TECHNIQUES OF CAPITAL

BUDGETING
 OUTLINE
• Importance
• Capital Budgeting Process
• Project Classification
• Investment Criteria
• Net Present Value
• Benefit Cost Ratio
• Internal Rate of Return
• Modified Internal Rate of Return
• Payback Period
• Accounting Rate of Return
 CAPITAL EXPENDITURES AND THEIR
IMPORTANCE
• The basic characteristics of a capital expenditure (also
referred to as a capital investment or just project) is that
it involves a current outlay (or current and future
outlays) of funds in the expectation of receiving a stream
of benefits in future

• Importance stems from

• Long-term consequences
• Substantial outlays
• Difficulty in reversing
 CAPITAL BUDGETING PROCESS

• Identification of Potential Investment Opportunities

• Assembling of Investment Proposals

• Decision Making

• Preparation of Capital Budget and Appropriations

• Implementation

• Performance Review
 Learning Objectives (1 of 2)
1. Understand how to identify the sources
and types of profitable investment
opportunities.
2. Evaluate investment opportunities using
net present value and describe why net
present value is the best measure to use.
 Learning Objectives (2 of 2)
3. Use the profitability index, internal rate of
return, and payback criteria to evaluate
investment opportunities.
4. Understand current business practice with
respect to the use of capital-budgeting
criteria.
AN OVERVIEW OF CAPITAL BUDGETING
 Types of Capital Investment
Projects
1. Revenue enhancing Investments (such as
introducing a new product line)
2. Cost-reducing investments (such as replacing
old equipment with a more efficient
equipment), and
3. Mandatory investments that are a result of
government mandates (such as investments to
meet safety and environmental regulations)
 PROJECT CLASSIFICATION

• Mandatory Investments

• Replacement Projects

• Expansion Projects

• Diversification Projects

• Research and Development Projects

• Miscellaneous Projects
 INVESTMENT CRITERIA

INVESTMENT
CRITERIA

DISCOUNTING NON-DISCOUNTING
CRITERIA CRITERIA

NET BENEFIT INTERNAL ACCOUNTING

PAYBACK
PRESENT COST RATE OF RATE OF
PERIOD
VALUE RATIO RETURN RETURN

 Centre for Financial Management , Bangalore

 PAYBACK PERIOD
Payback period is the length of time required to recover the initial
outlay on the project
Naveen Enterprise’s Capital Project
Year Cash flow Cumulative cash flow
0 -100 -100
1 34 - 66
2 32.5 -33.5
3 31.37 - 2.13
4 30.53 28.40
Pros Cons
• Simple • Fails to consider the time value
of money
• Rough and ready method • Ignores cash flows beyond the
for dealing with risk payback period
• Emphasises earlier cash inflows
 AVERAGE RATE OF RETURN
Average PAT
Average Book Value of Investment (Beginning)

Naveen Enterprise’s Capital Project

Year Book Value of PAT
Investment(Beg)

1 100 14
2 80 17.5
3 65 20.12
4 53.75 22.09
5 45.31 23.57

1/5 (14+17.5 +20.12+22.09+23.57)

ARR = 1/5(100+80+65+53.75+45.31) = 28.31%

Pros Cons
• Simple • Based on accounting profit,
• Based on accounting information not cash flow
businessmen are familiar with • Does not take into account the
• Considers benefits over the entire project life time value of money
 NET PRESENT VALUE

n Ct
NPV =  – Initial investment
t=1 (1 + rt )t
 NET PRESENT VALUE
The net present value of a project is the sum of the present value of all the cash
flows associated with it. The cash flows are discounted at an appropriate discount
rate (cost of capital)
Naveen Enterprise’s Capital Project ( Cost of Capital=15%)
Year Cash flow Discount factor Present
value 
0 -100.00 1.000 -100.00
1 34.00 0.870 29.58
2 32.50 0.756 24.57
3 31.37 0.658 20.64
4 30.53 0.572 17.46
5 79.90 0.497 39.71
Sum = 31.96
  Pros Cons
• Reflects the time value of money • Is an absolute measure and not a relative
• Considers the cash flow in its entirety measure
• Squares with the objective of wealth maximisation
 PROPERTIES OF THE NPV RULE

• NPVs ARE ADDITIVE

• INTERMEDIATE CASH FLOWS ARE INVESTED AT

COST OF CAPITAL

• NPV CALCULATION PERMITS TIME-VARYING

DISCOUNT RATES
 The Problem
Saber Electronics provides specialty manufacturing
services to defense contractors located in the
Seattle, Washington area. The initial outlay is $3
million and, management estimates that the firm
might generate cash flows for years one through
five equal to $500,000; $750,000; $1,500,000;
$2,000,000; and $2,000,000. Saber uses a 20%
discount rate for projects of this type. Is this a good
investment opportunity?
 Step 1: Picture the Problem
r = 20%

