Capital Budgeting

Pay Back Period

IRR – Internal Rate of Return
Exercise on Capital Budgeting Techniques

Muhammad Mubashir Nazir

MBA, FCCA, CISA, CIA, CRMA
 What is “Capital Budgeting?”
The capital budgeting process is the process of
identifying and evaluating capital projects, that is,
projects where the cash to the firm will be received
over a period longer than a year.
Any corporate decisions with an impact on future
earnings can be examined using this framework.
Example
Decisions about whether to buy a new machine,
expand business in another geographic area, move the
corporate headquarters to Karachi, or replace a
delivery truck, to name a few, can be examined using a
capital budgeting analysis.
 What is “Capital Budgeting?”
Capital budgeting is also referred as “Investment Appraisal”.
Capital budgeting refers to a process that involves a business
to determine:
• Whether the projects are worth following?
 a long-term venture
 building / prepare a new plant
 new machinery,
 New products
 Research development project
Many times, an eventual project’s lifetime cash inflows and
outflows are evaluated so as to determine whether the
generated returns congregate to a satisfactory target
benchmark.
Capital Budgeting Process

4. Monitor Decisions &

Conduct a Post Audit
 I. Generation of Ideas
• New Products
• Market Development
• Replacement Project
– to maintain the business
– for Cost Reduction
– Expansion Product
• Mandatory Project
• Other Projects
 Key Principles of Capital Budget
(LOS 36.b)
1. Decision are based on Cash Flows, not Accounting
Income.
2. Cash Flows are based on Opportunity Cost i.e. not
getting benefit from opportunity
3. Timing of Cash Flow
4. Cash Flows are analyzing on an After Tax
5. Financial Costs are reflected in the project required
Rate of Return.
Rate of Return %
= Current or Future Value – Original Value x 100
Original Value
 LOS
Learning Outcome Statements
(Certified in Strategy & Competitive Analysis)
• Strategic Analysis  Vision, Mission & Goals - Analytical
Planning - Economic Structure - Life Cycle Analysis -
Competitive Analysis etc.
• Internal Analysis  SWOT Analysis – Risk Assessment
• Creating Competitive Advantages
• Business Level Strategies
• Strategy Implementation & Performance Evaluation
Evaluation & Selection of Capital Project
(LOS 36.C)
• Independent vs. Mutual Exclusive Projects
– Mutual Exclusive Project ---- Invest in A or invest in B
• Coin toss head / tail
• Full time studies / full time job
• Use land in agriculture / building construction etc.
– Independent Project ---- Unrelated to each other
e.g. Invest in C, D, E etc.
• Project Sequencing
• Unlimited Funds vs. Capital Rationing
 Games
ْ ْ
of Chances
ْ ْ
َ َ ْ ْ ُ َ ْ َ َ ُ َ ْ َ َ ُ ْ َ َ ُ ْ َ َ َّ ُ َ َ َّ َ ُّ َ َ
َ ِ ‫اب و َأْلزْل َم ِر َجسَ ِم ْنَ عم‬
‫ل‬ َ َ ‫ين أمنوأ َ ِأنَّما أل ْخم َر وألم َي ِس َر وأْلنص‬ َ ‫يا أيه َا أل ِ َذ‬
َ‫ان أ ْ َن ُيوق َ َع َب ْي َن ُك ُ َم أل َع َد َأو َة‬ َ ُ ‫ط‬‫ي‬ْ َّ
‫ألش‬ َ
‫يد‬ُ ‫ر‬ ‫ي‬ ُ ‫ا‬ ‫م‬ َ َّ
‫ن‬ ‫أ‬ .َ‫ون‬َ َ
‫ح‬ُ ‫ل‬
ِ ‫ف‬ ُ
‫ت‬ َ
‫م‬ ْ ُ
‫ك‬ ‫ل‬ َ
‫ع‬ ‫ل‬ َ
‫وه‬ ُ ُ
‫ب‬ ‫ن‬
ِ َ
‫ت‬ ْ
‫اج‬ ‫ف‬ َ
‫ان‬ ‫ط‬ ْ
‫ي‬ َّ
‫ألش‬
ْ َ ْ َ َ ِ َّ ْ ِ ُ ِ ْ َ ْ ِ َ ْ ْ َ
ْ‫ل أن ُت َم‬ َ
َ ‫ألصَل َِةَ فه‬ َّ
َ ‫ن‬ َ َ
َ ِ ‫أّللَ وع‬ ِ ‫ن ِذك َِر‬ ْ َ ْ َّ ُ َ َ
َ ‫اء ِفي ألخم َِر وألمي ِس َِر ويص َدك َم ع‬ ْ َ َ ْ َ
َ ‫وألبغض‬ َ
َ ‫ُمنته‬
َ.‫ون‬ ُ َ ْ
O You! Who have attained to faith!
(1) Intoxicants,
(2) games of chance,
(3) worshiping idols practices, and
(4) the divining of the future
are but a evil of Satan’s doing; shun it, then, so that you might
attain to a happy state.
By means of intoxicants and games of chance Satan seeks only to
sow enmity and hatred among you, and to turn you away from the
remembrance of Allah and from prayer. Will you not, then desist?
(Al Mayidah 5:90-91)
 II. Analyze Project Proposal
1. Rate of Return
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)
4. Discount Cash Flow
5. Accounting Rate of Return (ARR)
6. Payback Period
7. Discount Payback Period
8. Profitability Index (PI)
 Expectations about the Target
Business in Future 2019-2025
• Impact of the Economy
– Political Changes
– Social Changes
– Psychological Changes
– Customer Expectations
– Technological Changes
• Likelihood & Impact of
Risks
2018 2025
 1. Rate of Return
• A Rate of Return is the gain or loss on an investment over
a specified time period, expressed as a percentage of the
investment's cost.
• Gains on investments are defined as income received plus
any capital gains realized on the sale of the investment.

