Second Edition
2
OBJECTIVES
3
DEFINITION
Capital Budgeting (CB) refers to the complete process of
generating/initiating investment proposals, evaluating,
ranking and selecting the best alternative(s), monitoring
and making follow up on investment(s) made.
Provides assessment for the financial feasibility of
investment options.
Evaluates, how an investment opportunity is worthwhile
and how it fits to the companys strategy, goals and
objectives?
CB techniques are invariably used for all types of
investment opportunities from the purchase of a new piece
of machinery to a whole factory.
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NATURE
CB Decisions have longterm impact on the business stability,
growth & success
CB Decisions involve huge investment of funds
CB Decisions are more complicated from concerns of future cash
flow estimates and their evaluation at the time of making
investment
CB Decisions are not easily reversible mainly because of loss of
investment
IMPORTANCE
Huge amount of resources are involved that has impact on
business strategy, growth, and survival.
Difficult to bail out, once an investment is made.
The capital investments are challenging and critical to the
success of the company. An incorrect decision may end with the
companys closingout from the market.
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CONCEPT
Investment refers to an outlay of funds on which
management expects a return. An investment creates
value for shareowners when expected returns from
investment exceed its cost.
Capital Expenditure refers to long term
commitment of resources that provide future benefits
to business.
Why investment is made?
Expansion Plans, Growth Strategies, Capacity Increase
Increase of efficiency of the manufacturing facilities
Deploying or replacing latest technology
Acquisition of Fixed Assets, Copy Rights, Franchises, Licenses,
Patents
Establishing new brands, new lines of business, new products
Opening new offices, new factories, overseas branches
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RELEVANT CONCEPTS
Independent Projects are projects where selection or
rejection of one project does not have any impact on the
selection or rejection of the other project. Management can
select any number of projects from the given options.
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DECISION MATRIX
Business Strength
Build gradually
Low improve & Divest Divest
defend
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EVALUATION TECHNIQUES
A: Traditional Techniques
1. Payback period (PB)
2. Discounted Payback Period (DPB)
3. Accounting Rate of Return (ARR)
Important Note
These techniques provide reliable evaluation under conditions of
perfect certainty. They are, nevertheless, widely used in practice in the
face of uncertainty.
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EVALUATION TECHNIQUES
NPV
PB
IRR
Discounted PB MIRR
TV
ARR
PI or B/C Ratio
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DECISION RULES
FOR ALL CAPITAL BUDGETING TECHNIQUES
Accept or Reject Criteria for
# Tech.
Single or Independent Project(s) Mutually Exclusive Projects
1. PB Less than the Target Period Shortest Payback Period
2. DPB Less than the Target Period Shortest Payback Period
3. ARR Above the Target Rate With the highest ARR
4. NPV A positive NPV With the highest positive NPV
5. IRR Higher than the Target Rate (Cost of With the highest IRR
Capital)
If PVTS>PVO Accept,
7. TV And if PVTS<PVO Reject
With the highest PVTS>PVO
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MERITS & DEMERITS
TRADITIONAL TECHNIQUES
# Tech. Merits Demerits
Simple and easy to understand and use.
Objective using cash flows. Ignores the time value of money.
Liquidity commercially realistic. Ignores cash flows after the
1. PB Cautious & risk averse ignores later cash payback period.
flows. Dont recommend the acceptable
First level estimator gives rough idea pay back period for the projects.
about the recouping of the investment.
Provides more accurate estimate of cash Ignores cash flows after the
inflows. recovery of initial investment.
2. DPB Provides more accurate estimate of the time More difficult to calculate than
frame for the recovery of initial investment. PB.
Simple and easy to calculate and use. Subjective profit, not cash flows.
Aids internal and external comparisons. Ignores the time value of money.
3. ARR Looks at the whole life of the project. Difficulty in use when with same
A useful tool to measure divisional ARR and various project sizes.
managerial performance.
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MERITS & DEMERITS
DCF TECHNIQUES
# Tech. Merits Demerits
Takes account of the time value of Adverse effects on accounting profits in
money. the short run.
Instrumental in understanding exact How to choose discount rate? As NPV
addition to shareholders wealth. is dependent on discount rate. Bank
rate, or WACC or another?
1. NPV Takes account of risk.
May not give satisfactory results where
Looks at total benefits over the projects have different lives.
entire life of the project.
