Capital budgeting

• It is a decision involving selection of capital

expenditure proposals.
• The life of the project is atleast one year and
usually much longer.
• Examples include decision to purchase new
plant and equipment
• Introduce new product in the market
• Essentially it must be determined whether the
future benefits are sufficiently large enough to
justify the current outlays.
 Capital budgeting
• A capital budgeting decision is one that involves the
allocation of funds to projects that will have a life of
atleast one year and usually much longer.
• Examples would include the development of a major
new product, a plant site location, or an equipment
replacement decision.
• Capital budgeting decision must be approached with
great care because of the following reasons:
1. Long time period: consequences of capital expenditure
extends into the future and will have to be endured for
a longer period whether the decision is good or bad.
2. Substantial expenditure: it involves large sums
of money and necessitates a careful planning
and evaluation.
3. Irreversibility: the decisions are quite often
irreversible, because there is little or no
second hand market for may types of capital
goods.
4. Over and under capacity: an erroneous
forecast of asset requirements can result in
serious consequences. First the equipment
must be modern and secondly it has to be of
adequate capacity.
 Difficulties
• There are three basic reasons why capital
expenditure decisions pose difficulties for the
decision maker. These are:
1. Uncertainty: the future business success is today’s
investment decision. The future in the real world is
never known with certainty.
2. Difficult to measure in quantitative terms: Even if
benefits are certain, some might be difficult to
measure in quantitative terms.
3. Time Element: the problem of phasing properly the
availability of capital assets in order to have them
come “on stream” at the correct time.
 Decision process
INVESTMENT OPPORTUNITIES

PROPOSALS
PLANNING PHASE
PROPOSALS

O R
PP EJE
RO TC
UT DE EVALUATION PHASE

PROJECTS
TI N
SEI

po R
so ej e

SELECTION PHASE
rP
sl a et c
d
er udec or p noi t aul &av E

ACCEPTED PROJECTS
ej o R
st c ej e

IMPLEMENTATION PHASE
rp
c
det
SEI TI NUT R OPP O

ONLINE PROJECTS
T NE MT SEV NI WE N

CONTROL PHASE

PROJECT TERMINATION
i t ne mev or p m
I

AUDITING PHASE
 Methods of classifying investments

• Independent
• Dependent
• Mutually exclusive
• Economically independent and statistically dependent
Prerequisite independent Mutual Exclusive

Weak Strong
complement substitute

Weak
Strong substitute
complement
 Profit (Service) Maintaining and profit
(service) adding investment
• Investment may fall into two basic
categories, profit-maintaining and profit-
adding when viewed from the
perspective of a business, or service
maintaining and service-adding when
viewed from the perspective of a
government or agency.
 Option for replacement decision
How long? What problems?
Can we go on?

g n ess Are there better opportunities?

i n us i
oth of b Is the product life coming to an end?
n ou t
Do Go e
c e w i t h sa m
Repla What if volume increases?
How secure are the markets?
Replace larger or smaller
Replace
differen Should a margin of capacity
Present point t proces
s
Of decision Be provided?

Et Can we profit from new technology?

c.
What risks are there?

Etc.
Expansion and new product investment
1. Expansion of current production to meet
increased demand
2. Expansion of production into fields closely
related to current operation – horizontal
integration and vertical integration.
3. Expansion of production into new fields not
associated with the current operations.
4. Research and development of new products.
 Reasons for using cash flows

• Economic value of a proposed investment

can be ascertained by use of cash flows.
• Use of cash flows avoids accounting
ambiguities
• Cash flows approach takes into account
the time value of money
 Incremental cash flows
• For any investment project generating
either expanded revenues or cost savings
for the firm, the appropriate cash flows
used in evaluating the project must be
incremental cash flow.
• The computation of incremental cash flow
should follow the “with and without”
principle rather than the “before and after”
principle
 Investment decision

Cash

Investment Investment
Opportunity Firm shareholder
Opportunities
(real asset) (financial assets)

Alternative: Shareholders
invest Pay dividend Invest for themselves
To shareholders
 Different methods of measurement

