p



2Capital Budgeting
m



  
2 J e 6
  66  of a firm are generally known as t e

6   6   
6  
 6  66 

2 J e firm¶s investment decisions would generally include


6 Ô  666 Ô  6 6 and 
   of t e
long-term assets. Sale of a division or business (6
 ) is also
as an investment decision.

2 pecisions like t e c ange in t e     66 6 Ô or

an 
6   
6 or a    

 

  ave long-term implications for t e firm¶s
expenditures and benefitsÔ and t ereforeÔ t ey s ould also be
evaluated as investment decisions.
Œ



  
2 J e exc ange of current funds for future benefits.

2 J e funds are invested in long-term assets.

2 J e future benefits will occur to t e firm over a

series of years.




  

2 mrowt

2
isk

2 Funding

2 Irreversibility

2 Complexity
J 


  
2 wne classification is as follows:
Ú Expansion of existing business
Ú Expansion of new business
Ú
eplacement and modernisation
2 Êet anot er useful way to classify investments is as
follows:
Ú utually exclusive investments
Ú Independent investments
Ú Contingent investments





 

2 J ree steps are involved in t e evaluation of an
investment:
1. Estimation of cas flows
2. Estimation of t e required rate of return (t e
opportunity cost of capital)
3. Application of a decision rule for making t e c oice
 


  
2 It s ould maximise t e s are olders¶ wealt .
2 It s ould consider all cas flows to determine t e true profitability of
t e project.
2 It s ould provide for an objective and unambiguous way of separating
good projects from bad projects.
2 It s ould elp ranking of projects according to t eir true profitability.
2 It s ould recognise t e fact t at bigger cas flows are preferable to
smaller ones and early cas flows are preferable to later ones.
2 It s ould elp to c oose among mutually exclusive projects t at project
w ic maximises t e s are olders¶ wealt .
2 It s ould be a criterion w ic is applicable to any conceivable
investment project independent of ot ers.


 

2 1. p


  p

  
Ú et Present Value (NPV)
Ú Internal
ate of
eturn (I

)
Ú Profitability Index (PI)
2 2. m


 
  
Ú Payback Period (PB)
Ú piscounted payback period (pPB)
Ú Accounting
ate of
eturn (A

)
m

 

2 Cas flows of t e investment project s ould be forecasted
based on realistic assumptions.
2 Appropriate discount rate s ould be identified to discount t e
forecasted cas flows.
2 Present value of cas flows s ould be calculated using t e
opportunity cost of capital as t e discount rate.
2 Net present value s ould be found out by subtracting present
value of cas outflows from present value of cas inflows. J e
project s ould be accepted if NPV is positive (i.e.Ô NPV > 0).
 m

 


2 J e formula for t e net present value can be written

as follows:
 C1 C2 C3 Cn 
NPV    V  
C0
 (1  k ) (1  k)
2 3 n
(1  k) (1  k) 
n
Ct
NPV  t

C0
t 1 (1  k )
 
 m

 
2 Assume t at Project * costs
s 2Ô 00 now and is expected to
generate year-end cas inflows of
s 900Ô
s 800Ô
s 700Ô
s
600 and
s 00 in years 1 t roug . J e opportunity cost of
t e capital may be assumed to be 10 per cent.
Õ m


2 Positive net present value of an investment represents t e maximum
amount a firm would be ready to pay for purc asing t e opportunity
of making investmentÔ or t e amount at w ic t e firm would be
willing to sell t e rig t to invest wit out being financially worse-
off.

