Capital Budgeting

DBA – G2
Presented To
Professor: Dr. Eman Badawy

Presented By
Maha Moussa Ghorab
Neveen Abd Elaziz Lotfy
Nour Elhoda Elsayed Fawaz
Manal Ahmed Soliman Elbarbary

Table of Contents
1-Introduction…………………………………………………..#2
2-What is the Capital budgeting ……………..…………….....#3
3-The purpose of capital budgeting ……….………….……...#4
4-The objective of capital budgeting……….………….……...#4
5- Nature of capital budgeting………………………………... #4
6-Importance of capital budgeting……………………………..#5
7-Components of Capital Budgeting…………………………...#6
8-Scope of Capital Budgeting…………………………………...#7
9-Features of Capital Budgeting………………………………..#8
10-process of Capital Budgeting……………..…………….#8,9,10
11- Factors Affecting of Capital Budgeting decision.……..…..#10
12- Advantages and Limitations of capital Budgeting……..….#11
13- Tools of capital Budgeting.…………………………..…..….#11
14- Methods of capital Budgeting……………………..……..….#12
15- Problems in capital Budgeting.…………………………..….#16
16- Dice ( acquisition decision) as an example …….………..….#17

Introduction

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 Expansion and Growth’ are the two common goals of an organization's operations. This is difficult to
accomplish if a company does not possess enough capital or has no fixed assets. It is at this point
that capital budgeting becomes essential. The capital budget is used by management to plan
expenditures on fixed assets. As a result of the budgets, the company's management usually
determines which long-term strategies it can invest in to achieve its growth goals.

The purpose of capital budgeting is to make long-term investment decisions about whether particular
projects will result in sustainable growth and provide the expected returns.1

Managers must carefully select those projects that promise the greatest future return. How well
Managers make these capital budgeting decisions is a critical factor in the long-run profitability of the
company. Capital Budgeting involves investment; A company must commit funds now in order to
receive a return in the future. An investment is not limited to stocks and bonds. The purchase of
inventory or equipment is also an investment. For example, the Facebook owner made an
investment by purchasing another social media platform ‘WhatsApp’ and expanding the data center
to make its largest center in accommodating more Data and introducing new facilities.

Capital budgeting decisions tend to fall into two broad categories:

a) Screening decisions relate to whether a proposed project meets some preset standard of
acceptance. For example, does a particular investment generate at least a minimum desired return of
say 20%? Screening involves grouping alternatives into acceptable and non-acceptable categories.

b) Preference decisions relate to selecting from several competing courses of action. Preference
decisions rank alternatives in order of desirability.

A Capital Budgeting decision rule should satisfy the following criteria:

• Must consider all of the project's cash flows.

• Must consider the Time Value of Money

• Must always lead to the correct decision when choosing among Mutually Exclusive Projects2

We will present Capital Budgeting and all the details related to it in this article:

 What is Capital Budgeting in detail

 Features of capital budgeting
 Understanding capital budgeting and how it works
 Techniques/Methods of capital budgeting with Examples
 Process of capital budgeting
 Factors affecting capital budgeting
 Objectives
 Limitations of capital budgeting

What is Capital Budgeting?

1
Team, D. C. (2022, December 20). What is capital budgeting? process, methods, formula, examples. Deskera Blog.
https://www.deskera.com/blog/capital-budgeting/
2
Shuaibu, Hussaini. (2018). Capital Budgeting Decisions; A conceptual valuation Analysis (WORKING PAPER).

2
 Capital budgeting is the process of making investment decisions in long-term assets. It is the
process of deciding whether or not to invest in a particular project as all the investment possibilities
may not be rewarding. Thus, the manager has to choose a project that gives a rate of return more
than the cost of financing such a project. That is why he has to value a project in terms of cost and
benefit.

Capital budgeting is a method of estimating the financial viability of capital investment over the life of
the investment. Unlike some other types of investment analysis, capital budgeting focuses on cash
flows rather than profits.

