Basics of Capital Budgeting

by Uditha Jayasinghe
 Contents
• The Opportunity Cost of an Investment
• The Concept of Time Value of Money
• The Present Value and Future Value
• Compounding and Discounting
• Discount Factor Table
• Annuity Factor Table
• Capital Budgeting Techniques
• The Concept of Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index
• Capital Rationing
• Payback and Accounting Rate of Return
• References
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 The Opportunity Cost of an Investment
• What options are available to investors?
– If prefers to avoid risk, then invest in government securities;
– If prefers to take risk, then invest in ordinary shares of a companies.

• The rates of return that are available from investments in securities in financial
markets such as ordinary shares and government securities represent the opportunity
cost of an investment in capital projects.

• The opportunity cost of the investment is also known as the minimum required rate of
return, cost of capital, or discount rate.

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 The Concept of Time Value of Money
• Money in the present is worth more than the same sum of money to be in the future.
(The concept that $1 received in the future is not equal to $1 received today is known
as the time value of money)

• This is true because money that you have right now can be invested and earn a return,
thus creating a larger amount of money in the future.

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 The Concept of Time Value of Money
A simple example can be used to illustrate the time value of money as follows;

Example: (P4.1)
Peter is trying to sell a piece of raw land. Yesterday he was offered $10,000 for the
property by John. He was about ready to accept the offer when Jimmy offered him
$11,424.
However, the second offer was to be paid a year from now. Peter has satisfied himself
that both buyers are honest and financially solvent, so he has no fear that the offer he
selects will fall through. Which offer should Peter choose?

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 The Concept of Time Value of Money
Alternate Sales Prices $10,000 $11,424

Year 0.………………….……….1

Mike, Peter’s financial adviser, points out that if Peter takes the first offer, he could invest
the $10,000 in the bank at an insured rate of 12%. At the end of one year, he would have:
$10,000 + (0.12 @ $10,000) or $10,000 @ 1.12 = $11,200
(Principal) + (Interest)

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 The Concept of Time Value of Money
• Because this is less than the $11,424, Peter could receive from the second offer, Mike
recommends that he take the second offer.
• This analysis uses the concept of Future Value (FV) or Compound Value, which is the
value of a sum after investing over one or more periods.
• The compound or future value of $10,000 at 12% is $11,200.

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 The Present Value and Future Value
The Concept of Present Value (PV)
• How much money must Peter put in the bank today so that he will have $11,424 next
year? We can write this as:
PV @ 1.12 = $11,424
• What is the amount of money that yields $11,424 if invested at 12% today?
PV = $11,424 / 1.12 = $10,200
• Therefore, the formula for Present Value (PV) can be written as follows:

PV = FV Where: FV is future cash flow

(1 + K)n K is the rate of interest/return

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 The Present Value and Future Value
• The Present Value analysis tells us that a payment of $11,424 to be received next year
has a present value of $10,200 today.

• In other words, at a 12% interest rate, Peter is indifferent between $10,200 today or
$11,424 next year.

• If you gave him $10,200 today, he could put it in the bank and receive $11,424 next
year. Because the second offer has a present value of $10,200, whereas the first offer
is for only $10,000, present value analysis also indicates that Peter should take the
second offer.

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 The Present Value and Future Value

In other words, both future value analysis and present value analysis lead to the same
decision. As it turns out, present value analysis and future value analysis must always lead
to the same decision.

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 Compounding and Discounting
• Compounding refers to growth in the capital value of an investment by reinvesting any
earnings back into the investment itself.
• Unlike simple-return investments, where a certain amount is added to the principle
value at the end of each period, and at the end of term you get back the capital, in
compounded investments you earn interest on the interest too. This magnifies the
return you can earn.

FVn = V0 (1 + K)n

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 Compounding and Discounting
Question: (P4.1)
Suppose you are investing £100,000 in a risk-free security yielding a return of 10%
payable at the end of each year. If the interest is reinvested, what would be your
investment value at the end of 4th and 10th year respectively?

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 Compounding and Discounting
The process of converting cash to be received in the future into a value at the present
time by the use of an interest rate is termed discounting and the resulting present value is
the discounted present value.