2 J e net present value can also be interpreted to represent t e

amount t e firm could raise at t e required rate of returnÔ in addition
to t e initial cas outlayÔ to distribute immediately to its
s are olders and by t e end of t e projects¶ lifeÔ to ave paid off all
t e capital raised and return on it.
 Ô

2 Accept t e project w en NPV is positive
NPV > 0
2
eject t e project w en NPV is negative
NPV < 0
2 ay accept t e project w en NPV is zero
NPV = 0

J

  
















 
 
  






 

 
m

2 NPV is most acceptable investment rule for t e
following reasons:
Ú Jime value
Ú easure of true profitability
Ú Value-additivity
Ú S are older value
2 66 6 
Ú Involved cas flow estimation
Ú piscount rate difficult to determine
Ú utually exclusive projects
Ú
anking of projects
mJmÔ ÔJŒJ
mJ

2 J e internal rate of return (I

) is t e rate t at

equates t e investment outlay wit t e present
value of cas inflow received after one period. J is
also implies t at t e rate of return is t e discount
rate w ic makes NPV = 0.
 Ô 
ÔJmŒ
2 ] 
   : Calculating I

by Jrial and
Error
Ú J e approac is to select any discount rate to compute
t e present value of cas inflows. If t e calculated
present value of t e expected cas inflow is lower t an
t e present value of cas outflowsÔ a lower rate s ould
be tried. wn t e ot er andÔ a ig er value s ould be
tried if t e present value of inflows is ig er t an t e
present value of outflows. J is process will be repeated
unless t e net present value becomes zero.
Ô 
ÔJmŒ
2 
 
> et us assume t at an investment would cost
s 20Ô000
and provide annual cas inflow of
s Ô
30 for 6 years
> J e I

of t e investment can be found out as follows

-
s 20Ô000 +
s Ô
30( 6Ô ) 0

s 20Ô000 -
s Ô
30( 6Ô )

s 20Ô000
6Ô - - 3.683

s Ô
30
m 

m
 
 Ô

2 Accept t e project w en r > k

2
eject t e project w en r < k

2 ay accept t e project w en r = k

2 In case of independent projectsÔ I

and NPV rules

will give t e same results if t e firm as no s ortage
of funds.


 

2 I

met od as following merits:
â Jime value
â Profitability measure
â Acceptance rule
â S are older value

2 I

met od may suffer from

Uultiple rates
Uutually exclusive projects
UValue additivity
 ŒJÔ
 Jm 
2 Profitability index is t e ratio of t e present value of
cas inflowsÔ at t e required rate of returnÔ to t e
initial cas outflow of t e investment
2 J e formula for calculating benefit-cost ratio or
profitability index is as follows:
 ŒJÔ
 Jm 
2 J e initial cas outlay of a project is
s 100Ô000 and it can
generate cas inflow of
s
0Ô000Ô
s 30Ô000Ô
s 0Ô000
and
s 20Ô000 in year 1 t roug
. Assume a 10 percent
rate of discount. J e PV of cas inflows at 10 percent
discount rate is:
Ô

2 J e following are t e PI acceptance rules:
Ú Accept t e project w en PI is greater t an one. PI > 1
Ú
eject t e project w en PI is less t an one. PI < 1
Ú ay accept t e project w en PI is equal to one. PI = 1
2 J e project wit positive NPV will ave PI greater
t an one. PI less t an means t at t e project¶s NPV
is negative.
 

 

2 J  It recognises t e time value of money.

2 º    : It is consistent wit t e s are older

value maximisation principle. A project wit PI greater t an
one will ave positive NPV and if acceptedÔ it will increase
s are olders¶ wealt .

2      In t e PI met odÔ since t e present value

of cas inflows is divided by t e initial cas outflowÔ it is a
relative measure of a project¶s profitability.

