Welcome To

2022
Lecturer: Abdirisak Ali Mohamed
Chapter

04
The Capital Budgeting
Decision
 Chapter 04 - Outline
 What is Capital Budgeting?
 Stages in Capital Budgeting Process
 Decision-making Criteria in Capital Budgeting
 Capital Budgeting Selection Strategies
 Methods of Evaluating Investment Proposals
 Payback Method/Period (PP)
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Capital Rationing
 NPV vs IRR
 Summary and Conclusions

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 What is Capital Budgeting?
Capital Budgeting is the process of evaluating and
selecting long-term investment projects that
achieve the goal of owner wealth maximization.
The purposes of Capital Budgeting Projects include:
to expand, replace, or renew fixed assets over a
long period.
Examples of Capital Budgeting projects:
◦ Buying a new computer system,
◦ Expanding the production capacity of an existing
plant or
◦ Modernizing its operations.
ADMINISTRATIVE CONSIDERATIONS

A good capital budgeting program

requires that a number of steps be taken
in the decision-making process.
1. Search for and discovery of investment
opportunities;
2. Collection of data;
3. Evaluation and decision making;
4. Reevaluation and adjustment;
Figure 12–1: Capital Budgeting Procedures

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ACCOUNTING FLOWS VERSUS CASH FLOWS
 In most capital budgeting decisions the emphasis is on cash
flow, rather than reported income.
 Let us consider the logic of using cash flow in the capital
budgeting process.
Table 12–1: Cash flow for Alston Corporation

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Table 12–2: Revised cash flow for Alston Corporation
METHODS OF RANKING INVESTMENT PROPOSALS

Three widely used methods for evaluating

capital expenditures will be considered,
along with the shortcomings and advantages
of each.
1. Payback Method/Period (PP);
2. Internal Rate of Return (IRR);
3. Net Present Value (NPV).
The first method, while not conceptually
sound, is often used. Approaches 2 and 3 are
more acceptable, and one or the other should
be applied to most situations.
 1) Payback Method/Period (PP)
 Under the payback method, we compute the time required to
recoup (regain) the initial investment.
 Assume we are called on to select between Investments A
and B in Table 12–3.
Table 12–3: Investment Alternatives

 Payback period of Investment A=2 years

 Payback period of Investment B = 3.8 years
10  Selection: Investment A, Because, Quickest payback
 Cont….
Advantages:
 Easy to understand and use;
 Places premium on liquidity;
 Emphasizes the shorter time-horizon
Disadvantages:
 ignores inflows after the cutoff period
 fails to consider the time value of money
 fails to consider any required rate of
return
 2) Internal Rate of Return (IRR)
 The internal rate of return (IRR) calls for
determining the yield on an investment.

 The simplest case would be an investment of $100 that

provides $120 after one year, or a 20 percent internal
rate of return.

 Formore complicated situations, we use Appendix B

(present value of a single amount) and Appendix D
(present value of an annuity) at the back of the book,
and the techniques described in Chapter 9, “The Time
Value of Money.”
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 Cont…..
 For example, a $1,000 investment returning an
annuity of $244 per year for five years provides
an internal rate of return of 7 percent, as
indicated by the following calculations.
1. First divide the investment (present value) by
the annuity.

2. Then proceed to Appendix D (present value of

an annuity). The factor of 4.1 for five years
indicates a yield of 7 percent.
 Cont….
Whenever an annuity is being evaluated, annuity
interest factors (PVIFA) can be used to find the final
IRR solution.

If an uneven cash inflow is involved, we are not so

lucky.

We need to use a trial and error method.

we use the trial and error approach to determine an

answer.

