CAPITAL BUDGETING By: Hira Babar

CAPITAL BUDGETING PROCESS

Monitoring
and post
Planning auditing
the capital
Analyzing budget
Individual
Generating Proposals
Ideas
CAPITAL BUDGETING PROJECTS

Other (R&D
etc)
Regulatory
New products safety and
and services environmental
projects
Expansion
projects

Replacement
Projects
PRINCIPLES OF CAPITAL BUDGETING
1. Decisions are based on Cashflows
2. Timing of cashflow is crucial
3. Cashflows are based on opportunity cost
4. Cashflows are analyzed on a after tax basis
5. Financing costs are ignored
IMPORTANT CB CONCEPTS Sunk cost

Funds Opp cost

Aspects of Capital Budgeting that are important to division
understand.

Proj
CB Incremental
sequencing CF

Indep Vs Cannibaliz
Mutually ation
exclusive
INVESTMENT DECISION CRITERIA
NET PRESENT VALUE
It is for projects with one investment outlay in the beginning of the period.

𝐶𝐹𝑡
𝑁𝑃𝑉 = σ𝑛𝑡=1 − 𝑂𝑢𝑡𝑙𝑎𝑦
1+𝑟 𝑡
 𝐶𝐹𝑡 = After tax cashflow at time t
 r = required rate of return for the investment
 Outlay = investment cashflow at time zero.

Decision Rule
 NPV > 0 Invest
 NPV < 0 Do not Invest
EXAMPLE
Gellete is considering an investment of $50million, the after tax cashflows for this
project are $16 million per year for the next four years plus another $20 million in
year 5. the required rate of return is 10%
INTERNAL RATE OF RETURN - IRR
It is also for projects with one investment outlays
IRR is a discount rate
It makes the PV of future after tax cashflows equal to the initial investment outlay

𝑛
𝐶𝐹𝑡
𝑁𝑃𝑉 = ෍ 𝑡
− 𝑂𝑢𝑡𝑙𝑎𝑦 = 0
1 + 𝐼𝑅𝑅
𝑡=1

Algebraically this equation is very difficult to solve for, hence we go for trial and error.

In the previous example at the discount rate 19.52% the NPV is zero
INTERNAL RATE OF RETURN - IRR
Any project with an IRR greater than its cost of capital is a profitable one, and thus it
is in a company’s interest to undertake such projects.
The higher a project's internal rate of return, the more desirable it is to undertake.
The use of "internal" refers to the omission of external factors, such as the cost of
capital or inflation, from the calculation.
the internal rate of return is the rate of growth a project is expected to generate.
NPV VS IRR
Let’s assume there are two projects A and B the Cashflows NPV and IRR are
provided. If these projects are mutually exclusive which one would you choose to do?
NPV VS IRR
Let’s assume there are two projects A and B the Cashflows NPV and IRR are
provided. If these projects are mutually exclusive which one would you choose to do?
MULTIPLE/NO IRR PROBLEM
For non-conventional projects we can have multiple or no IRR
PAYBACK PERIOD
It’s the number of years required to recover the original investment in the project.
Draw backs
 Ignores Time value of money
 Does not consider cashflows after payback period

DISCOUNTED PAYBACK PERIOD

It’s the number of years it takes for the cumulative discounted cashflows from the project to recover the
original investment in the project.

 Does not consider cashflows after discounted payback period

AVERAGE ACCOUNTING RATE OF RETURN
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝐴𝑅 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒

Easy to understand and calculate

Drawbacks
 Based on accounting numbers
 Doesn’t account for time value of money
 No sound cutoff to distinguish between good and bad investments
THANKYOU