Years

0 1 2 3 4 5
−$3M +$0.5M +$0.75M +$1.5M $2M $2M
Cash flows
(in $ millions)
Net
Present
Value = ?
 Step 2: Decide on a Solution
Strategy
 We need to analyze if this is a good
investment opportunity. We can do that by
computing the Net Present Value (NPV),
which requires computing the present value
of all cash flows.
 Step 3: Solve (2 of 3)
 NPV = −$3m + $.5m/(1.2) + $.75m/(1.2)2 +
$1.5m/(1.2)3 + $2m/(1.2)4 + $2m/(1.2)4
 NPV = −$3,000,000 + $416,666.67 +
$520,833.30 + $868,055.60 + $964,506 +
$803,755.10
 NPV = $573,817
 Independent Versus Mutually
Exclusive Investment Projects
 An independent investment project is one
that stands alone and can be undertaken
without influencing the acceptance or
rejection of any other project.
 Accepting a mutually exclusive project
prevents another project from being
accepted.
 Evaluating an Independent
Investment Opportunity
It requires two steps to evaluate:
[Link] NPV;
[Link] the project if NPV is positive and
reject if it is negative.
 Evaluating Mutually Exclusive
Investment Opportunities
Following are two situations where firm is faced with
mutually exclusive projects:
[Link] – When a firm is analyzing two or more
alternative investments, and each performs the same
function.
[Link] Constraints – Firm faces constraints such as
limited managerial time or limited financial capital
that limit its ability to invest in every positive NPV
project.
 BENEFIT COST RATIO/Profitability index
PVB
Benefit-cost Ratio : BCR =
I
PVB = present value of benefits
I = initial investment
To illustrate the calculation of these measures, let us consider a project which is being evaluated
by a firm that has a cost of capital of 12 percent.
Initial investment : Rs 100,000
Benefits: Year 1 25,000
Year 2 40,000
Year 3 40,000
Year 4 50,000
The benefit cost ratio measures for this project are:
25,000 40,000 40,000 50,000
(1.12)
+ (1.12)2
+ (1.12)3
+ (1.12)4
BCR = = 1.145 NBCR = BCR – 1= 0.145
100,000
Pros Cons
Measures bang per buck Provides no means for aggregation
 Centre for Financial Management , Bangalore
 INTERNAL RATE OF RETURN
Net Present Value

Discount rate

The internal rate of return (IRR) of a project is the discount rate that
makes its NPV equal to zero. It is represented by the point of intersection
in the above diagram
Net Present Value Internal Rate of Return
• Assumes that the • Assumes that the net
discount rate (cost present value is zero
of capital) is known.
• Calculates the net • Figures out the discount rate
present value, given that makes net present value zero
the discount rate.
 CALCULATION OF IRR
You have to try a few discount rates till you find the one that makes the
NPV zero
Year Cash Discounting Discounting Discounting
flow rate : 20% rate : 24% rate : 28%
Discount Present Discount Present Discount Present
factor Value factor Value factor Value

0 -100 1.000 -100.00 1.000 -100.00 1.000 -100.00

1 34.00 0.833 28.32 0.806 27.40 0.781 26.55
2 32.50 0.694 22.56 0.650 21.13 0.610 19.83
3 31.37 0.579 18.16 0.524 16.44 0.477 14.96
4 30.53 0.482 14.72 0.423 12.91 0.373 11.39
5 79.90 0.402 32.12 0.341 27.25 0.291 23.25

NPV = 15.88 NPV = 5.13 NPV = - 4.02

 Centre for Financial Management , Bangalore

 CALCULATION OF IRR

Smaller NPV at the smaller rate Bigger Smaller

discount + X discount – discount
rate Sum of the absolute values of the rate rate
NPV at the smaller and the bigger
discount rates

5.13
24% + 28% - 24% = 26.24%
5.13 + 4.02

 Centre for Financial Management , Bangalore

 PROBLEMS WITH IRR

• NON-CONVENTIONAL CASH FLOWS

• MUTUALLY EXCLUSIVE PROJECTS

• LENDING VS. BORROWING

• DIFFERENCES BETWEEN SHORT-TERM AND

LONG-TERM INTEREST RATES

 Centre for Financial Management , Bangalore

 NON-CONVENTIONAL CASH FLOWS

C0 C1 C2
-160 +1000 -1000

TWO IRRs : 25% & 400%

NPV

25% 400%
Discount rate( %)

NO IRR : C0 C1 C2
 MUTUALLY EXCLUSIVE PROJECTS

C0 C1 IRR NPV
(12%)

P -10,000 20,000 100% 7,857

Q -50,000 75,000 50% 16,964

 Centre for Financial Management , Bangalore

 LENDING VS BORROWING

C0 C1 IRR NPV
(10%)
A -4000 6000 50% 145

B 4000 -7000 75% -236

 Centre for Financial Management , Bangalore

 MODIFIED IRR

0 1 2 3 4 5 6

-120 -80 20 60 80 100 120

r=15% 115
-69.6 r =15% r =15% 105.76
PVC = 189.6 r =15% 91.26
r =15% 34.98
Terminal value (TV) = 467
PV = 189.6 MIRR = 16.2%
of TV

NPV 0

 Centre for Financial Management , Bangalore

INVESTMENT APPRAISAL
IN PRACTICE

• Over time, discounted cash flow methods have gained in

importance and internal rate of return is the most
popular evaluation method.

• Firms typically use multiple evaluation methods.

• Accounting rate of return and payback period are

widely employed as supplementary evaluation methods.

 Centre for Financial Management , Bangalore

 SUMMING UP
n Ct
• NPV =  –I
t=1 (1 + r)t
PVB
• BCR =
I
• IRR is the value of r in the following equation
n Ct
I= 
t = 1 (1 + r)t
• MIRR is calculated as follows:
TV
PVC =
(1 + MIRR)n
• The payback period is the length of time required to recover the initial cash outlay on the
project
• The accounting rate is defined as:
Average profit after tax
Average book value of investment
 Centre for Financial Management , Bangalore