Capital

Budgeting
Techniques
Group
Name ID
Souman Guha 16241002
Sazzad Hossain Khan 16241008
Mourin Rahman 16241022
Arafat Alam Khan 16241054
Tamzid Hossain 16241042
Mourshed Alam Zoha 16241032
Rasheek Tabassum 16241040
Mondira
What is Capital Budgeting??
• Capital budgeting: the
process of evaluating &
selecting long-term
investments that are
consistent with the
firm’s goal of
maximizing owner’s
wealth.
• For example, for manufacturing firms, they
will invest in fixed assets.

• These assets are known as earning assets, it

is the basis of a firm’s earning power & value.

• Capital Expenditure: an outlay of funds by the

firm that is expected to produce benefits over
a period of time greater than 1 year.
 • Operating expenditure:
an outlay of funds by the
firm resulting in
benefits received within
1 year

• Reasons for capital

expenditure are to:
• Expand
• Replace
• Renew fixed assets
Steps in the Process
• Proposal generation: proposals are made at
all levels of an organization & are reviewed by
finance personnel.

• Review & analysis: this is performed to assess

the appropriateness of proposals & evaluate
their economic viability.

• Decision making: capital budgeting decision

making is made on the basis of dollar limits.
• Implementation: following approval,
expenditures are made & projects
implemented.

• Follow-up: results are monitored & actual

costs & benefits are compared with those
that were expected.

Review & analysis and decision making take

the most time and effort.
 Basic terminology
• Independent projects: projects whose cash
flows are unrelated or independent of one
another; the acceptance of one does not
eliminate the others from further
consideration.

• Mutually exclusive projects: projects that

compete with one another; so that the
acceptance of one eliminates from further
consideration all other projects that serve a
similar function.
 Risk of a Single Asset

• For example, a firm that needs increased production capacity

could obtain it by:
• Expanding its plant
• Acquiring another company
• Contracting with another company for production
• The availability of funds affects firm’s
decisions

• Unlimited funds: the financial situation in which a firm

is able to accept all independent projects that provide
an acceptable return.

• Capital rationing: the financial situation in which a

firm has only a fixed number of dollars available for
capital expenditures, and numerous projects compete
for these dollars.
• There are 2 approaches to
capital budgeting decisions:

o Accept-reject approach: the

evaluation of capital
expenditure proposals to
determine whether they meet
the firm’s minimum
acceptance criterion.
Ranking approach: the ranking of capital expenditure
projects on the basis of some predetermined
measure, such as the rate of return.

Only acceptable projects should be ranked.

Ranking is useful in selecting the “best” of a group of
mutually exclusive projects and in evaluating projects
with a view to capital rationing.
 CASH FLOW PATTERN

• Cash flow patterns can be classified as either conventional or

nonconventional.

• Conventional cash flow pattern: An initial outflow followed only by a

series of inflows.

 Nonconventional Cash Flow pattern : An initial outflow

followed by a series of cash inflows and outflows
Payback period
• PAYBACK PERIOD: An unsophisticated capital
budgeting technique.

• The amount of time required for a firm to recover

its initial investment in a project as calculated
from cash inflows

• Decision Criteria:
• Payback period< Maximum acceptable period-
Accept the project
• Payback period> Maximum acceptable period-
Reject the project
Pros:
• Relatively easy to calculate
• Has simple intuitive appeal
• Considers timing of cash flows
• Quick evaluation of projects
• Measure’s risk exposure

Cons:
• Lack of linkage to the wealth maximization
• Failure to consider time factor in the value of money
• Ignores cash inflows that occur after payback period
• Ignores complexity of cash flow occur with capital investment
Capital expenditure data for biotela company

Project A Project B

Initial investment $42000 $45000

Year Operating CF Operating CF

1 $14000 $28000

2 $14000 $12000

3 $14000 $10000

4 $14000 $10000

5 $14000 $10000
• Payback period calculation for annuity cash inflows 42000/14000= 3
years
• Formula for Payback period calculation of mixed stream cash inflows:

• A+
NCo - C
D

A= The year in which CCF is nearer but smaller than initial outlay
NC= initial outlay of cash
C= CCF of year A
D= CF of following year A
 Relevant Cash flows of Yeaman Company

