CHAPTER FOUR

CAPITAL BUDGETING
4.1 Introduction to Capital Budgeting
Capital budgeting is the process of making
investment decision in long-term assets or
courses of action.
• Capital expenditure incurred today is expected to
bring its benefits over a period of time.
• These expenditures are related to the acquisition
& improvement of fixes assets.
 Cont…
• Capital budgeting is the planning of expenditure and the
benefit, which spread over a number of years.
• It is the process of deciding whether or not to invest in a
particular project, as the investment possibilities may not
be rewarding.
• The manager has to choose a project, which gives a rate of
return, which is more than the cost of financing the
project. For this the manager has to evaluate the worth of
the projects in-terms of cost and benefits.
• The benefits are the expected cash inflows from the
project, which are discounted against a standard, generally
the cost of capital.
 4.2 Importance of Investment Decision
• Affects Firm Growth
• Investment decisions have long term effects on the earning
potential and growth rate of a firm. These decisions decide the
position of an organization in the coming future. Proper planning
of investment may lead to a large flow of funds. Whereas, any
wrong decision may prove disastrous for a firm existence leading
to heavy losses.
• Determines Risk
• These decisions carry a high degree of risk as funds are
committed for a longer period. Individuals invest a large amount
on the basis of expected income in the future which is totally
uncertain. Different tools and techniques are used by investors
for analyzing available assets for a risk factor while taking such
decisions.
 Cont….
• Larger Investments
• Investment decisions are taken for the deployment of huge
funds for a longer period. Such decisions require proper
attention as the firm has limited funds whereas demand
exceeds the existing resources. Proper planning of
investment and monitoring of expenditures should be
necessarily done by each firm for attaining goals.
• No-Going Back
• Decisions related to investment are mostly of irreversible
nature. It is impossible to revert back from such decisions
once capital items are already acquired. Finding a market for
disposing of permanent assets without incurring heavy
losses is quite difficult.
 Cont…..
• Difficult Decisions
• Investment decisions involve several complexities as
they are based on future events that are beyond
prediction.
• Estimation of future cash flows becomes a big
problem as they change with variations in economic,
political, social, and technological forces.
• It becomes very difficult to accurately predict future
returns due to the uncertainty of future conditions.
 4.3 Steps in Capital Budgeting Process
• A) Project identification and generation: The first step
towards capital budgeting is to generate a proposal for
investments. There could be various reasons for taking
up investments in a business.
• B) Project Screening and Evaluation: This step mainly
involves selecting all correct criteria’s to judge the
desirability of a proposal. This has to match the objective
of the firm to maximize its market value. The tool of time
value of money comes handy in this step.
• C) Project Selection: There is no such defined method
for the selection of a proposal for investments as
different businesses have different requirements.
 Cont…
• D) Implementation: Money is spent and thus proposal
is implemented.
• The different responsibilities like implementing the
proposals, completion of the project within the
requisite time period and reduction of cost are allotted.
• E) Performance review: The final stage of capital
budgeting involves comparison of actual results with
the standard ones.
• The unfavorable results are identified and removing
the various difficulties of the projects helps for future
selection and execution of the proposals.
 4.4 Guidelines for capital Budgeting
• As capital budgeting involves substantial initial outlay and
years( at least more than one year) to reap the benefits, it is
critically important to understand some of the cardinal
principles or rules or guidelines when performing this capital
budgeting exercise.
• A) Use Cash Flows Not Accounting Profit.
• B) Focus on Incremental Cash flows. Simply it means that
you should compare the total cash flows of the company
with and without the project.
• After determining the incremental cash flows, you need to
consider the tax implication on these cash flows viz focus
only on “after-tax incremental cash flows” in the capital
budgeting analysis.
 Cont….
C) Consider any synergistic effect on the
project for example when this new product
the firm is going to introduce, will the sales of
the existing products also increase- are they
complementary to each other.
In financial terms therefore we need to
consider the sales of the new products Plus
the increase in sales of the existing products
 Cont…
D) Ignore sunk costs and consider only those costs
which are relevant to the projects.
E) Incorporate any NET additional working capital
requirements into the capital budgeting analysis for
example the need to have additional inventories,
accounts receivables and or cash (increase in current
assets) minus additional financing from accounts
payable, bank borrowings(current liabilities)
F) Excludes Interest Payments as this is already
reflected in the discount rate ( this rate implicitly
accounts for the cost of raising the financing )
 4.5 Measuring a Project’s Costs and
Benefits
• A firm invests only to increase the value of their
ownership interest.
• A firm will have cash flows in the future from its past
investment decisions.
• When it invests in new assets, it expects the future cash
flows to be greater than without this new investment.
• The expected cash flows could be related to
• (A) Initial investment
• (B) Operating cash flows
• (C) Terminal Cash flows
 (A) Initial Investment
It is the cash flows of an investment associated with
acquiring and disposing of assets in the investment.
In acquiring any asset, there are three types of cash
flows to consider:
1. Cost of the asset,
2. Set-up expenditures, including shipping and
installation; and
3. Any tax credit.
Cash flow from acquiring assets = Cost + Set-up
expenditures −Tax credit
 Example
• Suppose the firm buys equipment that costs $100,000
and it costs $10,000 to install it. If the firm is eligible for a
10% tax credit on this equipment (that is, 10% of the
total cost of buying and installing the equipment) the
change in the firm’s cash flow from acquiring the asset of
$99,000 is as follows:
 Cont....
• If the firm disposes of an asset, whether at the
end of its useful life or when it is replaced, two
types of cash flows must be considered:
• 1. what you receive or pay in disposing of the
asset; and
• 2. any tax consequences resulting from the
disposal.
Cash flow from disposing assets
=Proceeds or payment from disposing assets-
Taxes from disposing assets
 (B) Operating Cash Flow
• In most cases these are not the only cash
flows—the investment may result in
changes in revenues, expenditures, taxes,
and working capital.
• These are operating cash flows since they
result directly from the operating activities
—the day-to-day activities of the firm.
 Cont…
• To calculate the change in the firm’s operating
cash flows related to a new investment we are
considering:
a) Changes in revenues and expenses;
b) Cash flow from changes in taxes from changes in
revenues and expenses;
c) Cash flow from changes in cash flows from
depreciation tax shields; and
d) Changes in net working capital.
 Cont….

