hasanzulfiqar@yahoo.co.uk 1

ZULFIQAR HASAN 2

Definition of Capital Budgeting, Importance and scope of capital budgeting, types of investment projects, Capital Budgeting Technique: PBP, NPV, PI and IRR etc, Cash Flows: relevant vs irrelevant, Estimating Cash Flows, limitations of capital budgeting

Lecture Contents

ZULFIQAR HASAN 3

What is Capital Budgeting?

• The process of identifying, analyzing and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.(-James C. Van Horne)

• Capital Budgeting may be defined as the decision making process by which firms evaluate the purchase of major fixed assets including premises, machinery and equipment.

• Capital budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities.

• The process of identifying, analyzing and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.(-James C. Van Horne)

• Capital Budgeting may be defined as the decision making process by which firms evaluate the purchase of major fixed assets including premises, machinery and equipment.

• Capital budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities.

ZULFIQAR HASAN 4

Independent Project versus Mutually Exclusive Projects

• Independent Investment Projects: Independent means neither events depend on each other, they go on their own course by themselves. These are different projects with different outcomes and independent cash flows. All profitable projects are acceptable if capital budget is available.

• Mutually Exclusive Projects: Mutually exclusive is when two things cannot coexist at the same time. These are different projects with identical out come and interrelated cash flows. All profitable projects are ranked first and the most profitable project is selected.

• Mutually exclusive is the situation in which only one of two projects designed for the same purpose can be accepted and independent projects is a project whose feasibility can be assessed without consideration of any others.

• Independent Investment Projects: Independent means neither events depend on each other, they go on their own course by themselves. These are different projects with different outcomes and independent cash flows. All profitable projects are acceptable if capital budget is available.

• Mutually Exclusive Projects: Mutually exclusive is when two things cannot coexist at the same time. These are different projects with identical out come and interrelated cash flows. All profitable projects are ranked first and the most profitable project is selected.

• Mutually exclusive is the situation in which only one of two projects designed for the same purpose can be accepted and independent projects is a project whose feasibility can be assessed without consideration of any others.

ZULFIQAR HASAN 5

Types of Investment Projects /Application of Capital Budgeting

New Investments:This types of investment adds to the fixed assets of the firm.

Replacement or Reinstallation Investments:This type of investment replaces an existing asset.

ModernizationMechanizationSelection of alternative machineryExpansion

ZULFIQAR HASAN 6

Types of Cash FlowsNormal Cash Flows:

Cost (negative CF) followed by a series of positive cash inflows. One change of signs.

Nonnormal Cash Flows:Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.

Irrelevant Cash Flows:Sunk cost is not included in capital budgeting analysis, i.e., R&D expenses.

Relevant Cash Flows:Cash flows considered in capital budgeting, i.e., opportunity cost, cannibalization, and others.

ZULFIQAR HASAN 7

Sample Questions 01: What are the five steps involved in the capital budgeting process?

a. Proposal generation is the origination of proposed capital projects for the firm by individuals at various levels of the organization.

b. Review and analysis is the formal process of assessing the appropriateness and economic viability of the project in light of the firm's overall objectives. This is done by developing cash flows relevant to the project and evaluating them through capital budgeting techniques. Risk factors are also incorporated into the analysis phase.

c. Decision making is the step where the proposal is compared against predetermined criteria and either accepted or rejected.

d. Implementation of the project begins after the project has been accepted and funding is made available.

e. Follow-up is the post-implementation audit of expected and actual costs and revenues generated from the project to determine if the return on the proposal meets preimplementation projections.

a. Proposal generation is the origination of proposed capital projects for the firm by individuals at various levels of the organization.

b. Review and analysis is the formal process of assessing the appropriateness and economic viability of the project in light of the firm's overall objectives. This is done by developing cash flows relevant to the project and evaluating them through capital budgeting techniques. Risk factors are also incorporated into the analysis phase.

c. Decision making is the step where the proposal is compared against predetermined criteria and either accepted or rejected.

d. Implementation of the project begins after the project has been accepted and funding is made available.

e. Follow-up is the post-implementation audit of expected and actual costs and revenues generated from the project to determine if the return on the proposal meets preimplementation projections.

ZULFIQAR HASAN 8

Sample Question 02: What is capital budgeting? Do all capital expenditures involve fixed assets? Explain.