1. Payback
2. Average return on book value
3. Net present value
4. Internal rate of return
5. Profitability index
 NPV
• NPV rule recognizes that a dollar today is worth
more than a dollar tomorrow, because the dollar
today can be invested to start earning interest
immediately.
• Any investment rule which does not recognize
the time value of money cannot be sensible
• NPV depends solely on the forecasted cash
flows from the project and the opportunity cost of
capital
• Because the present values are all measured in
today’s dollars, you can add them up.
• If you have two projects A and B, the net present
value of the combined investment is :
• NPV(A+B) = NPV(A) + NPV(B)
• This additive property has important
implications. Suppose project B has a negative
NPV. If you tack it onto project A, the joint
project (A+B) will have a lower NPV than A on its
own. Therefore, you are unlikely to be misled
into accepting a poor project (B) just because it
is packaged with a good one (A).
 Payback
• Companies frequently require that the
initial outlay on any project should be
recoverable within some specified cutoff
period.
• The payback period of a project is found
by counting the number of years it takes
before cumulative forecasted cash flows
equal the initial investment.
 Cash flows, dollars
project C0 C1 C2 C3 Payback NPV at10
Period, percent
Consider
project A
years
and B :

A -2,000 + 0 0 1 -182
2,000

B -2,000 + + + 2 +3,492
1,000 1,000 5,000
 2,000 -$182
NPV(A) = -2,000 + 1.10
=

1,000 + 1,000
1,000 +
NPV(B) = -2,000 + (1.10)2 (1.10)3 = +$3492
1.10

Thus the net present value rule tells us to reject project A and accept project B.
 Payback rule
project C0 C1 C2 C3 NPV at 10 Payback
percent period

B -2,000 + 1,000 +5,000 3,492 2

+ 1,000

C -2,000 + 2,000 3,409 2

0 + 5,000

D -2,000 + 1,000 + 1,000 +100,000 74,867 2

• The payback rule says that these projects are all
equally attractive. But project B has a higher
NPV than project C for any positive interest rate
($1,000 in each of years 1 and 2 is more
valuable than $2,000 in year 2). And project D
has a higher NPV than either B or C.
• In order to use the payback rule a firm has to
decide on an appropriate cutoff date. If it uses
the same cutoff regardless of project life, it will
tend to accept too many short-lived projects and
too few long-lived ones. If, on average, the
cutoff periods are too long, it will accept some
projects with negative NPVs; if, on average, they
are too short, it will reject some projects that
have positive NPVs.
 Discounted Payback
• Some companies discount the cash flows before
they compute the payback period. The
discounted payback rule asks, “How many
periods does the project have to last in order to
make sense in terms of net present value?
• The discounted cash flow surmounts the
objection that equal weight is given to all flows
starting in year1. The cash flow for investment
before the cut off date.
• The discounted payback rule still takes no
account of any cash flows after the cutoff date.
 Example of Discounted payback method

• Suppose there are two mutually exclusive

investments, A and B. Each requires a $20,000
investment and is expected to generate a level
stream of cash flows starting in year 1. The cash
flow for investment A is $6,500 and lasts for 6
years. The cash flow for B is $6,000 but lasts for
10 years. The appropriate discount rate for each
project is 10 percent. Investment B is clearly a
better investment on the basis of net present
value:
 NPV(A) = -20,000 + ∑6 t=1 6,500 = + $8,309
(1.10) t

NPV(B) = -20,000 + ∑10 t=1 6,000 = + $16,867

(1.10) t

Yet A has higher cash receipts than B in each year of its life, and
so obviously A has the shorter discounted payback. The discounted
Payback of B is a bit more than 4 years, since the present value of
$6,000 for 4 years is $19,019.
Discounted payback is a whisker better than undiscounted payback.
 Average return on book value
• Some companies judge an investment project by
looking at its book rate of return.
• To calculate book rate of return it is necessary to
divide the average forecasted profits of a project
after depreciation and taxes by the average
book value of the investment.
• This ratio is then measured against the book
rate of return for the firm as a whole or against
some external yardstick, such as the average
book rate of return for the industry.
 • Computing
the average
book rate of
return on an Project A Year 1 Year 2 Year 3
investment of
$9,000 in
project A Revenue 12,000 10,000 8,000

Out-of-pocket cost 6,000 5,000 4,000

Avg. book
avg. annual
rate = income
of return
avg.annual investment Cash flow 6,000 5,000 4,000

Depreciation 3,000 3,000 3,000

= 2,000 = .44
4,500
Net Income 3,000 2,000 1,000
 Internal rate of return

Rate of return payoff

= _______________ - 1
Investment

Alternatively, we could write down the NPV of the investment and find
that discount rate which makes NPV = 0

C1
NPV = Co + _______________ = 0
1 + discount rate
Implies Discount rate = C1 - 1
- C0
C1 is the payoff and –C0 the required investment, and so our two
equations say exactly the same thing. The discount rate that makes
NPV= 0 is also the rate of return.

