Capital Budgeting

Capital Budgeting
 Capital budgeting is the process of evaluating
proposed log term investment projects.

 The projects may be the purchase of fixed assets,

investment in research and development,
advertising etc.

 Careful capital budgeting is vital to ensure that the

proposed investment will add value to the firm.
 Decision practices
 Financial managers apply two decision practices
when selecting capital budgeting projects.

 Accept /rejects decision

 Ranking

 Accept/reject decision: this decision focuses on the

question whether the proposed project would add
value to the firm or will earn a rate of return that
will be acceptable to the company.
 Ranking: ranking compares projects to a
standard measure like for instance the
standard is how quickly the project pays off
the initial investment, then the project that
pays off the investment most rapidly would
be ranked first.
 Types of Projects
 Firm invest in two categories of projects, independent
projects and mutually exclusive projects.

 Independent projects: independent projects do not

compete with each other, a firm may accept none, some
or all from among a group of independent projects. Like
a new telephone system and a warehouse.
 Mutually exclusive projects: competes against each
other , that is the best project among the proposed group
of projects will be selected like purchasing of Xerox
copier or Toshiba copier.
Stages in Capital Budgeting Process

 Finding projects
 Estimating the incremental cash flows
associated with projects.
 Evaluating and selecting the projects
 Implementing and monitoring the projects
Capital budgeting decision methods

 Payback method
 Discounted payback method
 Net present value
 Internal rate of return
 Profitability index
 Decision-making Criteria in
Capital Budgeting
How do we decide if
a capital
investment project
should be accepted
or rejected?
 Decision-making Criteria in
Capital Budgeting
 The Ideal Evaluation Method should:

a) include all cash flows that occur during

the life of the project,
b) consider the time value of money,
c) incorporate the required rate of return
on the project.
 Payback Method
 The number of years needed to
recover the initial cash outlay.
 How long will it take for the project
to generate enough cash to pay for
itself?
 Payback Period
 How long will it take for the project
to generate enough cash to pay for
itself?
(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8
 Payback Method
 How long will it take for the project
to generate enough cash to pay for
itself?
(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8

Payback period = 3.33 years.

 Drawbacks of Payback Method

 Does not consider time value of money.

 Does not consider any required rate of
return.
 Does not consider all of the project’s
cash flows.
 Discounted Payback

 Discounts the cash flows at the firm’s

required rate of return.
 Payback period is calculated using
these discounted net cash flows.
 Problem:
 does not examine all cash flows.
 Other Methods

1) Net Present Value (NPV)

2) Profitability Index (PI)
3) Internal Rate of Return (IRR)

Each of these decision-making criteria:

 Examines all net cash flows,
 Considers the time value of money, and
 Considers the required rate of return.
 Net Present Value

 NPV = the total PV of the annual net

cash flows - the initial outlay.


ACFt
NPV = - IO
(1 + k) t
t=1
 Net Present Value

 Decision Rule:

 If NPV is positive, ACCEPT.

 If NPV is negative, REJECT.
 Profitability Index


ACFt
NPV = t - IO
(1 + k)
t=1
 Profitability Index


ACFt
NPV = t - IO
(1 + k)
t=1


ACFt
PI = IO
(1 + k) t
t=1
 Profitability Index

 Decision Rule:

 If PI is greater than or equal

to 1, ACCEPT.
 If PI is less than 1, REJECT.
 Internal Rate of Return (IRR)
n
ACFt
IRR:

t=1
(1 + IRR) t = IO

 IRR is the rate of return that makes the

PV of the cash flows equal to the initial
outlay.
 IRR
 Decision Rule:

 If IRR is greater than or equal

to the required rate of return,
ACCEPT.
 If IRR is less than the required
rate of return, REJECT.