Capital Budgeting Decisions

Capital budgeting
• It involves taking long term investment
decisions which require huge amount for
investment and will generate return in future.
Therefore such expenditure is called capex .
Projects can be
• Independent
• Mutually exclusive
• Mutually dependent
 Profit vs. cash flows
•Meaning of profit
•Meaning of cash flow and important Factors
•DEP
•TAX
•NWC
•Therefore Cash flow= PAT+DEP - increase in NWC
(+decrease in NWC)

3
 Capital budgeting decisions
• Decision can be for two types –
for new project –One need to consider
• Initial investment and
• Total expected cash flows
• Terminal cash flows
For replacement- two things to be considered
• Incremental investment
• Incremental cash flows
• Components of cash flows for new
investment
1. Initial investment – total investment including
import charges, duty, other charges
transportation , installation charges etc.
2. Annual net cash inflows(NCF)=PAT + DEP plus
or minus adjustment for Change in NWC
3. Terminal cash flows is SALVAGES VALUE

5
• Components of cash flows for incremental cash
flows
• Incremental investment
• Incremental cash flows

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 Capital Budgeting
• Budgeting for the acquisition of “capital assets”
or long term asset
• Capital budgeting techniques
Non discounting
(a) Payback period
(b) Accounting Rate of Return
Discounting
(a) Net Present Value
(b) Internal Rate of Return
(c) PI
(d) Discounted pay back
 Payback Period
Time period required to recover the cost of the
investment from the annual cash inflow
produced by the investment.

Amount invested
Expected annual net cash inflow
 Payback Period –
Uneven Cash Flows
Cumulative
Annual Net Net Cash
Casey Co. wants
Year Cash Flows Flows
to install a
0 $ (16,000) $ (16,000)
machine that costs
1 3,000 (13,000)
$16,000 and has an 2 4,000 (9,000)
8-year useful life 3 4,000 (5,000)
with zero salvage 4 4,000 (1,000)
value. Annual net 5 5,000
cash flows are: 6 3,000
7 2,000
8 2,000
 Payback Period –
Uneven Cash Flows
Cumulative
We recover the $16,000 Annual Net Net Cash
purchase price between Year Cash Flow s Flow s
years 4 and 5, about 0 $ (16,000) $ (16,000)
4.2 years for the 1 3,000 (13,000)
payback period. 2 4,000 (9,000)
3 4,000 (5,000)
4 4,000 (1,000)
4.2
5 5,000
6 3,000
7 2,000
8 2,000
 Using the Payback Period
Consider two projects, each with a 5-year life and
each costing $6,000. Payback = 5
Payback = 3 years Project One Project Tw o
Net Cash Net Cash
Year Inflow s Inflow s
Pa
1 $ 2,000 $ 1,000
2 2,000 1,000
3 2,000 1,000
4 2,000 1,000
5 2,000 1,000,000

Would you invest in Project One just because

it has a shorter payback period?
 Accounting Rate of Return
Average annual operating income from asset
Average amount invested in asset
• Compare accounting rate of return to
company’s required minimum rate of return for
investments of similar risk.
• The minimum return is based on the company’s
cost of capital.
Accounting Rate of Return
Average Investment =

Original Investment + Residual Value

2

For Casey, average investment =

($130,000 + $0)/ 2 = $65,000
Solution to Accounting Rate of Return
Problem
Average annual operating income from asset
Average amount invested in asset
$13,000 / $65,000 = 20%
 Accounting Rate of Return
The decision rule is:
A project is acceptable if its rate of return is greater
than management’s minimum rate of return.

The higher the rate of return for a given risk, the more
attractive the investment.
 Discounted Cash Flows

• Considers both the estimated total cash

inflows and the time value of money.
• Two methods
1) net present value
2) internal rate of return
 Net Present Value Method
• Find PV of future cash flows and compare
with capital outlay
• Interest rate used = required minimum rate
of return
• Proposal is acceptable when NPV is zero or
positive.
• The higher the positive NPV, the more
attractive the investment.
 Net Present Value
• We will assume that Casey Co’s annual cash
inflows of $26,000 are uniform over the
asset’s useful life.
• The present value of the annual cash inflows
can be computed by using the present value
of an annuity of 1 for 10 periods. Assume the
company requires a minimum return of 12%.
 Net Present Value
Cash When? Type of Present Present
Flow cash flow value value of
factor cash flows
(130,000) Now ($130,000)
26,000 Yrs 1-10 Annuity 5.650 146,900

NPV $16,900

Analysis of the proposal: The proposed capital expenditure

is acceptable at a required rate of return of 12% because the net
present value is positive
 Net Present Value

When annual cash inflows are unequal, use

present value of one tables.
 Cash When? Type of PV factor Present
Flow
(130,000)
Net
Now
Present Value
cash flow value
($130,000)
36,000 1 Lump sum .893 32,148
32,000 2 “ .797 25,504
29,000 3 “ .712 20,648
27,000 4 “ .636 17,172
26,000 5 “ .567 14,742
24,000 6 “ .507 12,168
,,
23,000 7 “ .452 10,396
22,000 8 “ .404 8,888
21,000 9 “ .361 7,581
20,000 10 “ .322 6,440
NPV $25,687
 Internal Rate of Return
• Interest yield of the potential investment
• The interest rate that will cause the present
value of the proposed capital expenditure to
equal the present value of the expected
annual cash inflows.
 Internal Rate of Return
• STEP 1.Compute the internal rate of return
factor using this formula:

Capital Investment
Annual Cash Inflows

$130,000 / $26,000 = 5.0

Internal Rate of Return Method
• STEP 2. Use the factor and the present
value of an annuity of 1 table to find the
internal rate of return.
• Locate the discount factor that is closest to
5.0 on the line for 10 periods.
 Internal Rate of Return
Decision Criteria
The decision rule is:
Accept when internal rate of return is equal to
or greater than the required rate of return
Reject when internal rate of return is less than
required rate
 Internal Rate of Return –
Uneven Cash Flows
• If cash inflows are unequal, trial and error
solution will result if present value tables
are used.
• Use business calculators and electronic
spreadsheets
 Comparing Methods
Payback Accounting Net present Internal rate
period rate of return value of return
Basis of Cash Accrual Cash flows Cash flows
measurement flows income Profitability Profitability
Measure Number Percent Dollar Percent
expressed as of years Amount
Easy to Easy to Considers time Considers time
Understand Understand value of money value of money
Strengths Allows Allows Accommodates Allows
comparison comparison different risk comparisons
across projects across projects levels over of dissimilar
a project's life projects
Doesn't Doesn't Difficult to Doesn't reflect
consider time consider time compare varying risk
value of money value of money dissimilar levels over the
Limitations projects project's life

Doesn't Doesn't give

consider cash annual rates
flows after over the life
payback period of a project