Chapter 4

Capital Budgeting
(Long Term Investment Decisions)
Topics Covered:
➢Introduction

➢Types of Projects

➢Why Capital Decisions are important?

➢Cash Flows in Capital Budgeting

➢Techniques/Methods of Capital Budgeting

➢Capital Rationing
 Introduction
Capital budgeting is the process of analyzing investment opportunities and making long-
term investment decisions i.e. it is a process making investment decisions in capital
expenditures.

A capital expenditure is an expenditure the benefits of which are expected to be received

over a period of time exceeding one year. The main characteristic of a capital expenditure is
that the expenditure is incurred at one point in time whereas benefits of the expenditure are
realized at different points of time in future.

Capital Budgeting involves evaluation of (and decision about) projects. Which projects
should be accepted? Here, our goal is to accept a project which maximizes the shareholder
wealth.
 Example:
An example of capital expenditure includes:

- Cost of acquisition of permanent assets.

- Cost of addition, expansion, improvement of alteration in

fixed assets.

- Cost of replacement of permanent assets.

- Research and development project cost, etc.

 Types of Projects
➢ Independent -- A project whose acceptance (or rejection) does
not prevent the acceptance of other projects under consideration.

➢ Dependent -- A project whose acceptance depends on the

acceptance of one or more other projects.

➢ Mutually Exclusive -- A project whose acceptance precludes the

acceptance of one or more alternative projects.
Why Capital Decisions are important?
Investment decisions require special attention because of the
following reasons:
◦ They influence the firm’s growth in the long run.

◦ They involve commitment of large amount of funds.

◦ They are irreversible, or reversible at substantial loss.

◦ They are among the complex decisions to make.

Cash Flows in Capital Budgeting
❖ Initial Cash Outlay - amount of capital spent to get project going.
❖ If spend $10 million to build new plant then the Initial Outlay (IO) = $10 million

CF0 = Cash Flow time 0 = -10 million

❖Annual Cash Inflows--after-tax CF

❖Cash inflows from the project

CFn = Sales - Costs

 Techniques/Methods of Capital Budgeting
There are many methods of evaluating profitability of capital investment proposal.
They generally grouped as traditional (non-discount) and Time adjusted (Discounted) Methods.
A. Traditional (non -discounted) methods
1. Payback period method
2. Average rate of return method (Accounting rate of return)
B. Time adjusted (Discounted) Method
3. Net present value method (NPV)
4. Internal rate of return method (IRR)
5. Profitability Index method (PI)
Payback Period
The PBP is the length of time required for a project's cumulative net cash inflows after tax to return
its net investment in a project from operational resource (Measures the time needed for a project to
break even on its net investments).

Decision Rule: Accept the project if the actual or computed Pay Back period is less than the maximum
payback set by the firm. Otherwise the project is rejected.

In ranking two projects having the same maximum allowable payback, the project with shorter
payback period should be chosen because it pays for itself more quickly.

Projects are ranked according to the length of their pay back period and the shorter coverage time is
preferred. For a single project the payback period is specified by the management.
Example:
P R O J E C T
Time A B
0 (10,000) (10,000)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 3,500 3,500 3,500

Cumulative CF -6,500 -3,000 +500 Payback 2.86 years
Example:
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000

Cumulative CF -9,500 -9,000 -4,400 +5,600 Payback = 3.44 years
Advantages and Disadvantages:
Advantages:
– easy to use (“quick and dirty” approach).

– emphasizes liquidity and crude measure of risk.

Disadvantages:

➢ It ignores the time value of money.

➢It ignores cash flows beyond the payback period.

➢It biases capital budgeting decisions in favor of short-term projects and against long-term projects.
Example:
Which project should be chosen?

CF0 CF1 CF2 CF3

A -100,000 90,000 9,000 1,000
B -100,000 1,000 9,000 90,000

CF0 CF1 CF2 CF3 CF4

X -100,000 90,000 10,000 0 0
Y -100,000 90,000 9000 80,000 1,000,000
Discounted Payback Period
The Discounted payback method can correct the first shortcoming of
the payback method.

To find the discounted pay back

(1) Find the PV of each cash flow on the time line.

(2) Find the payback using the discounted CF.

 Accounting rate of Return
ARR is a measure of a project's profitability from a conventional accounting stand point.
Formula: ARR = Average annual net profits (net income) x 100%
Average investment (capital employed)

Average annual net profits=sum total of the profits/Number of the years

Average investment = Book value at beginning + Book value at end
2
Investment costs are averaged because on the average, firm’s will have one half of their initial purchase price in
the records.

