Capital Budgeting

Decision Methods
 Outline
 What is Capital Budgeting ?
 Importance of Capital Budgeting.
 Calculation techniques of different methods of
capital budgeting for proposed project.
 Advantages and Limitations of different methods
 Summary
 What is Capital Budgeting ?

 Refers to future purchase of plant assets.

 Process that relates to the evaluation of several

alternative proposed investment projects for a firm.
 Importance of Capital Budgeting

 Involves commitment of large amount of funds for

long term.
 Essential for evaluating future events which are
uncertain.
 Ensure the selecting the right source of financing at the
right time.
 Capital Budgeting Methods

 Payback Period

 Net present value (NPV)

 Internal Rate of Return (IRR)

 Payback Period

 Payback Period: Length of time require to

recover the amount of initial investment.

 Minimum Acceptance Criteria

- Set by management

 Ranking Criteria:
- Set by management
Example
Time Project A Project B
0 (10,000) in taka. (10,000) in taka.
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

Formula of Payback period

= A + (B / C)

A = Last period with a negative cumulative cash flow

B = Absolute value of cumulative cash flow at the end of
the period ‘A’ .
C = Cash flow during the period of full recovery.
Project B
Year Cash Flow Cumulative
Cash flow
0 (10,000) (10,000)
1 500 (9,500)
2 500 (9,000)
3 4,600 (4,400)
4 10,000 5,600

 Payback period (project ‘B)

= A + (B/C)
= 3 + ( 4,400 / 10,000)
= 3.4 years
 Payback period (project ‘A)
= 2.9 years

Accept Project ‘A’ & Reject project ‘B’

 Payback
Advantages & Limitations

 Advantages
 Easy to understand
 Provides a good ranking of projects in terms of liquidity

 Limitations:
 Ignores the time value of money
 Ignores cash flows after the payback period
 Net Present Value
(NPV)

 Net Present Value (NPV) : Present value of all the costs and
benefits of a project.

 Estimating NPV:
› 1. Estimate future cash flows: how much? and when?
› 2. Estimate discount rate
› 3. Estimate initial costs

NPV = Total PV of future CF’s - Initial Investment

 Minimum Acceptance Criteria: Accept if NPV > 0

 Ranking Criteria: Choose the highest NPV

  NPV of project ‘B:

NPV ‘B
= [ + + + ] - 10,000
= [ 455 + 413 + 3,456 + 6,830 ] – 10,000
= 11,154 - 10,000
NPV ‘B = 1,154 in taka
NPV of project ‘A:

NPV ‘A = 1,095 in taka

 Accept Project ‘B’ & Reject project ‘A’

 Why use Net Present Value (NPV)

 NPV uses all the cash flows of the project. (Not up to certain period)

 Consider the time value of money by discounting the cash

flows properly.

 Accepting positive projects benefits the shareholders.

 Internal Rate of Return (IRR)

 IRR: The discount that sets NPV to zero.

 Minimum Acceptance Criteria:

› Accept if the IRR exceeds the required return.
 Ranking Criteria:
› Select alternative with the highest IRR
 Reinvestment assumption:
› All future cash flows assumed reinvested at the IRR.
  

Accept Project ‘A’ & Reject project ‘B’

 Ex:
 Suppose that you have identified a possible tenant
who would be prepared to rent your office block
for 3 years at a fixed annual rent of $ 16,000. you
forecast that after you’ve collected the 3 rd year’s
rent the building could be sold by $450,000. (For
simplicity assume that the cash flow’s are certain
and that the opportunity cost of capital is 7%).
Should you build the office block? (Land cost
50,000 and construction cost 300,000).
 IRR
Advantages & Limitations
 Advantages:
 Easy to understand and communicate.

o Limitation:
o Does not differentiate between investing and borrowing.
o There may be multiple IRR.
o Mutually exclusive projects.
Pitfalls with the IRR rule
 Mutually exclusive projects
 Choosing between mutually exclusive projects
using NPV rule is straightforward: Choose the
one which results in the higher NPV.
 This does not necessarily mean that it will have
the higher IRR.
 You decide to develop a building which cost $
350,000 and you have 2 possible applications for
it: you can sell it in 1 year time for $ 400,000 or
you will rent it out for 3 years ( this will give you
an annual income of $ 16,000) and then sell the
building for $ 450,000. (Discount rate 7%).