Capital asset management requires a lot of money; therefore, before making such investments, they
must do capital budgeting to ensure that the investment will procure profits for the company. The
companies must undertake initiatives that will lead to a growth in their profitability and also boost their
shareholder’s or investor’s wealth

Following are the categories of projects that can be examined using the capital
budgeting process:

 The decision to buy new machinery

 Expansion of business in other geographical areas
 Replacement of obsolete equipment
 New product or market development etc

Thus, capital budgeting is the most important responsibility undertaken by a financial

manager. This is because:

1. It involves the purchase of long-term assets and such decisions may determine the future
success of the firm.
2. These decisions help in maximizing shareholder value.
3. Principles applicable to the capital budgeting process also apply to other corporate
decisions like working capital management.3

The Purpose of Capital Budgeting:

Capital budgeting's main goal is to identify projects that produce cash flows that exceed the cost
of the project for a company.

3
Capital budgeting: Meaning, process and techniques. QuickBooks. (2023, April 25).
https://quickbooks.intuit.com/in/resources/budgeting/capital-budgeting/
3
 Capital budgeting is used by companies to evaluate major projects and investments,
such as new plants or equipment.
The process involves analyzing a project's cash inflows and outflows to determine
whether the expected return meets a set benchmark.

The objective of capital budgeting

 It helps businesses prioritize investments and allocate financial resources more effectively,
reducing the risk of investing in unprofitable projects and maximizing returns.
 Additionally, it provides a framework for evaluating investment opportunities and assessing
their potential risks and rewards. It’s like conducting a financial autopsy – you want to
examine all the details to determine if an investment is worth pursuing.
 Finally, capital budgeting enables businesses to plan and budget for future investments,
making sure they have the necessary financial resources to pursue them. 4

Example of a Capital Budgeting Decision?

Capital budgeting decisions are often associated with choosing to undertake a new project that
will expand a company's current operations. Opening a new store location, for example, would be
one such decision for a fast-food chain or clothing retailer. 5

What Is the Difference Between Capital Budgeting and Working Capital Management?

Working capital management is a company-wide process that evaluates current projects to

determine whether they are adding value to the business, while capital budgeting focuses on
expanding the current operations or assets of the business.

Nature of Capital Budgeting:

1- Capital budgeting decisions involve the exchange of current funds for the benefits to be
achieved in the future.
2- The future benefits are expected to be realized over a series of years.
3-The funds are invested in non-flexible and long-term activities.
4-They have a long-term and significant effect on the profitability of the concern.
5-They involve, generally, huge funds.
6-They are irreversible decisions.
7- They are “strategic” investment decisions, involving large sums of money, a major departure
from the past practices of the firm, and significant change in the firm’s expected earnings
associated with a high degree of risk, as compared to “tactical” investment decisions which
involve a relatively small amount of funds that do not result in a major departure from the past
practices of the firm.

4
Srivastava, A. (2023, July 13). Capital budgeting: What is it, types, methods, process & examples.
Happay. https://happay.com/blog/capital-budgeting/
5
Kenton, W. (n.d.). Capital budgeting: Definition, methods, and examples. Investopedia.
https://www.investopedia.com/terms/c/capitalbudgeting.asp
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Importance of Capital Budgeting:

1-Huge Investments
Capital budgeting requires huge investments of funds, but the available funds are limited,
therefore, the firms before investing in projects, plan to control their capital expenditure.

2-Long-Term

Capital expenditure is long-term in nature or permanent in nature. Therefore financial risks

involved in the investment decision are. If higher risks are involved, it needs careful planning of
capital budgeting.

3-Irreversible

The capital investment decisions are irreversible and are not changed back. Once the decision is
taken for purchasing a permanent asset, it is very difficult to dispose of those assets without
involving huge losses.

4-Long-Term Effect

Capital budgeting not only reduces the cost but also increases the revenue in the long term and
will bring significant changes in the profit of the company by avoiding over or more investment or
under-investment.

Investments lead to being unable to utilize assets or overutilization of fixed assets. Therefore,
before making the investment, it is required careful planning and analysis of the project thoroughly.6

6
Kumar, A. (2023, May 22). What is capital budgeting? meaning, definitions, scope, process, 6
methods. Getuplearn. https://getuplearn.com/blog/capital-budgeting/

5
Components of Capital Budgeting
The following are the basic components of capital budgeting analysis:

Cash Outflows: The amount to be invested in the project initially or during the lifetime of the
project at a later stage is to be estimated carefully at the outset. Not only the cost of the asset is
important, but other expenditures like transportation costs, installation costs, and working
capital requirements are also relevant.

Cash Inflows: The expected benefits from the investment translated in monetary terms are to be
estimated next. The exercise is to be done with utmost care as to quantum and timing.

