CAPITAL BUDGETING

• Capital budgeting is the decision making process

with respect to investment in fixed assets( Keown
etal, 2004).
• It is the decision process that managers use to
identify those projects that add to the firms
value (Brigham and Ehrhardt, 2005)
• It is sometimes the most important task that
faces the management team of any organization
as capital budgeting determines the company’s
strategic direction.
 CAPITAL BUDGETING
• Capital budgeting decisions is important for the
following reasons:
 The result of capital budgeting decisions
continues for many years and may reduce
flexibility.
 Moves into new products, services or markets
must be preceded by capital expenditure.
Therefore, careful consideration must be given
before a particular direction is chosen for the
company.
 CAPITAL BUDGETING
 Poor capital budgeting can have serious
financial consequences. If the firm does not
invest enough it will not have the most
modern equipment to help them remain
competitive. On the other hand, if it invests
too much, it will incur high depreciation costs
and other expenses.
 CAPITAL BUDGETING
• The same general concepts employed in
security valuation will apply in capital
budgeting.
• However , an important distinction is to be
made. Stocks and bonds exist in securities
markets and investors select from those
available while capital budgeting projects are
created by the firm. For example,
 An example
• An employee may come up with an idea for a
new product. This would then be submitted to
the research and development department
who investigates whether there is a large
enough market for the proposed product.
Assessments will then be made as to the cost
to make the product. If it is concluded that the
product can be produced profitably then the
project will be undertaken.
 Project Classification
• In analyzing capital budgeting decisions a firm may
choose to classify its projects. Categories include:

 Replacement – this can be broken down into 2 groups

namely, replacement that affects the maintenance of
business, and replacement for cost reduction. The
replacement of worn-out or damaged equipment is
necessary if the firm is to continue in business. When it
comes to cost reduction, these replacement projects
lower the cost of labor, materials and equipment. Eg.
Replacing costs of making hard copy files (paper, filing
cabinets etc.)which require clerical staff with efficient
storing of records on computers.
 CAPITAL BUDGETING
 Expansion of existing products or markets –
this includes expenditure to increase the
output of existing products, or to increase the
number of distribution outlets in markets
being served.
 Expansion into new products or markets –
these projects involve strategic decision that
could change the fundamental nature of the
business.
 CAPITAL BUDGETING
 Long term contracts- companies sometimes
enter into long term contractual
arrangements to provide products or services
to specific customers.
 Safety and/or environmental projects – this
involve expenditure necessary to comply with
government orders or labor agreements. This
category often involve non-revenue-producing
projects.
 Independent projects
• These are projects that can be accepted or
rejected individually.
 Mutually exclusive projects
• These are projects that cannot be performed at
the same time. That is, a company could chose
Project 1 or Project 2, or it can reject both, but it
cannot accept both projects.
• Mutually exclusive means that if one project is
taken on, the other must be rejected.
• For example, your company is considering the
installation of a computer system and evaluates 4
service providers. The acceptance of one supplier
for this installation will mean rejection of the
other 3 suppliers.
 Unlimited Funds vs Capital Rationing
• Capital rationing occurs when management
places a constraint on the size of the firm’s
capital budget during a particular period.
• There are a few possible reasons a firm may
chose to impose a capital-rationing constraint:
 Management may consider market conditions
to be adverse eg. Where there are high
interest rates in the market the cost of
funding projects will be high.
 Unlimited Funds vs Capital Rationing
 There may be a shortage of qualified mangers
to direct new projects . This can happen with
projects of a highly technical nature.
 There may be intangible considerations such
as a fear of debt. That is, wishing to
completely avoid paying any interest cost.
There are strong suggestions of the negative
effect that capital rationing has on the firm.
 Unlimited Funds vs Capital Rationing
• In practice, capital-rationing’s negative effect
depends on the severity of the rationing. If the
rationing is short lived then the firms share
price will not suffer to any great extent.
However, when a compay imposes capital
rationing at the cost of modernizing or
expanding operations, it will face negative
effects of falling share prices due to a loss of
competitive advantage.
 Unlimited Funds vs Capital Rationing
• Unlimited funds
• On the other hand when no limit is placed on
the capital to be expended, the firm will take
on projects that will provide a return. That is,
any project that is successfully evaluated the
funding will be made avalilable.
 CAPITAL BUDGETING DECISION RULE
• We will focus on the following decision rules:
1.Payback period
2.Discounted payback period
3.Accounting rate of return
4.Net Present Value
5.Internal rate of return
6.Profitability index
 Payback Period
• The payback period is the number of years
needed to recover the initial cash outlay of
the capital budgeting project.
• This criterion measures how quickly the
project will return its original investment. It
deals with free cash flows which measures
the true timing of the benefits.
•
 Payback Period
• The accept or reject criterion centers on
whether the projects payback period is less
than or equal to the firms maximum desired
payback period.
• Take for example a firm with a maximum
payback period of 3 years. They are
considering an investment proposal which
requires an initial cash outlay of $10,000.
 Payback Period
• The firm would yield the following set of
annual free cash flows. What is the payback
period? Should the project be accepted?
Years After-tax free cash flows
1 $ 2,000
2 4,000
3 4,000
4 3,000
5 10,000
 Payback Period
• So, what the first question is asking is how
many years will it take for the company to
recover the projects cost of $10,000. This is
represented as a negative cash flow (-$10,000).
• Looking at the cash flow streams we see where
at the end of the first year we would have
recovered $2000, leaving a balance of $8,000
($10,000 – $2,000)to be recovered.
 Payback Period
• At the end of the second year we would
recover $6,000 of the total project cost.
• At the end of the third year we would have
recovered the initial outlay of $10,000.
Therefore, payback period would be 3 years.
The firm would therefore accept the project
as the payback for the project is calculated to
be equal to its desired payback period.
 Payback Period
• Suppose that the cash flow for this firm in year
3 was $3,000 instead of $4,000.
Years After-tax free cash flows
1 $ 2,000
2 4,000
3 3,000
4 3,000
5 10,000
 Payback Period
• At the end of the second year we would recover
$6,000 of the total project cost.
• At the end of year 3 we would have only
recovered $9,000.
• Based on the firms maximum payback period
this project would be rejected. As the maximum
period to recover the cost of a project is 3 years
and only $9,000 of the total $10,000 was
recovered.
 Payback Period
• The actual payback for the project would be
calculated as 3.33 years. There is only $1000
remaining at the end of year 3 and year 4 has a
total cash flow of $3,000. Therefore, 3 +
1000/3,000 gives a payback period of 3.33
years.
• Note that in rejecting this project the company
does not take into consideration the $10,000 to
received in year 5.
 Payback Period
• A general equation that can be used to find the
payback period is:
Paybacks = year before full recovery + unrecovered cost at start of year
cash flow during year

From our previous example our calculations would be:

Payback = 3 + $1000
$3000

Payback = 3 + 0.33
= 3.33 years
 Payback Period
• One major drawback of the payback period
criterion is that it ignores the time value of
money and does not discount these free cash
flows back to the present.
 Discounted Payback
• The discounted payback approach is a
variation of the original payback period
approach. It is similar to the regular payback
period except that the expected cash flow are
discounted by the project’s cost of capital.
• This method is defined as the number of years
needed to recover the initial cash outlay from
the discounted free cash flows.
 Discounted Payback
• The accept-reject criterion then becomes
whether the projects discounted payback
period is less than or equal to the firm’s
maximum desired discounted payback period.
• Assuming that the required rate of return on
project’s A and B is 17% the discounted free
cash flows would be as shown in the tables
below.
 Project A

Years Undiscounted PVIF 17% , n Discounted free cash Cumulative

Free cash flows flows discounted
free cash
flows.
0 -$10,000 1.0 -$10,000 -$10,000
1 6000 0.855 5,130 -4,870
2 4000 0.731 2,924 -1,946

