CHAPTER 7:

Capital Budgeting
Techniques
SIGNIFICANCE OF CAPITAL
BUDGETING
 Capital budgeting is an essential tool in financial management.
 Capital budgeting provides a wide scope for financial managers to evaluate
different projects in terms of their viability to be taken up for investments and
helps in exposing the risk and uncertainty of different projects.
 It also keeps a check on over or under investments. The management is provided
with an effective control on cost of capital expenditure projects Ultimately the fate
of a business is decided on how optimally the available resources are used .
Example of Capital Budgeting:
Capital budgeting for a small scale expansion involves three steps:
 recording the investment’s cost,
 projecting the investment’s cash flows and comparing the projected earnings with
inflation rates and
 the time value of the investment.
 For example,
 equipment that costs P15,000 and generates a P5,000 annual return would appear to "pay back"
on the investment in 3 years. However, if economists expect inflation to rise 30 percent annually,
then the estimated return value at the end of the first year (P20,000) is actually worth P15,385
when you account for inflation (P20,000 divided by 1.3 equals P15,385). The investment
generates only P385 in real value after the first year.
IMPORTANCE OF CAPITAL
BUDGETING
 1) Long term investments involve risks: Capital expenditures are long term investments which
involve more financial risks. That is why proper planning through capital budgeting is needed.
 2) Huge investments and irreversible ones: As the investments are huge but the funds are limited,
proper planning through capital expenditure is a pre-requisite. Also, the capital investment
decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall
incur losses.
 3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in the
profitability of the company. It helps avoid over or under investments. Proper planning and
analysis of the projects helps in the long run
CAPITAL BUDGETING TECHNIQUES /
METHODS
 There are different methods adopted for capital budgeting. The traditional
methods or non discount methods include: Payback period and Accounting rate of
return method. The discounted cash flow method includes the NPV method,
profitability index method and IRR.
Payback period method:

this method refers to the period in which the proposal will generate cash to recover
the initial investment made. It purely emphasizes on the cash inflows, economic life
of the project and the investment made in the project, with no consideration to time
value of money. Through this method selection of a proposal is based on the earning
capacity of the project. With simple calculations, selection or rejection of the project
can be done, with results that will help gauge the risks involved. However, as the
method is based on thumb rule, it does not consider the importance of time value of
money and so the relevant dimensions of profitability.
Payback period = Cash outlay
(investment) / Annual cash inflow
 Example
Project A Project B
Cost 1,000,000 1,000,000
Expected future cash flow
Year 1 500,000 1,000,000
Year 2 500,000 50,000
Year 3 1,100,000 50,000
Year 4 none none
total 2,100,000 1,100,000
Payback 2 years 1 year

 Payback period of project B is shorter than A, but project A provides higher returns.
Hence, project A is superior to B.
Accounting Rate of Return method
(ARR):
 This method helps to overcome the disadvantages of the payback period method.
The rate of return is expressed as a percentage of the earnings of the investment in
a particular project. It works on the criteria that any project having ARR higher
than the minimum rate established by the management will be considered and
those below the predetermined rate are rejected. This method takes into account
the entire economic life of a project providing a better means of comparison. It
also ensures compensation of expected profitability of projects through the
concept of net earnings. However, this method also ignores time value of money
and doesn’t consider the length of life of the projects. Also it is not consistent with
the firm’s objective of maximizing the market value of shares
 ARR= Average income/Average Investment

Example :Suppose a business make an initial investment of 150,000 in a 3 years project .The total
income over the term of the project is expected to be 52,200 ,and the salvage value at the end of the
project is expected to be 24,000.

CALCULATE THE AVERAGE ACCOUNTING NET INCOME

The average net income is simply to total net income divided by the term of the project .
This amount already allows for the deprecation expense.

Average net income = Total net income /term

Average net income =52,200/3
Average net income =17,400

The average annual net income for the project is 17,400

 CALCULATE THE AVERAGE INVESTMENT
The beginning investment is the initial amount invested by the business at the start of
year 1 which is 150,000.Over the term of the 3 years the value of the investment is
reduced by depreciation to its salvage value of 24,000.
The simple arithmetic average of these two value is calculated as follows:

Average investment=(beginning investment + ending investment value)/2

Average investment =( initial investment + salvage value )/2
Average investment = (150,000 + 24,000)/2
Average investment = 87,000

The average investment in the project over the three years is therefore 87,000
 CALCULATE THE ACCOUNTING RATE OF RETURN
The accounting rate of return can now be calculated by applying the ARR formula to the average net
income and the average investment value calculated above.
ARR= average net income/ Average investment
ARR= 17,400 /87,000
ARR= 0.20 or 20%
 The accounting rate return method shows that the return on this project is 20% a year for 3 years
Discounted Cash Flow method:

The discounted cash flow technique calculates the cash inflow and outflow through
the life of an asset. These are then discounted through a discounting factor. The
discounted cash inflows and outflows are then compared. This technique takes into
account the interest factor and the return after the payback period.
 Represent the initial capital Considered over 4 years investment
investment

All value in Year 0 Year 1 Year 2 Year 3 Year 4

Peso
Cost 100,000 10,000 10,000 10,000 10,000
Benefits 0 25,000 35,000 45,000 45,000

Benefits Costs Absolute return

150,000 - 140,000 =10,000

However ,most of the benefits occur later in the project.