Unfortunately there is no wholly satisfactory way of defining the true

rate of return of a long-lived asset. The best available concept is the
so-called discounted cash-flow (DCF) rate of return or internal rate of
return (IRR). The internal rate of return is frequently used in finance.

The internal rate of return is defined as the rate of discount which

makes NPV=0. This means that to find the IRR for an investment
project lasting T years, we must solve for IRR in the following
expression:
NPV = C0 + C1 + C1 + C1 + ….. + CT = 0
1 + IRR (1 + IRR)2 (1 + IRR)3 (1 + IRR)T

Actual calculation of IRR usually involves trial and error. For

example, consider a project which produces the following flows:
 Cash flows, dollars
C0 C1 C2
-4,000 +2,000 +4,000

The internal rate of return is IRR in the equation

NPV = - 4,000 + 2,000 + 4,000 =0

1+ IRR (1 + IRR)2

Let us arbitrarily try a discount rate of 25 percent. In this case

NPV = - 4,000 + 2,000 + 4,000 = + $160
1.25 (1. 25)2
The NPV is positive; therefore, the IRR must be greater
than zero. The next step might be to try a discount rate
of 30 percent. In this case net present value is :

• NPV = - 4,000 + 2,000 + 4,000 = - 94

1.30 (1.30)2

In this case net present value is – 94: Therefore the IRR must lie
between the rate of 25 and 30. we can find the rate by interpolation.

25 + 5 X 160 = 25 +5 X 160
160 – (-94) 254

= 28.15 percent is the IRR

 Profitability index
• The profitability index ( or the benefit cost ratio) is the present
value of forecasted future cash flows divided by the initial
investment:

• Profitability index = PVCi

PVC0

The profitability index rule tells us to accept all projects with an index
greater than 1. If the profitability index is greater than 1, the
present value PV of Ci is greater than the initial investment - C0
and so the project must have a positive net present value.
 Profitability index
• The benefit cost ratio in the case of previous example at
the discount rate of 25 percent would be
4160
= 1.04

4000
 Time value of money

• In 1624, the Indians sold Manhattan Island at the

ridiculously low figure of $24.
• Was the amount really ridiculous?
• If the Indians had merely taken the $24 and reinvested
it at 6 percent annual interest upto 1992, they would
have had $50 billion, an amount sufficient to repurchase
most of New York City.
• If the Indians had been slightly more astutute and had
invested the $24 at 7.5% compound annually, they
would now have over $8 trillion and the tribal chiefs
would now rival oil sheikhs and Japanese tycoons as
the richest people in the world.
• Another popular example is that $1 received 1,992 years
ago, invested at 6 % could now be used to purchase all
the wealth in the world.
• Time value of money applies to day to day decisions.
• Understanding the effective rate on a business loan
• The mortgage payment in a real estate loan
• Distinction must be made on money received today and
money received in the future.
 Future value
• Assume that an investor has $1000 and
wishes to know its worth after four years if
it grows at 10 percent per year. At the end
of the first year, he will have $1000 X 1.10
or 1,100. By the end of the year two, the
$1,100 will have grown to $1,210 ($1,100
X 1.10). The four-year pattern is indicated
below.
• 1st year $1,000 X 1.10 = $1,100
• 2nd year $1,100 X1.10 = $1,210
• 3rd year $1,210 X1.10 = $1,331
• 4th year $1,331 X 1.10 = $1,464
If:
• FV = Future value
• PV = Present value
• i = Interest rate
• n = Number of periods
• The formula for calculation of FV = PV(1+i)n
• In this case PV = $1,000, I = 10%, n=4, so we have
• FV = $1,000(1.10)4 or $1,000 X 1.464 = $1,464
• Future value of $1
Periods 1% 2% 3% 4% 6% 8% 10%

