Capital budgeting is the process of evaluating and

selecting long-term investments that are

consistent with the firm’s goal of maximizing
owner wealth.
The capital budgeting process consists of five steps:
1. Proposal generation. Proposals for new investment projects
are made at all levels within a business organization and are
reviewed by finance personnel.
2. Review and analysis. Financial managers perform formal
review and analysis to assess the merits of investment
proposals
3. Decision making. Firms typically delegate capital
expenditure decision making on the basis of dollar limits.
4. Implementation. Following approval, expenditures are made
and projects implemented. Expenditures for a large project
often occur in phases.
5. Follow-up. Results are monitored and actual costs and
benefits are compared with those that were expected. Action
may be required if actual outcomes differ from projected
ones.
i. New Products or expansion of existing products.
ii. Replacement of existing equipment or buildings.
iii. Research and development.
iv. Exploration.
v. Other (e.g., safety or pollution related)
 Accept – Reject Decision
 Mutually Exclusive Project Decision
 Capital Rationing Decision
 Capital Budgeting Evaluation Techniques

Non –discounting techniques Discounting techniques

Ignores the time value of money
1) Average Rate Return /Accounting
rate of return (ARR)
2) Pay back period (PBP)
Considers the time value of money
1) Net present value (NPV)
2) Internal Rate of Return (IRR)
3) Profit index or Benefit –cost
Ratio (BCR)
Pay Back Period (PBP): It refers to the number of years required
to recover the initial investment in the form of cumulative cash
inflows.
Decision Criterion:
If actual PBP is less than standard PBP accept the project and
vice versa.
1. PBP = Net Cash Outflow / Net Cash Inflow
 Discounting Techniques :
Under discounted cash flow techniques, the future net cash flows generated by
a capital project are discounted to ascertain their present values .
NPV: Net Present Value
Under NPV method future cash flows are discounted at minimum required rate
of return of the project and then deduct it from initial out lay to arrive at the
NPV of the project .
NPV = PV (Benefits) – Initial investment
Decision criteria:
1) Accept if NPV > 0
2) Reject if NPV < 0
3) May accept or Reject if NPV = 0
 The Internal Rate of Return (IRR) is a sophisticated
capital budgeting technique; the discount rate that
equates the NPV of an investment opportunity with $0
(because the present value of cash inflows equals the
initial investment); it is the rate of return that the firm
will earn if it invests in the project and receives the
given cash inflows.

Decision criteria:
 If the IRR is greater than the cost of capital, accept the
project.
 If the IRR is less than the cost of capital, reject the project.
A company is interested to invest Tk 50,000 in a project. It is expected that the project would
have a life five years. The cash flows from the project in different years would be as
follows-
Year Cash flows (TK)
1 20,000
2 18,000
3 25000
4 27000
5 28000
Depreciation should be charged on a straight line basis. The cost of capital is 10%. The
company’s tax rate is 40%. Evaluate project on the basis of PBP, ARR, NPV, PI,ARR.
Problem:
Bonna Co. considering the following project at the beginning of 2007.. The particulars of expected
net profit before tax are given below-

Particulars Project-A
Initial Investment TK 1,00,000
EBIT
2007 26,000
2008 30,000
2009 32,000
2010 35,000
2011 40,000
Scrape Value 10,000

It is estimated that each project will require an additional working capital of TK 20,000. The company can arrange fund
@10%. The rates of Tax @45%. The project will be depreciated on a straight line method. Calculate PBP,ARR, NPV & IRR.
A company ltd is considering the purchase of a new machine. Two
alternative machines have been suggested, each having an initial cost of
TK 4,00,000, estimated salvage value TK 50,000 and requiring an
additional working capital TK 20,000. Earnings before tax are expected to
be as follows. The company has a required rate of return of 10%.Which
machine would be bought. Use NPV and IRR method
Year Project-A Project-B
1 40,000 1,20,000
2 1,20,000 1,60,000

3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000
Company uses straight line method, tax rate 50%.