In case the projects have different cash
Particularly useful for mutually outlays, it may not give dependable
exclusive projects. results.
Involves tedious calculations.
Takes account of the time value of
money. Difficult to use in choosing projects of
varying sizes.
2. IRR Easy to be understood by managers.
Difficult to choose when projects have
Takes into account total cash the same IRR.
inflows and total outflows.
Not dependent on the discount rate.
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MERITS & DEMERITS
DCF TECHNIQUES
# Tech. Merits Demerits
There is much confusion about the re
Quicker to calculate than IRR. investment rate used in this formula.
MIRR is invariably lower than IRR One implication of MIRR is that the
3. MIRR that may be due to more realistic project may not generate cash flows as
assumption about reinvestment rate. predicted and that NPV of the project is
overstated.
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NPV compared w. IRR
ISSUES
When investment amount in given projects is different then the results from
NPV and IRR techniques shall lead to different conclusions.
When length of the given projects in terms of time is different then the
results obtained from NPV and IRR techniques shall lead to different
conclusions.
When the interest rates of given projects are different then the results
obtained from NPV and IRR shall lead to different conclusions.
When timing of cash flows is different i.e. timing of cash flows from the two
projects differs such that most of the cash flows from one project come in the
early years while most of the cash flows from other project come in the later
years, the results from NPV and IRR techniques shall lead to different
conclusions.
RESOLUTION OF ISSUES
The value of early cash flows depends on the return that is earned on those cash
flows, i.e. the rate at which these funds are reinvested.
The NPV method implicitly assumes that the rate at which cash flows can be re
invested is the cost of capital,
The IRR method assumes that the company reinvest the funds at the IRR.
The best assumption is that projects cash flows is reinvested at the cost of
capital, that goes for the recommendation of NPV method.
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NPV, IRR & MIRR
NPV and IRR always lead to the same accept/reject decision for independent
projects.
NPV and IRR may lead to different accept/reject decisions for mutually
exclusive projects.
Where NPV and IRR give different accept/reject decision then NPV results
should be accepted.
NPV assumes reinvestment of cash inflows at r (opportunity cost of capital).
IRR assumes reinvestment of cash inflows at IRR.
IRR indicates the minimum rate expected by the investors to get their
investment back from the project. They definitely get idea from IRR that how
much extra earnings are required to cover their cost of capital and net return on
their investment.
Reinvestment of cash inflows at opportunity cost, r, is more realistic, so NPV
method is best. NPV should be used to choose between mutually exclusive
projects.
MIRR assumes cash inflows are reinvested at WACC.
MIRR also avoids the problem of multiple IRRs. MIRR is better than IRR.
When there are nonnormal cash flows and there are more than one IRRs, use
MIRR.
IRR is an estimate of a projects rate of return, so it is comparable to the Yield
To Maturity (YTM) on a bond.
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CRUX OF ALL CAPITAL
BUDGETING TECHNIQUES
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NONFINANCIAL FACTORS
Company Goodwill, Image & Reputation
Management may reject an investment opportunity, as it will reflect badly on the
company goodwill, image and reputation.
Company Policies, Objectives & Culture
Management is bound to check, if the investment opportunity conforms to the
policies, objectives and culture of the company?
Environmental, Social, Legal & Ethical Issues
Management is required to make sure that the investment opportunity under
consideration is, legally, environmentally, socially and ethically acceptable and
viable.
Impact on Stakeholder Relationships
Management appraises the impact of the investment on competitors, shareholders,
employees, buyers, bankers, suppliers and government institutions, etc.
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PRESENT VALUE
Finding present values is called discounting, and it is simply the reverse of
compounding. In general, the present value of a cash flow due n years in the
future is the amount which, if it were on hand today, would grow to equal the
future amount. By solving for PV in the future value equation, the present
value, or discounting, equation can be developed and written in several forms:
n
FV n 1
PV = = FV n = FV n ( PVIF i, n ).
1+i
n
(1 + i )
Where:
PVIFi, n = Present Value Interest Factor at given rate and number of periods
PV = Present Value, or investment amount at the start of the project
i = interest rate per annum
n = number of periods
FVn = future value after n periods
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CAPITAL RATIONING
The management has not only to determine the profitable investment
opportunities, but it has also to decide about that combination of
projects which delivers highest NPV within the available funds.