Cut-Off Rate: The minimum rate of return that the firm would expect to have for accepting a
particular proposal should be pre-determined. Generally, it is the firm’s marginal cost of capital.

Ranking Proposals: A number of investment opportunities may be available and may be

attractive also. In such a case more than one opportunity may also be availed of. Ranking different
investment proposals in order of priority will help management in taking appropriate decisions,
particularly when there is a financial constraint.

Risk and Uncertainty: The future is always uncertain; Risk is embedded in its veins. Corporate
life, therefore, can be healthy only when the elements of risk and uncertainty are properly
assessed and suitable steps are taken to evaluate the profitability on the basis of the assessment
of inherent risk and uncertainty. For this purpose, probabilities may be assigned to the varying
expected net revenues. The probabilities are hard to determine since a wide range of factors like
the economy in general, economic factors peculiar to investment, competition, technological
development, consumer preferences, labor conditions, etc. Make it impossible to foretell the
future. Still, efforts should be made to examine the effects of the factors, and proper adjustments
be made in evaluating investment proposals.

Non-Monetary Aspects: The monetary evaluation of investment proposals may lead to wrong
conclusions at times. Non-monetary considerations should also be weighed.

For example, the image of the company is very important to consider and should also be
weighed.7

Scope of Capital Budgeting

7
Kumar, A. (2023, May 22). What is capital budgeting? meaning, definitions, scope, process, 6
methods. Getuplearn. https://getuplearn.com/blog/capital-budgeting/
6
The various scopes of capital budgeting are as follows:

Long-Term Effects

Capital budgeting decisions cannot be changed so easily. Wrong decisions, once taken, will lead
to heavy losses to the firm. To take a simple example, suppose construction of a premise has
been started and the management has gone half the way. Now, the construction can’t be left
hanging in between, since the amount spent cannot be recovered.

Risk and Uncertainty

A great deal of certainty surrounds a capital budgeting decision. Investment is present and return
is future. The future is uncertain and full of risk. The longer the period of the project, the greater is
the risk and uncertainty. The estimates about costs, revenues, and profits may not come true.

Large Funds

Any capital expenditure will naturally involve a huge amount of the fixed commitment as regards
large sums of money making capital budgeting an important exercise.

Corporate Image

The profits are vitally affected by capital budgeting decisions. These influence the market value of
the shares. All accepted projects should yield profits leading to the maximization of shareholder
wealth. The shareholders and other investors should be convinced about the success and future
prospects of the project. If they don’t invest, the objectives of the business would fail. The image of
the company will also fall down. Capital budgeting decisions should improve the image of the
company.8

Features of capital budgeting

8
Kumar, A. (2023, May 22). What is capital budgeting? meaning, definitions, scope, process, 6
methods. Getuplearn. https://getuplearn.com/blog/capital-budgeting/

7
  Long-term: It involves making long-term investment decisions that will
affect your company’s financial health.
 Time-sensitive: It takes into account the time value of money, which means
that a dollar today is worth more than a dollar in the future. It’s like trying
to decide whether to eat a cookie now or wait for two cookies later – you
have to consider the value of delayed gratification.
 Risk-conscious: Another feature is risk assessment. Businesses must
carefully evaluate the potential risks and rewards of each investment
opportunity to make informed decisions.
 Predictive: Capital budgeting requires accurate financial forecasting, which
involves predicting future cash flows and expenses.
 Needs collaboration: Finally, capital budgeting requires collaboration and
communication among different departments and stakeholders within a
company.

Capital budgeting process

1. Identification of Investment Opportunities:

Explore the available investment opportunities. After that, they recognize the investment
opportunities keeping in mind the sales target set up. One must consider some points before
searching for the best investment opportunities. It includes regularly monitoring the external
environment to get an idea about new investment opportunities. Then, define the corporate
strategy based on the organization’s SWOT analysis, and seek suggestions from its employees by
discussing the strategies and objectives with them.
Definition: The process of identifying potential investment opportunities for a company’s capital
budget.
Sources of Investment Opportunities: Can come from internal or external sources, such as
research and development, acquisitions, or partnerships.
Techniques for Screening Investment Opportunities: Methods used to evaluate potential
investment opportunities, such as payback period, net present value, and internal rate of return.