Where;
∆OCF = change in operating cash flow
∆R = change in revenues
∆E = change in expenses
∆D = change in depreciation
τ = tax rate
 Example
• Suppose you are evaluating a project that is
expected to increase sales by $200,000 and
expenses by $150,000. The project’s assets will
have a $10,000 depreciation expense for tax
purposes. If the tax rate is 40%,
• What is the operating cash flow from this project?
 ( C) Terminal (Net )Cash Flows
• An investment’s cash flows consist of two types of cash
flows: (1) cash flows related to acquiring and disposing the
assets represented in the investment and (2) cash flows
related to operations.
• The sum of the cash flows from asset acquisition and
disposition and from operations is referred to as net cash
flows(NCF).
• The net cash flows are therefore the incremental cash
flows related to an investment.
• Net cash flow
=(Investment cash flow+ Change in operating cash flow
(OCF ∆ ))
4.6 Selection and Application of Capital
Budgeting Criteria
• Criteria for Selection of capital budgeting techniques
can be categorized into two categories.
1 ) Non-Discounted cash flow (NDCF) criteria
a) Pay back reside (PB)
b) Accounting Rate of return (ARR)
2) Discounted cash flow (DCF) criteria.
a) Discounted payback Period (DPB).
b) Net Present Value (NPV)
c) Internal Rate of Return (IRR)
d) Profitability Index (PI)
 A) Payback period
• Pay back period(PBP) is the period of time required
for the cumulative expected cash flows from an
investment project to equal the initial cash outflow.
• When deciding between 2 or more competing
projects, the usual decision is to accept the one
with the shortest payback.
• Pay back is commonly used as a first screening
method.
• Project should be rejected if its payback period is
more than the company’s target payback period
 Example
• Bluesky corporation has determined that the
after-tax cash flows for the project will be
$10,000; $12,000; $15,000; $10,000; and
$7,000, respectively, for each of the Years 1
through 5.
• The initial cash outlay will be $40,000.
 Payback Solution (#1)

0 1 2 3 (a) 4 5

–40 K (-b) 10 K 12 K 15 K 10 K(d) 7K

10 K 22 K 37 K(c) 47 K 54 K

Cumulative
Inflows PBP = a + ( b – c ) / d
= 3 + (40 – 37) / 10
= 3 + (3) / 10 = 3.3
Years
13.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Decision Rule
The management of Basket Wonders has
set a maximum PBP of 3.5 years for
projects of this type.
Should this project be accepted?
Yes! The firm will receive back the initial
cash outlay in less than 3.5 years. [3.3
Years < 3.5 Year Max.]