Project A Project B

Initial investment $50000 $50000

Year Operating CF Operating CF

1 $5000 $40000

2 $5000 $2000

3 $40000 $8000

4 $10000 $10000

5 $10000 $10000

3 years 3 years
 • Cash flow calculation after payback period

Project X Project Y
Initial investment $10000 $10000

Year Operating CF Operating CF

1 $5000 $3000

2 $5000 $4000

3 $1000 $3000

4 $100 $4000

5 $100 $3000

2 years 3 years
 NET PRESENT VALUE
• NPV is considered a sophisticated capital budgeting technique.
• NPV measures the amount of value created by a given projects
• NPV is 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
Characteristics
• A very important capital budgeting tool.
• Helps firm assess the level of importance various capital budgeting projects have. Why
doing such a thing is important?
• Capital budgeting projects normally requires expenditures in millions and billions of
dollars, before embarking on any such project they want to be reasonably sure that the
cash inflows generated from the project will pay off project’s costs within a reasonable
amount of time. Firms generally can carry out multiple projects, capital budgeting tools
like NPV help firms choose the best among them.
• NPV= present value of cash inflows- initial investment

Decision Criteria:
Npv> 0 , accept the project
Npv<0 , reject the project
 Project A
Year Cash Flow Year
0 (42000)
1 14000
2 14000
3 14000
4 14000
5 14000
Project B
Cash Flow
0 (45000)
1 28000
2 12000
3 10000
4 10000
5 10000
Math related to npv
 NPV at 10% discount rate

NPV(A) = 11071
NPV(B) = 10924
Advantages
o With the NPV method, the advantage is that it is a direct measure of the
dollar contribution to the stockholders.
o Considers time value of money
o Considers all cash flows

Disadvantage:
o It is based on estimated future cash flows of the project and estimates
may be far from actual results.
 profitability index
• A variation of the NPV rule is called profitability index
• PI is simply equal to the present value of cash inflows divided by the initial cash outflow.

• NPV and PI methods will always come to the same conclusion regarding whether a particular
investment is worth doing or not

• Decision Criteria:
• PI>1 - Accept the project
• PI< 1- Reject the project
• PI=1 - Indifferent
Advantages of PI

1.it considers time value of money.

2.It takes into account the cash inflows and outflows throughout the economic
life of the project.
3.Though PI method is almost similar to NPV method and has got the same
advantages, the former is still a better measure because PI measures the
relative profitability and NPV, being an absolute measure.
4.PI ascertains the exact rate of return of the project.
Disadvantages of PI
It is difficult to understand interest rate or discount rate.
It is difficult to calculate profitability index if two projects having different useful
life.
Internal rate of return (irr)
• The internal rate of return is the discount rate that equates the NPV of an
investment with $0 (because the present value of cash inflows equals the
initial investment)

• It is the rate of return the the firm will earn if it invests in the project and
receives the given cash flows
 Decision criteria:
 IRR> Cost of capital- Accept the project
 IRR< Cost of capital- Reject the project
Pros
• Considers time value of money
• Considers all cash inflows
• Gives percentage result whether to accept or reject the project
• Don’t give misguiding result
Cons
• Percentage result which is easier for average manager
• Projects with non conventional cash flow produces multiple IRR problem
• Don’t provide information regarding maximizing wealth
 Project A
Year Cash Flow Year
0 (42000)
1 14000
2 14000
3 14000
4 14000
5 14000
Project B
Cash Flow
0 (45000)
1 28000
2 12000
3 10000
4 10000
5 10000
 NPV at 0% discount rate

NPV(A) = 28000
NPV(B) = 25000

NPV at 10% discount rate

NPV(A) = 11071
NPV(B) = 10924
Internal Rate of Return

IRR(A) = 19.9%
IRR(B) = 21.7%
 Findings

1. The IRR of project B is greater Than the IRR of project A. If manager uses the
IRR method to rank project will always choose B over A when both projects
are acceptable.

2. The NPV of project A is sometimes higher and sometimes lower than the NPV
of project B. So NPV method cannot ensure about its consistency. Actually
NPV method depends on the cost of capital.
 Net Present Value

Discount Rate Project A Project B

0% 28000 25000
10% 11071 10924
19.9% 0 -
21.7% - 0
NPV profile in a graph
Conflicting Rankings

• Ranking different investment opportunities is an important

consideration when projects are mutually exclusive or when capital
rationing is necessary. When projects are mutually exclusive,
ranking enables the firm to determine which project is best from a
financial standpoint.
Which Approach is Better?
 Thanks
For Your Attention

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