Nehal Ahmed
Associate Professor, BIBM
Capital Budgeting
Technique
Capital Budgeting Process
Capital Budgeting is the process of planning
expenditures on assets whose cash flows are expected
to extend beyond one year.
Capital budgeting refers to the investment decision
involving fixed asset of a firm.
The term capital refers to the fixed assets used in
production and budget is a plan that details projected
inflows and outflows during some future periods.
Thus capital budget in an outline of planned
expenditures on fixed assets and capital budgeting is
the process of analyzing projects and deciding which are
acceptable projects.
Classification of Projects
By project size
By type of benefit
By degree of dependence
By type of cash flow
Steps Involved in Capital Budgeting
Determine the cost of the asset.
Estimate the cash flows expected from the asset.
Evaluate the risk of the projected cash flows to
determine the appropriate rate of return.
Compute the PV of the expected cash flows.
Compare the present value of the expected cash
inflows with initial investment.
Time Value of Money
Future Value: The amount an investment is worth
after one or more periods.
Compounding: The process of accumulating
interest on an investment over time to
earn more interest.
Present value: The current value of future cash flows
discounted at the appropriate discount
rate.
Discount: Calculate the present value of some
future amount.
Time Value of Money
Future value of the investment for n periods at a rate i
percent per period is
( )
n
i 1 PV FV + =
The present value of a cash flow due n years if it were
on hand today, would grow to equal the future amount.
( )
n
i 1
FV
PV
+
=
Capital Budgeting Evaluation
Techniques
The basic methods we will discuss are:
Payback period (PBP)
Discounted Payback Period
Net Present Value (NPV)
Benefit Cost Ratio (BCR)
Internal Rate of Return (IRR)
Payback Period
Payback period is defined as the length of time
or expected member of years required to
recover the original investment.
To compute a projects pay back period, simply
add up the expected each flows for each year
until the commutative value is equal to the total
amount initially invested.
Example: Payback Period
The exact period can be found using the following formula:
Year 0 1 2 3 4
Net cash flow 3,000 1,500 1,200 800 300
Cumulative net cash flow 3,000 1,500 300 500 800


.

\

+


.