3 3000 0.624 1,872 -74

4 2000 0.534 1,068 994

5 1000 0.456 456 1,450

 Project B
Year Undiscounted Free PVIF 17% , n Discounted free cash Cummulative
cash flows flows discounted
free cash
flows.
0 -$10,000 1.0 -$10,000 -$10,000

1 5,000 0.856 4,275 -5,725

2 5,000 0.731 3,655 -2,070
3 0 0.624 0 -2,070
4 0 0.534 0 -2,070
5 0 0.456 0 -2,070
 Discounted Payback
• With project A, after the third year only $74 of
the initial outlay remains to be recaptured.
Year 4 projects a discounted cash flow of
$1,068. Therefore, $74 / $1,068 = 0.07. So,
we would need 3.07 years to recover the
initial outlay of $10,000.
• Discounted Payback A = 3 + $74/$1,068
= 3.07 years.
 Discounted Payback
• If the firms maximum discounted payback
period is 4 years then Project A would be
accepted.

• Project B however, does not have a

discounted payback period as it never fully
recaptures the initial outlay($10,000). It would
therefore be rejected.
 Criticism and benefits
• The discounted payback period is superior to
the traditional payback period in that it
accounts for the time value of money in its
calculations. It is however still limited by the
subjectivity attached to a firms decision on its
maximum desired payback period.
• The benefits include:
o Both methods deal with free cash flows as
opposed to accounting profit.
 Criticism and benefits
Therefore they focus on the true timing of the
projects benefits and costs.
o They are easy to visualize, quickly understood and
easy to calculate.
o They are useful as screening devices to eliminate
projects whose returns do not materialize until
later years.
o The disadvantages however outweigh the benefits
and superior methods such as NPV are more
utilized.
Accounting/Average rate of return
• This capital budgeting method uses accounting
information. It is dependent on average
earnings and the initial outlay for the project.
• It is known for its simplicity as it makes use of
readily available accounting information. Once
the average rate of return for a proposal has
been calculated it may be compare with a
required or cutoff rate of return to determine
acceptance or rejection.
Accounting/Average rate of return
• Take for example, a firm with average
earnings of $210,000 over a five year period.
It wants to take on a project which requires an
initial investment of $1,800,000.

• Average rate of return = $210,000 = 11.67%

$1,800,000
The firm’s required rate of return is 20%,
therefore the project would be rejected.
Accounting/Average rate of return
• The principal short fall of this method is that it
focuses on accounting profits rather than cash
flows.
• It fails to take into consideration the timing of
cash inflows and outflows. It ignores the time
value concept of money.
 Net Present Value
• The net present value of an investment
proposal is equal to the present value its free
cash flows less the investments initial outlay.
The net present value can be expressed as:
n
• NPV = ∑ FCFt - IO
t=1 (1 +k)t
 Net Present Value
• Where,
FCF – the annual free cash flow in time period t
(this can take on either a positive or
negative values)
k - the appropriate discount rate; that is, the
required rate of return or cost of capital.
IO – the initial cash outlay
n – the projects expected life.
 Net Present Value
• The project’s net present value gives a
measurement of the net value of an
investment proposal in terms of today’s
dollar’s.
• Because all cash flows are discounted back to
the present, comparing the difference between
the present value of the annual free cash flows
and the investment outlay is appropriate.
 Net Present Value
• The difference between the present value of
the annual free cash flows and the initial
outlays determines the net value of accepting
the investment proposal in terms of today’s
dollars.
• Whenever the project’s NPV is greater than or
equal to zero, we will accept the project .
Whenever the NPV is negative, we will reject
the project.
 Net Present Value
• NPV ≥ 0.00 ; Accept
• NPV ≤ 0.00 ; Reject