2 – Gathering of the Investment Proposals

After identifying the investment opportunities, the second process in capital budgeting is to collect
investment proposals. Before reaching the committee of the capital budgeting process, these
proposals are seen by various authorized persons in the organization to check whether the bids
given are according to the requirements. Then the classification of the investment is done based
on the different categories such as expansion, replacement, welfare investment, etc. This

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classification into the various types makes decision-making more comfortable and facilitates
budgeting and control.

3-Decision-Making Process in Capital Budgeting

Decision-making is the third step. In the decision-making stage, the executives will have to decide
which investment needs to be made from the available investment opportunities, keeping in mind
the sanctioning power open to them.
Definition:The process of assessing the quality and profitability of a potential investment based
on its expected cash flows.
Techniques for Evaluating Cash Flows
Methods used to evaluate the quality of expected cash flows, such as net present value, internal
rate of return, and profitability index.
Sensitivity Analysis and Scenario Analysis
Tools used to assess the impact of changes in assumptions on the expected cash flows of a
potential investment.

4 – Capital Budget Preparations and Appropriations

After the decision-making step, the next step is to classify the investment outlays into higher and
smaller value investments.
Definition: The process of selecting the most appropriate investment opportunities based on
their evaluation.
Capital Budgeting Decision Criteria
Factors used to determine whether or not to invest in a particular project, such as net present
value, internal rate of return, and payback period.
Techniques for Ranking Projects
Methods used to rank potential investments against each other, such as the profitability index and
the discounted payback period.

5 – Implementation

After completing all the above steps, it implements the investment proposal, i.e., put into a
concrete project. Several challenges can be faced by the management personnel while executing
the tasks as they can be time-consuming. For the implementation at a reasonable cost and
expeditiously, the following things could be helpful: –
 Formulation of the project adequately: Inadequate formulation is one of the main reasons for the
delay. So, the concerned person should consider all the necessary details in advance and one should
do a proper analysis well to avoid any delay in the project implementation., the concerned person
should consider all the necessary details in advance, and one should do a proper analysis well to
avoid any delay in the project implementation.
 Use responsibility accounting principle: For the expeditious execution of the various tasks and
the cost control, one should assign specific responsibilities to the project managers, i.e., the timely
completion of the project within the specified cost limits.
 Network technique use: Several network techniques like the Critical Path Method (CPM) and
Program Evaluation and Review Technique (PERT) are available for project planning and control,
which will help monitor the projects properly and efficiently.
Definition
The process of executing and managing approved projects.
Project Planning and Execution
The process of developing a project plan and executing it according to
schedule.

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Project Monitoring and Control
The process of tracking project progress, identifying issues, and making
necessary adjustments.

6 – Review of Performance:

A review of performance is the last step in capital budgeting. But, the management must first
compare the actual results with the projected results. The correct time to make this comparison is
when the operations get stabilized.
Definition: The process of evaluating completed projects and monitoring their
ongoing performance.
Post-implementation Review
An assessment of the success of a project and any lessons learned.
Performance Measurement and Control
The process of measuring project performance against established criteria and
taking corrective action as needed.
Thus, the process is complex, consisting of the various steps required to be
followed strictly before finalizing the project.9

Factors Affecting Capital Budgeting Decisions

1. Risk and Uncertainty

Companies need to consider the risks associated with the investment and the uncertainties
involved in estimating future cash flows. Higher-risk investments require higher return expectations
to justify the investment, while lower-risk investments may be acceptable at a lower rate of return.

2. Capital Constraints
Capital constraints refer to the limitations on the amount of available capital for investment.
Companies must balance their capital needs with their available resources, including equity, debt,
and retained earnings. Capital constraints may affect a company’s ability to pursue all of its
desirable investment opportunities and may require the company to prioritize investments based
on their profitability.

3. Business Environment
Companies must assess the potential impact of changes in the business environment on their
investment opportunities and factor in the effects of these changes in their capital budgeting
decisions.

4. Government Policies
Changes in tax laws, environmental regulations, and other government policies can significantly
affect the profitability of investment opportunities.

9
Capital budgeting process - top 6 steps, examples - wallstreetmojo. (n.d.).
https://www.wallstreetmojo.com/capital-budgeting-process/

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5. Social and Environmental Factors

Companies need to consider the social and environmental impact of their investments and factor
in potential reputational risks associated with their investment decisions.

