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Capital Budgeting

Financial markets (Universitas IBA)

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CAPITAL BUDGETING

Capital Budgeting: The total process of generating, evaluating, selecting and following
up on capital expenditure alternatives.

Capital Expenditure: An outlay made by a firm for a fixed or an intangible asset from
which benefits are expected to be received over a period greater than a year.

Independent Projects: Capital expenditure alternatives that compete with each other, but
in such a way that the acceptance of one project does not eliminate the other projects
from further consideration.

Mutually Exclusive Projects: A group of capital budgeting projects that compete with
one another in such a way that the acceptance of one eliminates all other in the group
from further consideration.

Capital Rationing: The allocation of limited amount of funds to a group of competing

capital budgeting process.

Ranking Approach: Evaluating the relative attractiveness of capital projects on the basis
of some predetermined criterion.

Present Value: The value of a future sum or stream of dollars discounted at a specified
rate. The process of finding present value is actually the inverse of the compounding
process.

Future value: The value of a single sum or an annuity compounded at a given interest
rate for a specified time period.

Importance of Capital Budgeting:

1. To achieve long-term goal of firm.

2. Huge Capital Investment.

3. Long Term Investment.

4. Risky Investment.

5. Balancing amomg liquidity, profitability and value of the firm.

6. Searching for alternative investment opportunities.

7. Ranking of projects and best use of limited capital.

Types of Investment Decision

1. Accept-Reject Decision
2. Mutually Exclusive Projects Decision

3. Capital Rationing Decision

Steps in Capital Budgeting:

1. Identification of investment projects

2. Evaluation of alternative investment projects

3. Selection of the best investment projects

4. Implementation of the projects

5. Continuous evaluation of the selected projects.

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Application of Capital Budgeting:

1. Purchase of Fixed assets

2. Mechanisation of production method

3. Selection from alternative equipments

4. Introduction of new product

5. Expansion of business

6. Modernization and replacement

7. Make or buy decision.

Related Issues in Capital Budgeting:

Prospective Investment porposals

1. Cost of the projects

2. Life of the projects

3. Cash inflows and outflows

4. Salvage value of the projects

5. Dsicounting rate

6. Techniques of evaluation

Capital Budgeting Methods

1. Average/Accounting Rate of Return Methods of Capital Budgeting

Formula 1: Based on original investment

ARR = Net Profit After Tax X 100

Original Investment

Formula 2: Based on Average investment

ARR = Net Profit After Tax X 100

Average Investment

*Average investment
= Original Investment – Salvage value + Salvage value
2

2. Pay Back Period Methods of Capital Budgeting

Formula 1: When Annual Cash Flows are uniform

PBP = Investment
Cash flow after tax

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Formula 1: When Annual Cash Flows are uniform

PBP = A + NCO - C
D
Where, A = Year in which the accumulated cash flows are nearer to NCO
NCO = Net Cash Outlay
C = Accumulated cash outlay of the year ‘A’
D = Cash flow of the succeeding year of the year ‘A’

Formula : NPV

Where there is one single investment in the beginning

n CFt Sn  Wn
NPV = t 1 t
  COo
(1  K ) (1  K )n
n CFt
Or, NPV = t 1  COo
(1  K ) t
Or, NPV = PV of NCB – PV of NCO

Here,
NPV = Net Present Value
CFt= Cash flow at different time period.
Sn= Salvage value at N year.
Wn= Working capital structure
Coo= Initial cash out flow
K = Cost of capital.

Where there is a number of investment at interval

n CFt Sn  Wn  n COt
NPV = t 1   t 1
(1  K ) t (1  K ) n (1  K ) t
Or, NPV = PV of NCB – PV of NCO

Here,
Cot= Cash out flow at different times.

