The Basics of Capital Budgeting: Should We Build This Plant?

The Basics of Capital
Budgeting
Should we
build this
plant?
10-1
What is capital budgeting?

Capital Budgeting is the process of evaluating
and selecting long term investments that are
consistent with the goal pf shareholders
wealth maximization.
It involves the following actions,
Analysis of potential additions to fixed assets.
Long-term decisions; involve large
expenditures.
10-2
Importance of Capital
Budgeting
Capital budgeting decisions are of
paramount importance in financial
decision making,
First of all, such decision affects the
profitability of a firm because of the fact
that they relate to fixed assets. The fixed
assets are the true earning assets of the
firm. They enable the firm to generate
finished goods that can ultimately be sold
for profit. Thus capital budgeting decisions
determine the future destiny of a firm.
10-3
Budgeting
Secondly, capital expenditure decisions has its
effect over long time span and inevitably affect

the company's future cost structure. For
example, if a particular plant has been
purchased by a company to start a new product,
the company commits itself to a sizable amount
of fixed cost, in terms of labor, insurance, rent,
salaries and so on. If the investment turn-out to
be unsuccessful in future, the firm will have to
bear the burden of fixed costs.
In short, future costs, break-even point, sales
and profits will all be determined by the
selection assets.
10-4
Budgeting
Thirdly, Capital investment decisions,
once made are not easily reversible
without much financial loss to the firm
because there may be no market for
second hand plant and equipment and
their conversion to other users may not
be financially viable.
10-5
Capital Budgeting Process & Its

Types
Capital Budgeting process refers to the

total process of generating, evaluating,
selecting and following up on capital
expenditure alternatives.
There are 3 types of capital budgeting
decisions,
Accept/Reject decisions
The mutually exclusive choice decisions
The capital rationing decisions
10-6
Accept/Reject decisions
This is the fundamental decision in capital
budgeting. If the project is accepted, the
firm would invest in it; if the proposal is
rejected, the firm does not invest in it.
In general, all those proposals which yield
a rate of return greater than a certain
required rate of return or cost of capital
are accepted and the rest are the
rejected.
By applying this criterion, all independent
projects are accepted.
10-7
The Mutually Exclusive choice

decisions
The Mutually Exclusive projects are those
which competes with other project in
such a way that the acceptance of one
will exclude the acceptance of other
projects. The alternatives are mutually
exclusive and only one may be chosen.
For example, a company is intending to
buy a folding machine. There are 3
competing brands each with a different
initial investment and operating costs.
The 3 machines represent mutually
exclusive alternatives and only one of
10-8
these can be selected.
The capital rationing decisions

It is the financial situation in which a firm
has only fixed amount to allocate among
competing capital expenditure. The firm
allocates funds to projects in a manner
that it maximizes long term return.
Thus capital rationing refers to a situation
in which a firm has more acceptable
investments than it can finance. It is
concerned with selection of group of
investment proposals out of many
acceptable under the accept/reject
decision. Capital rationing employs ranking
of the acceptable investments projects.10-9
Steps to capital budgeting

process
1.
2.
3.
4.
5.
6.
Identification of potential investment

opportunities
Assembling of investment proposals
Decision Making
Preparation of capital budget and
appropriations
Implementation
Performance Review
10-10
Investment Criteria
Investment Criteria
Discounting Criteria
NPV
Benefit Cost
Ratio
Non-discounting Criteria
IRR
Payback
Period
ARR
10-11
Net Present Value

The NPV (Net Present value) of a project
is the sum of the present values of all
the cash flows-positive as well as
negative- that are expected to occur
over the life of the project. The general
formula of NPV is:
Ct
NPV of Project =
initial
investment
(1+r)t 10-12
Net Present Value

where,
Ct = Cash flow at the end of the year t
n= life of the project
r = Discount rate
Decision Rule:
NPV > Zero = Accepted
NPV < Zero = Rejected
10-13
Net Present Value