% Rate of Return = ((Current Value - Original Value) /

Original value) x 100
Example:
Original Value = $M 5000, Current Value = $M 5500
(5500-5000) / 5000 = 10%
 2. Net Present Value (NPV)

Key Terms
• CF-0 = Initial investment outlay (a negative cash flow)
• CF-t = After – tax cash flow at time
• k = Required Rate of Return for Project
Time Project A Project B
2019 $M -5,000 $M -5,000
2020 1,000 300
2021 1,500 500
2022 800 1,000
2023 500 1,500
Required Rate of Return 1.5 0.8
 2. Net Present Value (NPV) - Example

Time Proj. A B
• A Positive NPV project is
2019 (5,000) (5,000)
expected to increase
2020 1,000 300 shareholders wealth.
2021 1,500 500 • A Negative NPV project is
2022 800 1,000 expected to decrease
shareholder wealth
2023 500 1,500
• And a Zero NPV project has
Required Rate 1.5 0.8 no expected effect on
of Return shareholder wealth.

NPV A = - 5000 +1000/(1.5)1 +1500 +800 +500 = (3,381)

(1.5)2 (1.5)3 (1.5)4
NPV B = -5000 +300/(0.8)1 +500 +1000 +1500 = 1,771
((0.8)2 (0.8)3 (0.8)4
 4. Discount Cash Flow (DCF)
The most widely used method of discounting is
exponential discounting, which values future
cash flows as "how much money would have to
be invested currently, at a given rate of return,
to yield the cash flow in future.“
 4. Discount Cash Flow (DCF)

• DPV = The discounted present value of the future cash flow (FV),
or FV adjusted for the delay in receipt.
• FV = is the nominal value of a cash flow amount in a future
period.
• r = the interest rate or discount rate which reflects the cost of
tying up capital and may also allow for the risk that the payment
may not be received in full.
• n = the time in years before the future cash flow occurs.
 3. Interest Rate of Return (IRR)
• The internal rate of return is a method of calculating
rate of return.
• The term internal refers to the fact that the internal
rate excludes external factors, such as inflation, the cost
of capital, or various financial risks. It is also called the
discounted cash flow rate of return.
• One of those tools is internal rate of return, or IRR. The
IRR measures how well a project, capital expenditure or
investment performs over time.
• The internal rate of return has many uses. It helps
companies compare one investment to another or
determine whether or not a particular project is viable.
 3. IRR Decision Rule
• Determine the required rate of return for a given project.
• Note that the required rate of return may be higher or lower
than the firm’s cost of capital to adjust for differences
between project risk and the firm’s average project risk.
• Use IRR to calculate NPV.

Time Project A Project B

2019 -5,000 5,000
2020 1,000 300
2021 1,500 500
2022 800 1,000
2023 500 1,500
Internal Rate of Return (IRR) 3 4
 5. Accounting Rate of Return (ARR)
ARR = Average Return during period
Average Investment

Average Investment = (Book Value at Beginning of Year 1 + Book

Value at end of Useful Time) / 2
Average Return during Incremental Revenue – Increment Expenses
Period = Initial Investment
Average Profit = Profit after Tax
Life of Investment
Investment 2018 $ 1,000,000
Investment value in 2025 $ 1,200,000
Incremental Revenue $ 100,000
Incremental Expenses $ 600,000
 6. Payback Period
The payback period (PBP) is the number of years it takes to
recover the initial cost of an investment.
Payback Period = (Full Years until Recovery) + (Not yet
Recovered Investment at the Beginning of Last Year / Cash
Flow during the Last Year)
Time Project A Project B
2019 (5,000) (5,000)
2020 1,000 1,300
2021 1,500 1,700
2022 2,000 1,000
2023 1,000 1,500
Internal Rate of Return (IRR) 3 4
 7. Discount Payback Period
Discount Payback Period is the number of years it takes a project to
recover its initial investment in present value terms , therefore, must
be greater.
The discounted payback address one of the drawbacks of the payback
period by discounting cash flows at the project’s required rate of
return.
Net Cash Flow Discounted Net Cumulative
Time
Project A Cash Flow DNCF
2019 (5,000) (5,000) (5,000)
2020 1,000 900 -4,100
2021 1,500 1,250 -2,800
2022 2,000 1,500 -1,200
2023 1,000 600 -400
 8. Profitability Index
The Profitability Index (PI) is
Time Proj. A B the present value of a
2019 (5,000) (5,000) project’s future cash flows
divided by the initial cash
2020 1,000 300 outlay:
2021 1,500 500 PV >>> The Present Value of
2022 800 1,000 the future Cash Flows
2023 500 1,500 PI = PV of Future Cash Flow /
Initial Investment
Required Rate 1.5 0.8 PI = (NPV + Initial
of Return Investment) / Initial
Investment

Initial Investment NPV PI

Project A 5,000 (3,381) 32%
Project B 5,000 1771 135%
 Making a Decision
Project A

Project B
Risks

Profitability
 Weaknesses of Capital Budgeting
• Not done the Risk Assessment in the project
• Producing ranking of mutually projects
• Inputs must be estimated
• Value estimates are very sensitive to input
values
• Conflict of Interest
• Bad Intentions