Capital Budgeting

By

Gayan Abeyrathna
(Master of Acc., BBM sp. In Acc. & Fin., DICA-SL)
Lecturer in Accountancy
Advanced Technological Institute
Kegalle

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Outline
 Introduction.
 Cash flows, Incremental cash flows
 Nature of Investment Decision.
 Objective of Capital Budgeting.
 Important Concepts of Capital Budgeting.
 Investment Appraisal Methods.
 Effect of Performance Measurement on Capital Investment Decisions.
 Capital Investment Process

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What is capital budgeting?

• Analysis of potential additions to fixed assets.

• Long-term decisions; involve large expenditures.
• Very important to firm’s future.

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What is capital budgeting?(Contd……)
• Capital: Operating assets used in production
• Budget: A plan that details projected cash flows
during some period.
• Capital Budgeting: Process of analyzing projects
and deciding which ones to include in the capital
budget.
• Criteria: Project should maximize shareholders
wealth
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Nature of Investment decisions
 This includes expansion, acquisition, modernization and
replacement of long term assets, sale of a division of the
business etc.
 Exchange of current funds for future benefits.
 Funds are invested in long term assets.
 The future benefits will occur to the firm over a series of
years.
 Directly effect the firm value.

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 Independent and mutually exclusive
projects

• Independent projects – if the cash flows of one

are unaffected by the acceptance of the other.
• Mutually exclusive projects – if the cash flows of
one can be adversely impacted by the acceptance
of the other.
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Example

Bridge vs. Ship to get products across a river

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Relevant cash flows
••The cash flows in the capital-budgeting
time line need to be relevant cash flows;
that is they need to be incremental in
nature.

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Incremental Cash Flows
• • Those cash flows that will only occur if the project is
accepted.
• • Consider following costs/effects when determining the
incremental cash flows.
• •Sunk costs
• •Opportunity costs
• • Side effects – erosion and synergy
• •Allocated costs
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Steps to capital budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.

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Normal and Non-normal cash flow streams

• Normal cash flow stream – Cost (negative

CF) followed by a series of positive cash
inflows. One change of signs.
• Non-normal cash flow stream – Two or
more changes of signs. Most common:
Cost (negative CF), then string of positive
CFs, then cost to close project. Nuclear
power plant, strip mine, etc. 11
 Investment appraisal methods

Considering the time value of Ignoring the time value of

money concept money concept

•Net present value •Payback period

•Internal rate of •Accounting rate of
return(IRR) return (ARR/ROI)
•Profitability Index(PI)
•Discounted Payback
•MIRR 12
What is the payback period?
•The number of years required to recover a
project’s cost, or “How long does it take to
get our money back?”
•Calculated by adding project’s cash inflows
to its cost until the cumulative cash flow for
the project turns positive.
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Calculating payback
0 1 2 2.4 3
Project L

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50
PaybackL == 2 + 30 / 80 = 2.375 years

0 1 1.6 2 3
Project S
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40

PaybackS == 1 + 30 / 50 = 1.6 years

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 Discounted payback period
DF= 1/(1+r)^n
• Uses discounted cash flows rather than raw CFs.
0 10% 1 2 2.7 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79

Disc PaybackL == 2 + 41.32 / 60.11 = 2.7 years

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Accounting Rate of Return

•The accounting rate of return compares the

average accounting profit with the average
investment cost of project
•The accounting profit can be expressed
either before tax or after tax

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Calculation procedures
Average net profit per year (over the life of the project)
ARR =
Average investment cost

Total profit
Average net profit per year =
No. of life of the project
Initial investment
Average investment cost =
2

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 Acceptance criterion
In evaluating an investment project, the ARR of the project is
compared with a predetermined minimum acceptable
accounting Rate of return:
ARRs Comments
< minimum acceptable rate Reject project
= minimum acceptable rate Accept project
> minimum acceptable rate Accept project
Highest Choose highest ARR
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Net Present Value (NPV)
•Sum of the PVs of all cash inflows and
outflows of a project:
n
CFt
NPV   t
t0 ( 1  k )

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Rationale for the NPV method
NPV= PV of inflows – Cost
= Net gain in wealth
• If projects are independent, accept if the project NPV > 0.
• If projects are mutually exclusive, accept projects with the
highest positive NPV, those that add the most value.
• In this example, would accept S if mutually exclusive (NPVs
> NPVL), and would accept both if independent.

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Internal Rate of Return (IRR)

• IRR is the discount rate that forces PV of inflows equal to cost,

and the NPV = 0:
n
CFt
0  t
t0 ( 1  IRR )

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A project costs Rs.400 and produces a regular cash inflow of Rs.200 at
the end of each of the next three years. Calculate the IRR. If the
minimum rate of return is 15 %, suggest with reason whether you
Should accept the project or not.

Rs.200 Rs.200 Rs.200

+ + - Rs.400 =0
NPV = (1+r)1 (1+r)2 (1+r)3

Assuming the discount rate is 22%

Rs.200 Rs.200 Rs.200
+ + - Rs.400 = 8.4
NPV = 1.22 1.222 1.223

Assuming the discount rate is 24%

Rs.200 Rs.200 Rs.200
+ + - Rs.400 = -3.8
NPV = 1.24 1.242 1.243

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 P
IRR = L + P–N (H – L)

Where L = Discount rate of the low trial

H = Discount rate of the high trial
P = NPV of cash flows of the low trial
N = NPV of cash flows of the high trial

8.4
IRR = 22% + 8.4 – (-3.8) (24 – 22)%

= 23.38%

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Modified Internal Rate of Return
(MIRR)
•MIRR is the discount rate that causes the PV
of a project’s terminal value (TV) to equal
the PV of costs.
•TV is found by compounding inflows at
WACC.
•Thus, MIRR assumes cash inflows are
reinvested at WACC.
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Calculating MIRR
0 10% 1 2 3

-100.0 10.0 60.0 80.0

10%
66.0
10% 12.1
MIRR = 16.5%
158.1
-100.0 Rs.158.1 TV inflows
Rs.1 =
(1 + MIRRL) 3
PV outflows 00
MIRRL = 16.5%
Profitability Index
• The profitability index (PI) is the present value of future cash flows
divided by the initial cost.
• It measures the “bang for the buck.”
• PV of Benefits / PV of Costs or
• PV of Inflows / PV Outflows
• PI > 1.0 :: Accept
Thank you.. !!!!

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