Decision Rule at a glance

1. NPV>0 → Accepted
2. TPV> NCO → Accepted
3. NPV = O → May accepted or rejected.
4. NPV < O → Rejected
5. TPV < NCO → Rejected

FORMULA : IRR
IRR = A + × (B-A)
Where, IRR = Internal Rate of Return
A = Lower Discount Rate.
B = Higher Discount Rate.
C = NPV of Lower Discount Rate.
D = NPV of Higher Discount Rate

ILLUSTRATION (NPV)
ABC co. has two projects for consideration

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Year Cash flows

Project A Project B
0 (50,000) (50,000)
1 10,000 12,000
2 15,000 10,000
3 12,000 15,000
4 20,000 25,000
5 10,000 9,500
Salvage value 5,000 2,500

If the tax rate is 40% and the discount rate is 12%, which of the two projects will be
accepted ?

SOLUTION:

Depreciation = = = 9,000.

Year CFBT Dep. EBT Tax 40% EAT CFAT Factor 12% PV
1 10,000 9,000 1,000 400 600 9,600 .892 8,563
2 15,000 9,000 6,000 2,400 3,600 12,600 .797 10,042
3 12,000 9,000 3,000 1,200 1,800 10,800 .712 7,690
4 20,000 9,000 11,000 4,400 6,600 15,600 .635 9,906
5 10,000 9,000 1,000 400 600 9,600 .567 5,443
S.V 5,000 --- 5,000 --- 5,000 5,000 .567 2,835
44,479

NPV = PV of NCB – PV of NCO

= 44,479 – 50,000
= (5,521)

Depreciation = = 9,500
Year CFBT Dep. EBT Tax 40% EAT CFAT Factor 12% PV
1 12,000 9,500 2,500 1,000 1,500 11,000 .892 9,812
2 10,000 9,500 500 200 300 9,800 .797 7,811
3 15,000 9,500 5,500 2,200 3,300 12,800 .712 9,101
4 25,000 9,500 15,500 15,500 9,300 18,800 .635 11,938
5 9,500 9,500 0 0 0 9,500 .567 5,387
44,049

NPV = PV of NCB – PV of NCO

= 44,049 – 50,000
= (5,951)
Decision: Both the companies have a negative NPV. So none of them would be
considered for investment.

FORMULA : IRR
IRR = A + × (B-A)
Where, IRR = Internal Rate of Return
A = Lower Discount Rate.
B = Higher Discount Rate.
C = NPV of Lower Discount Rate.
D = NPV of Higher Discount Rate

ILLUSTRATION: (IRR)
The cost of a 3 year project is estimated as tk. 20,000. The estimated inflows for three
years have been estimated as tk. 8,000 per year. If the cost of capital is 7% whether
investment in the project is worthy or not?

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Calculation of IRR
Year CFAT Factor 7% PV Factor 10% PV
1-3 8,000 2,624 20,992 2,486 19,888
Less : NCO 20,000 20,000
992 -112

IRR = A + × (B-A)
= 7% + (10-7)%
= 7% + × 3%
= 7% + 2.695%
= 9.695%

Illustration 1 : ARR and PBP

Nishat Enterprise wants to buy a machine costing tk. 1,50,000 for an expected life of
5 years. The projected net profit after tax is follows:
Years Net Profit After Tax
1 Tk. 20,000
2 Tk. 18,000
3 Tk. 15,000
4 Tk.17,000
5 Tk. 15,000

Calculate the average rate of return (ARR) of Nishat Enterprise

Illustration 2 : NPV

A Company is considering an investment proposal to install new milling controls at a

cost of tk. 50,000. The facility has a life expectancy of five years and no salvage
value. The tax rate is 35 per cent. Assume the firm uses straight-line depreciation.
The cost of capital is 10%. The Earnings before depreciation and taxes from the
investment proposal are as follows.
Years EBDT
1 Tk. 10,000
2 Tk. 10,692
3 Tk. 12,769
4 Tk.13,462
5 Tk. 20,385
Compute the following and suggest whether the proposal is to be accepted or not

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