V0 (Present Value) = FVn

(1 + K)n

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 Compounding and Discounting
Question: (P4.2)
If the compounded value at 10% for 5 years is £161,051, what would be the present
value?

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 Discount Factor Table
.

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 Annuity Factor Table
.

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 Capital Budgeting Techniques
Capital Budgeting is the selection of the best project in which to invest the company’s
resources, based on each project’s perceived risk and expected return.
Categories of capital
budgeting techniques

Accounting base/non Discounted cash flow

discounted techniques techniques

1. Net Present Value (NPV)

1. Accounting Rate of Return (ARR) 2. Internal Rate of Return (IRR)
2. Payback Period (PB) 3. Profitability Index (PI)
4. Discounted Payback Period (DPB)
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 The Concept of Net Present Value
• Net Present Value (NPV) is the value of all future cash flows (positive and negative)
over the entire life of an investment discounted to the present. (i.e. The NPV is the
difference between present value of future net cash flows and the investment value -
V0).

• How to calculate the NPV?

The Present Value of cash inflows - Present Value of cash outflows.

• How to interpret NPV?

If NPV of the project is positive, Accept the project. (NPV > 0, Invest)
If NPV of the project is negative, Reject the project. (NPV < 0, do not Invest)
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 The Concept of Net Present Value
Example: (P4.2)
The value of $100,000 invested at 10%, compounded annually, for four years;
Year Opening Value Interest Earned Total Investment
1 100,000
2
3
4

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 The Concept of Net Present Value
Example: (P4.2) - Answer
The value of $100,000 invested at 10%, compounded annually, for four years;
Year Opening Value Interest Earned Total Investment
1 100,000 10,000 110,000
2 110,000 11,000 121,000
3 121,000 12,100 133,100
4 133,100 13,310 146,410

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 The Concept of Net Present Value
Example: (P4.3)
The cash in and out flows of 4 projects are as follows;
Description Project A Project B Project C Project D
Project investment outlay ($) 100,000 100,000 100,000 100,000
End of year cash flows: ($)
Year 1 110,000
Year 2 121,000
Year 3 133,100
Year 4 146,410
Present Value of inflows – 10%
Net Present Value
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 The Concept of Net Present Value
Example: (P4.3) - Answer
The cash in and out flows of 4 projects are as follows;
Description Project A Project B Project C Project D
Project investment outlay ($) 100,000 100,000 100,000 100,000
End of year cash flows: ($)
Year 1 110,000
Year 2 121,000
Year 3 133,100
Year 4 146,410
Present Value of inflows – 10% 100,000 100,000 100,000 100,000
Net Present Value 0 0 0 0
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 The Concept of Net Present Value
Question: (P4.3)
David wants to invest $50,000. The project life is 5 years and David will get the cash
benefit in following manner;
Description Year 1 Year 2 Year 3 Year 4 Year 5
Cash inflow ($) 20,000 14,000 12,000 10,000 8,000

Rate of interest is 10% per annum.

Required:
Calculate Net Present Value & comment on investment decision.

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 The Concept of Net Present Value
Question: (P4.4)
ABC Company is evaluating two projects with an expected life of three years and an
investment outlay of $1 million. The estimated net cash inflows for each project are as
follows:
Year Project A Project B
Year 1 300,000 600,000
Year 2 1,000,000 600,000
Year 3 400,000 600,000

The opportunity cost of capital for both projects is 10%. You are required to calculate the
net present value for each project.
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 The Concept of Net Present Value
Question: (P4.5)
Alpha Ltd., has the opportunity to invest in two investments with the following initial cost
& returns. Residual value in case of X is $4,000 and in case of Y is $2,000. The cost of
capital in both situations are 10%.

Investment Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Investment X (90,000) 40,000 30,000 20,000 20,000 20,000
Investment Y (20,000) 10,000 8,000 6,000 4,000 4,000

Required:
Calculate the NPV of Investment X & Y.