Advantages and Limitations of capital budgeting

Advantages

 Helps in maximizing returns: It helps in identifying profitable investment opportunities and

maximizing returns on investments.
 Ensures effective utilization of resources: It helps in the effective allocation and
utilization of resources by identifying the most profitable investment opportunities.
 Provides a long-term perspective: it enables companies to take a long-term perspective
while making investment decisions, which helps in achieving the long-term goals of the
company.
 Reduces risk: By considering factors such as risk, uncertainty, and the time value of
money, capital budgeting helps in reducing the risk associated with investment decisions.
 Facilitates decision-making: It provides a structured and systematic approach for
evaluating investment proposals, which facilitates decision-making.

Limitations

 Inaccurate estimates: It relies heavily on estimates of future cash flows and discount
rates, which may be inaccurate, leading to incorrect investment decisions.
 Ignores qualitative factors: Capital budgeting does not consider qualitative factors such
as social responsibility or environmental impact, which may be important in certain cases.
 High degree of complexity: Budgeting techniques can be complex and time-consuming to
implement, especially for large and complex investment projects.
 Limited scope: Some techniques are limited in scope as they only consider financial
factors and do not take into account non-financial factors such as reputation or brand value.

Tools for capital budgeting

There are several tools available for capital budgeting, each designed to serve specific purposes.

Here are a few of them.

 Accounting software: like QuickBooks and Xero can be used to manage financial data
related to capital budgeting projects.
 Spreadsheet software: Spreadsheet software like Microsoft Excel is widely used for
capital budgeting as it allows users to create detailed financial models and perform various
calculations with ease.
 Project management software: like Asana, Trello, and Basecamp can be used for
planning and tracking the progress of capital budgeting projects.
 Investment analysis software: Investment analysis software like Prophix and
Investopedia Advisor allows users to analyze investment opportunities and assess their
potential risks and returns10

10
Srivastava, A. (2023, July 13). Capital budgeting: What is it, types, methods, process & examples.
Happay. https://happay.com/blog/capital-budgeting/

11
Methods of Capital Budgeting
By matching the available resources and projects it can be invested. The funds available are
always living funds. There are many considerations taken for the investment decision process
such as environment and economic conditions. The methods of capital budgeting are classified as
follows:

Traditional Methods or Non-Discount Methods

1-Pay Back Period Methods

Pay-back period is the time required to recover the initial investment in a project. It is one of the
non-discounted cash flow methods of capital budgeting. If the actual pay-back period is less than
the predetermined pay-back period, the project would be accepted. If not, it would be rejected.

Advantages: 1-It is easy to calculate and simple to understand.

2-Pay-back method provides further improvement over the accounting rate return.
3-Pay-back method reduces the possibility of loss on account of obsolescence.
Disadvantages:1-It ignores the time value of money.
2-It ignores all cash inflows after the pay-back period.
3-It is one of the misleading evaluations of capital budgeting.

initial investment
Formula: Payback Period =
Annual cash flow

Example 1: The project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, and the life of the
project is 5 years. Calculate the pay-back period.a

𝑅𝑠. 30,000
——————————– = 3 𝑌𝑒𝑎𝑟
𝑅𝑠. 10,000

The annual cash inflow is calculated by considering the amount of net income on the amount of
depreciation project (Asset) before taxation but after taxation. The income precision earned is

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expressed as a percentage of the initial investment, is called the unadjusted rate of return. The
above problem will be calculated as below:

Annual Return –
Unadjusted Rate of Return = x100
Investment

𝑅𝑠. 10,000
= ——————————–x100=33.33%
𝑅𝑠. 30,000

2-Post Payback Profitability Method

One of the major limitations of the pay-back period method is that it does not consider the cash
inflows earned after a pay-back period and if the real profitability of the project cannot be
assessed. To improve this method, it can be made by considering the receivable after the pay-
back period. These returns are called post-pay-back profits.

3-Accounting Rate of Return

The average rate of return means the average rate of return or profit taken for considering the
project evaluation. This method is one of the traditional methods for evaluating project proposals.
If the actual accounting rate of return is more than the predetermined required rate of return, the
project would be accepted. If not it would be rejected.

Advantages:
1-It is easy to calculate and simple to understand.
2-It is based on accounting information rather than cash inflow.
3-It is not based on the time value of money.
4-It considers the total benefits associated with the project.
Disadvantages :
1-It ignores the time value of money
2-It ignores the reinvestment potential of a project.
3-Different methods are used for accounting profit. So, it leads to difficulties in
calculation of the project.