Year
Cash Flow
Taka(10,00,000)
200,000
200,000
300,000
3,00,000
350,000
If the cost of capital (r) = 10%. Calculate the

NPV.
10-14
Net Present Value

200,000 200000
NPV =
1000,000 - +
(1.10)1 (1.10)2
300,000
300,000 350000
+ +
(1.10)3 (1.10)4 (1.10)5
10-15
Net Present Value: Different

discount rate
Year
Cash Flow
0
1
Taka(12000)
4000
5000
3
4
5
7000
6000
5000
If the cost of capital (r) =

14%,15%,16%,18%, & 20% respectively.
Calculate the NPV.
10-16
Net Present Value: Different discount

rate
PV of C1= 4000 / 1.14
= 3,509
PV of C2= 5000 / 1.14 x 1.15
PV of C3= 7000 / 1.14 x 1.15 x 1.16 = 4,603
PV of C4= 6000 / 1.14 x 1.15 x 1.16 x 1.18
= 3,814
=3,344
PV of C5= 5000 / 1.14 x 1.15 x 1.16 x 1.18
x 1.20 = 2,322
NPV =3509+3814+4603+3344+2322
12,000
= 5,592
10-17
Benefit Cost Ratio

Benefit cost ratio = PVB / I
Where,
PVB = Present value of Benefits
I
= Initial Investment
Net Benefit Cost ration = BCR 1

Where,
BCR = Benefit cost ration
Decision Rule:
When BCR or NBCR Rule
>1
>0 = Accepted
<1
<0
= Rejected
10-18
Benefit Cost Ratio

Problem: Let us consider a project which is being
evaluated by a firm that has a cost of capital of 12%
Initial Investment =
Tk. 100,000
Benefits
Year 1
25,000
Year 2
40,000
Year 3
40,000
Year 4
50,000
[1] Calculate the Benefit cost ratio
[2] Calculate Net Benefit cost ratio
10-19
Benefit Cost Ratio
BCR = [25000/1.12 + 40000/(1.12)2+

40000/(1.12)3+ 50000/(1.12)4] / 100000
= 1.145
NBCR = BCR 1
= 1.145 1
= 0.145
10-20
Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0
Put differently, it is the discount rate which
equates the present value of future cash
flows with the initial investment.
CFt
0
t
(
1
IRR
)
t0
n
10-21

In the NPV calculation we assume that
the discount rate (cost of capital) is
known and determine the NPV. In the IRR
calculation, we set the NPV equal to Zero
and determine the discount rate that
satisfy this condition.
Decision rule
If the IRR is > Cost of Capital = Accept
If the IRR is < Cost of Capital = Rejected
10-22

Problem:
year
0 1
23
4 Cash flow
(100000) 30000 30000 40000 45000
The IRR is the value of r which satisfies
the following equations
100,000 = 30000/(1+r)1 + 30000/(1+r)2 +
40000/(1+r)3 + 45000/(1+r)4
The calculation of r involves a process of
Trial & Error method. We will try different
values of r till we find the right hand side
of the above equation is equal to left hand
side.
10-23

Let us, to begin with, Try r = 15%
30000/(1.15)1 + 30000/(1.15)2 + 40000/
(1.15)3 + 45000/(1.15)4
=100,802
This value is slightly higher than our
initial investment[left hand side]. So we
will increase the value of r from 15% to
16%.
(a higher r lowers and smaller r
increases the right hand side value) 10-24

Try r = 16%
30000/(1.16)1 + 30000/(1.16)2 + 40000/
(1.16)3 + 45000/(1.16)4
=98,641
As the value is now less than 100,000,
we may conclude that the value of r
lies between 15% & 16%.
If we need more refined estimate of r,
then use the following procedure
10-25

[1] determine the Net present value of
the two closest rate of return
(100802 100000) = 802
(100000 98,641) = 1,359
[2] Find the sum of the absolute values
of the NPV obtained in step 1.
(802+1359) = 2,161.
[3] Calculate the ratio of the net
present value of the smaller discount
rate,
10-26

