
• The PI is … 1 $20,000

2-9 $40,000

10 $10,000
 Internal Rate of Return Method
Year Cash Flow PVF @10% Present PVF Present Value
Value @8%
0 (50000) 1 (50000) 1 (50000)
1 10000 0.909 9090 0.926 9260
2 10650 0.825 8797 0.857 9127
3 12600 0.751 9463 0.794 10004
4 13250 0.683 9050 0.735 9739
5 19750 0.621 12265 0.681 13450
48665 – 50000 51580 – 50000 = +ve
= - 1335 (Negative) 1580
Rationale for the IRRMethod
If IRR > WACC, then the project’s
rate of return is greater than its
cost-- some return is left over to
boost stockholders’ returns.

Example: WACC = 10%, IRR = 15%.

Profitable.
Decisions on Projects Sand L
per IRR

• If Sand Lare independent, accept both.

IRRs> r =10%.
• If Sand Lare mutually exclusive, accept S
because IRRS> IRRL.
Consider another project with a 3-year
life. If terminated prior to Year 3, the
machinery will have positive salvage
value.

Year CF Salvage Value

0 ($5,000) $5,000
1 2,100 3,100
2 2,000 2,000
3 1,750 0
Choosing the Optimal Capital
Budget
• Finance theory says to accept all positive
NPV projects.
• Two problems can occur when there is not
enough internally generated cash to fund all
positive NPVprojects:
–An increasing marginal cost of capital.
–Capital rationing
Increasing Marginal Cost of
Capital

• Externally raised capital can have large

flotation costs, which increase the costof
capital.
• Investors often perceive large capital
budgets as being risky, which drives up the
cost of capital.

(More...)
 Capital
Rationing
• Capital rationing occurs when a
company chooses not to fund all
positive NPVprojects.
• The company typically sets an upper
limit on the total amount of capital
expenditures that it will make in the
upcoming year.
(More...)
Reason: Companies want to avoid the direct
costs (i.e., flotation costs) and the indirect
costs of issuing new capital.
Solution: Increase the cost of capital by
enough to reflect all ofthese costs, and then
accept all projects that still have a positive
NPV with the higher cost of capital.

(More...)
Reason: Companies don’t have enough
managerial, marketing, or engineering staff
to implement all positive NPVprojects.

Solution: Use linear programming to

maximize NPV subject to not exceedingthe
constraints on staffing.

(More...)
Reason: Companies believe that the project’s
managers forecast unreasonably high cash flow
estimates, so companies “filter” out the worst
projects by limiting the total amount of projects
that can be accepted.
Solution: Implement a post-audit process and
tie the managers’ compensation to the
subsequent performance of the project.