We begin with Investment A. 14

 Cont…

1. To find a beginning value to start our first

trial, average the inflows as if we were really
getting an annuity.
  Cont…
 Cont…
 The factor falls between 9 and 10 percent. This is
only a first approximation— our actual answer will
be closer to 10 percent or higher because our
method of averaging cash flows theoretically
moved receipts from the first two years into the last
year. This averaging understates the actual internal
rate of return.
 The same method would overstate the IRR for
Investment B because it would move cash from the
last two years into the first three years. Since we
know that cash flows in the early years are worth
more and increase our return, we can usually gauge
whether our first approximation is overstated or
understated.
 Cont…
4. We now enter into a trial and error process to arrive
at an answer. Because these cash flows are uneven
rather than an annuity, we need to use Appendix B. We
will begin with 10 percent and then try 12 percent.
 Cont…
 The answer must fall between 10 percent and 12 percent,
indicating an approximate answer of 11 percent.
 If we want to be more accurate, the results can be
interpolated. Because the internal rate of return is determined
when the present value of the inflows (PVI) equals the present
value of the outflows (PV0), we need to find a discount rate
that equates the PVI s to the cost of $10,000 (PV0). The total
difference in present values between 10 percent and 12
percent is $303.
 Cont…
 The solution at 10 percent is $177 away from
$10,000. Actually the solution is ($177/$303) percent
of the way between 10 and 12 percent. Since there is
a 2 percentage point difference between the two rates
used to evaluate the cash inflows, we need to
multiply the fraction by 2 percent and then add our
answer to 10 percent for the final answer of:

 InInvestment B the same process will yield an

answer of 14.33%.
 Cont…
The use of the internal rate of return calls for the
prudent selection of Investment B in preference to
Investment A, the exact opposite of the conclusion
reached under the payback method.

The final selection of any project under the internal rate

of return method will also depend on the yield exceeding
some minimum cost standard, such as the cost of capital
to the firm.
 3) Net Present Value (NPV)

 The final method of investment selection is to

determine the net present value of an investment.
 The basic discount rate is usually the cost of capital
to the firm.
 Thus inflows that arrive in later years must provide
a return that at least equals the cost of financing
those returns.
 If we once again evaluate Investments A and B—
using an assumed cost of capital, or a discount rate,
of 10 percent—we arrive at the following figures
for net present value.
 Cont…

Table 12–4: Capital budgeting results

 SELECTION STRATEGY
 In both the internal rate of return and net present
value methods, the profitability must equal or
exceed the cost of capital for the project to be
potentially acceptable.
 However, other distinctions are necessary—namely,
whether the projects are mutually exclusive or not.
 If investments are mutually exclusive, the selection
of one alternative will preclude (Stop) the selection
of any other alternative.
 Assume we are going to build a specialized
assembly plant, and four major international cities
are under consideration, only one of which will be
 Cont…
Assume the Cost of Capital to be 10%.

 Among the mutually exclusive alternatives, only

Bangkok would be selected.
 If the alternatives were not mutually exclusive, we
would accept all of the alternatives that provide a
return in excess of our cost of capital, and only
Singapore would be rejected.
 Cont…
Applying this logic to Investments A and B
in the prior discussion and assuming a cost
of capital of 10%, only Investment B would
be accepted if the alternatives were
mutually exclusive, while both would
clearly qualify if they were not mutually
exclusive.
 CAPITAL RATIONING
 Occurs when a limit is set on the amount of
funds available to a firm for investment.

 Firm must rank investments based on their

NPVs
 Those with positive NPVs greater than the cost
of capital are accepted until all funds are
exhausted.
 Example:The executive planning committee
may emerge from a lengthy capital budgeting
session to announce that only $5 million may be
spent on new capital projects this year.
 Cont….
 With capital rationing, as indicated in Table 12–7,
acceptable projects must be ranked, and only those
with the highest positive net present value are
accepted.
 Table 12–7: Capital Rationing
 NET PRESENT VALUE PROFILE

An interesting way to summarize the

characteristics of an investment is through
the use of the net present value profile.

The profile allows us to graphically portray

the net present value of a project at different
discount rates.
Let’sapply the profile to the investments we
discussed earlier in the chapter.
The projects are summarized again below.
 Cont…

Figure 12–2: Net present value profile

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