802/2161 = 0.37
[4] Add the number obtained in step 3 to
the smaller discount rate
15+0.37=15.37%.
10-27
Pay Back Period

Pay back period is the length of time
required to recover the initial cash
outlay on the project.
The number of years required to recover
a projects cost, or How long does it
take to get our money back?
For Example, if a project involves in
cash outlay of Tk. 60000 and generate
cash inflow of Tk. 100000,Tk. 150,000
Tk. 150,000 and Tk. 200000 in the
1st,2nd,3rd & 4th year respectively. Its pay
10-28
back period will be 4 years.
Pay Back Period

Because the sum of the cash inflows
during 4 years is equal to the initial outlay.
When the annual cash inflow is a constant
sum the pay back period is simply the
initial outlay divided by the annual cash
inflow.
For example, A project involves in a initial
cash outlay of Tk. 1000,000 and a
constant annual cash inflow of Tk.
300,000. Calculate the payback period.
1000,000/300,000 = 3 1/3 years.
10-29
Pay Back Period
Strengths
Provides an indication of a projects risk

and liquidity.
Easy to calculate and understand.
Weaknesses
Ignores the time value of money.

Ignores CFs occurring after the payback
period.
It is a measure of Projects capital recovery,
not profitability.
10-30
Accounting Rate of Return

It is also know as average rate of return.
Can be defined as
Profit after Tax
Book value of the investment
The numerator of this ratio may be

measured as the average annual post tax
profit over the life of the investment.
The Denominator is the average book value
of fixed assets committed to the project.
10-31

Acceptance/Rejection Criteria
The higher the accounting rate of return, the
better the project.
In general, projects which have an
accounting rate of return equal to or greater
than a pre specified cut-off rate of return
which is usually between 10% to 30% are
accepted;others are rejected.
10-32

Year
Book Value
of fixed Asset
Profit
after Tax
1
2
3
4
5
90,000
80,000
70,000
60,000
50,000
20,000
22,000
24,000
26,000
28,000
10-33

The Accounting rate of Return is
(20,000+22,000+24,000+26,000+28,000
)
5
(90,000+80,000+70,000+60,000+50,000
)
5
= 34%
10-34
Problem: The expected cash flow of a project are as

follows
Year
Cash Flow
Taka(100,000)
20,000
30,000
40,000
50,000
30,000
If the cost of capital (r) = 12%.

10-35
Calculate the NPV.

Benefit Cost ratio
Net Benefit cost ratio
Internal rate of Return
Payback Period
10-36

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The Basics of Capital

What is capital budgeting?

effect over long time span and inevitably affect

Capital Budgeting Process & Its

Capital Budgeting process refers to the

The Mutually Exclusive choice

The capital rationing decisions

Steps to capital budgeting

Identification of potential investment

Net Present Value

Net Present Value

Net Present Value

If the cost of capital (r) = 10%. Calculate the

Net Present Value

Net Present Value: Different

If the cost of capital (r) =

Net Present Value: Different discount

PV of C1= 4000 / 1.14

PV of C2= 5000 / 1.14 x 1.15

PV of C3= 7000 / 1.14 x 1.15 x 1.16 = 4,603

PV of C4= 6000 / 1.14 x 1.15 x 1.16 x 1.18

Benefit Cost Ratio

Net Benefit Cost ration = BCR 1

Benefit Cost Ratio

Benefit Cost Ratio

BCR = [25000/1.12 + 40000/(1.12)2+

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

Pay Back Period

Pay Back Period

Pay Back Period

Provides an indication of a projects risk

Ignores the time value of money.

Accounting Rate of Return

The numerator of this ratio may be

Accounting Rate of Return

Accounting Rate of Return

Accounting Rate of Return

Problem: The expected cash flow of a project are as

If the cost of capital (r) = 12%.

Calculate the NPV.

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