Chapter 12

Capital Budgeting
 Outline
• What is Capital Budgeting ?
• Importance of Capital Budgeting.
• Calculation techniques of different methods of
capital budgeting for proposed project.
• Advantages and Limitations of different methods
• Practice
 What is Capital Budgeting ?

• Process that relates to the evaluation of

several alternative proposed investment
projects for a firm.

- Example ?
 Importance of Capital Budgeting

✔ Involves commitment of large amount of funds for long

term.
✔ Essential for evaluating future events which are
uncertain.
✔ Ensure the selecting the right source of financing at the
right time.
 Capital Budgeting
Methods

❑Payback Period (PBP)

❑Net present value (NPV)

❑Profitability Index (P.I)

❑Internal Rate of Return (IRR)

 Payback Period

⦿Payback Period: Length of time require to

recover the amount of initial investment.

• Minimum Acceptance Criteria

- Set by management

• Ranking Criteria:
- Lowest is better
 Example
Time Project A Project B
0 (10,000) in taka. (10,000) in taka.
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

 
 Project B
Year Cash Flow Cumulative
Cash flow
0 (10,000) (10,000)
1 500 (9,500)
2 500 (9,000)
3 4,600 (4,400)
4 10,000 5,600

  [ Project A, 2.9 years] H.W

Accept Project ‘A’ & Reject project ‘B’

 Payback
Advantages & Limitations

▪ Advantages
▪ Easy to understand
▪ Provides a good ranking of projects in terms of liquidity

⮚Limitations:
⮚ Ignores the time value of money
⮚ Ignores cash flows after the payback period

(Ahmed, 2012)
 Net Present Value
(NPV)

• Net Present Value (NPV) : Present value of all the costs and
benefits of a project.

• Estimating NPV:
– 1. Estimate future cash flows (CF)
– 2. Estimate discount rate (K) / WACC
– 3. Estimate initial investment / Cost

NPV = Total PV of future CF’s - Initial Investment

• Minimum Acceptance Criteria: Accept if NPV > 0

• Ranking Criteria: Choose the highest NPV (If projects are qualified)
 NPV of Project ‘B:

 
  
Project A, NPV

  A = 3,500
I = 10%
N =4
 

 
* HW 16 & 10 B

• Accept Project ‘B’ & Reject project ‘A’

 Why use Net Present Value (NPV)

▪ NPV uses all the cash flows of the project. (Not up to certain period)

▪ Consider the time value of money by discounting the cash

flows properly.

▪ Accepting positive projects benefits the shareholders.

(Rose, Westerfield & Jaffe, 2006)

 Profitability
Index (P.I)

P.I of Project ‘B:

 

• Accept Project ‘B’ & Reject project ‘A’

 Internal Rate of Return
(IRR)

• IRR: The discount that sets NPV to zero.

• Minimum Acceptance Criteria:

– Accept if the IRR exceeds the WACC or required return.
• Ranking Criteria:
– Select alternative with the highest IRR (if projects are qualified)
 IRR of project B
Step 1: Assume discount rate is 10%
Step 2: calculate NPV by assuming K
is 10%

+ 10 % 12% “ - 22% 30%

+ NPV 1154 0 - (2,207)
 IRR of project B L.D.R = Lower discount rate
Step 3: H.D.R= Higher discount rate

 
Here:
L.D.R = 10%
H.D.R= 22%
  NPV of L.D.R= 1,154
NPV of H.D.R= (2,207)

 
HW 19
 
Assume, Discount rate/WACC 10% .
 
Decision: IF IRR of project A is 12%,
Accept Project ‘B’ &
Reject project ‘A’
 Mutual exclusive vs Independent project
Mutual exclusive : Disjoint if they cannot both occur at the same time.
Example, a single coin toss, which can result in either heads or tails, but not both.

Independent project: The occurrence of one event does not affect the occurrence

of the other.

If projects are If Independent

A B projects , following
mutually exclusive,
following project project should be
1) PBP 2 years 3.5 should be accepted accepted
yeras
2) NPV $3,200 $4,500 1 PBP = A 1 PBP = Depends
3) NPV ($3,200) ($4,500) 2 NPV= B 2 NPV= Both

4) IRR (Cost 12.4% 11 % 3 NPV = None 3 NPV = None

10%) 4 IRR = A 4 IRR = A
 Yea CASH Cumulative
r flow Cash flow • 409 pg ; 10
Project B Cost of capital 10%. Calculate PBP,
0 (10,000) (10,000) NPV
1 12,000 2,000
2 8,000 10,000
3 6,000 16,000

   

 
 RANDOM math
A) Calculate NPV, assume cost/K is 11% Year Project Project
B) BASED on NPV which project should be IUB NSU
selected
C) Calculate the IRR of both project 0 (9,000) (8,000)
D) BASED on IRR which project should be 1 12,000 9,500
selected
2 (0) (1,000)
3 8,000 14,000

C) IRR H.W
&
H.W 14
Yea CASH flow • Pg 410/15:
r
Spend/invest 10,000 at the end of third year.
0 (60,000)
Cost of capital 10%. Calculate PBP, NPV & IRR
1 15,000
2 25,000 ✔ PBP as usual method.
✔ No impact for new investment [10,000]
3 40,000

 
 
 IRR of the project L.D.R = Lower discount rate
H.D.R= Higher discount rate

 
Here:
L.D.R = 3%
H.D.R= 10%
  NPV of L.D.R= 5,583
NPV of H.D.R= (3,188)

 
 **Few important facts

✔ Practice of any particular method varies industry to industry.

✔ Factors that investor should also consider

- Future potentiality of project
- Risk of the project

✔ In future finance course you will learn that part, In sha Allah.