1. BBA, MBA(Finance), London, UK
Topic # 08
Capital Budgeting
Techniques
Zulfiqar Hasan
BBA, MBA(Finance), London, UK
Associate Professor

2. Lecture Contents
Definition of Capital Budgeting, Importance and scope of capital budgeting, types of investment projects, Capital Budgeting Technique: PBP, NPV, PI and IRR etc, Cash Flows: relevant vs irrelevant, Estimating Cash Flows, limitations of capital budgeting
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3. What is Capital Budgeting?
The process of identifying, analyzing and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.(-James C. Van Horne)
Capital Budgeting may be defined as the decision making process by which firms evaluate the purchase of major fixed assets including premises, machinery and equipment.
Capital budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities.
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4. Independent Project versus Mutually Exclusive Projects
Independent Investment Projects: Independent means neither events depend on each other, they go on their own course by themselves. These are different projects with different outcomes and independent cash flows. All profitable projects are acceptable if capital budget is available.
Mutually Exclusive Projects: Mutually exclusive is when two things cannot coexist at the same time. These are different projects with identical out come and interrelated cash flows. All profitable projects are ranked first and the most profitable project is selected.
Mutually exclusive is the situation in which only one of two projects designed for the same purpose can be accepted and independent projects is a project whose feasibility can be assessed without consideration of any others.
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5. Types of Investment Projects /Application of Capital Budgeting
New Investments:
This types of investment adds to the fixed assets of the firm.
Replacement or Reinstallation Investments:
This type of investment replaces an existing asset.
Modernization
Mechanization
Selection of alternative machinery
Expansion
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6. Irrelevant Cash Flows:
Types of Cash Flows
Normal Cash Flows:
Cost (negative CF) followed by a series of positive cash inflows. One change of signs.
Nonnormal Cash Flows:
Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.
Irrelevant Cash Flows:
Sunk cost is not included in capital budgeting analysis, i.e., R&D expenses.
Relevant Cash Flows:
Cash flows considered in capital budgeting, i.e., opportunity cost, cannibalization, and others.
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7. Sample Questions 01: What are the five steps involved in the capital budgeting process?
Proposal generation is the origination of proposed capital projects for the firm by individuals at various levels of the organization.
Review and analysis is the formal process of assessing the appropriateness and economic viability of the project in light of the firm's overall objectives. This is done by developing cash flows relevant to the project and evaluating them through capital budgeting techniques. Risk factors are also incorporated into the analysis phase.
Decision making is the step where the proposal is compared against predetermined criteria and either accepted or rejected.
Implementation of the project begins after the project has been accepted and funding is made available.
Follow-up is the post-implementation audit of expected and actual costs and revenues generated from the project to determine if the return on the proposal meets preimplementation projections.
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8. Sample Question 02: What is capital budgeting
Sample Question 02: What is capital budgeting? Do all capital expenditures involve fixed assets? Explain.
Capital budgeting is the process used to evaluate and select long-term investments consistent with the goal of owner wealth maximization. Capital expenditures are outlays made by the firm that are expected to produce benefits over the long term (a period greater than one year).
Not all capital expenditures are made for fixed assets. An expenditure made for an advertising campaign may have long-term benefits.
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9. Capital Budgeting Techniques
Payback Period (PBP)
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Equivalent Annual Annuity (EAA)
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10. Capital Budgeting Decision Rules
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11. Payback Period (PBP)
Definition: PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.
The Payback Period represents the amount of time that it takes for a Capital Budgeting project to recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule specifies that all independent projects with a Payback Period less than a specified number of years should be accepted. When choosing among mutually exclusive projects, the project with the quickest payback is preferred.
The payback period is the time taken to recover the initial investment.