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 Internal Rate of Return (IRR)
• The internal rate of return (IRR) is an alternative technique for use in making capital
investment decisions that also takes into account the time value of money.

• IRR is the discount rate that will cause the net present value of an investment to be
zero.

• Alternatively, the internal rate of return can be described as the maximum cost of
capital that can be applied to finance a project without causing harm to the
shareholders.

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 Internal Rate of Return (IRR)
• The IRR can be found by trial and error by using a number of discount factors until the
NPV equals zero. E.g. Question 1 – If the cost of capital is further reduced, (below
14%) we can find the rate which gives us zero NPV.

• A formula for making this calculation (which is known as interpolation) is as follows:

ra + NPVa * (rb – ra) Where ra = Lower discount rate

(NPVa – NPVb) rb = Higher discount rate

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 Internal Rate of Return (IRR)
.
Project NPV
+
NPV > 0
Shareholder wealth increases

0 IRR Shareholder’s required rate of return

NPV < 0
- Shareholder wealth decreases

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 Internal Rate of Return (IRR)
Question: (P4.6)
The initial investment of project X is $100,000 and the scrap value would be 10% of the
investment. The expected cash inflows are as follows;
Year Cash inflow Required:
1 50,000 1. Calculate the net present value;
(a) If the cost of capital is 10% and,
2 35,000 (b) If the cost of capital is 20% and,
3 20,000 (c) If the cost of capital is 14%
4 15,000 2. Calculate Internal Rate of Return of the project X

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 Internal Rate of Return (IRR)
Question: (P4.7)
Find the IRR of the project given below and state whether the project should be accepted
if the company requires a minimum return of 17%.
0 Investment ($4,000)
1 Receipts $1,200
2 Receipts $1,410
3 Receipts $1,875
4 Receipts $1,150

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 Profitability Index
Profitability Index (PI) is the highest return in present value terms, per $1 of capital
invested. i.e. the ratio of PV to capital investment.

PI = PV of cash inflows
Initial cash outflow

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 Profitability Index
Question: (P4.8)
Capital for investment is limited in Year 0 to $5,000. There are four investment projects
available with a positive NPV, but these require a total of $10,000 for investment. All four
projects are fully divisible. The investment required for each project and the project NPVs
are as follows:
Project I II III IV .
Investment in Year 0 $5,000 $2,100 $1,400 $1,500
NPV $6,250 $4,200 $1,540 $1,950
Which projects should be selected for investment, in order to maximise the total NPV?

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 Capital Rationing
Situations may occur where there are insufficient funds available to enable a firm to
undertake all those projects that yield a positive net present value. The situation is
described as capital rationing.
Types of capital
rationing

Hard capital rationing Soft capital rationing

The shortage of capital is The shortage of capital is
imposed by external factors. imposed internally by
E.g. A bank management decision

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 Payback
Payback Period (PB)
• Payback period is the time required to repay the cost of the original investment.
• A project is rejected, if the payback period is above the company’s target payback
period.
• Payback is based on relevant cash flows.
• Disadvantages of payback period:
– Ignores the cash flows after the end of the payback period.
– Ignores the time value of money.
– May lead to excessive investment in short-term projects.
– Cut-off payback period by an organization is arbitrary.

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 Payback
Question: (P4.9)
A project is expected to have the following cash flows:
Year Cash flow $000
0 (1,900)
1 300
2 500
3 600
4 800
5 500
What is the expected payback period?

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 Accounting Rate of Return (ARR)
Accounting Rate of Return (ARR)
ARR or ROCE compares the profit of an investment to the amount invested in the project,
as a percentage.

ARR or ROCE = Average annual profit / Initial investment

ARR or ROCE = Average annual profit / Average investment

Where: average investment = (Initial outlay + Scrap value) / 2

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 References
• BPP Learning Media, 2016. Foundations in Accountancy
FMA / ACCA Paper F2 Management Accounting. 5th ed.
London W12 8AA : BPP Learning Media Ltd.

• Drury, C., 2018. Management and Cost Accounting. 10th

ed. Hampshire SP10 5BE, United Kingdom: Cengage
Learning EMEA.

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 Thank You

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