There are two types of capital rationing.
External Capital Rationing
 Factors that are outside the company due to financial market
conditions.
Internal Capital Rationing
 Factors that are within the company due to policy, procedure or
other constraints.
Capital Rationing is about selecting projects in a way that helps a
company completing them within the given financial resources.
Financial resources are limited, therefore, should be used in way that is
the best combination from companys wealth maximization point of
view.
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ILLUSTRATIVE MODEL
There are two mutually exclusive projects A and B for the
consideration of XYZ company. The data for the initial investments
and subsequent cash inflows is given on next slide.
Calculate:
PB, DPB, ARR
NPV, IRR, MIRR, TV & PI
Provide recommendations based on the results of budgeting
techniques to make the accept or reject decision in relation to
Project A or B?
Important note
Project A and Project B are competing each other and only one of them can be
selected (i.e. mutually exclusive projects). The project that has superior
financial performance shall be selected. The performance of these two mutually
exclusive projects shall be evaluated under 8 capital budgeting techniques.
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CASH FLOWS FOR PROJECTS A & B
Project A: Project B:
Net Cash flows in/(out) Net Cash flows in/(out)
Year
For the year Accumulated For the year Accumulated
AED. AED. AED. AED.
0 (100,000) (100,000) (100,000) (100,000)
1 45,000 (55,000) 30,000 (70,000)
2 40,000 (15,000) 30,000 (40,000)
3 35,000 20,000 44,000 4,000
4 50,000 70,000 66,000 70,000
Decision Rule
The project that has longer discounted payback period shall be rejected. The Project B has longer
period to recoup the investment than Project A, therefore, Project B is rejected and Project A is
selected. This technique is the refinement of the Pay Back Method. It is also interesting to note that
results for acceptance or rejection are same under these two techniques. However, we have got the
exact idea about the recovery of the initial investment to the business.
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3. ACCOUNTING RATE OF RETURN
: Calculate annual profit
Annual Profit = Income  Depreciation
: Calculate average profit
Average Accounting Profit = Total Profits / # of Yrs.
: Calculate average capital invested
Average Capital = (Initial Investment + Residual Value)/2
: Calculate Accounting Rate of Return
ARR = (Average Profit/Average Capital) x 100
Annual Profit in the context of this model refers to the earnings from the project less all
other expenses including depreciation. The model used here gave us only depreciation
expense, therefore, it is deducted from the income given in each year. This is for the
reason of simplicity of the model. Further, cash inflows are the income in the absence of
any other expense for example, only depreciation is the expense to be charged against
these earnings In practice, we take net profit after tax for this working.
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ARR CALCULATION
Project A
Average Accounting Profit = (Income Depreciation)/4
Average Accounting Profit = (170,000  80,000)/4
= 22,500
Average investment = (Initial Investment + Residual Value)/2
= (100,000 + 20,000)/2 = 60,000
ARR = 22,500/60,000 x 100 = 37.50%
Project B
Average Accounting Profit = (170,00080,000)/4 = 22,500
Average Investment = (100,000 + 20,000)/2 = 60,000
ARR = (22,500/60,000) x 100 = 37.50%
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ACCOUNTING RATE OF RETURN
Decision Rules
For Independent Projects
Ranking shall be made of all independent projects based on their estimated ARR. The
projects that have higher estimated ARR than the minimum required ARR shall be
selected and all other projects shall be rejected.
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4. NET PRESENT VALUE
The XYZ companys interest rate is 10% p.a.
Formula to calculate Discount Factor @ 10% p.a. for AED. 1 is given as follows:
Discount Factor = 1/(1+10%)^n
n
CFt
NPV CF0 .
t 1 1 r
t
1 2 3=1x2
0 (100,000) 1.000 (100,000)
1 30,000 0.909 27,270
2 30,000 0.826 24,780
3 44,000 0.751 33,044
4 66,000 0.683 45,078
NPV 30,172
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Calculation of NPVs by using EXCEL
Formula
NPV = NPV(RATE%, VALUES)
Project A = NPV(10%, values) = AED. 31,285
Project B = NPV(10%, values) = AED. 27,457
Important Note
In our manual workings, all individual discounting factors have been rounded off to
four digits. In Excel workings, the system has taken full discounting factors without
rounding them off. There is definitely a difference in both workings. But results are
consistent and do not allow the decision be changed. For all practical purposes
except under exam conditions, we should use Excel formula to reach the exact
decision.
