Capital Budgeting

Capital Budgeting is employed to evaluate

expenditure decisions which involve current outlays
but are likely to produce benefits over a period of
time longer than one year.
Capital Budgeting is the process of evaluating &
selecting long term investments that are consistent
with the firm's goal of owner wealth maximization.

# Expenditure :
Capital Expenditure : An outlay of funds by the firm
that is expected to produce benefits over a period of
time greater than one year.
Current Expenditure : An outlay of funds by the firm
resulting in benefits received within one year.

# Key Motives for Making Capital Expenditure

1. Expansion
2. Replacement
3. Renewal
4.Other purposes

# Steps in Capital Budgeting Process

1.Proposal generation
2.Review &analysis
3. Decision making
4.Implementation
5.Follow-up

# Independent Projects : Projects whose cash flows

are unrelated or independent of one another ; the
acceptance of one does not eliminates the others
from future consideration.

# Mutually Exclusive Projects : Projects that compete with one

another, so that acceptance of one eliminates the others from
further consideration.
# Unlimited Funds : The financial situation in which a firm is
able to accept all independent projects that provide an
acceptable return.
# Capital Rationing:The financial situation in which a firm has
only a fixed number of dollars to allocate among competing
capital expenditure.

RANKING APPROACH : The ranking of capital

expenditure projects on the basis of some
predetermined measures such as the rate of return

Capital Budgeting Techniques

1. Payback Period
Payback Periods are a commonly used criterion for
evaluating proposed investments.
The Payback Period is the exact amount of time
required for the firm to recover its initial investment in a
project as calculated from cash inflows.
In the case of an annuity, the Payback Period can be
found by dividing the initial investment by the annual
cash inflow .
For a mixed stream, the yearly cash inflows must be
accumulated until the initial investment is recovered.

(Original Invet.- CCF YFR)

Payback = [YFR - 1] + -------------------------------CF YFR

Where , YFR
=Year of full recovery
CCF YFR = Cumulative CF at the start of year of full
recovery
CF YFR
= Cash flow during YFR
Payback Period is generally viewed as an
unsophisticated capital budgeting technique, because it
does not explicitly consider the time value of money by
discounting cash flows to find the present value. Payback
period also ignores cash flows beyond payback period.

2. Net Present Value (NPV)

A sophisticated capital budgeting technique; found by
subtracting a projects initial investment from the present
value of its cash inflows discounted at a rate equal to the
firms cost of capital.

NPV= Present value of cash inflow Initial Investment

NPV = CF0 + CF1 + CF2 + CF3 ..+ CFN
(1+k)1
(1+k)2 (1+k)3 (1+k)n

CF = Present Value of Cash Inflows

CF0 = Cash flow in zero year / Initial Investment
K = Discount Rate / Required Return/ Cost of Capital

The Decision Criterion

The decision criterion when NPV is used to make
accept- reject decisions is as follows :

* If NPV is greater than $ 0, accept the project: if

NVP is less than $ 0 ,reject the project.
If NPV is greater than $ 0, the firm will earn a
return greater than its cost of capital. Such action
should enhance the market value of the firm &
therefore wealth of its owner

3. Internal Rate of Return (IRR)

IRR is defined as the discount rate that equates the
present value of cash inflows with the initial investment
associated with a project, thereby causing NPV = 0.
The IRR, in other words, the discount rate that equates
the net present value of an investment opportunity with
$0 .

0 = CFo + CF1____ + CF2____ + + CFN____

(1+ IRR)1 (1+ IRR)2
(1+ IRR)n
Where, CF0 = Cash outflow at zero year
CFN = Present Value of Cash Inflows

The Decision Criterion

If IRR is 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. Such an outcome should enhance the
market value of the firm & therefore the wealth of its
owner.

## Interpolation
IRR = L + A X (H - L)
B
L= Lower discounting rate, H = Higher discounting rate
A= NPV at lower discount rate
B = Difference between the PV of all net cash benefits at
lower
discounting rate and higher rate , OR
NPV at lower discount rate NVP at higher discount
rate

Problem - 1
Capital Budgeting : Replacement Decision
# A machine purchased six years ago for $ 150000
has been depreciated to a book value of $ 90000.
It originally had a projected life of 15 years and
zero salvage value. A new machine will cost $
250000 and result in a reduced operating cost of $
30000 per year for the next nine years. The older
machine could be sold for $ 50000. The cost of
capital is 10%. The new machine will be
depreciated on a straight line basis over nine years
life with $ 25000 salvage value. The company tax
rate is 55%. Determine whether the old machine
should be replaced

Replacement Decision:
Whether to purchase capital assets to take the place
of existing assets to maintain or improve existing
operations.

Expansion Decisions :
Whether to purchase capital projects and add them
to existing assets to increase existing operations
Independent Projects :
Projects whose cash flows are not affected by
decision made about other projects.

Mutually Exclusive Projects:

A set of projects in which the acceptance of one
project means the other cannot be accepted.