Decision Rule: If the Accounting rate of Return is greater than or equal to the target Accounting rate of Return
set by the firm, accept the project and in ranking projects, the one with the higher ARR is selected.
Example:
A project requires an investment of $ 500,000 and has a scrap value of $ 20,000 after 5 years. It
is expected to yield profits after depreciation and taxes during the five years amounting to
$40,000, $ 60,000, $ 70,000, $ 50,000, $ 20,000 (assume the..target ARR is 12.5 %.)
.

Solution:
Average profit = $ 240,000/5 = $ 48,000 ARR = Average annual net profit x 100

Net investment in the project = ($ 500,000 - $ 20,000) Net investment in the project

2
ARR = 48,000 x 100%
t investment in the project = ($ 4 = 260,000 80,000 - $ 20,000) = 260,000 260,000
2 = 18.4%
Since it is higher than the target figure, the project should be accepted.
Advantages and Disadvantages:
Advantages: -

➢Easy to understand and calculate.

➢It considers profitability.

Disadvantages: -

➢It uses accounting income rather than cash flows.

➢It ignores the time value of money.

Net Present Value
Net Present Value (NPV) is the net sum of total discounted benefits (cash inflows)
and total discounted costs.

It represents the present worth of an investment in excess of the investment itself.

The NPV method is a system of finding out the excess (or short) of the present value
of the earnings from the investments over and above the present value of the
investment itself.
Steps to find out the NPV:
1. Find the project costs.

2. Find the future cash flows as estimated for the projected business, net of cash
outflows.

3. Select an appropriate rate and a period to be considered for such evaluation to find
the present value of the future cash flows for the period by discounting by the
selected rate.

4. Find out the difference between the present value of cash inflows (net) and the
investment cost (present value of investments over the life of the project).This
difference represents NPV.
Formula and Decision Rule:
CFt
NPV = 
Where:
− C0
(1 + r ) t CF = Cash inflows at different periods
r = discounting rate
C0 = cash outflow in the beginning
NPV = Net Present Value
t = time period

Decision Rule: The decision rule here is to accept a project if the NPV is positive and
reject it if it is negative. A project who NPV approaching zero is a marginal project. The
planner has to remodify, otherwise it will be very risk to take such projects.
Example:
AZ company is considering to invest in a particular project. The Cash outlay and the
benefits of the project for 5 years are shown below:

Year Cashflow
0 Br. (100,000)
1 20,000
2 30,000
3 40,000
4 40,000
5 35,000

Required: If the discounting rate is 10%, Calculate the NPV

Solution:
Year Cash flows ($) Present Value Factor PV of CFs
0 (100,000) 1 (100,000)
1 20,000 0.9091 18,182
2 30,000 0.8264 24,792
3 40,000 0.7513 30,052
4 40,000 0.6830 27,320
5 35,000 0.6209 21,732
NPV of the project = 122,078 – 100,000 = $ 22,078
Decision: Accept this project since its NPV is positive.
Advantages and Disadvantages:
Advantages:

➢It considers the magnitude and timing of cash flows .

➢It provides an objective criterion for decision making which maximizes shareholders
wealth.

➢It is the most conceptually correct capital budgeting approach for selection of mutually
exclusive project.

➢It considers the total cash flows arising from the proposed project over its life time.

Disadvantages: - Net Present Value (NPV) is more difficult to compute & interpret.
Profitability Index
Very Similar to Net Present Value.

Instead of Subtracting the Initial Outlay from the PV of Inflows, the Profitability Index
is the ratio of Initial Outlay to the PV of Inflows.

PI = PV of Inflows
Initial Outlay
Decision Rule: PI >1, is should be accepted and increases the value of the firm.
PI <1, it should be rejected and decreases the value of the firm.
PI =1, it is at break-even (may accept the project)
Internal rate of return
IRR is defined as the discount rate the net present value is zero.

IRR method finds out the rate at which – when applied on future cash inflows –
the present value of such inflows taken together should equal with the present
value of the cost of investment.

It is called "Internal", as it is purely related to the return of the particular

projected investment only.
Calculation of IRR
To calculate IRR, we can use the following methods:

C1 C2
0 = C0 + + + …...
(1 + r)1 (1 + r)2

•Spreadsheets (use financial function =IRR)

•Financial calculators (IRR using cash flow register)
•Manual (Trial and error until PV of all cash flows equal zero)
Decision:
If IR greater than the cost of capital, accept the project

If IRR is less than the cost of capital, reject the project

This criterion guarantees that the firm earns at least its required return.

Alternatively, the IRR can be described as the maximum cost of capital that
can be applied to finance a project without causing harm to the
shareholders.
Advantages and Disadvantages:
Advantages:

▪It has advantages of NPV.

