Capital Budgeting

Strategic Finance
Capital Budgeting
Strategic Finance-Abdullah 1
Learning Goals
• By the end of the lecture students are
expected to be able to:
1. Describe what is meant by capital investment
appraisal;
2. Identify five capital investment appraisal

techniques;
3. Incorporate such techniques into quantitative

Content
• Main sources of finance

• Capital budgeting
• Techniques of capital budgeting
• Payback period
• Accounting Rate of Return
• Net present value
• Internal rate of return
• Discounted payback period
The main sources of finance
• Bank loans and overdrafts
• Leasing/hire purchase
• Trade credit
• Government grants, loans and guarantees
• Venture capitalists and business angels
• Invoice discounting and factoring
• Retained profits.
Investment Appraisal Techniques
1. Payback method
2. Return on Capital Employed (ROCE)
3. Net Present Value (NPV) method
4. Internal Rate of Return (IRR)method
5. The discounted payback method
Payback method
• Payback period: is the number of years it takes to
recover the original investment in nominal cash flows.
– It takes into account the risk factor.
• Distant cash flows are given less importance
– It is a simple method to understand
– However, it ignores:
• the time value of money
• the timing of cash flows within the payback period
• Any cash flows after the payback period.
Payback method - Example
Year: 0 1 2 3 45
Cash flow ($m): (100) 20 30 40 20 20
Calculate the payback period.
• Payback period falls between 3rd and 4th year.

• Payback period = 3.5 years.
The return on capital employed method
• Return on capital employed is the ratio of average
annual profit to capital invested.
• Other names used
• ROI(Return on Investment)
• ARR (Accounting Rate of Return)
• The most widely used formulae is:
Average Annual Accounting profit

ROCE 
Average Investment
Initial Investment  Scrap Value

Average Investment 
2
ROCE - Example
Carbon plc is considering the purchase of a new machine and has found
two which meet its specification. Each machine has an expected life of
five years. Machine 1 would generate annual cash flows (receipts less
payments) of £210 000 and would cost £570 000. Its scrap value at the
end of five years would be £70 000. Machine 2 would generate annual
cash flows of £510 000 and would cost £1 616 000. The scrap value of
this machine at the end of five years would be £301 000. Carbon plc
uses the straight-line method of depreciation and has a target return on
capital employed of 20 per cent.
Calculate the return on capital employed for both Machine 1 and

Machine 2 on an average investment basis and state which machine you
would recommend, giving reasons.
ROCE - Solution
ROCE
• Advantages
1. It is a quick and simple calculation.
2. It involves the familiar concept of a percentage
return.
3. It looks at the entire project life.
• Disadvantages
1. Based on profits and NOT cash flows
2. It is a relative measure
3. Length of the project is not considered
4. Ignores the time value of money
Net Present Value
• Net present value is the difference between the
present value of future benefits and the present value
of capital invested, discounted at a company’s cost of
capital.
• The NPV decision rule is to accept all projects with a

positive net present value.
NPV Example
ABC Plc. is planning to invest $100,000 in a three
year project that is expected to generate cash
inflows as given in the table below. Current
Weighted Average Cost of Capital of ABC Plc. is 10%.
Determine the NPV of the project.
Year Cash flow ($) PV factor 10% PV of cash flow($)
0 (100,000.00) 1 (100,000.00)
1 25,000.00 0.9091 22,727.50
2 35,000.00 0.8264 28,924.00
3 70,000.00 0.7513 52,591.00
4,242.50
Internal Rate of Return (IRR)
The internal rate of return (IRR) of an

investment project is the cost of capital
or required rate of return which, when
used to discount the cash flows of a
project, produces a net present value of
zero.
Internal Rate of return (IRR)
 The IRR method of investment appraisal is to

accept projects whose IRR (the rate at which the
NPV is zero) exceeds a target rate of return.
o The IRR is calculated using interpolation.
𝐼𝑅𝑅=𝑎 % + 𝑁𝑃 𝑉 𝑎
×(𝑏 − 𝑎) %
𝑁𝑃 𝑉 𝑎 − 𝑁𝑃 𝑉 𝑏
Where
a is lower of two rates of return used
b is higher of two rates of return used
NPVa is NPV obtained using rate a
NPVb is NPV obtained using rate b
IRR - Example
Find the IRR of the project given below
and states whether the project should be
accepted if the company requires a
minimum return of 17%.
Time Cash flow ($)
0 (4,000)
1 1,200
2 1,410
3 1,875
4 1,150
Solution to IRR Example
Time Cash flow($) DF(17%) Present Value($) DF(14%) Present Value ($)
0 (4,000) 1 (4,000) 1 (4,000)

