MR.

NAVIN HANDOUT CAPITAL BUDGETING

CAPITAL BUDGETING/INVESTMENT APPRAISAL

Capital budgeting is a method of analysing and comparing substantial future long term

(strategic) investments and expenditures to determine which ones are most viable (generating

value in the form of wealth for both the firm and its shareholders).

In other words, it’s a process that a company management (financial controller/financial

managers) uses to identify which capital projects will generate the biggest return (Net

Operating Cash Flows) compared with the funds invested (Initial Investment/Capital

Outlay/Initial Outlay) in the project.

Each project is ranked by its potential future return, so the company management can choose

which one to invest in first. (obviously the one that adds the most value)

NB: FOR CASH FLOWS THAT ARE CONSTANT THE PRESENT VALUE OF AN ANNUNITY IS USED

WHERE CASH FLOWS ARE DIFFERENTIAL THE PRESENT VALUE OF A SINGLE SUM IS USED
 MR. NAVIN HANDOUT CAPITAL BUDGETING

TYPICAL CAPITAL BUDGETING DECISIONS

Any decision that involves a cash outlay now in order to obtain a future return is a capital

budgeting decision. Typical capital budgeting decisions include:

1. Cost reduction decisions. Should new equipment be purchased to reduce costs.

2. Expansion decisions. Should a new plant, warehouse, or other facility be acquired to increase

capacity and sales?

3. Equipment selection decisions. Which of several available machines should be purchased?

4. Lease or buy decisions. Should new equipment be leased or purchased?

5. Equipment replacement decisions. Should old equipment be replaced now or later?

SCREENING VS PREFERENCE DECISIONS.

Capital budgeting decisions fall into two broad categories— screening decisions and preference

decisions. Screening decisions relate to whether a proposed project is acceptable—whether it

passes a present hurdle. For example, a company may have a policy of accepting projects only if

they provide a return of at least 20% on the investment. The required rate of return is the

minimum rate of return a project must yield to be acceptable.

 MR. NAVIN HANDOUT CAPITAL BUDGETING

Preference decisions, by contrast, relate to selecting from among several acceptable alternatives.

To illustrate, a company may be considering several different machines to replace an existing

machine on the assembly line. The choice of which machine to purchase is a preference decision.

Cash Flows versus Net

IMPORTANT UNDERLYING ASSUMPTIONS IN CAPITAL BUDGETING

1. TIME VALUE OF MONEY (TVM): This is an important and crucial concept in corporate finance. It is

based on the following; “a dollar today is worth more than a dollar in the future”. Certain capital budgeting

techniques incorporate the TVM into its computation. That is, they discount future cash flows back to the present

period.

2. COST OF CAPITAL/DISCOUNT RATE/RATE OF RETURN: This represents the cost of borrowing

(consists of both debt and equity sources of finance) and is imputed as the rate that allows future cash flows to be

discounted. The greater the uncertainty of future cash flows, the greater the risk factor in the project hence the

higher the RATE OF RETURN.

It is also referred to as the weighted average cost of capital.

3. INDEPENDENT VS MUTUALLY EXCLUSIVE PROJECTS:

Independent projects are unrelated to each other. Each project is evaluated based on its own profitability.

Whereas, Mutually Exclusive Projects consists of different projects where only one can be selected.
 MR. NAVIN HANDOUT CAPITAL BUDGETING

CAPITAL BUDGETING TECHNIQUES

TRADITIONAL METHODS (DON TAKE TVM INTO CONSIDERATION)

 ACCOUNTING RATE OF RETURN/ANNUAL RATE OF RETURN/SIMPLE RATE OF RETURN

 PAYBACK PERIOD

DISCOUNTED CASH FLOW METHODS

 NET PRESENT VALUE (NPV)

 INTERNAL RATE OF RETURN (IRR)

 PROFITABILITY INDEX (PI)

 MR. NAVIN HANDOUT CAPITAL BUDGETING

Net Present Value Method (NPV)

The net present value (NPV) method can be a very good way to analyse the profitability of an
investment in a company, or a new project within a company. But like many methods in
finance, it is not the end-all, be-all solution -- it carries a few unique advantages and
disadvantages that may not make it useful for some investment decisions.
How net present value works
The basic principle of the net present value method is that a dollar in the future is not worth as
much as one dollar today. Thus, net present value calculates the present value of future cash
flows in excess of the present value of the investment outlay.