Difference
Difference in Project A NPV = 34,380 31,285 = 3,095
Difference in Project B NPV = 30,172 27,457 = 2,715
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Profiling of the Project A & B on
the basis of their NPVs
Discount Rate NPV Project A NPV Project B
AED. AED.
10% 31,285 31,285
13% 23,072 18,599
16% 15,998 11,032
19% 9,886 4,552
22% 4,594 (1,009)
25%  (5,791)
28% (3,995) (9,910)
IMPORTANT NOTE
The point where the NPV profile crosses the horizontal axis indicates a
project's IRR. This is the point where IRR is equal to the discount rate and
therefore makes NPV of projects equal to zero.
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Profiling of Projects A & B on NPV Basis
35,000
30,000
NPV of Projects A & B in AED.
25,000
20,000
15,000
NPV Project A
10,000
NPV Project B
5,000
Discount Rate

10 13 16 19 22 25 28
(5,000)
(10,000)
(15,000)
Discount Rate (%)
We can clearly see in the graph the results from using of different discount
rates for projects A and B. The NPV of both projects come to zero at 22%
and 25% discount rates. This is the graphical determination of IRR as well.
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NPV DECISION RULES
NOTE
In the case of both Projects A and B, NPV is reducing when discount rates are increasing.
To generalize, when discount rate increases, NPV decreases and vice versa.
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5. INTERNAL RATE OF RETURN
IRR is the discount rate which delivers a zero NPV for a given project. That means a rate
at which PV of all cash inflows equals to total investment at a given point in time.
IRR Calculation for Project A
NPV = AED. 34,380 when the discount rate is 10%
NPV = ??? When the discount rate is 25%
Cash flow in Discount Factor for AED. Present Value in
Year
AED. 1 @ 25% p.a. AED.
1 2 3=1x2
0 (100,000) 1.000 (100,000)
1 45,000 0.800 36,000
2 40,000 0.640 25,600
3 35,000 0.512 17,920
4 50,000 0.410 20,500
NPV (20)
N.B. : If we reduce the IRR to get the NPV exactly equal to zero. Then after
rounding off it shall be again equal to 25%. Therefore, IRR for Project A is 25%.
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IRR Calculation for Project B
NPV = AED. 30,172 when the discount rate is 10%
NPV = ??? When the discount rate is 25%
Tip
Select any cell where you want to see the result. Write =IRR(values, [guess]).
In the place of values give range of cells as given in the above table including
investment at Y0.
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CALCULATING IRR WITH EXCEL
FOR PROJECT B
Year Cash flow AED.
0 (100,000)
1 30,000
2 30,000
3 44,000
4 66,000
TIP
Calculating IRR with EXCEL is easier than from the interpolation formula,
as given hereinabove. So it is advised to calculate IRR with EXCEL.
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Calculating IRR by using Interpolation Formula
Project B: IRR Calculation by using Interpolation Formula
Total change in NPV = 30,172 ( 7,212) = 37,384
Total change in discount rate = 25% 10% = 15%
IRR = 10% + 30,172/37,384 x 15% = 22%
The discount rate is chosen by hit and trial method. In this example, we have
reduced discount rate from 25% to 10% to find out the exact rate that shall make
the project NPV equal to Zero. And we found the exact rate of 22% that gives
NPV equal to zero by using Interpolation Formula.
Decision Rules
If Project As IRR>Project Bs IRR then select Project A , &
If Project Bs IRR>Project As IRR then select Project B
In this case Project As IRR>Project Bs IRR, therefore, Project A is selected.
Because its IRR 25% which is higher than that of Project Bs 22%.
It is also worth noting here that IRR>Discount Rate of 10%. If these two projects
were not competing each other (i.e. independent projects), then both would have
been selected. If IRR<Discount rate of 10%, then both project would have been
rejected.
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6. MODIFIED INTERNAL RATE OF RETURN
46
MIRR FORMULA
,
MIRR = 1
( , )
Where n is the number of equal periods at the end of cash flows occur.
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MIRR DECISION RULES
Calculation
According to the data given at slide 26, Cost of Capital for the Project A and B is same at 10%
p.a. According to the assumption used in the formula for MIRR, the minimum return on re
invested cash inflows is equal to Cost of Capital or Weighted Average Cost of Capital
(WACC) instead of IRR of the given projects.