• Capital budgeting is the process used to evaluate and select long-term investments consistent with the goal of owner wealth maximization. Capital expenditures are outlays made by the firm that are expected to produce benefits over the long term (a period greater than one year).

• Not all capital expenditures are made for fixed assets. An expenditure made for an advertising campaign may have long-term benefits.

ZULFIQAR HASAN 9

Capital Budgeting Techniques

Payback Period (PBP)Net Present Value (NPV)Profitability Index (PI)Internal Rate of Return (IRR)Modified Internal Rate of Return (MIRR)Equivalent Annual Annuity (EAA)

Payback Period (PBP)Net Present Value (NPV)Profitability Index (PI)Internal Rate of Return (IRR)Modified Internal Rate of Return (MIRR)Equivalent Annual Annuity (EAA)

ZULFIQAR HASAN 10

Capital Budgeting Decision Rules

ZULFIQAR HASAN 11

Definition:Definition: PBPPBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.The Payback Period represents the amount of time that it takes for a Capital Budgeting project to recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule specifies that all independent projects with a Payback Period less than a specified number of years should be accepted. When choosing among mutually exclusive projects, the project with the quickest payback is preferred.

The payback period is the time taken to recover the initial investment. The shorter the payback period, the better

Definition:Definition: PBPPBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.The Payback Period represents the amount of time that it takes for a Capital Budgeting project to recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule specifies that all independent projects with a Payback Period less than a specified number of years should be accepted. When choosing among mutually exclusive projects, the project with the quickest payback is preferred.

The payback period is the time taken to recover the initial investment. The shorter the payback period, the better

ZULFIQAR HASAN 12

Calculation of PBP: The Simple Rule

yearrecovery the during

generatedflow cash Total

yearrecovery the of start at

dunrecovere investment of Amount

investment initial of

recovery full before

yearsof Number

PBP

Calculation of PBP: The Algebraic Formula

d

) c - b ( a PBP

Herea = Number of YEAR before Full Recovery Yearb = Initial Investmentc= Cumulative cash flow at year a d= Actual cash flow at full recovery year

ZULFIQAR HASAN 13

Example 01: Payback Period

Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outflow (investment) will be $40,000. Calculate Payback Period

Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outflow (investment) will be $40,000. Calculate Payback Period

0 1 2 3 4 5

-40000 10000 12000 15000 10000 (d) 7000

CumulativeInflows

(a)

Years 3.3$10000

$30003

$10000

) $37000 - $40000 ( 3

d

) c - b ( a PBP

10000 22000 37000 47000 54000(c)

(b)

ZULFIQAR HASAN 14

PBP Acceptance Rules

• Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.]

• Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.]

The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type.

Should this project be accepted?

Payback Method Decision Rule:

Accepted projects depends on the firm’s view of payback time period.

ZULFIQAR HASAN 15

Practice 01: Payback Period

Jordan Enterprises is considering a capital expenditure that requires an initial investment of $42,000 and returns after-tax cash inflows of $7,000 per year for 10 years. The firm has a maximum acceptable payback period of 8 years.

a. Determine the payback period for this project.

b. Should the company accept the project? Why or why not?

a. 6 yearsb. The company should accept the project, since 6 < 8.

ZULFIQAR HASAN 16

Practice 01

Assume that your company is investigating a new labor-saving machine that will cost $10,000. The machine is expected to provide cost savings each year as shown in the following timeline:

0 1 2 3 4 5

2000 2500 3000 3500 4000-10,000

1.If the Target PBP is 3.5 Years, should you purchase the machine?

3.7143 years

ZULFIQAR HASAN 17

Practice 01

Suppose the expected cash flows for projects L and S are as follows:

Year Project L Project S0 -$100 -$1001 $10 $702 $60 $453 $80 $20

1. What is the payback period for Project L or S?A. 1.7 years B. 1.9 years C. 2.4 years D. 2.7 years

2. Which project should be accepted if they are Independent?

3. Which project should be accepted if they are mutually exclusive?

ZULFIQAR HASAN 18

PBP Strengths & Weaknesses

STRENGHTSSTRENGHTS1. Easy to use and understand2. Can be used as a measure of liquidity3. Easier to forecast ST than LT flows

STRENGHTSSTRENGHTS1. Easy to use and understand2. Can be used as a measure of liquidity3. Easier to forecast ST than LT flows

WEAKNESSES1. It does not consider cash flows that occur after the

payback time period.2. It does not consider the time value of money.3. It does not take account of the cost of capital.