Is the peso in the 4 years
time worth as much peso today ?
 Is the peso in the 4 years
time worth as much peso today ?

 Discounted cash flow DCF and related concept Net present Value NPV is an approach to invested
appraisal that suggested the answer is ”No “.
 some weighing should be allocated to the future costs and benefits to reflect the time value of
money.
 A discount rate is applied to the future cost and benefits to reflect their present value
 present value Factor for Discount rate of 6%?
Year Year 0 Year 1 Year 2 Year 3 Year 4
Present
value Factor 1.000 0.943 0.890 0.840 0.792
for Discount
rate of 6%

For example Benefits of 1000 in year 4 is 792

792 present value of those benefits

Present value is applied to both costs and benefits

 All value in Peso Year 0 Year 1 Year 2 Year 3 Year 4

Cost 100,000 10,000 10,000 10,000 10,000

Benefits 0 25,000 35,000 45,000 45,000

Cash flows -100,000 +15,000 +25,000 +35,000 +35,000

How to get cash flows: benefits - cost

Ex. In year 1
25000 – 10,000 = 15,000
All value in Year 0 Year 1 Year 2 Year 3 Year 4
Peso

Cost 100,000 10,000 10,000 10,000 10,000

Benefits 0 25,000 35,000 45,000 45,000

Cash flows -100,000 +15,000 +25,000 +35,000 +35,000

Discount factor 1.000 0.943 0.890 0.840 0.792

How to get the
discounted cash flow:
Discounted -100,000 14,145 22,250 29,400 27,720
cash flow cash flow x discount factor
Net present Value (NPV) Method:

 This is one of the widely used methods for evaluating capital investment
proposals. In this technique the cash inflow that is expected at different periods of
time is discounted at a particular rate.
 The present values of the cash inflow are compared to the original investment. If
the difference between them is positive (+) then it is accepted or otherwise
rejected.
 This method considers the time value of money and is consistent with the
objective of maximizing profits for the owners. However, understanding the
concept of cost of capital is not an easy task.
 All value in Year 0 Year 1 Year 2 Year 3 Year 4
Peso

Cost 100,000 10,000 10,000 10,000 10,000

Benefits 0 25,000 35,000 45,000 45,000
Cash flows -100,000 +15,000 +25,000 +35,000 +35,000
Discount factor 1.000 0.943 0.890 0.840 0.792
Discounted -100,000 14,145 22,250 29,400 27,720
cash flow

Discounted cash flow added up to produce the NET PRESENT VALUE of the project.

-100,000 + 14,145 + 22,250 + 29,400 + 27,720 = - 6,485

the NPV is
Decision Role negative so the project
is rejected
If the NVP > 0 Accept
If the NVP < 0 rejected
 Example: Calculate NVP of the two project and suggest which of
the two Projects should be accepted assuming discount rate@ 10 %
Project x Project Y
Initial investment 40,000 60,000
Estimated life 5 years 5 years
Scrap value 2,000 4,000

Cash inflows
Year 1 2 3 4 5
Project x 10,000 20,000 20,000 6,000 4,000
Project y 40,000 20,000 10,000 6,000 4,000

PV FACTOR @10% DISCOUNT

Year 1 2 3 4 5
PV 0.909 0.826 0.751 0.683 0.621
Factor@10%
 PROJECT X PROJECT Y
YEAR CASH DF@10 PV YEAR CASH DF@10 PV
FLOW % FLOW %
0 (40,000) 1 (40,000) 0 (60,000) 1 (60,000)
1 10,000 0.909 9,090 1 40,000 0.909 36,860
2 20,000 0.826 16,520 2 20,000 0.826 16,520
3 20,000 0.751 15,020 3 10,000 0.751 7,510
4 6,000 0.683 4,098 4 6,000 0.683 4,098
5 4,000 0.621 2,484 5 4,000 0.621 2,484
Scrap 2,000 0.621 1,242 Scrap 4,000 0.621 2484
value(5) value(5)
NPV 8, 454 NPV 9,456

In selecting the project we must choose the highest NVP

*the PROJECT Y
Internal Rate of Return (IRR):

 This is defined as the rate at which the net present value of the investment is zero.
The discounted cash inflow is equal to the discounted cash outflow. This method
also considers time value of money. It tries to arrive to a rate of interest at which
funds invested in the project could be repaid out of the cash inflows. However,
computation of IRR is a tedious task.
 It is called internal rate because it depends solely on the outlay and proceeds
associated with the project and not any rate determined outside the investment.
Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of return
to the initial cash outflow of the investment. It may be gross or net, net being simply
gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC)
ratio is as follows.