Lecture 6 Presented by

Dr. Md. Anwar Ullah, FCMA

Southeast University

Capital
Budgeting

1
 Learning objectives

• Understand the key motives and process of capital expenditure

• Define basic capital budgeting terminology
• Discuss the major components of relevant cash flows
• Calculate the initial investment
• Find the terminal cash flow
• To identify the four investment appraisal methods and how to
evaluate investment proposals using these methods

2
 Introduction
• Capital budgeting is the process of identifying,
evaluating, and implementing a firm’s investment
opportunities.

• It seeks to identify investments that will enhance

a firm’s competitive advantage and increase
shareholder wealth.

• The typical capital budgeting decision involves

a large up-front investment followed by a series
of smaller cash inflows.

• Poor capital budgeting decisions can ultimately

result in company bankruptcy.

3
 Key Motives
for Capital Expenditures

• Examples
– Replacing worn out or obsolete assets
– Improving business efficiency
– Acquiring assets for expansion into new products
or markets
– Acquiring another business
– Complying with legal requirements
– Satisfying work-force demands
– Environmental requirements

4
 Steps in the Process

• Step 1: Proposal Generation

– How are projects initiated?
– How much is available to spend?

• Step 2: Review and Analysis

– Preliminary project review
– Technically feasible?
– Compatible with corporate strategy?

• Step 3: Decision Making

– What are the costs and benefits?
– What is the project’s return?
– What are the risks involved?

5
 Steps in the Process

• Step 4: Implementation
– When to implement?
– How to implement?

• Step 5: Follow-Up
– Is the project within budget?
– What lessons can be drawn?

6
 Independent versus
Mutually Exclusive Projects

• Mutually exclusive projects are investments

that compete in some way for a company’s
resources. A firm can select one or another but
not both.

• Independent projects, on the other hand, do not

compete with the firm’s resources. A company
can select one, or the other, or both—so long as
they meet minimum profitability thresholds.

7
 Unlimited Funds
versus
Capital Rationing

• If the firm has unlimited funds for making investments,

then all independent projects that provide returns
greater than some specified level can be accepted
and implemented.

• However, in most cases firms face capital rationing

restrictions since they only have a given amount
of funds to invest in potential investment projects
at any given time.

8
 Accept-Reject Decision
versus
Ranking Approaches

• Two basic approaches to capital budgeting

decisions are available.
– The accept-reject approach involves evaluating
capital expenditure proposals to determine whether
they meet the firm’s minimum acceptance criterion.

– The ranking approach involves ranking projects

on the basis of some predetermined measure,
such as the rate of return.

9
 Conventional
versus
Nonconventional Cash Flow Patterns
A conventional cash flow pattern consists of an initial
outflow followed only by a series of inflows as shown
in the following Figure:

10
 Conventional
versus
Nonconventional Cash Flow Patterns

• A nonconventional cash flow pattern is one in which

an initial outflow is followed by a series of inflows
and outflows as shown in the following Figure

• Difficulties often arise in evaluating projects

with nonconventional cash flow patterns; we will limit
our discussion in this book to conventional projects. 11
The Relevant Cash Flows

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 The Relevant Cash Flows
• Major Cash Flow Components:
– Initial cash flows are cash flows resulting initially
from the project. These are typically net negative
outflows.

– Operating cash flows are the cash flows generated

by the project during its operation. These cash

flows typically are net positive cash flows.

– Terminal cash flows result from the disposition

of the project. These are typically positive net
cash flows.

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The Relevant Cash Flows

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 Methods of Investment Appraisal
• Payback period
– The length of time: cash proceeds recover the initial capital
expenditure
• Accounting Rate of Return (ARR)
– A return measurement by using average annual profits
• Net Present Value (NPV)
– The present value of the net cash inflows less the initial
investment
• Internal Rate of Return (IRR)
– A return measurement takes into account the time value of
money

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 Example

There are two optional projects for your company to

choose. However, you can only choose one of them.

The data for the initial investments are in the following

table. You are required to calculate:
– Payback period
– ARR
– NPV
– IRR, and
– Your recommendation

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 Data for the Projects
Project A Project B
Initial investment Tk.100,000 Tk.100,000
Cash inflows
Year 1 Tk.45,000 Tk.30,000
Year 2 Tk.40,000 Tk.30,000
Year 3 Tk.35,000 Tk.44,000
Year 4 Tk.30,000 Tk.46,000
• The depreciation is Tk.20,000 per year.
• The residual value for both projects is the same, Tk.20,000.

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 Payback Period
• The Payback period = the point in time at which cash
flows turn from negative to positive

Project A Cash flows Cumulated cash flow

Year 0 -100,000 -100,000
Year 1 45,000 -55,000
Year 2 40,000 -15,000
Year 3 35,000 +20,000
Year 4 50,000 +70,000

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 Payback Period

• Payback period (A) = change in cash flow required to

reach zero/total cash flow in year

=15,000/35,000 = 0.43 + 2 years = 2.43 years

• Payback period (B) = 40,000/44,000 = 0.91 + 2 years =

2.91 years
• Which project is the better one based on payback
period?

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 Payback Period

Project B Cash flows Cumulated cash flow

Year 0 -100,000 -100,000
Year 1 30,000 -70,000
Year 2 30,000 -40,000
Year 3 44,000 +4,000
Year 4 66,000 +70,000

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 ARR
Step 1: calculate annual profit
– Annual profit = net cash inflow – depreciation

Step 2: calculate average profit

– Average profit = total profits / number of years

Step 3: calculate average capital invested

– Average capital invested = (initial cost + residual value) /2

Step 4: calculate ARR

– ARR = average profit/average capital invested x 100

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 ARR
• Project A
– Average profit = (25,000 + 20,000 + 15,000 + 10,000)/4 =
70,000/4 = 17,500
– Average capital invested = (100,000+20,000) /2 = 60,000
– ARR = 17,500/60,000 x 100 = 29%

• Project B
– Average profit = (10,000 + 10,000 + 24,000 + 26,000)/4 = 17,500
– Average capital invested = (100,000 + 20,000)/2 = 60,000
– ARR = 17,500/60,000 x 100 = 29%

• Which project is the better one?

