CapitalBudgeting

PreparedBy: WaelShamsEL-Din

Agenda
WhatisCapitalBudgeting.
WhyCapitalBudgetingissoImportant.
TheCapitalBudgetingDecisions.
MethodsofCapitalBudgeting
Payback
Discounted

Payback
Net Present Value (NPV)
rate of Return (IRR)
Internal
Modified Internal rate of Return (MIRR)
Profitability Index (PI)
2

What is Capital
Budgeting
?

Capital budgeting is the process of analyzing

Potential Projects.
Capital budgeting can be defined as the
process of analyzing, evaluating, and deciding
whether resources should be allocated to a
project or not.
Process of Capital budgeting ensure optimal
allocation of resources and helps management
work towards the goal of shareholder wealth
maximization.

WhyCapitalBudgetingissoImportant?
Involve

Massive investment of Resources.

Have Long-term Implications for the Firm.
Involve uncertainty and risk for the Firm.
Due to the above factors, capital budgeting decisions
become critical and must be evaluated very
carefully. Any firm that does not follow the capital
budgeting process will not be able to Maximize
Shareholder Wealth and management will not be
acting in the best interests of shareholders.

TheCapitalBudgetingDecision
TypesofDecisions
Expansion of Facilities
Replacement
Lease or Make or buy

MethodsofCapitalBudgeting
Payback
Discounted Payback
Net

Present Value (NPV)

Internal rate of Return (IRR)
Modified

Internal rate of Return (MIRR)

Profitability

Index (PI)
LetusseehowthesemethodsWork

PaybackPeriodMethod

The payback Period defined as the expected

number of years required to recover the
original investment, it is the formal method
used to evaluate capital budgeting project.

01234
*-----------*-----------*----------*-------------*
-1000500400
300100

-1000 + 500+400 = 100

100/300 = 0.33
Payback = 2.33 Years

PaybackPeriodPros&Cons
Advantage
1. Easy to calculate
2. Provide an indication
of a projects risk and liquidity
Disadvantage
Ignore cash flow after payback period
Doesnt consider time value of Money

DiscountedPayback
It

is a similar to the regular payback period except

that the expected cash flow is discounted by the
projects cost of capital. Thus the discounted
payback period is defined as the number of years
required to cover the investment from discounted net
cash flows.

01234
*-----------*-----------*----------*-------------*
-1000500400 300 100
45533022568
- 1000 + 455 + 330 = 215/225 = 0.95
Discounted Payback Period = 2.95 Years

DiscountedPaybackPeriodPros&Cons
Advantage
Consider Time value of Money
Disadvantage
Ignore cash flow after payback period
Ignores cash flows
after the payback
Period.

NetPresentValue(NPV)
The net present value ( NPV) Method is based

upon the discounted cash flow (DCF) Technique ,

it is based on all discounted cash flows of the
project by using cost of capital rate and then sums
those cash flows, the project should be accepted if
NPV is positive or = Zero.

CalculationofNPV
Costof
Capital@
10%

1234
*--------------------*-----------*-----------*-------------*
-1000
500400 300100

+455
+330
+225
+68
====
+78

IfPositiveNPVwewillaccepttheProject()

Internal rate of Return (IRR) is defined as the

InternalRateofReturn(IRR)

discounted rate that forces a projects NPV to equal

zero. The project should be accepted if the IRR is
greater than cost of capital
0

1234
*--------------------*-----------*-----------*-------------*
-1000
500400 300100
-1000+500+400+300+100=Zero
(1+IRR)1(1+IRR)2(1+IRR)3(1+IRR)4

If IRR > WACC we will accept the project because the

projects rate of return is greater than its cost.
If IRR < WACC we will Reject the project because the
projects rate of return is less than its

ModifiedInternalRateofReturn(MIRR)

Modified Internal rate of Return (MIRR) correct some of the

problem with regular IRR since MIRR involves finding the
terminal value (TV) of the cash inflows, compounded at the
firms cost of capital and then determining the discount rate that
forces the Present value of the TV to equal the PV of the out
flows.

1234
*--------------------*-----------*-----------*-------------*
500400 300100
-1000
330 +

484
665.50
======

TV

1579.50

CalculationofMIRR
PV = FV (TV)
(1+MIRR) 4
1000 = 1579.50
(1+MIRR) 4
MIRR = 12.10%
If MIRR > WACC ,we Accept the project
If MIRR < WACC ,we Reject the project
Since 12.10%> 10% () Accept.

1234
Costof
*--------------------*-----------*-----------*-------------*
Capital@ -1000
500400 300100
10%

Profitability Index (PI )

+455
+330
+225
+68
====
+1078

Profitability index shows the

dollars of present value divided
by the initialPI=1078=$1.08
cost, so it measure
1000
relative profitability.

So the project is expected to produce $1.08 for each $ 1 of

investment, if we compare 2 projects we will select the project
with higher (PI) and must be greater than (1).

WhichApproachisBetter?
On a purely theoretical basis, NPV is considered the better
approach because: NPV measures how much wealth a project creates (or
destroys if the NPV is negative for shareholders.
Also NPV consider reinvestment of cash flow at cost of
capital which is more conservative.
Despite the fact most of the financial managers prefer to
use the IRR approach in addition to NPV method because
of the preference for rates of return.

Thank You