\

=
year ery cov re full during flow cash Total
year ery cov re full of start at t cos ered cov Unre
investment original of
ery cov re full before Years
Payback
years 4 . 2
800
300
2 Payback , A oject Pr For = + =
years 27 . 3
1500
400
3 Payback , B oject Pr For = + =
Discounted Payback Period
The discounted payback period is the length of time until
the sum of discounted cash flows is equal to the initial
investment.
Example: Calculate the discounted payback period for
projects A with discount rate 10%
Year 0 1 2 3 4
Cash Flow 3,000 1,500 1,200 800 300
Discounted Cash Flow 3,000 1363.64 991.74 601.05 204.90
Cumulative net cash flow (discounted) 3,000 1636.36 644.62 43.57 161.33
years 2 . 3
90 . 204
57 . 43
3 Payback Discounted , A oject Pr For = + =
Net Present Value
Net present value (NPV) is a measure of how much value
is created or added today by undertaking an investment.
capital budgeting process can be viewed as a search for
investments with positive net present values.
NPV relies on discounted cash flow (DCF) techniques,
which is the process of valuing an investment by
discounting its future cash flows. NPV is computed using
the following equation:
( ) ( ) ( ) ( )
0
n
1 t
t
t
0
n
n
2
2
1
1
I
k 1
CF
I
k 1
CF
k 1
CF
k 1
CF
NPV
+
=
+
+ +
+
+
+
=
=
Example: Net Present Value
Considering project A when k = 10%
0 K = 10% 1 2 3 4
(3,000) 1,500 1,200 800 300
1,363.64
991.74
601.05
204.90
Tk. 161.33
Cash flow
NPV
A
=
( ) ( ) ( ) ( )
33 . 161 . Tk 3000
1 . 1
300
1 . 1
800
1 . 1
200 , 1
1 . 1
500 , 1
NPV
4 3 2 1
A
= + + + =
Decision Criteria for NPV
If NPV > 0, accept the project.
If NPV < 0, reject the project.
If NPV = 0, the firm would be indifferent to the
project.
Benefit Cost Ratio
Profitability index (PI) or benefit cost ratio is defined as
the present value of the future cash flows divided by
the initial investment.
If a project has a positive NPV, then the present value
of the future cash flows must be bigger than the initial
investment.
The profitability index would thus be greater than 1 for
positive NPV investment and less than 1 for a negative
NPV investment.
Investment Initial
Inflow Cash of PV
PI =
Internal Rate of Return (IRR)
The internal rate of return (IRR) is defined as the
discount rate that equates the present value of the
initial investment outlays to the present value of
the future cash inflows.
( )
( ) ( ) ( )
( )
0 I
IRR 1
CF
) I ( Investment Initial
IRR 1
CF
IRR 1
CF
IRR 1
CF
IRR 1
CF
0
n
1 t
t
t
0
n
n
3
3
2
2 1
=
+
=
+
+ +
+
+
+
+
+
=
Computational Procedure
Given the cash flow and investment outlay,
choose a discount rate at random and calculate
the projects NPV.
If the NPV is positive, choose a higher discount
rate and repeat the procedure.
If the NPV is negative, choose a lower discount
rate and repeat the procedure.
Find the discount rate, which makes the NPV = 0
is the IRR.
IRR for a Hypothetical Project
When discount rate is 10%
Year Net Cash Flow Discount Factor PV of Cash Flow
1 452 0.909 411
2 500 0.826 413
3 278 0.751 209
PV of Cash Inflow 1033
Less: Initial Investment  1000
NPV + 33
IRR for a Hypothetical Project
Year Net Cash Flow Discount Factor PV of Cash Flow
1 452 0.877 396
2 500 0.769 385
3 278 0.675 188
PV of Cash Inflow 969
Less: Initial Investment  1000
NPV  31
When discount rate is 14%
IRR for a Hypothetical Project
Year Net Cash Flow Discount Factor PV of Cash Flow
1 452 0.893 403
2 500 0.797 399
3 278 0.712 198
PV of Cash Inflow 1000
Less: Initial Investment  1000
NPV 0
When discount rate is 12%
Alternative method
Choose a discount rate at random which makes
the NPV of the project positive. This discount rate
is known as lower discount rate (LDR).
Choose a higher discount rate (HDR), which
makes the NPV negative.
Solve the following equation
( )
( ) LDR HDR
HDR @ NPV LDR @ NPV
LDR @ NPV
LDR IRR
+ =
Example: IRR
LDR = 10%, HDR = 14%,
NPV @ 10% = + 33, NPV @ 14% =  31
( )
( ) LDR HDR
HDR @ NPV LDR @ NPV
LDR @ NPV
LDR IRR
+ =
% 12 %) 10 % 14 (
31) 3 3 (
33
% 10 IRR =
+
+ =
Decision Criteria for IRR
If IRR>Cost of Capital (k), accept the project.
If IRR<Cost of Capital (k), reject the project.
If IRR = Cost of Capital (k), the firm would be
indifferent to the project.
Modified Internal Rate of Return
The IRR assumes that a projects annual cash flows can be
reinvested at the projects internal rate of return, which
should be the projects cost of capital.
MIRR is the discount rate at which the present value of a
projects cost is equal to the sum of the present value of
its future cash inflow, where the cash inflows are
reinvested at the firms cost of capital. So MIRR is more
accurate measure for calculating the firms return.
Problems of IRR
Difficult to calculate  Trial and Error method
Nonconventional cash flow A double change in the
sign of the cash flow gives two solution for IRR, which
is known as multiple IRR problem.
Differences in the scale of investment  IRR ignores
the size of the investment because the result of the
IRR method is expressed as a percentage.
The IRR assumes that a projects annual cash flows
can be reinvested at the projects internal rate of
return, which should be the projects cost of capital.
MIRR is an alternative to address abovementioned
problem.
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