Advantages of the NPV method

The obvious advantage of the net present value method is that it takes into account the basic
idea that a future dollar is worth less than a dollar today. In every period, the cash flows are
discounted by another period of capital cost.
The NPV method also tells us whether an investment will create value for the company or the
investor, and by how much in terms of dollars.
The final advantages are that the NPV method takes into consideration the cost of capital and
the risk inherent in making projections about the future. In general, a projection of cash flows
10 years into the future is inherently less certain than cash flows projected next year. Cash
flows that are projected further in the future have less impact on the net present value than
more predictable cash flows that happen in earlier periods.
Disadvantages of NPV
The biggest disadvantage to the net present value method is that it requires some guesswork
about the firm's cost of capital. Assuming a cost of capital that is too low will result in making
suboptimal investments. Assuming a cost of capital that is too high will result in forgoing too
many good investments.

FORMULA:
PRESENT VALUE OF CASH FLOWS – INITIAL INVESTMENT

DECISION RULE:
Accept the project with the highest NPV. Negative NPV is unacceptable.
 MR. NAVIN HANDOUT CAPITAL BUDGETING

Accounting Rate of Return/Annual Rate of Return (ARR)

Accounting rate of return (also known as simple rate of return) is the ratio of estimated
accounting profit of a project to the average investment made in the project. ARR is used in
investment appraisal since it examines how much returns can be generated per $ of capital
invested.

FORMULA:

ARR EXPECTED ANNUAL NET INCOME

= AVERAGE INVESTMENT
*where Average Investment = Initial Investment + Salvage Value
2

DECISION RULE:

Accept the project only if its ARR is equal to or greater than the required accounting rate of
return. In case of mutually exclusive projects, accept the one with highest ARR.

Advantages

1. Like payback period, this method of investment appraisal is easy to calculate.

2. It recognizes the profitability factor of investment.

Disadvantages

1. It ignores time value of money. Suppose, if we use ARR to compare two projects having

equal initial investments. The project which has higher annual income in the latter years of

its useful life may rank higher than the one having higher annual income in the beginning

years, even if the present value of the income generated by the latter project is higher.

2. It can be calculated in different ways. Thus, there is problem of consistency.

 MR. NAVIN HANDOUT CAPITAL BUDGETING

3. It uses accounting income rather than cash flow information. Thus, it is not suitable for

projects which having high maintenance costs because their viability also depends upon

timely cash inflows.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present value of an investment
becomes zero. In other words, IRR is the discount rate which equates the present value of the
future cash flows of an investment with the initial investment/initial capital outlay. It is one of
the several measures used for investment appraisal.

Decision Rule

A project should only be accepted if its IRR is NOT less than the company’s cost of capital.
When comparing two or more mutually exclusive projects, the project having highest value of
IRR should be accepted.
IRR > COST OF CAPITAL = ACCEPT
IRR < COST OF CAPITAL = REJECT
 MR. NAVIN HANDOUT CAPITAL BUDGETING

PAYBACK PERIOD

The payback method of evaluating capital expenditure projects is very popular because it's easy

to calculate and understand. It has severe limitations, however, and ignores many important

factors that should be considered when evaluating the economic feasibility of projects.

The main objective of the payback method is to determine the number of years that it takes
to recover the initial investment.

FORMULA:

Payback Period = Cost of Capital Investment

Average Annual Cash Flow

*where Average Annual Cash Flow = Net Income + Depreciation

Advantages

The most significant advantage of the payback method is its simplicity. It's an easy way to
compare several projects and then to take the project that has the shortest payback time.
However, the payback has several practical and theoretical drawbacks.
Disadvantages

Ignores the time value of money: The most serious disadvantage of the payback method is that
it does not consider the time value of money. Cash flows received during the early years of a
project get a higher weight than cash flows received in later years. Two projects could have the
same payback period, but one project generates more cash flow in the early years, whereas the
other project has higher cash flows in the later years. In this instance, the payback method does
not provide a clear determination as to which project to select.

Neglects cash flows received after payback period: For some projects, the largest cash flows
may not occur until after the payback period has ended. These projects could have higher
returns on investment and may be preferable to projects that have shorter payback times.
 MR. NAVIN HANDOUT CAPITAL BUDGETING

Ignores a project's profitability: Just because a project has a short payback period does not
mean that it is profitable. If the cash flows end at the payback period or are drastically reduced,
a project might never return a profit and therefore, it would be an unwise investment.

Does not consider a project's return on investment: Some companies require capital
investments to exceed a certain hurdle of rate of return; otherwise the project is declined. The
payback method does not consider a project's rate of return.

They payback method is a handy tool to use as an initial evaluation of different projects. It
works very well for small projects and for those that have consistent cash flows each year.
However, the payback method does not give a complete analysis as to the attractiveness of
projects that receive cash flows after the end of the payback period. And it does not consider
the profitability of a project nor its return on investment.

DECISION RULE:

The project with the shortest payback time is selected since the initial investment will be
recovered relatively quickly and the firm can reinvest in other projects.