Capital Budgeting Techniques
Capital Budgeting Techniques
Capital Budgeting Techniques
Introduction
Capital Budgeting is the process of determining which real investment
projects should be accepted and given an allocation of funds from the
firm.
To evaluate capital budgeting processes, their consistency with the g
oal of shareholder wealth maximization is of utmost importance.
C0 C1 C2 C
Wealth =
(1 r ) 0 (1 r )1 (1 r ) 2
........
(1 r )
Payback period = A+ ,
B
where A= the last periodC with a negative cash flow;
B= the absolute value of cumulative cash flow at the end of the p
eriod A;
C= the total cash flow during the period after A
Payback Period: Example
Company C is planning to undertake another project requiring initial inv
estment of $50 million and is expected to generate $10 million in Year 1
, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $
22 million in Year 5. Calculate the payback value of the project.
Sometimes the above data is difficult to obtain – this is the main weak
ness of all DCF techniques.
Net Present Value (NPV)
Forecast cash flow (C1, C2,… Ct) generated by a project over it
s economic life;
Determine the appropriate opportunity cost of capital (r);
Use the opportunity cost of capital (r) to discount the project’s f
uture cash flows, and sum them up (PV);
Calculate the net present value (NPV) by subtracting the initial i
nvestment cost (C0);
The NPV rule for investment decision:
Accept a project if the NPV is greater the zero (NPV>0)
Reject a project if the NPV is less than zero (NPV<0)
Net Present Value (NPV)
Net present value formula:
C1 C2 C
NPV C0 ......
(1 r ) (1 r ) 2 (1 r )
Time value of money:
A dollar today is worth more than a dollar tomorrow
Opportunity cost of capital:
A safe dollar is worth more than a risky one
Additively of present values:
Risk-adjusted present values are comparable quantities.
NPV: Example
Examples: Details of two projects investments and returns are given
below:
Particulars Project A Project B
C0 tk. 40,000 tk. 40,000
C1 14,000 22,000
C2 16,000 20,000
C3 18,000 18,000
C4 20,000 16,000
C5 25,000 17,000
If discount rate is 10%, the PV factors for (1-5) years are .909,.826,.75
1,.683 and .621 respectively.
NPV: Strengths and Weaknesses
Strengths
Resulting number is easy to interpret: shows how wealth will chang
e if the project is accepted.
Acceptance criteria is consistent with shareholder wealth maximiza
tion.
Relatively straightforward to calculate
Weaknesses
Requires knowledge of finance to use.
An improper NPV analysis may lead to the wrong choices of projec
ts when the firm has capital rationing.
cash flow, the future cash flow may be difficult to measure
Ross (1995) on NPV rule
The Good:
Rejecting an investment when it should be rejected
The Bad:
Rejecting an investment when it should be accepted
The Ugly:
Accepting an investment when it should be rejected
Internal Rate of Return
IRR is the discount rate that equates the present value of the future n
et cash flows from an investment project with the project’s initial cash
outflow.
If IRR ≥ opportunity cost of capital (or hurdle rate), then accept the pr
oject; otherwise reject it.
C1 C2 C
0 C0 ........
(1 irr ) (1 irr )
1 2
(1 irr )
IRR: Example
Example: A project costs tk. 36,000 and is expected to generate cash i
nflows of tk. 11,200 annually for 5 years. Calculate the IRR of the proje
ct.
PVFCIFs
PI
CF0
Decision Criterion Using PI
• For independent projects: Accept all projects with PI greater than one (this is i
dentical to the NPV rule).
• For mutually exclusive projects: Among the projects with PI greater than one,
accept the one with the highest PI.
Profitability Index (PI): Example
Examples: Details of two projects investments and returns are given
below:
Particulars Project A Project B
C0 tk. 40,000 tk. 40,000
C1 14,000 22,000
C2 16,000 20,000
C3 18,000 18,000
C4 20,000 16,000
C5 25,000 17,000
If discount rate is 10%, the PV factors for (1-5) years are .909,.826,.75
1,.683 and .621 respectively.
PI: Strengths and Weaknesses
Strengths
PI number is easy to interpret: shows how many $ (in PV terms) yo
u get back per $ invested.
Acceptance criteria is generally consistent with shareholder wealth
maximization.
Relatively straightforward to calculate.
Useful when there is capital rationing.
Weaknesses
Requires knowledge of finance to use.
It is possible that PI cannot be used if the initial cash flow is an inflo
w.
Method needs to be adjusted when there are mutually exclusive pr
ojects.
Capital Rationing and Profitability Index