Modern Methods or Discount Methods

1-Net Present Value Method

The net present value method is one of the modern methods for evaluating project proposals. In
this method, cash inflows are considered with the time value of the money. Net present value
describes as the summation of the present value of cash inflow and the present value of cash
outflow.
Net present value is the difference between the total present value of future cash inflows and the
total present value of future cash outflows. If the present value of cash inflows is more than the
present value of cash outflows, it would be accepted. If not, it would be rejected.

Advantages:
1-It recognizes the time value of money.
2-It considers the total benefits arising out of the proposal.

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 3-It is the best method for the selection of mutually exclusive projects.
4-It helps to achieve the maximization of shareholders’ wealth.
Disadvantages
1-It is difficult to understand and calculate.
2-It needs the discount factors for the calculation of present values.
3-It is not suitable for projects having different effective lives.

2-Internal Rate of Return Method

The internal rate of return is time adjusted technique and covers the disadvantages of the
traditional techniques. In other words, it is a rate at which discount cash flows to zero. It is
expected by the following ratio

cash∈ flow
Internal Rate of Return Method=
initial investment
If the present value of the sum total of the compounded reinvested cash flows is greater than the
present value of the outflows, the proposed project is accepted. If not it would be rejected.

Advantages:
1-It considers the time value of money.
2-It takes into account the total cash inflow and outflow
3-It does not use the concept of the required rate of return.
4-It gives the approximate/nearest rate of return.
Disadvantages:
1-It involves complicated computational methods
2-It produces multiple rates which may be confusing for taking decisions.
3-It is assumed that all intermediate cash flows are reinvested at the internal rate of return.

3. Modified Internal Rate of Return (MIRR)

The Modified Internal Rate of Return (MIRR) method is a capital budgeting technique used to
determine the rate of return on investment by considering both the cost of the investment and the
reinvestment rate of future cash flows.

Formula: MIRR = [(FV of positive cash flows / PV of negative cash flows)^(1/n)] – 1

Where:
FV = Future Value PV = Present Value n = Number of periods
For example, if an investment costs $100,000 and is expected to generate $25,000 in annual
cash inflows for the next five years, with a reinvestment rate of 8%, the MIRR calculation would be
as follows:
MIRR = [(54,961.35 / 100,000)^(1/5)] – 1 = 8.41%

Advantages:
1-Considers the reinvestment of future cash flows
2-Accounts for the time value of money
3-Provides a measure of the investment’s profitability
Disadvantage:
1-Requires accurate estimates of future cash flows and reinvestment rates
2-Can be complex and time-consuming to calculate
3-May not be appropriate for investments with uneven cash flows

4. Profitability Index (PI):

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The Profitability Index (PI) method technique is used to evaluate investment opportunities by
calculating the ratio of the present value of cash inflows to the initial investment cost.

Formula: PI = PV of Expected Cash Inflows / Initial Investment

Wheree
PV = Present Value Initial Investment = Total cost of the investment
Expected Cash Inflows = Future cash inflows discounted to their present value
Example: if an investment costs $100,000 and is expected to generate $25,000 in annual cash
inflows for the next five years, with a discount rate of 10%, the PI calculation would be as follows:
PI = ($18,655.94 + $16,959.04 + $15,417.31 + $14,015.74 + $12,742.49) / $100,000 = 0.784
Advantages
1-Considers the time value of money
2-Accounts for all expected cash inflows and outflows
3-Provides a measure of the investment’s profitability
4-Can be used to compare multiple investment opportunities
Disadvantage
1-May lead to incorrect decisions when evaluating mutually exclusive projects
2-May not always lead to the best investment decisions when budgets are limited .

Capital Rationing

The capital rationing method of capital budgeting is not based on a single formula like the other
methods. Instead, it involves setting a fixed budget for capital investments and then selecting the
combination of projects that maximizes the overall value of the firm within that budget constraint.
Therefore, the capital rationing method involves a complex decision-making process that
considers multiple factors such as project profitability, risk, and liquidity. The decision-making
process often involves using quantitative and qualitative criteria to evaluate each project’s
potential impact on the firm’s financial performance.