13.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
B) The accounting rate of return method
• The accounting rate of return method of appraising
a capital project is to estimate the accounting rate of
return or return on investment (ROI) that project
should yield. If it exceeds a target rate of return, the
project will be undertaken.
The others include:
ARR =Estimated total profits X 100 %
Estimated initial investment
ARR =Estimated average profits X 100 %
Estimated initial investment
 Example
• Take Bluesky Data
ARR= Estimated total profits X 100 %
Estimated initial investment
ARR=x100%=1.35=135%
The Decision rule
This method will accept all those projects whose ARR is
higher than the minimum rate established by the
management and reject those projects which have ARR
less than the minimum rate.
 2. Discounted cash flow
• Discounted cash flow, or DCF for short, is an
investment appraisal technique which takes
into account both the time value of money
and also the profitability over a project’s
life.
• DCF is therefore superior to both ARR and
pay back as method of investment
appraisal.
 (A) Discounted Payback period
Some Companies use variant of the regular
payback, the Discounted payback period, which
is similar to regular payback period except that
the expected cash flows are discounted by the
project’s cost of capital.
By Discounted pay back period we mean the
number of years required to recover the
Investment from discounted net cash flows.
Each cash inflow is divided by (1+r)t where, t= year
in which cash flow occurs, r = projects cost of
capital
 (B) Net Present Value Method
• NPV is the present value of an investment
project’s net cash flows minus the project’s initial
cash outflow.
n
CFt
NPV   t
 CF0
t 1 (1  k )

 CF1 CF2 CFn 

=  2
 ...  n 
 CF0
 (1  k ) (1  k ) (1  k ) 
where : k = cost of capital (required return)
 Cont…
• NPV= PV-I
• The following steps are involved in the calculation of NPV.
1) Cash flows of the investment project should be forecasted
based on realistic assumptions
2) Appropriate discount rate should be identified to discount
the forecasted cash flows.
3) This rate is the firm’s cost of capital which is equal to the
required rate of return expected by investors on
investment of equivalent risk.
4) Present value of cash flows should be calculated using the
cost of capital as the discount rate
5) NPV should be found by subtracting present value of cash
outflows from present value of cash inflows.
 Decision Rule
• Accept the project when NPV is positive; NPV > 0
• Reject the project when NPV is negative; NPV < 0
• May accept the project when NPV is zero; NPV = 0
• The NPV method can be used to select between
mutually exclusive projects; the one with the higher
NPV should be selected.
• The PV of future cash flows is computed using the
cost of capital as a discount rate.
• In case of annuity, the PV would be
• PV=AxPVIFi,n, where, A is the amount of annuity
 Example
Consider Bluesky Corporation Data and Bluesky
has determined that the appropriate discount
rate (k) for this project is 13%.

NPV = $10,000 $12,000 $15,000

+ + +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + - $40,000
(1.13) (1.13)5
 NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $
7,000(PVIF13%,5) – $40,000
NPV = $10,000(0.885) + $12,000(0.783) +
$15,000(0.693) + $10,000(0.613) + $
7,000(0.543) – $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 – $40,000
= - $1,428
 NPV Acceptance Criterion
The management of Basket Wonders has
determined that the required rate is
13% for projects of this type.
Should this project be accepted?

No! The NPV is negative. This means that the

project is reducing shareholder wealth. [Reject
as NPV < 0 ]
 (C) Internal Rate of Return Methods

• The IRR is the discount rate at which the NPV for a

project equals zero.
• This rate means that the present value of the cash
inflows for the project would equal the present
value of its outflows.
• At, IRR, I=PV or NPV=0