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 NPV
• Assume that your company’s cost of capital is 10%
• Discount factors at 10% are:
– Year 1 0.909
– Year 2 0.826
– Year 3 0.751
– Year 4 0.683

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 NPV
Project A Cash flow Discount factor Discounted cash flow

Year 0 -100,000 1.00 (100,000)

Year 1 45,000 0.909 40,905
Year 2 40,000 0.826 33,040
Year 3 35,000 0.751 26,285
Year 4 50,000 0.683 34,150
NPV Tk.34,380

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 NPV
Project B Cash flow Discount factor Discounted cash flow

Year 0 -100,000 1.00 (100,000)

Year 1 30,000 0.909 27,270
Year 2 30,000 0.826 24,780
Year 3 44,000 0.751 33,044
Year 4 66,000 0.683 45,078
NPV Tk.30,172

• Which project is the better one based on NPV?

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 IRR
• IRR: the discount rate when the net present value is zero
• Project A
– NPV = Tk.34,380 when the discount rate is 10%
– NPV = ? When the discount rate is 25%

Project A Cash flow Discount factor Discounted cash flow

Year 0 -100,000 1.00 (100,000)
Year 1 45,000 0.800 36,000
Year 2 40,000 0.640 25,600
Year 3 35,000 0.512 17,920
Year 4 50,000 0.410 20,500
NPV Tk.20

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 IRR
• Project B
– NPV = Tk.30,172 when the discount rate is 10%
– NPV = ? When the discount rate is 25%

Project B Cash flow Discount factor Discounted cash flow

Year 0 -100,000 1.00 (100,000)
Year 1 30,000 0.800 24,000
Year 2 30,000 0.640 19,200
Year 3 44,000 0.512 22,258
Year 4 66,000 0.410 27,060
NPV -7,482

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 IRR

• Project A: IRR = 25%

• Project B
– Total change in NPV = 30,172 + 7,482 = 37,654
– Total change in discount rate = 25% - 10% = 15%
– IRR = 10% + 30,172/37,654 x15 = 22%
• Which project is better?

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 Project Selection

Methods Single project Choice of projects A or B?

Payback less than the target Shortest payback A

period period

ARR Above the target rate With the highest ARR N/A

NPV A positive NPV With the highest NPV A

IRR Higher than the target With the highest IRR A

rate (cost of capital)

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 Advantages & Disadvantages
Method Advantages Disadvantages
Payback • simple and easy to understand and • ignores the time
use value of money
• objective – using cash flows • ignores cash flows
• liquidity – commercially realistic after the payback
• cautious & risk averse – ignores period
later cash flows
ARR • simple and easy to understand and • subjective – profit,
use not cash flows
• aids internal and external • ignores the time
comparisons value of money
• looks at the whole life of the project • difficulty in use when
•A useful tool to measure divisional with same ARR and
managerial performance various project sizes

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 Advantages & Disadvantages

Method Advantages Disadvantages

NPV • takes account of the time • difficult to be understood
value of money by managers
• concerns of shareholder • adverse effects on
wealth accounting profits in the
• takes account of risk short run
• looks at the whole life of the • how to choose discount
project rate?
IRR • takes account of the time • difficult to use in choosing
value of money projects of varying sizes
• easy to be understood by • difficult to choose when
managers have the same IRR

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 NPV Vs. IRR

• NPV and IRR will generally give us the same

decision
• Exceptions
– Non-conventional cash flows – cash flow signs change
more than once
– Mutually exclusive projects
• Initial investments are substantially different
• Timing of cash flows is substantially different
 IRR and Mutually Exclusive Projects

• Mutually exclusive projects

– If you choose one, you can’t choose the other
– Example: You can choose to attend graduate school at either
Harvard or Stanford, but not both

• Intuitively you would use the following decision rules:

– NPV – choose the project with the higher NPV
– IRR – choose the project with the higher IRR
 Conflicts Between NPV and IRR

• NPV directly measures the increase in value to the firm

• Whenever there is a conflict between NPV and another decision
rule, you should always use NPV
• IRR is unreliable in the following situations
– Non-conventional cash flows
– Mutually exclusive projects
 Capital Budgeting In Practice

• We should consider several investment

criteria when making decisions
• NPV and IRR are the most commonly used
primary investment criteria
• Payback is a commonly used secondary
investment criteria
 Summary – Discounted Cash Flow Criteria

• Net present value

– Difference between market value and cost
– Take the project if the NPV is positive
– Has no serious problems
– Preferred decision criterion
• Internal rate of return
– Discount rate that makes NPV = 0
– Take the project if the IRR is greater than the required return
– Same decision as NPV with conventional cash flows
– IRR is unreliable with non-conventional cash flows or mutually exclusive
projects
• Profitability Index
– Benefit-cost ratio
– Take investment if PI > 1
– Cannot be used to rank mutually exclusive projects
– May be used to rank projects in the presence of capital rationing
 Summary – Payback Criteria

• Payback period
– Length of time until initial investment is recovered
– Take the project if it pays back in some specified period
– Doesn’t account for time value of money and there is an arbitrary
cutoff period
• Discounted payback period
– Length of time until initial investment is recovered on a
discounted basis
– Take the project if it pays back in some specified period
– There is an arbitrary cutoff period