The shorter the payback period, the better
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12. Calculation of PBP: The Simple Rule
Calculation of PBP: The Algebraic Formula
Here
a = Number of YEAR before Full Recovery Year
b = Initial Investment
c= Cumulative cash flow at year a
d= Actual cash flow at full recovery year
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13. Example 01: Payback Period
Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She 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 outflow (investment) will be $40,000. Calculate Payback Period
(a)
(d) 7000
(b)
(c)
Cumulative
Inflows
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14. Should this project be accepted?
PBP Acceptance Rules
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.]
Payback Method Decision Rule:
Accepted projects depends on the firm’s view of payback time period.
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15. Practice 01: Payback Period
Jordan Enterprises is considering a capital expenditure that requires an initial investment of $42,000 and returns after-tax cash inflows of $7,000 per year for 10 years. The firm has a maximum acceptable payback period of 8 years.
Determine the payback period for this project.
Should the company accept the project? Why or why not?
6 years
The company should accept the project, since 6 < 8.
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16. If the Target PBP is 3.5 Years, should you purchase the machine?
Practice 01
Assume that your company is investigating a new labor-saving machine that will cost $10,000. The machine is expected to provide cost savings each year as shown in the following timeline: 1 2 3 4 5
2000
2500
3000
3500
4000
-10,000
If the Target PBP is 3.5 Years, should you purchase the machine?
years
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17. 1.7 years B. 1.9 years C. 2.4 years D. 2.7 years
Practice 01
Suppose the expected cash flows for projects L and S are as follows:
Year Project L Project S
$ $100
$ $70
$ $45
$ $20
What is the payback period for Project L or S?
1.7 years B. 1.9 years C. 2.4 years D. 2.7 years
Which project should be accepted if they are Independent?
Which project should be accepted if they are mutually exclusive?
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18. PBP Strengths & Weaknesses
STRENGHTS
Easy to use and understand
Can be used as a measure of liquidity
Easier to forecast ST than LT flows
WEAKNESSES
It does not consider cash flows that occur after the payback time period.
It does not consider the time value of money.
It does not take account of the cost of capital.
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19. Discounted Payback Period
Discounted Payback Period is the length of time required to recover the initial cash outflow from the discounted future cash inflows. This is the approach where the present values of cash inflows are cumulated until they equal the initial investment.
The discounted payback period is the amount of time that it takes to cover the cost of a project, by adding positive discounted cash flow coming from the profits of the project.
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20. Example 01: Discounted Payback Period
An investment project has annual cash inflows of $7000, $7500, $8000, and $8500, and a discount rate of 14%. What is the discounted payback period for these cash flows if the initial cost is $8000? What if the initial cost is $13000? What if it is $18000?
Solution 1 2 3 4
Annual Cash flow
-8000
$7000
7500
8000
8500
PV of Cash flow
-8000
Cumulative Cash flow
Result: b years c years
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21. Net Present Value (NPV)
The Net Present Value (NPV) of a Capital Budgeting project indicates the expected impact of the project on the value of the firm. Projects with a positive NPV are expected to increase the value of the firm. Thus, the NPV decision rule specifies that all independent projects with a positive NPV should be accepted. When choosing among mutually exclusive projects, the project with the largest (positive) NPV should be selected.
NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow.
The net present value (NPV) is the difference between the present value of the cash flows (the benefit) and the cost of the investment (IO):
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22. Example 02: Calculating NPV
Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She 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 outflow (investment) will be $40,000. Calculate Net Present Value 13%).
= -$1424
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23. All projects with NPV greater than or equal to zero should be accepted
NPV Decision Rule
For independent projects, if the NPV > 0, accept the project, otherwise reject it.
For mutually exclusive projects, accept the project with the highest NPV.
All projects with NPV greater than or equal to zero should be accepted
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 ]
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24. Practice 01 NPV
Assume that your company is investigating a new labor-saving machine that will cost $10,000. The machine is expected to provide cost savings each year as shown in the following timeline: 1 2 3 4 5
2000
2500
3000
3500
4000
-10,000
Calculate NPV if your required return is 12%. Should this machine be purchased?