CF1 + CF2 + CFn

ICO = (1 + IRR)1 (1 + IRR)2 (1 + IRR)n
 Decision Rule
• Accept the project when r > k. where r is
IRR and k is Cost of capital or required rate
of return
• Reject the project when r < k.
• May accept the project when r = k.
• In case of independent projects, IRR and
NPV rules will give the same results if the
firm has no shortage of funds.
 Example
• Bluesky corporation has determined that the
after-tax cash flows for the project will be
$10,000; $12,000; $15,000; $10,000; and
$7,000, respectively, for each of the Years 1
through 5. The initial cash outlay will be
$40,000.
 IRR Solution (Try 15%)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5)
$40,000 = $10,000(0.870) + $12,000(0.756) +$15,000(0.658) +
$10,000(0.572) + $ 7,000(0.497)
$40,000 = $8,700 + $9,072 + $9,870 +$5,720 + $3,479 =
$36,841 [Rate is too high!!]
 IRR Solution (Interpolate)

0.10 $41,444 $1,444

X
0.05 IRR $40,000 $4,603
0.15 $36,841

X $1,444 0.05 $4,603

=
 IRR Solution (Interpolate)

0.10 $41,444 $1,444

X
0.05 IRR $40,000 $4,603
0.15 $36,841

X $1,444 0.05 $4,603

=
 IRR Solution (Interpolate)

0.10 $41,444 $1,444

X
0.05 IRR $40,000 $4,603
0.15 $36,841

($1,444)(0.05) $4,603
X= X = 0.0157

IRR = 0.10 + 0.0157 = 0.1157 or 11.57%

 IRR Acceptance Criterion
The management of Basket Wonders has
determined that the hurdle rate is 13% for
projects of this type.

Should this project be accepted?

No! The firm will receive 11.57% for each

dollar invested in this project at a cost of 13%.
[ IRR < Hurdle Rate ]
 (D) The Profitability Index (PI) Method
• The profitability index is called also benefit cost ratio;
the ratio of the sum of the present values of a project’s
net cash inflows to the project’s present values of cash
outflows.
• The PI indicates the increase in the value of the firm
created by each birr invested in the project.
• The PI approach measures the present value of return
per birr invested, while the NPV is based on the
difference between the present value of future cash
inflows and the cash outflows.
• PI = PV/I where, PV = present value of cash inflows
• I = Initial investment.
 Decision Rule
 PI = 1 The projects benefits are expected to
equal its costs.
 PI < 1 The projects costs are expected to exceed
its benefits; reject the project.
 PI > 1 The projects benefits are expected to
exceed its costs; accept the project.
 Example
Consider the illustration used in NPV
PI= = =-0.0357
• The profitability index of the Bluesky corporation is -
0.0357.
• This is less than 1. Bluesky has simply and quickly
reject the project.
 4.7 Methods of Incorporating Risk into
Capital Budgeting
• investment projects are exposed to various degrees of
risk. There can be three types of decision making:
• (i) Decision making under certainty: When cash flows are
certain
• (ii) Decision making involving risk: When cash flows
involve risk and probability can be assigned.
• (iii) Decision making under uncertainty: When the cash
flows are uncertain and probability cannot be assigned.
 Risk and Uncertainty
Risk is the variability in terms of actual returns
comparing with the estimated returns.
Most common techniques of risk measurement
are Standard Deviation and Coefficient of
variations.
There is a thin difference between risk and
uncertainty.
In case of risk, probability distribution of cash flow
is known.
When no information is known to formulate
probability distribution of cash flows, the situation
is referred as uncertainty
 Reasons for adjustment of Risk in
Capital Budgeting decisions
• Main reasons for considering risk in capital budgeting
decisions are as follows
• 1. There is an opportunity cost involved while investing in a
project for the level of risk.
• Adjustment of risk is necessary to help make the decision as
to whether the returns out of the project are proportionate
with the risks borne and whether it is worth investing in the
project over the other investment options available.
• 2. Risk adjustment is required to know the real value of the
Cash Inflows.
• Higher risk will lead to higher risk premium and also
expectation of higher return.
A) Risk Adjusted Discount Rate
• The use of risk adjusted discount rate (RADR) is based on
the concept that investors demands higher returns from
the risky projects.
• The required rate of return on any investment should
include compensation for delaying consumption plus
compensation for inflation equal to risk free rate of
return, plus compensation for any kind of risk taken.
• If the risk associated with any investment project is
higher than risk involved in a similar kind of project,
discount rate is adjusted upward in order to compensate
this additional risk borne.
 Cont…
Risk-adjusted discount rate (RADR): the risk
adjustment is made in the denominator of the
present-value calculation
K = rf + RP
K = risk adjusted discount rate
rf = risk-free rate (short-term U.S. Treasury
securities)
RP = risk premium
 Example
• An enterprise is investing ` $1000,000 in a project. The
risk-free rate of return is 7%. Risk premium expected by
the Management is 7%. The life of the project is 5 years.
Following are the cash flows that are estimated over the
life of the project.
Year Cash flows (` in hundred thousands)
1 25
2 60
3 75
4 80
5 65
CALCULATE Net Present Value of the project based on Risk free rate
and also on the basis of Risks adjusted discount rate.
 The Present Value of the Cash Flows for all the years by
discounting the cash flow at 7% is calculated as below:
Year Cash flows in Discounting Present value of Cash
hundred Factor @7% Flows in hundred
thousands thousands

