CAPITAL BUDGETING

WHAT IS CAPITAL BUDGETING?

• Capital budgeting is the making of long-run planning decisions for investments in projects and
programs.
• It is a decision-making and control tool that focuses primarily on projects or programs that
span multiple years.
Identification stage
To distinguish which types of capital expenditure projects are necessary to accomplish organization objectives.

Search stage.
To explore alternative capital investments that will achieve organization objectives.

Information-acquisition stage.
To consider the expected costs and the expected benefits of alternative capital investments.

Selection stage.
To choose projects for implementation.

Financing stage.
To obtain project funding.

Implementation and control stage.

To get projects underway and monitor their performance.
CAPITAL BUDGETING TECHNIQUES
• TRADITIONAL METHODS
• PAYBACK PERIOD
• ACCOUNTING RATE OF RETURN
• DISCOUNTED CASH FLOW METHOD
• NET PRESENT VALUE (NPV) METHOD
• INTERNAL RATE OF RETURN (IRR) METHOD
TRADITIONAL METHODS
PAY BACK PERIOD
• Payback measures the time it will take to recoup, in the form of expected future cash
Definition
flows, the initial investment in a project.

• Assume that TastyJuices Inc. is considering buying some a juicing equipment for
Example $210,000, with an estimated useful life of 11 years, and zero predicted residual value.
TastyJuices Inc expects use of the equipment to generate $35,000 of net cash inflows
from operations per year.
How long would it
take to recover the • $210,000 ÷ $35,000 = 6 years. 6 years is the payback period.
investment?
• Suppose that an alternative to the $210,000 piece of equipment, there is another one
Alternative
that also costs $210,000 but will generate $42,000 per year during its 5 year-life

What is the payback • $210,000 ÷ $42,000 = 5 years

period?

Which piece of • Machine 1 is preferable because it will continue to generate net cash inflows for five
equipment is years after its payback period. This will give the company an additional net cash inflow
preferable? of $175,000.
PAYBACK PERIOD – UNEVEN CASH FLOWS
What will happen when • When cash flows are uneven, calculations must take a cumulative form. But,
cash flows are uneven? however we assume cashflows are uniform within a year.
• Assume that YummyBakes’ baking machine purchased for $200,000 is going to yield
Example net cash flows of $35000, $50000, $75000, $60000 and $25000 during its useful life
of 5 years. What is the payback period?

FIRST, TABULATE CASH FLOWS AND CUMULATIVE CASHFLOWS

CUMULATIVE
 
(𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 −¿𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑣𝑒𝑐𝑎𝑠h 𝑓𝑙𝑜𝑤𝑠𝑜𝑓 𝑐𝑜𝑚𝑝𝑙𝑒𝑡𝑒𝑑 𝑦𝑒𝑎𝑟𝑠)
YEAR CASHFLOWS CASH FLOWS
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑=𝑛𝑜𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑐𝑜𝑚𝑝𝑙𝑒𝑡𝑒𝑑+
𝑐𝑎𝑠h 𝑓𝑙𝑜𝑤 𝑜𝑓 𝑦𝑒𝑎𝑟 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑜𝑓 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦
1 35000 35000
2 50000 85000
3 75000 160000 THE INVESTMENT IS RECOUPED
4 60000 220000 BETWEEN YEARS 3 AND 4 (200000 −160000)
 
5 25000 245000 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 =3+
60000

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑=3.667 years∨3 years∧8months

 
Alternate method of finding the payback
period

200000
cf cum cf
1 35000 35000
2 50000 85000
3 75000 160000 addl required 40000 (200000-160000)
4 60000 220000 cash flow in 4th year 60000
5 25000 245000
cash flows are uniform in a given year
(60000/1
4th year 5000 monthly cash flow 2)
how many months for 40000?
8 months 8 (40000/5000)
3 years and 8 months
PAYBACK PERIOD

ADVANTAGES DISADVANTAGES
• It emphasizes more on annual cash • Does not recognize importance of time
inflows, economic life of the project value of money,
and original investment. • Does not consider profitability of
• The selection of the project is based
economic life of project,
on the earning capacity of a project. • Does not reflect all the relevant
• It involves simple calculation, selection
dimensions of profitability.
or rejection of the project can be
made easily, results obtained is more
reliable, best method for evaluating
high risk projects.
ACCOUNTING RATE OF RETURN
• Accounting rate of return (also known as simple rate of return) is the ratio of estimated
Definition accounting profit of a project to the average investment made in the project. ARR is used in
investment appraisal.

 
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
Formula 𝐴𝑅𝑅=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Decision • Accept the project only if its ARR is equal to or greater than the required accounting rate of
rule return. In case of mutually exclusive projects, accept the one with highest ARR.
ARR – EXAMPLE 1
An initial investment of Rs.500000 is expected to generate annual cash inflow of Rs.120000
for 5 years. Depreciation is allowed on the straight line basis. It is estimated that the project
will generate scrap value of Rs.42000 at end of the 5th year. Calculate its accounting rate of
return assuming that there are no other expenses on the project.

• Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years

• Annual Depreciation = (500000 − 42000) ÷ 5 = 91600
• Average Accounting Profit = 120000-91600 = 28400
• Accounting Rate of Return = 28400 ÷ 500000 = 5.68%
ARR – EXAMPLE 2
The 4 Pillars Clothing Factory wants to replace an old machine with a new one. The old machine can be
sold to a small factory for Rs.400,000. The new machine would increase annual revenue by Rs.60,00,000
and annual operating expenses by Rs.24,00,000. The new machine would cost Rs.1,44,00,000. The
estimated useful life of the machine is 12 years with Rs.600,000 salvage value.
Required:
Compute accounting rate of return of the machine using above information.
Should 4 Pillars Clothing Factory purchase the machine if management wants an accounting rate of return
of 15% on all capital investments?
• ARR = Average accounting profit/Average investment
• ARR = 2450000/14000000
• ARR=17.5%

• Average accounting profit

• = Incremental revenues – (incremental expenses + • Average investment
depreciation) • =Initial investment– net realizable value of old
• =6000000-(2400000+(14400000-600000)/12) machine
• =6000000-(2400000+1150000) • =14400000-400000
• =2450000 • =14000000
ACCOUNTING RATE FO RETURN
ADVANTAGES
• Relatively simple to calculate and
easy to apply
• It states the economic desirability of
an investment in terms of
Percentage of return on the original
outlay
• Unlike PBP, ARR considers all the
benefits arising out of the proposal
through out its economic life.
DISADVANTAGES
• It ignores time value of money, i.e treats
profit earned in the first year equal to
profits earned in later years.
• It is based on accounting profits rather
than cash flows
• It ignores the life of a proposal, i.e a
proposal with a longer life may have the
same ARR as another proposal with a
shorter life has.
DISCOUNTED CASH FLOW
METHOD
DISCOUNTED CASH FLOW METHODS
• Discounted cash-flow (DCF) methods measure all expected future cash inflows and
outflows of a project as if they occurred at a single point in time.
DCF METHODS • The discounted cash-flow methods incorporate the time value of money.
• There are two main DCF methods - Net present value (NPV) method, Internal rate-of-
return (IRR) method
• The NPV method computes the expected net monetary gain or loss from a project by
discounting all expected cash flows to the present point in time, using the required rate
NET PRESENT of return.
VALUE • Management’s minimum desired rate of return is also called the discount rate, hurdle
rate, required rate of return, or cost of capital.
• Only projects with a zero or positive net present value are acceptable.

• The internal rate-of-return (IRR) method calculates the discount rate at which the present
value of expected cash inflows from a project equals the present value of expected cash
INTERNAL RATE outflows.
OF RETURN • If IRR > rate of return, accept
• If IRR< rate of return, reject
ILLUSTRATION
• Healthy Living is a non-profit organization. One of its goals is to improve the diagnostic capabilities of its Miami
facility. Management identifies a need to consider the purchase of new, state-of-the-art equipment. The search
stage yields several alternative models, but management focuses on one machine as being particularly suitable.
The administration next begins to acquire information to do more detailed evaluation.
• The required net initial investment consists of the cost of the new machine ($245,000) plus an additional cash
investment in working capital (supplies and spare parts) of $5,000. Management expects the new machine to
have a three-year useful life and a $0 terminal disposal price at the end of the three years. This proposed
investment will yield net cash savings of $125,000, $130,000, and $110,000 over its life. The working capital
investment of $5,000 is expected to be recovered at the end of year 3.
• Operating cash flows are assumed to occur at the end of the year.
• Management also identifies the following nonfinancial quantitative and qualitative benefits of investing in the
new diagnostic machine.
• Improved diagnoses and patient care
• Reduced inconvenience of transporting patients to other facilities for diagnoses
• Nonfinancial benefits are not incorporated into the analysis. In the selection stage, management must decide
whether Healthy Living should purchase the new machine.
• Assume that the required rate of return for Healthy Living is 10%.
STREAM OF CASH FLOWS

OPERATING CASH INFLOW OF

CAPITAL INVESTMENT+ YEAR 3 + WORKING CAPITAL
WORKING CAPITAL RECOVERY
NPV EVALUATION
DISCOUNT RATE 10%

YEAR NET CASH FLOWS PV FACTOR AT 10% DISOCUNTED CASH FLOWS

0 -250000 1 -250000
1 125000 0.9091 113636
2 130000 0.8264 107438
3 115000 0.7513 86401

NPV 57476
This project is acceptable because its net present value is $57,476.
SCENARIO 2
• Assume that Healthy Living is considering another investment that will generate
$80,000 per year for three years, and have a residual value of $4,000 at the end of
the third year.
• The cost of this investment is $220,000 including working capital.
• The working capital investment of $5,000 is expected to be recovered at the end of
year 3.
• Healthy Living expects a return of 10%.
• Should the investment be made?
 NPV EVALUATION CAPITAL INVESTMENT + WC INVESTMENT