Example: if a company has $1,000,000 in available funds and two potential investments with total
costs of $800,000 and $1,200,000, the company would have to choose between the two
investments based on the availability of capital.
Advantages
 Enables a company to prioritize investments based on available funds
 Helps avoid over-committing to investments
 Encourages better financial management
Disadvantage:
 May limit a company’s ability to pursue all profitable investments
 May result in missed opportunities
 Can be difficult to determine the optimal allocation of capital.11

11
Srivastava, A. (2023, July 13). Capital budgeting: What is it, types, methods, process & examples.
Happay. https://happay.com/blog/capital-budgeting/

15
Problems in Capital Budgeting
The difficulties and problems in capital budgeting decisions are as follows:

Uncertainty

All capital budgeting decisions involve long-term which is uncertain. Even if every care is taken
and the project is evaluated to every minute detail, dealing with the capital budgeting decisions,
therefore, should try to be as analytical as possible.
The uncertainty of the capital budgeting decisions may be with reference to the cost of the project;
future expected returns from the project, etc.

Time Value of Money

The implications of a capital budgeting decision are scattered over a long period. The cost and
benefit of a decision may occur at different points in time. As a result, the cost of a project is
incurred immediately; it is recovered in a number of years. Moreover, the longer the time period
involved, the greater would be the uncertainty.

Measurement Problem

A finance manager may also face difficulties in measuring the cost and benefits of a project in
quantitative terms. For example, the new product proposed to be launched by a firm may result in
an increase or decrease in sales of other products already being sold by the same firm but by how
much, is very difficult to ascertain because the sales of other products may increase or decrease
due to other factors also.