▪It is a relative measure of return per $ of net investment and therefore, it is better than the Net
Present Value (NPV) method when projects have the same Net Present Value (NPV) but different
PV of cash out flows.

Disadvantages:

▪May conflict with the Net Present Value (NPV) method when dealing with mutually exclusive
investments
Comparison of Appraisal Methods
• NPV vs. PI –

• Both methods use the concept of time value of money.

• For given project, NPV and PI would give the same result, i.e. Accept or Reject.

• However, in case of mutually exclusive projects NPV method should be preferred.

• NPV indicates the economic contribution or surplus of the project in absolute

terms. Higher the NPV, better the project.
 Comparison of Appraisal Methods
• NPV vs. IRR –

• Both methods use the concept of time value of money.

• However, for certain situations both methods may give conflicting results
(w.r.t. accept / reject)

• Conflict arises in projects where cash outflows arise at different points of

time and huge differences between initial CFAT and later years CFAT.
 Comparison of Appraisal Methods
• NPV vs. IRR –

• Under situations of variance, NPV method should be adopted since it is

directly linked to the wealth maximization principle.

• Also, it is presumed that cash inflows are re-invested at the rate of IRR,
while NPV method, re-investment is at the cut-off rate. Re-investment at
the cut-off rate is more realistic / practical than re-investment at IRR rate.
Unequal Projects Lives
• In case of mutually exclusive projects, NPV is a correct method.

• But, for projects with unequal lives, NPV may give incorrect results.

• Hence, for comparison purposes, it is important to bring the projects at a same footing.

• Therefore, Annual Equivalent Value (AEV) is computed by dividing the NPV by the PV
Annuity factor over the project life.

• The AEVs are compared and decision taken for selection of project.

AEV = NPV
PV Annuity Factor (r, n)
Example:
Year CFs CFs • WACC = 10%
Project A ($) Project B ($)
• NPVA = € 3,303
0 (100,000) (138,668)
1 50,000 60,000 • NPVB = € 4,679

2 70,000 80,000 • ADF 10%,2 = 1.7355

3 30,200 • ADF 10%,3 = 2.4869
Capital Rationing
• Firms normally have fixed annual budget for Capex. (max amt.)

• Firms select a combination of projects within the budget to maximize the profitability.

• Such type of selection process is known as Capital Rationing.

• Capital Rationing may be due to external and/ or internal constraints.

• External factors include imperfections in capital market, such as lack of market information,
non-availability of easy funds etc.

• Internal capital rationing consists of self-imposed restrictions by the management, e.g. no

borrowing policy, min. expected rate of return.
Example:
Analyze the projects on the next page with NPV, IRR, and PI
assuming the opportunity cost of capital is 10% and the firm is
constrained to only invest $50,000 now (and no constraint is
expected in future years).
Example (All $ numbers are in thousands)
Year Proj. A Proj. B Proj. C Proj. D Proj. E

0 -$50 -$20 -$20 -$20 -$10

1 $60 $24.2 -$10 $25 $12.6

2 $0 $0 $37.862 $0 $0

NPV $4.545 $2.0 $2.2 $2.727 $1.4545

IRR 20% 21% 14.84% 25% 26%

PI 1.0909 1.1 1.11 1.136 1.145

Capital Rationing Example: Comparison of Rankings
NPV rankings (best to worst)
◦ A, D, C, B, E
◦ A uses up the available capital
◦ Overall NPV = $4,545.45
IRR rankings (best to worst)
◦ E, D, B, A, C
◦ E, D, B use up the available capital
◦ Overall NPV = NPVE+D+B=$6,181.82
PI rankings (best to worst)
◦ E, D, C, B, A
◦ E, D, C use up the available capital
◦ Overall NPV = NPVE+D+C=$6,381.82

The PI rankings produce the best set of investments to accept given the capital rationing
constraint.
Capital Rationing Conclusions
PI is best for initial ranking of independent projects under capital
rationing.

Comparing NPV’s of feasible combinations of projects would also work.

IRR may be useful if the capital rationing constraint extends over

multiple periods (see project C).
• ABC Company is a factory that is currently contemplating on investing two projects: Project A and
Project B. The relevant operating cash flows for the two projects are presented below.

• Required: If the WACC = 10%, Evaluate the projects in terms of PBP, DPBP, NPV, PI & IRR
Key:
Techniques Project A Project B

Payback Period 3 years 2.5 years

Discounted Payback 3.8 years 3.3 years

Net Present Value (NPV) 11,071 10,924

Profitability Index (PI) 1.26 1.24

Internal Rate of Return (IRR) 19.9% 21.7%

End!