The following example illustrates the use of the

present value capital budgeting criterion.
 Example
• Ski – Doo is considering investing in machinery that
will reduce its manufacturing costs associated with
its newest line of snowmobiles. The firm has a
required rate of return of 12%. The table below
shows the free cash flows over a year period, and
the present value of this cash flow stream.
 Example
Years Free cash Present value Present value
flows factor at 12%
1 15,000 0.893 13,395
2 14,000 0.797 11,158
3 13,000 0.712 9,256
4 12,000 0.636 7,632
5 11,000 0.567 6,237
Present value of free
cash flows $47,678
Initial outlay -40,000
Net present Value $7,678
 Example
• The present value of the free cash flows are
calculated to be $47, 678 as calculated in the
table above. Subtracting the initial
outlay(initial cost) of the project of $40,000 ,
we end up with a Net Present Value of $7,678.
• Since this value is greater than zero, the NPV
criterion indicates that the project should be
accepted.
 Net Present Value
• The disadvantage of the NPV method stems
from the need for detailed, long term forecast
of the cash accruing after the acceptance of
specific projects.
• As a capital budgeting tool the NPV criterion
is considered most favorable due to its
numerous advantages.
 Net Present Value
Advantages include:

• It deals with free cash flow rather than accounting profit.

• It is sensitive to the true timing of the benefits resulting from
the project. It recognizes that the time value of money allows
comparison of the benefits and costs in a logical manner.
• The acceptance of a project using this criterion will increase
the value of the firm. This is due to the rule of accepting only
projects with positive NPVs.
 Internal Rate of return (IRR)
• The IRR is the rate that forces the NPV to be
equal to zero.
• It is defined as the discount rate that equates
the present value of a projects expected cash
inflows to the present value of the projects
cost.

• PV (Inflows) = PV( Investment costs)

 Internal Rate of return (IRR)
n
• NPV = ∑ FCFt - IO = 0
t=1 (1 +IRR)t
Consider the following cash flow stream for Project S.
Years Cash flows
0 -1,000
1 500
2 400
3 300
4 100
 Internal Rate of return (IRR)

• NPV = -1000 + 500 + 400 + 300 + 100 = 0

( 1+ IRR)1 ( 1+ IRR)2 ( 1+ IRR)3 ( 1+ IRR)4

Thus we have an equation with one unknown, IRR.

We need to solve for IRR.

• To solve for IRR is not as easy as our calculation with the NPV criterion.
• To find IRR we use the above equation to solve for the discount rate that causes
the equation and the NPV to be equal to zero. We solve using trial and error .
 Internal Rate of return (IRR)
• After trying some discount rates we eventually
find the answer to be 14.5%. This is the
discount rate that causes the NPV to be equal
to zero and is represented by IRR in the
formula.
 Internal Rate of return (IRR)
• The logic behind IRR is that it represents the
expected rate of return.
• A surplus is provided when the IRR exceeds the
cost of the funds used to support the project.
This surplus will accrue to the firms
shareholders.
• Therefore accepting a project whose IRR
exceeds the cost of capital increases
shareholder wealth.
 Profitability Index (PI)
• Also called the benefit or cost ratio.
• Refers to the ratio of present value of the
future free cash flows to the initial outlay
• That is, the ratio of the present value of the
future benefits to its initial cost.
 Profitability Index (PI)
n
PI = ∑ FCFt
t=1 (1 +k)t
IO
 Profitability Index (PI)
• Where,
FCF – the annual free cash flow in time period t
(this can take on either a positive or
negative values)
k - the appropriate discount rate; that is, the
required rate of return or cost of capital.
IO – the initial cash outlay
n – the projects expected life.
 Profitability Index (PI)
• The decision criterion is this; Accept the
project if the PI is greater than or equal to
1.00, and reject the project if the PI is less
than 1.00.

• PI ≥ 1.00 ; Accept
• PI ≤ 1.00 ; Reject
 Profitability Index (PI)
• The Profitability index criterion yields the same accept-reject
decision as the NPV criterion.
• Whenever the PV of the projects net cash flow is greater than
its initial cash outlay the project’s NPV will be positively
signaling a decision to accept. When this happens, the
projects profitability will be greater than 1.

• Thus these two decision criteria will always yield the same
accept-reject decision.
• Note however, that they will not necessarily rank acceptable
projects in the same order.
• END