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Dice manufacturing company: (the acquisition decision)
early January 2015, Mr Nagy Toma, CEO of Dice Manufacturing Company, was
sitting in his office in a quiet neighborhood of the vibrant Egyptian capital of Cairo,
thinking about the future of the textile company he started with his family a little over
25 years ago. Toma was proud of the milestones that the firm achieved and their agile
business model but worried about the best way to grow the company in the future.
Prior to 2011, Dice followed an exclusively export-oriented model that relied on fulfilling
order contracts from international clothing brands, growing organically to become among
the largest garment exporters in the Egyptian market. The January 2011 Egyptian revolution
suddenly threatened the company’s successful business model. Factory closures from the
political unrest and an inability to secure much needed imported raw material inputs due to
currency shortages resulted in supply chain interruptions that ultimately lead to the loss of
most of their international contracts. While several well-established medium-sized
businesses were forced to close, Dice was quick to adjust its model by shifting to locally
sourced raw materials and using this as an opportunity to re-channel their production to
successfully tap into the local market. The stabilization of the Egyptian economy in recent
months, however, saw the return of the international demand for the company’s products
alongside the strong local demand that the firm established over the past period.
Dice is now facing an interesting growth dilemma unlike many of their peers. At a time when
various businesses are wary of the future of the Egyptian economy and hesitant to invest,
Toma thinks that this is the right time to quickly expand to capture local and international
market share. Given that timing is key, this can only be achieved through acquisitions. Toma
calls on Victor ElMalek, Dice’s chief financial officer (CFO), to propose the acquisition of
Alex Clothing Co., and its subsidiary United Dyers. Toma believes the firm is at a
crossroads. He hopes that ElMalek will be able to advise him on a fair value for the
acquisition and evaluate whether this acquisition will be a good strategic fit to Dice.
Egyptian economic and textile industry overview
The Egyptian economy grew at a meager 2% annually between 2011 and 2014. Exports of
Egyptian goods and services were negatively affected not only by disruptions to
manufacturing from the political unrest following the January 2011 revolution but also slow
global economic activity. This was augmented by loss of tourism income and declining
Suez Canal revenues which put a strain on domestic foreign reserves and lead to an
economic crisis and severe currency shortages. The election of President Sisi in 2013,
combined with aid from the Gulf, contributed to increased confidence and was reflected in
higher private and government consumption in 2014.
The textile industry is considered one of the oldest and most important economic sectors,
employing over 1 million Egyptians. During the period 2005–2010, the textile industry
represented around 3% of gross domestic product (GDP) and a major generator of export
revenue, contributing to about 10% of total export revenue. Prior to the 2011 uprising,
Egyptian textile firms exported close to $1bn worth of goods to the USA, benefiting from the
qualifying industrial zone system and to the European Union following the 2005 euro
Mediterranean Partnership Agreement that provided Egyptian textile products duty- and
quota-free entry. Although the sector is predominantly state-owned, private-sector
companies have a strong presence and cater to licensing contracts to produce top
international brands [1].
The deterioration of the overall business environment in Egypt after the 2011 revolution
deeply impacted the textile industry, which within a year of the political upheaval lost around
10% of their export revenue as a result of the political and economic crisis. Exhibit 2
summarizes the value of exports of Egyptian textile between 2011 and 2014. Although the
depreciation of the Egyptian pound between 2012 and 2013 slightly benefited the industry
by increasing the competitiveness of Egyptian textile exports, the reliance on import
components dampened this effect [2]. Several of the large Egyptian textile manufacturers
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had to scale back on their expansions in a couple of years directly following the revolution,
but forecasts for overall economic activity for 2015 and beyond, including the textile
industry, show improvements with recovery in domestic and global demand. Further
depreciation of the Egyptian pound and reduced reliance on imported inputs by textile
producers is expected to benefit the industry by boosting textile exports which is forecasted
to grow between 15%–20% in 2015.
Dice manufacturing company: an overview Background
Dice Sports and Casual Wear Manufacturing Societe Anonyme Egyptienne (French:
Egyptian Joint Stock Company) commonly referred to as Dice Manufacturing Company is
an Egyptian family-run business that was established by brothers Maged and Nagy Toma in
1989 with a core business of producing readymade garments for men, women and
children. The company positioned itself in a unique niche in the Egyptian textile market by
distinguishing itself for top-quality production, workmanship and management. This was
possible as most of the company’s competitors were nationalized companies focusing on
core non-value-adding operations and targeting the local market. This allowed Dice to focus
exclusively on export-oriented production to international and worldwide brands such as
Benetton, Nautica, Calvin Klein, Otto, Bon Prix and Auchon, among other top brands. To
cater to this growing international demand, the company expanded over the years to own
four manufacturing plants located in the northern border of Cairo, with the management and
administrative offices located in the largest plant facility. The company also expanded
vertically and currently relies on a fully vertically integrated business model, with operations
including knitting, dyeing, printing, cutting, embroidery, sewing, ironing and packaging,
giving the firm full control over the value chain. Exhibit 3 provides a timeline of the
company’s history.
Ownership and governance
Dice is majority-owned by the Toma family, who by early 2015, held a 70% ownership stake
of the company and its subsidiaries with the remaining 30% owned by Qalaa Holdings, one
of the largest investment companies in Africa and the Middle East. Qalaa, which invests in
core high-growth businesses in the region, saw potential in Dice’s business model and
purchased an equity stake from Tomas in 2008, which is indirectly held through Sphinx
Private Equity Management.
Alex Clothing Co.: an acquisition target
Deal description
Dice now is evaluating acquiring Alex Clothing Co., a clothing company located in the city
of Alexandria, along with its subsidiary United Dyers, an automated dyeing house located in
Sadat City in Cairo, for a combined cash acquisition value of EGP80m. The acquisition of
Alex Clothing Co. would not only allow Dice to integrate horizontally by acquiring a similar
firm but also has strategic benefits. Alex Co. is in Egypt’s second-biggest city, where Dice’s
second-largest customer base is located. It also gives Dice the chance to accommodate
demand in Alexandria and surrounding cities by easily distributing goods to nearby shops.
Alexandria has the additional geographic advantage of bringing Egypt’s main port, making
exporting easier and less time-consuming. Although Alex Co. is currently generating
revenues of around EGP210m, its production facilities are not fully used and therefore the
acquisition would not only allow Dice to quickly access a higher production capacity to
grow revenue and fulfill demand but also gain increased market share by taking over a
company with an established revenues stream from customers in another major city.
Moreover, Alex Co.’s subsidiary, United Dyers, would allow the firm to efficiently vertically
integrate the dying processes instead of outsourcing. The firm has a net debt balance of
around EGP10mn on its balance sheet and will therefore have a minimal effect on Dice’s
overall capital structure post-acquisition.
ElMalek has projected the main operational financial forecasts from the target’s standalone
business for the next six years in Exhibit 10 assuming the company operates under a
business as usual model. ElMalek additionally ran a combined analysis that consolidates
the company within Dice (Exhibit 11). The projections reflect solid revenue growth for Alex
Co. starting the second year after integration as Dice passes along the strong international
order pipeline and uses the firm’s excess capacity.
Deal financing
ElMalek plans to source the funds to finance the EGP80m acquisition as follows. Dice will
secure an EGP25m long-term loan from commercial banks to be repaid over 5 years. Dice
was currently paying between 0.75%–1% spread over the long-term treasury on its existing

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