King Faisal University [ ] 1 Business School Management Department Finance Pre-MBA Dr Abdeldjelil Ferhat BOUDAH 1

King Faisal University [ ] CHAPTER 11 CAPITAL BUDGETING TECHNIQUES 2 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES INTRODUCTION I- PAYBACK PERIOD II- NET PRESENT VALUE CONCLUSION 3 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES INTRODUCTION The relevant cash flows developed earlier on must be analyzed to assess whether a project is acceptable or to be ranked. A number of techniques are available for performing such analyses. 4 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES The preferred approaches integrate time value money procedures (Chapter 5), risk and return considerations (Chapter 6), and valuation concepts (Chapter 7,8), to select capital expenditures that are consistent with firm’s goal of maximizing owners’ wealth. 5 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES I- PAYBACK PERIOD Payback periods are a commonly used criterion for evaluating proposed investments. The payback period is the exact amount of time required for the firm to recover its initial investment in a project as calculated from cash inflows. 6 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES In the case of annuity, the payback period can be found by dividing the initial investment by the annual cash inflows; for a mixed stream, the yearly cash inflows must be accumulated until the initial investment is recovered. 7 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES Example 8 Dr Abdeldjelil Ferhat BOUDAH Calculation for the Payback Period for two alternative investment projects Project YProject X $10000 Initial Investment

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES Example 9 Dr Abdeldjelil Ferhat BOUDAH Project YProject X $10000 Initial Investment Cash inflowsYear $3000$

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES Example 10 Dr Abdeldjelil Ferhat BOUDAH Project YProject X $10000 Initial Investment Cash inflowsYear $4000$ years2 yearsPayback Period

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES Although popular, the Payback Period is generally viewed as unsophisticated capital budgeting technique, because it does not explicitly consider the time value of money by discounting cash flows to find present value. Therefore, the technique that is used instead is what it call the discounted payback period. 11 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES The methodology for computing discounted payback is almost identical to that of payback, except that cumulative present values are used instead of cumulative cash flows. 12 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES EXAMPLE : Let us say that Discount rate = 10% 13 Dr Abdeldjelil Ferhat BOUDAH Cumulative CFPV of CFCFPeriod -$ $ $ $4003

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES II- NET PRESENT VALUE Net Present Value is a sophisticated capital budgeting technique; found by subtracting a project's initial investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital. 14 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES EQUATION OF NET PRESENT VALUE (NPV) NPV= PV OF CASH INFLOWS – INITIAL INVESTMENT 15 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES EXAMPLE The Net Present Value (NPV) approach can be illustrated by using Bennett Company data presented as follows: 16 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES EXAMPLE 17 Dr Abdeldjelil Ferhat BOUDAH The Calculation of NPVs for Bennett Company Capital Expenditure Alternatives Project B (Mixed Stream)Project A (Annuity)Year $28000$ $12000$ $10000$ $10000$ $10000$ $45000$42000Initial Investment

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES SOLUTION 18 Dr Abdeldjelil Ferhat BOUDAH Project A (Annuity) PRESENT VALUEPVIFCFYear $ $ $ $ $ $ $ $ $ $ $53060$42000 Initial Investment

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES SOLUTION 19 Dr Abdeldjelil Ferhat BOUDAH Project B (MIXED STREAM) PRESENT VALUEPVIFCFYear $ $ $ $ $ $ $ $ $ $ $55914$45000 Initial Investment

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES SOLUTION 20 Dr Abdeldjelil Ferhat BOUDAH The Calculation of NPVs for Bennett Company Capital Expenditure Alternatives Project B (Mixed Stream) Project A (Annuity) $55914$53060PRESENT VALUE $45000$42000Initial Investment $10914$11060NPV

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES The Decision Criterion The decision when NPV is used to make accept-reject decisions is as follows: -If NPV is greater than $0, accept the project. - If NPV is less than $0, reject the project. If NPV is greater than zero, the firm will earn a return greater than its cost of capital. Such action should enhance the market value of the firm and therefore the wealth of its owners 21 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CHAPTER 11 : CAPITAL BUDGETING TECHNIQUES CONCLUSION There are different kinds of techniques used for capital budgeting purposes. For NPV is considered as famous technique that is applied by firms, especially when it comes to make decision for long-term period projects. Further, Discounted Payback method is also very demanding because it helps to know the minimum period required for certain investments. 22 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] 23 بحمد الله