Decision Rules
In case of independent projects, the project having MIRR greater than Cost of Capital is
acceptable. For mutually exclusive projects, the project having higher MIRR shall be selected.
Conclusion
Project A has higher MIRR than that of Project B. Therefore, A should be selected according
to the criteria established for acceptance and rejection of projects under MIRR.
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7. TERMINAL VALUE
This technique assumes that each cash inflow is reinvested in an other
opportunity at a certain rate of return from the moment it is received till the
moment the project is finished.
So each cash inflow shall be compounded separately based on its expected rate
of return. The total compounded cash balance shall be discounted at the rate of
interest XYZ agreed with its banks. This technique shall give us better
estimation of cash inflows at the end of the project. In addition to data given at
slide 26, following data shall be used in the calculation for Terminal Value of
Projects A & B:
At the end of year Expected rate of return (%)
1 7
2 9
3 6
4 8
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TV CALCULATION
Total Total
Net cash Net cash
compounde compounded
Yr. RoI YuI CF inflows inflows for
d sum for sum for
Project A Project B
Project A Project B
1 2 3 4 5 6=4x5 7 8=4x7
% AED. AED. AED. AED.
1 7 3 1.225 45,000 55,125 30,000 36,750
2 9 2 1.188 40,000 47,520 30,000 35,640
3 6 1 1.060 35,000 37,100 44,000 46,640
4 8 0  50,000 50,000 66,000 66,000
Total 170,000 189,745 170,000 185,030
Important Note
A variation of Terminal Value (TV) is based on the pattern of NPV
technique and is known as Net Terminal Value (NTV) technique.
Symbolically, NTV = PVTS PVO.
It has the same Decision Rules that are used for NPV technique. If NTV is
positive accept the project and if it is negative then reject it.
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DECISION RULES FOR TV
For single project, If the Present Value of the Total of compounded reinvested cash
inflows (PVTS) is greater than the Present Value of the Outflows (PVO),
the proposed project is accepted, otherwise not.
For multiple projects (mutually exclusive projects), the project having PVTS
greater than all competing projects when compared with PVOs relating to them,
shall be selected. Symbolically,
PVTS>PVO Accept
PVTS<PVO Reject
Conclusion
In both projects PVTS is greater than PVO. Since we have to select any one of
them, that is Project A because its PVTS is greater than Project B when both
compared with their PVO which is same in this case.
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8. PROFITABILITY INDEX (PI)
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DECISION RULES FOR PI
If PI for any single project exceeds 1, the project can be accepted. For
the mutually exclusive projects, the project that has higher PI should
be considered for investment.
Conclusion
In the given illustration of two Projects A and B, Project A has higher
PI than that of Project B. Management should select Project A out of
the proposed investment opportunities.
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SUMMARY OF RESULTS
Accept
Results for Mutually Exclusive Projects
# Technique Project
A B A or B?
1. PB 2.43 years 2.91 years A
2. DPB 3.007 years 3.331 years A
3. ARR 37.50% 37.50% N/A
4. NPV AED. 34,380 AED. 30,172 A
5. IRR 25% 22% A
6. MIRR 18.44% 17.50% A
7. TV AED. 129,596 AED. 126, 375 A
8. PI (B/C Ratio) 1.344 1.302 A
Final Conclusion
Based on the results of all CB techniques used in this illustration, we recommend the
management of XYZ company to go for Project A.
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ABBREVIATIONS
# Abbreviation Description
1 AED. UAE Dirham
2 ARR Accounting Rate of Return
3 CB Capital Budgeting
4 DPB Discounted Payback Period
5 DCF Discounted Cash Flow
6 IRR Internal Rate of Return
7 MIRR Modified Internal Rate of Return
8 NPV Net Present Value
9 NTV Net Terminal Value
10 PB Payback Period
11 PI Profitability Index (also known as B/C Ratio)
12 PVO Present Value of Cash Outflows
13 PVTS PV of Total Compounded Reinvested Cash inflows
14 WACC Weighted Average Cost of Capital
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Thank You!
Ahmad Tariq Bhatti
Works & lives in
Dubai, UAE
For Feedback & Queries:
at.bhatty@gmail.com