1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial investment 100.00
Net Present Value (NPV) 144.34
When the risk free rate is 7% and the risk premium expected by the
management is 7% , the risk adjusted discount rate 7%+7%=14%
Discounting the above cash flows using the Risk Adjusted Discount
Rate would be as below
Year Cash flows ` in Discounting Present Value of Cash
Factor@14% Flows ` in lakhs
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of present value of Cash flow 199.79
Initial investment 100.00
Net present value (NPV) 99.79
 B) Certainty Equivalent (CE) Method for Risk
Analysis
Certainty equivalent: a certain (risk-free) cash flow
that would be acceptable as opposed to the
expected value of a risky cash flow
With the certainty equivalent method, the risk
adjustment is made in the numerator of the
present-value calculation.
Steps in the Certainty Equivalent (CE) approach
• Step 1: Remove risks by substituting equivalent
certain cash flows from risky cash flows.
• This can be done by multiplying each risky cash
flow by the appropriate t value (CE coefficient)
α=

Step 2: Discounted value of cash flow is obtained

by applying risk less rate of interest.
Since you have already accounted for risk in the
numerator using CE coefficient, using the cost of
capital to discount cash flows will tantamount to
double counting of risk
 Cont…
• Step 3: After that normal capital budgeting method
is applied except in case of IRR method, where IRR
is compared with risk free rate of interest rather than
the firm’s required rate of return.
• Certainty Equivalent Coefficients transform expected
values of uncertain flows into their Certainty Equivalents.
It is important to note that the value of Certainty
Equivalent Coefficient lies between 0 & 1.
• Certainty Equivalent Coefficient 1 indicates that the cash
flow is certain or management is risk neutral.
• In industrial situation, cash flows are generally uncertain
and managements are usually risk averse. Under this
method
 Cont…
• Reduce the forecasts of cash flows to some conservative
levels.The certainty-equivalent coefficient assumes a
value between 0 and 1, and varies inversely with risk.
Decision-maker subjectively or objectively establishes
the coefficients.
n
 t NCFt
NPV =  (1  k )
t =0
t
f

• The certainty—equivalent coefficient can be determined

as a relationship between the certain cash flows and the
risky cash flows.
NCF*t Certain net cash flow
t  =
NCFt Risky net cash flow
58
 Cont…
• First, the forecaster, expecting the reduction that will be
made in his forecasts, may inflate them in anticipation.

• Second, if forecasts have to pass through several layers

of management, the effect may be to greatly exaggerate
the original forecast or to make it ultra-conservative.

• Third, by focusing explicit attention only on the gloomy

outcomes, chances are increased for passing by some
good investments.

59
Example

60
 C) Sensitivity Analysis
• Sensitivity analysis is a way of analysing
change in the project’s NPV (or IRR) for a
given change in one of the variables.
• The decision maker, while performing
sensitivity analysis, computes the project’s
NPV (or IRR) for each forecast under three
assumptions:
– pessimistic,
– expected, and
– optimistic.

61
 Cont…
• The following three steps are involved in the
use of sensitivity analysis:

1. Identification of all those variables, which have

an influence on the project’s NPV (or IRR).
2. Definition of the underlying (mathematical)
relationship between the variables.
3. Analysis of the impact of the change in each of
the variables on the project’s NPV.

62
 D) Scenario Analysis
• One way to examine the risk of investment is to
analyse the impact of alternative combinations of
variables, called scenarios, on the project’s NPV
(or IRR).
• The decision-maker can develop some plausible
scenarios for this purpose. For instance, we can
consider three scenarios: pessimistic, optimistic
and expected.

63
END OF CHAPTER FOUR