Capital Budgeting Techniques

Chapter 04
Project Classifications

• Independent Projects: A project whose

acceptance (or rejection) does not prevent
the acceptance of other projects under
consideration. Or

• Projects whose cash flows are not affected

by decisions made about other projects.

• e.g. Do I dedicate the ground floor to retail?

That decision is (at least largely) independent
of whether you build 50 or 100 stories.
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Project Classifications

• Mutually Exclusive Projects: A set of

projects where the acceptance of one project
means the others cannot be accepted.

• e.g. Do I build a 50 story building or a 100

story building? That is a mutually exclusive
decision. You can't build both on the same
sight.

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Project Classifications

 Dependent( contingent)projects: A project

whose acceptance depends on the acceptance
of one or more other projects.

 e.g. for example a company decides to start a

new project but for that the company also has
to build roads, sewerage facilities etc.

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Introduction

 Capital Budgeting is the process of determining

which real investment projects should be
accepted and given an allocation of funds from
the firm.

 To evaluate capital budgeting processes, their

consistency with the goal of shareholder wealth
maximization is of utmost importance.
 Capital Budgeting Decision
Techniques

 Payback period: most commonly used

 Net present value (NPV): best technique

theoretically

 Internal rate of return (IRR): widely used.

 Profitability index (PI): related to NPV

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 Proposed Project Data

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 outlay
will be $40,000.
 Proposed Project Data

Max Vaber is evaluating a new project for his firm

Xt co. He has determined that the after-tax
cash flows for the project will be $40000;
$50000; $40000; $30000; and $50000,
respectively, for each of the Years 1 through 5.
The initial cash outlay will be $200000.
 Proposed Project Data

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 $90000; $90000; $12,0000;
$90000;$90000 and $90,000, respectively, for
each of the Years 1 through 6. The initial cash
outlay will be $500000.
 Proposed Project Data

Marina is evaluating a new project for her firm,

Bakery Café(BC). She has determined that
the after-tax cash flows for the project will be
$11,000; $13,000; $16,000; $10,000; and
$8,000, respectively, for each of the Years 1
through 5. The initial cash outlay will be
$50,000.
 1. Payback Period

The payback period is the amount of time

required for the firm to recover its initial
investment

• If the project’s payback period is less than the

maximum acceptable payback period, accept the
project
• If the project’s payback period is greater than the
maximum acceptable payback period, reject the
project

Management determines maximum acceptable

payback period 11
 Advantages And disadvantages Of
Payback Method

Advantages of payback method:

• Computational simplicity
• Easy to understand
• Focus on cash flow

Disadvantages of payback method:

• As a decision rule, the Payback Period suffers from several flaws. For
instance, it ignores the Time Value of Money, does not consider all of the
project's cash flows, and the accept/reject criterion is arbitrary.

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 Payback Solution

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
 Net Present Value (NPV)

NPV is the present value of an

investment project’s net cash
flows minus the project’s
initial cash outflow.(ICO)

CF1 CF2 CFn

NPV = (1+k)1 + (1+k)2+ . . + (1+k)n - ICO
 NPV Solution

Basket Wonders has determined that

the appropriate discount rate (k) for
this project is 13%.
$10,000 $12,000 $15,000
NPV = + + +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
+ - $40,000
(1.13)4 (1.13) 5
NPV: Strengths and Weaknesses
 Strengths
 Resulting number is easy to interpret: shows how
wealth will change if the project is accepted.
 Acceptance criteria is consistent with shareholder
wealth maximization.
 Relatively straight forward to calculate

 Weaknesses
 Requires financial and economics information to use.
 An improper NPV analysis may lead to the wrong
choices of projects.
 Internal Rate of Return (IRR)

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.
Lets do numerical questions on IRR
IRR: Strengths and Weaknesses

 Strengths
 IRR number is easy to interpret: shows the
return the project generates.
 Acceptance criteria is generally consistent with
shareholder wealth maximization.

 Weaknesses
 Requires finance/economics information to use.
 Difficult to calculate.
 It is possible that there exists no IRR.
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.
PI Acceptance Criterion

PI = $38,572 / $40,000
= 0.9643

Should this project be accepted?

No! The PI is less than 1.00. This

means that the project is not
profitable. [Reject as PI < 1.00 ]
 PI Strengths
and Weaknesses

Strengths: Weaknesses:
 Same as NPV  Same as NPV
 Allows  Provides only
comparison of relative profitability
different scale  Potential Ranking
projects Problems
Class Activity 01
 Jawad is evaluating a new project for his firm,
Jawad Corporation, he has determined that the
after-tax cash flows for the project will be
$20,000; $25,000; $35,000 and $32,000; ,
respectively, for each of the Years 1 through 4.
The initial cash outlay will be $65,000. If the
hurdle rate for the project is 18%, calculate
the following capital budgeting techniques;
 ii. NPV
 iv. Profitability Index
Class Activity 02

 An investment of $1,000 today will return $900

at the end of 1 year, $500 at the end of 2
years, and $100 at the end of 3 years. What is
its, NPVand IRR (internal rate of return) if
Hurdle rate is 15%?
 LR = 15%

 HR = 40%
Class Activity 04

 Hassan made an investment of $80,000 today

which will return $45,000 at the end of 1 year,
$35,000 at the end of 2 years, and $25,000 at
the end of 3 years. What is its, NPV, PI and
IRR (internal rate of return) if Hurdle rate is
18%?
 LR = 18%
 HR = 20%
THANKS