2 ike NPV met odÔ PI criterion also requires calculation of

cas flows and estimate of t e discount rate. In practiceÔ
estimation of cas flows and discount rate pose problems.
 Ô
Ô
2 £  is t e number of years required to recover t e
original cas outlay invested in a project.
2 If t e project generates constant annual cas inflowsÔ t e
payback period can be computed by dividing cas outlay by
t e annual cas inflow. J at is:
Initial Investment C0
Payback =
Annual Cas Inflow C
 
2 Assume t at a project requires an outlay of
s
0Ô000 and yields annual cas inflow of
s
12Ô 00 for 7 years. J e payback period for t e
project is:

s 0Ô000
PB
years

s 12Ô000
 Ô
Ô
2 ]      In case of unequal cas inflowsÔ t e
payback period can be found out by adding up t e cas inflows
until t e total is equal to t e initial cas outlay.
2 Suppose t at a project requires a cas outlay of
s 20Ô000Ô and
generates cas inflows of
s 8Ô000;
s 7Ô000;
s
Ô000; and

s 3Ô000 during t e next
years. W at is t e project¶s
payback?
3 years 12 ö (1Ô000/3Ô000) mont s
3 years
mont s
Ô

2 J e project would be accepted if its payback period
is less t an t e maximum or   
 
period set by management.
2 As a ranking met odÔ it gives ig est ranking to t e
projectÔ w ic as t e s ortest payback period and
lowest ranking to t e project wit ig est payback
period.


   
2 Certain virtues:
Ú Simplicity
Ú Cost effective
Ú S ort-term effects
Ú
isk s ield
Ú iquidity
2 Serious limitations:
U Cas flows after payback
U Cas flows ignored
U Cas flow patterns
U Administrative difficulties
U Inconsistent wit s are older value
 !
mJ Ô
Ô
2 J e 6 
 
6 is t e number of periods
taken in recovering t e investment outlay on t e present
value basis.
2 J e discounted payback period still fails to consider t e
cas flows occurring after t e payback period.

p
  
  
Ô
mJm"ÔJŒJ
mJ
2 J e accounting rate of return is t e ratio of t e average after-
tax profit divided by t e average investment. J e average
investment would be equal to alf of t e original investment if
it were depreciated constantly.
×

2 A variation of t e A

met od is to divide average earnings

after taxes by t e original cost of t e project instead of t e
average cost.
 
2 A project will cost
s
0Ô000. Its stream of
earnings before depreciationÔ interest and taxes
(EBpIJ) during first year t roug five years is
expected to be
s 10Ô000Ô
s 12Ô000Ô
s 1
Ô000Ô
s
16Ô000 and
s 20Ô000. Assume a 0 per cent tax
rate and depreciation on straig t-line basis.
 
 Ô
 


Ô

2 J is met od will accept all t ose projects w ose
A

is ig er t an t e minimum rate establis ed
by t e management and reject t ose projects w ic
ave A

less t an t e minimum rate.

2 J is met od would rank a project as number one if

it as ig est A

and lowest rank would be
assigned to t e project wit lowest A

.


 Ô


2 J e A

met od may claim some merits

â Simplicity
â Accounting data
â Accounting profitability
2 Serious s ortcomings
UCas flows ignored
UJime value ignored
UArbitrary cut-off
 

 #m $

  Œ%
2 A conventional investment as cas flows t e pattern of an
initial cas outlay followed by cas inflows. Conventional
projects ave only one c ange in t e sign of cas flows; for
exampleÔ t e initial outflow followed by inflowsÔ i.e.Ô    .

2 A non-conventional investmentÔ on t e ot er andÔ as cas

outflows mingled wit cas inflows t roug out t e life of t e
project. Non-conventional investments ave more t an one
c ange in t e signs of cas flows; for exampleÔ       
.
m!JmJÔ!!
Jm

2 J e I

met od is assumed to imply t at t e cas

flows generated by t e project can be reinvested at
its internal rate of returnÔ w ereas t e NPV met od
is t oug t to assume t at t e cas flows are
reinvested at t e opportunity cost of capital.
Ôm"J
mJ!JŒÔJÔ
2 J ere is no problem in using NPV met od w en
t e opportunity cost of capital varies over time.
2 If t e opportunity cost of capital varies over timeÔ
t e use of t e I

rule creates problemsÔ as t ere is
not a unique benc mark opportunity cost of capital
to compare wit I

.