DISCOUNT
RATE 10%

NET CASH PV FACTOR AT DISOCUNTED CASH

YEAR FLOWS 10% FLOWS

0 -220000 1 -220000
1 80000 0.9091 72727
OPERATING CASH INFLOWS+SALVAGE VALUE
2 80000 0.8264 66116 + WORKING CAPITAL RECOVERY
3 89000 0.7513 66867

NPV -14290

This project is NOT acceptable because its net present value is -$14,290.
NET PRESENT VALUE METHOD

ADVANTAGES
• It recognizes the time value of
money.
• It considers the cash inflow of the
entire project.
• It estimates the present value of
their cash inflows by using a
discount rate equal to the cost of
capital.
• It is consistent with the objective of
maximizing the welfare of owners.
DISADVANTAGES
• It is very difficult to find and understand
the concept of cost of capital
• It may not give reliable answers when
dealing with alternative projects under
the conditions of unequal lives of
project.
IRR METHOD
• SCENARIO 1
• The required net initial investment
consists of the cost of the new machine
($245,000) plus an additional cash
investment in working capital (supplies
and spare parts) of $5,000.
• Management expects the new machine
to have a three-year useful life and a $0
terminal disposal price at the end of the
three years.
• This proposed investment will yield net
cash savings of $125,000, $130,000, and
$110,000 over its life.
• The working capital investment of
$5,000 is expected to be recovered at
the end of year 3.
• SCENARIO 2
• Assume that Healthy Living is considering
another investment that will generate $80,000
per year for three years, and have a residual
value of $4,000 at the end of the third year.
• The cost of this investment is $220,000 including
working capital.
• The working capital investment of $5,000 is
expected to be recovered at the end of year 3.
If Healthy life expects a required rate of
return of 10% on its investments, which
project should be accepted BASED ON IRR?
 SCENARIO 1 SCENARIO 2
IRR 22.82% IRR 6.33%

DISOCUN DISOCUN
PV TED NET PV TED
FACTOR CASH CASH FACTOR CASH
YEAR NET CASH FLOWS AT 10% FLOWS YEAR FLOWS AT 10% FLOWS
0 -250000 1 -250000 0 -220000 1 -220000
1 125000 0.8142 101775 1 80000 0.940468 75237
2 130000 0.6629 86180 2 80000 0.884481 70758
3 115000 0.5398 62071 3 89000 0.831826 74033

NPV 26 NPV 28

IRR indicates the rate at which a project starts generating a positive NPV. This rate should be as high as possible,
preferably higher than the discount rate.
SCENARIO 1 has IRR of 22.82>10%  so, accept
SCENARIO2 has IRR of 6.33% <10%  so, reject
INTERNAL RATE OF RETURN METHOD
ADVANTAGES
• It consider the time value of money.
• IRR attempts to find the maximum rate of
interest at which funds invested in the
project could be repaid out of the cash
inflows arising from the project.
• It is not in conflict with the concept of
maximizing the welfare of the equity
shareholders.
• It considers cash inflows throughout the
life of the project.
DISADVANTAGES
• Computation of IRR is tedious and difficult to
understand
• Both NPV and IRR assume that the cash
inflows can be reinvested at the discounting
rate in the new projects. However,
reinvestment of funds at the cut off rate is
more appropriate than at the IRR.
• It may give results inconsistent with NPV
method. This is especially true in case of
mutually exclusive project.
ADVANTAGES OF NPV OVER IRR
• The NPV method has the important advantage that the end result of
the computations is expressed in dollars and not in a percentage.
• Individual projects can be added to see the effect of accepting a
combination of projects.
• It can be used in situations where the required rate of return varies
over the life of the project.
• The IRR of individual projects cannot be added or averaged to derive
the IRR of a combination of projects.
RELEVANT CASH FLOWS FOR DCF METHODS
• Relevant cash flows are expected future cash flows that differ among the
alternatives. Capital investment projects typically have three major categories of
cash flows:
Relevant cash flows • Net initial investment
• Cash flow from operations
• Cash flow from terminal disposal of assets and recovery of working capital

• Initial asset investment

Net initial investment • Initial working capital investment
• Current disposal value of old asset

• Cash inflows may result from producing and selling additional goods or services, or,
Cash flows from as in the Healthy Living example, from savings in cash operating costs.
operations • Depreciation is irrelevant in DCF analysis because it is a noncash allocation of costs.
• DCF is based on inflows and outflows of cash.
• At the end of the machine’s useful life the terminal disposal price may be zero or an
Terminal disposal price
amount considerably less than the initial machine investment.
Working capital • The initial investment in working capital is usually fully recouped when the project is
recovery terminated.