Capital Budgeting Decision

By Dr. Umer Iqbal

23rd of March 2022
 What is Capital Budgeting?

• Choosing projects that add value to a company

– Construction of a new plant.
– Big investment in an outside venture.
• Process by which investors determine the value of a potential investment
project.
• Project’s cash inflows and outflows
 Capital Budgeting Decision

• A firm may adopt three types of capital budgeting decisions.

i. Mutually Exclusive Projects

ii. Accept-Reject Decisions or Acceptance Rule
iii. Capital Rationing Decision
 Capital Budgeting Decision

Mutually Exclusive Projects

– Firm accepts one project; it may rule out the necessity for others.
– The alternatives are mutually exclusive and only one is to be chosen.

Example:
There is a need to transport supplies from a loading dock to the warehouse. Firm may
adopt two proposals; The alternatives are mutually exclusive and only one is to be
chosen.
(a) Fork lifts to pick up the goods and move them
(b) Conveyor belt may be connected between the dock and the warehouse

If one proposal is accepted, it will eliminate the other.

 Capital Budgeting Decision

Accept-Reject Decisions or Acceptance Rule

– Yield a higher rate of return in comparison with a certain rate of return or cost of capital
are accepted, and, naturally, the others are rejected.

Example:
Return from a project is, say, 10%, after tax and an investment proposal which shows a
return of 12% may be accepted.
An investment opportunity will be accepted if NPV > 0.
The same will be rejected if NPV < 0.
 Capital Budgeting Decision

Capital Rationing Decision

– Situations where the supply of funds to the firm is limited in some way.
– Different situations ranging from that where the borrowing and lending rates faced by
the firm differ.
– It occurs when a firm has more acceptable proposals than it can finance.
– Firm ranks the projects from highest to lowest priority based on cut-off point.
– Those proposals which are above the cut-off point will be accepted.
 Capital Budgeting Decision

Capital Rationing Decision

Example:
Minimum acceptable rate of return (after-tax) is 10%.
Investments to be made QR. 12,00,000.
Four alternative investment opportunities are there—A. B, C, and D:
A—8%, B—11%, C—13%, and D—12%. Since project A is already rejected.
 Capital Budgeting Techniques

1. Project Evaluation and Selection

2. Potential Difficulties

3. Project Monitoring

4. Post-Completion Audit
 1. Project Evaluation and Selection

I. Payback Period (PBP)

II. Internal Rate of Return (IRR)

III. Net Present Value (NPV)

IV. Profitability Index (PI)

I. Payback Period (PBP)
 I. Payback Period (PBP)

Proposed Project Data

• Mr. A is evaluating a new project
for his firm, XYZ Co. He 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.
 II. Internal Rate of Return

Proposed Project Data

• IRR is the discount rate that
equates the present value of the
future net cash flows from an
investment project with the
project’s initial cash outflow.
 II. Internal Rate of Return

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the discounted

cash flows to equal $40,000.
 II. Internal Rate of Return at 10%
$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) +
$10,000(PVIF10%,4) + $ 7,000(PVIF10%,5)

$40,000 = $10,000(0.909) + $12,000(0.826) + $15,000(0.751) +

$10,000(0.683) + $ 7,000(0.621)

$40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347

= $41,444
 II. Internal Rate of Return at 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
 II. Internal Rate of Return (Interpolate)
0.10 $41,444 $1,444
X
0.05 IRR $40,000
$4,603
0.15 $36,841
X= ($1,444)(0.05)
X = 0.0157 $4,603
IRR = 0.10 + 0.0157 = 0.1157 or 11.57%; Discount Rate > IRR
 III. Net Present Value (NPV)

NPV is the present value of an investment project’s net cash flows minus the
project’s initial cash outflow.

CF1 CF2 CFn

NPV = + +...+ - ICO
(1+k) (1+k)2
1
(1+k)n
 III. Net Present Value (NPV)

XYZ Company 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 + 5 - $40,000
(1.13) (1.13)
 III. Net Present Value (NPV)

XYZ Company has determined that the appropriate discount rate (k) for this
project is 13%.

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
Rejected because; NPV < 0
 IV. Profitability Index (PI)

PI is the ratio of the present

value of a project’s future net
cash flows to the project’s initial
cash outflow.

The PI is less than 1.00. This means PI = $38,572 / $40,000

that the project is not profitable. = .9643
[Reject as PI < 1.00 ]
 Evaluation Summary

Method Project Comparison Decision

PBP 3.3 3.5 Accept

IRR 11.47% 13% Reject

NPV -$1,424 $0 Reject

PI .96 1.00 Reject

 Post-Completion Audit
• Process that checks the outcomes of individual investment projects after
the initial investment is completed and the project is operational.
• A formal comparison of the actual costs and benefits of a project with
original estimates.
• Identify any project weaknesses
• Develop a possible set of corrective actions
• Provide appropriate feedback
• Result: Making better future decisions!
Thank You