1 1.010 1.020 1.030 1.040 1.060 1.080 1.100

2 1.020 1.040 1.061 1.082 1.124 1.166 1.210

3 1.030 1.061 1..093 1.125 1.191 1.260 1.331

4 1.041 1.082 1.126 1.170 1.262 1.360 1.464

5 1.051 1..104 1.159 1.217 1.228 1.469 1.611

10 1.105 1.219 1.344 1.480 1.791 2.159 2.594

20 1.220 1.486 1.806 2.191 3.207 4.661 6.727

 Relationship of present value and
future value

$1,464 future
value
$

10 % interest

$1000 Present
value

0 1 2 3 4
Number of periods
 Present value

• The formula for the present value is derived

from the original formula for future value
• FV = PV(1+i)n -------Future Value
• PV = FV[1/(1+i)n] -----Present Value
• The present value of $1,464 in the previous example is
$1,000 today that is it is calculated as follows:
• PV= FV X PVif (n =4, I= 10%) if = interest factor as
given in the chart
• PV = $1,464 X 0.683 = $1,000
• Present value of $1
Periods 1% 2% 3% 4% 6% 8% 10%

1 0.990 0.980 0.971 0.962 0..943 0.926 0.909

2 0.980 0.961 0.943 0.925 0.890 0.857 0.826

3 0.971 0.942 0.915 0.889 0.840 0.794 0.751

4 0.961 0.924 0.888 0.855 0.792 0.735 0.683

5 0.951 0.906 0.863 0.822 0.747 0.681 0.621

10 0.905 0.820 0.744 0.676 0.558 0.463 0.386

20 0.820 0.673 0.554 0.456 0.312 0.215 0.149

 Compounding process of
annuity
Period 1 Period 2 Period 3 Period 4
Period 0
$1,000 X 1.000 = $1,000

$1,000 for one period – 10%

$1,000 X 1.100 = $1,100

$1,000 for two periods – 10%

$1,000 X 1.210 = $1.210

$1,000 for three periods – 10%

$1,000 X 1.331 = $1.331

$4,641
To find the present value of annuity the process is reversed.In theory, each individual payment is discounted
back to the present and then all of the discounted payments are added up, yielding the present value of annuity.
 The relationship between the present value and
future value

• It would be noticed that the future value and the

present value are the flip side of each other.
• Because you can earn a return on your money,
$1.00 received in the future is less than $1.00
today, and the longer you have to wait to receive
the dollar, the less it is worth.
• Because we want to avoid large mathematical
rounding errors, we actually carry the decimal
points 3 places. For example $.683
Future value for say $.68 at 10 – Graphical presentation

Value at the end of each period

1.00
1.00

.909

0.90 .826

0.80
.751

0.70

.683
0.60

0.00
Period 0 Period 1 Period 2 Period 3 Period 4
• Present value of $1.00 at 10%
• Value at the beginning of each period

1.00
1.00

0.90
.909

0..80 .826

0.70 .751

.683
0.60

1.00
Period 0 Period 1 Period 2 Period 3 Period 4
 The PV of a 2 year annuity is
$3.50
simply the present value of one
payment at the end of period 1 PV of a 4 year
and one payment at the end of annuity
Period 2
3.00 3.17
PV of $1.00 to be received
In 1 year
.909
2.50
2.49
.826 PV of $1.00 to be received
2.00 .909 In 2 years

1.50 1.74

.909 .826 .751 PV of $1.00 to be received

In 3 years
1.00
.909
.909
0.50 .826 .751 .683
PV of $1.00 to be received
In 4 years
0.00

Period 1 Period 2 Period 3 Period 4

 Relationship between the PV of a single amount and the
present value of an annuity

• The relationship between the present

value of $1.00 and the present value of a
$1.00 annuity. The assumption is that you
will receive $1.00 at the end of each
period. This is the same concept as a
lottery, where you win $2 million over 20
years and receive $100,000 per year for
twenty years.
 PV of a 4 year
$5.00 The PV of a 2 year annuity is annuity
simply the future value of one
Future value of an annuity
4.641
$4.50 payment at the end of period 1
and one payment at the end of
Period 2
of $1.00 at 10%

$3.50 PV of $1.00 invested

at the end of
Period 4
1.00
3.00

2.50 3.31
1.10 PV of $1.00 invested for
1.00 1 year
2.00 2.10

1.50 1.00 .1.10 1.21 PV of $1.00 invested for

2 years

1.00 1.00
1.00 1.10
.1.21
0.50 .1.33
PV of $1.00 invested
For 3 years
0.00

Period 1 Period 2 Period 3 Period 4