1 1,200 0.855 1,026 0.877 1,052
2 1,410 0.731 1,031 0.769 1,084
3 1,875 0.624 1,170 0.675 1,266
4 1,150 0.534 614 0.592 681
NPV (159) NPV 83
IRR – Graphical Representation
The closer our NPVs are to zero, the closer our

estimate will be to the true IRR.
Capital rationing decisions
• A situation in which a company has a limited amount
of capital to invest in potential projects
• Two types of capital rationing
– Soft capital rationing
• is brought about by internal factors
– Hard capital rationing
• is brought about by external factors
Reasons for soft capital rationing
1. Reluctant to issue additional capital

• Concerns about outsiders gaining control of the business
• Dilution of earnings per share.
2. Do NOT want to raise additional debt capital

• Do not wish to be committed to large fixed interest
payments.
3. Management may wish to limit investment to a level

that can be financed solely from retained earnings.
Hard capital rationing
• Share prices are depressed
• Restrictions on bank lending due to government
control
• Lending institutions perception about the business
– Consider some businesses to be too risky
• The costs associated with making small issues of
capital may be too great.
Reducing the strain on capital
• Seek joint venture partners
• Licensing and franchising agreements
• Outsourcing
• Alternative sources of capital
– Venture capital
– Debt finance secured on the assets of the project
– Sale and leaseback
– Grant aid
– More effective capital management
Profitability Index
• The ratio of the present value of the project's future
cash flows (not including the capital investment)
divided by the present value of the total capital
investment.
– e.g. Project A requiring an investment of $10,000 gives a PV
of $12,400 and Project B requiring an investment of $20,000
gives a PV of $22,800
• Profitability Index: Project A  1.24, B1.14
Capital Rationing - Example
• Assuming that projects are divisible and only $60,000

available, determine the projects, or part thereof, will
give rise to highest NPV in total.
Capital Rationing - solution
• The assumption here is that the projects are divisible.
Capital Rationing – Example contd..
• Profitability Index is a better indicator of which projects

create the highest increase in shareholder wealth.
Problems with Profitability Index Method
• Only applicable if projects are divisible
• Selection criteria is too simple.

– Strategic importance is not considered
• Limited use when there is differing cash flow

patterns
• Ignores the absolute size of the projects
Incorporating inflation into NPV
• Real cash flows (ie adjusted for inflation)
should be discounted at a real discount rate.
• Nominal cash flows should be discounted at a
nominal discount rate.
• Fisher Formula on real and nominal rates
(1 + i) = (1 + r)(1 + h)
Where:
h = rate of inflation
r = real rate of interest
i = nominal (money) rate of interest
Which rate to use?
• Nominal rate, if:

– Cash flows are actual amounts to be received or
paid
• Real rate, if:
– If the cash flows are expressed in terms of the
value of the dollar at time 0 (that is, in constant
price level terms)
Why is finance needed?
• For investment in non-current assets.
• To sustain the company through initial loss-making
periods.
• For investment in current assets.
• For continued growth and to remain as a going
concern.
– Overtrading is a major cause of business failure for high
growth start-ups.

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Strategic Finance

2. Identify five capital investment appraisal

3. Incorporate such techniques into quantitative

• Main sources of finance

2. Return on Capital Employed (ROCE)

3. Net Present Value (NPV) method

4. Internal Rate of Return (IRR)method

5. The discounted payback method

Calculate the payback period.

• Payback period falls between 3rd and 4th year.

Average Annual Accounting profit

Initial Investment  Scrap Value

Calculate the return on capital employed for both Machine 1 and

• The NPV decision rule is to accept all projects with a

Year Cash flow ($) PV factor 10% PV of cash flow($)

The internal rate of return (IRR) of an

 The IRR method of investment appraisal is to

0 (4,000) 1 (4,000) 1 (4,000)

The closer our NPVs are to zero, the closer our

1. Reluctant to issue additional capital

• Dilution of earnings per share.

2. Do NOT want to raise additional debt capital

3. Management may wish to limit investment to a level

• Assuming that projects are divisible and only $60,000

• The assumption here is that the projects are divisible.

• Profitability Index is a better indicator of which projects

• Selection criteria is too simple.

• Limited use when there is differing cash flow

• Ignores the absolute size of the projects

• Nominal rate, if:

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