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25. Year Project L Project S 0 -$100 -$100 1 $10 $70 2 $60 $45 3 $80 $20
Practice 02
Suppose the expected cash flows for projects L and S are as follows:
Year Project L Project S
$ $100
$ $70
$ $45
$ $20
At a discount rate of 10%, what is the NPV for Project L or S?
Which project should be accepted if they are Independent?
Which project should be accepted if they are mutually exclusive?
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26. Suppose the expected cash flows for projects L and S are as follows:
Practice 03
Suppose the expected cash flows for projects L and S are as follows:
Year Soap Shampoo
$ $1000
$ $170
2 $ $135
3 -$ $465
4 $170 $305
At a discount rate of 12%, 13% and 15% what is the NPV Project L and Project S?
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27. NPV Strengths and Weaknesses
Cash flows assumed to be reinvested at the hurdle rate.
Accounts for TVM.
Considers all cash flows.
Weaknesses:
May not include managerial options embedded in the project.
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28. Practice 04 Expected Net Cash Flows Year Project X Project Y $(10,000)
You are financial analyst for Damon electronics Company. The director of capital budgeting has asked you to analyze two proposed capital investments, Projects X and Y. Each project has a cost of $10000, and the required rate of return for each project is 12%. The projects’ expected net cash flows are as follows:
Calculate PBP and NPV.
Which project or projects Should be accepted if they are independent?
Which project should be accepte4d if they are mutually exclusive?
Expected Net Cash Flows
Year
Project X
Project Y
$(10,000) 1
6500
3500 2
3000 3 4
1000
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29. 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 profitability index is the same as the NPV, except that we divide the PVCF by the initial outlay
CF CF CFn
(1+i)1 (1+i) (1+i)n +
CF0
PI =
<< OR >>
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30. PI Decision Rule
For independent projects, if PI > 1.0, then accept the project; otherwise reject it.
For mutually exclusive projects, accept the project with the highest PI. However, the PI ignores the scale of investment. Therefore, like the IRR, use of the PI can still lead to conflicts when ranking investments.
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31. Example 03: Profitability Index
Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She 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 outflow (investment) will be $40,000. Calculate Profitability index 13%).
PI for the Basket Wonders:
PI = $38,572 / $40,000 =
Should this project be accepted?
No! The PI is less than This means that the project is not profitable. [Reject as PI < 1.00 ]
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32. Suppose the expected cash flows for projects L and S are as follows:
Practice 05
Suppose the expected cash flows for projects L and S are as follows:
Year Project L Project S
$ $100
$ $70
$ $45
$ $20
At a discount rate of 10%, what is the profitability index for Project L and S?
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33. PI Strengths and Weaknesses
Same as NPV
Allows comparison of different scale projects
Weaknesses
Same as NPV
Provides only relative profitability
Potential Ranking Problems
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34. IRR Acceptance Criterion
The Internal Rate of Return (IRR) of a Capital Budgeting project is the discount rate at which the Net Present Value (NPV) of a project equals zero. The IRR decision rule specifies that all independent projects with an IRR greater than the cost of capital should be accepted. When choosing among mutually exclusive projects, the project with the highest IRR should be selected (as long as the IRR is greater than the cost of capital).
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 ]
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35. IRR Strengths and Weaknesses
Accounts for TVM
Considers all Cash flows
Less subjectivity
Weaknesses
Assumes all cash flows reinvested at the IRR
Difficulties with project rankings and Multiple IRRs
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36. Importance & Limitations of capital Budgeting
Profit earning capacity
Acceptance of long term proposal
Steps of reducing risk
Effect of Cost structure
Advanced plan for Fund collection
Competitions
Exchangeability
Legibility of fixed assets
Limitations
Lack of sufficient information
Reliability of information
Problem of measuring future uncertainty
Problem of selecting different time
Problem of quantitative measurement
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