ZULFIQAR HASAN 19

Discounted Payback Period

• Discounted Payback Period is the length of time required to recover the initial cash outflow from the discounted future cash inflows. This is the approach where the present values of cash inflows are cumulated until they equal the initial investment.

• The discounted payback period is the amount of time that it takes to cover the cost of a project, by adding positive discounted cash flow coming from the profits of the project.

ZULFIQAR HASAN 20

Example 01: Discounted Payback PeriodAn investment project has annual cash inflows of $7000, $7500, $8000, and $8500, and a discount rate of 14%. What is the discounted payback period for these cash flows if the initial cost is $8000? What if the initial cost is $13000? What if it is $18000?

22343.9517311.1311911.366140.35Cumulative Cash flow

5032.825399.775771.016140.35-8000PV of Cash flow

850080007500$7000-8000Annual Cash flow

43210

Solution

d

) c - b ( a PBP

Year 1.3232.015771.01

) 6140.35 - 8000 ( 1 PBP

Result: b. 2.20 years c. 3.14 years

ZULFIQAR HASAN 21

0nn

33

22

11 CF

)i1(

CF......

)i1(

CF

)i1(

CF

)i1(

CF

NPV

1. The Net Present Value (NPV) of a Capital Budgeting project indicates the expected impact of the project on the value of the firm. Projects with a positive NPV are expected to

increase the value of the firm. Thus, the NPV decision rule specifies that all independent projects with a positive NPV should be accepted. When choosing among mutually exclusive projects, the project with the largest (positive) NPV should be selected. 2. NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow.3. The net present value (NPV) is the difference between the

present value of the cash flows (the benefit) and the cost of the investment (IO):

ZULFIQAR HASAN 22

Example 02: Calculating NPV

Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outflow (investment) will be $40,000. Calculate Net Present Value (@ 13%).

= -$1424

40000$)13.1(

7000$

)13.1(

10000$

)13.1(

15000$

)13.1(

12000$

)13.1(

10000$NPV

)1()1()1()1()1(NPV

54321

055

44

33

22

11

CFi

CF

i

CF

i

CF

i

CF

i

CF

ZULFIQAR HASAN 23

NPV Decision Rule

1. For independent projects, if the NPV > 0, accept the project, otherwise reject it.

2. For mutually exclusive projects, accept the project with the highest NPV.

3. All projects with NPV greater than or equal to zero should be accepted

The management of Basket Wonders has determined that the required rate is 13% for projects of this type.

Should this project be accepted?

No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject Reject as NPVNPV < 00 ]

ZULFIQAR HASAN 24

Practice 01 NPV

Assume that your company is investigating a new labor-saving machine that will cost $10,000. The machine is expected to provide cost savings each year as shown in the following timeline:

0 1 2 3 4 5

2000 2500 3000 3500 4000-10,000

1. Calculate NPV if your required return is 12%. Should this machine be purchased?

ZULFIQAR HASAN 25

Practice 02

Suppose the expected cash flows for projects L and S are as follows:

Year Project L Project S0 -$100 -$1001 $10 $702 $60 $453 $80 $20

1. At a discount rate of 10%, what is the NPV for Project L or S?

2. Which project should be accepted if they are Independent?

3. Which project should be accepted if they are mutually exclusive?

ZULFIQAR HASAN 26

Practice 03

Suppose the expected cash flows for projects L and S are as follows:

Year Soap Shampoo0 -$1000 -$10001 $110 $1702 $250 $1353 -$480 -$4654 $170 $305

At a discount rate of 12%, 13% and 15% what is the NPV Project L and Project S?

ZULFIQAR HASAN 27

NPV Strengths and Weaknesses

Strengths:1. Cash flows assumed to be reinvested at the

hurdle rate.2. Accounts for TVM.3. Considers all cash flows.

Strengths:1. Cash flows assumed to be reinvested at the

hurdle rate.2. Accounts for TVM.3. Considers all cash flows.

Weaknesses:1. May not include managerial options

embedded in the project.

ZULFIQAR HASAN 28

Practice 04

• You are financial analyst for Damon electronics Company. The director of capital budgeting has asked you to analyze two proposed capital investments, Projects X and Y. Each project has a cost of $10000, and the required rate of return for each project is 12%. The projects’ expected net cash flows are as follows:

• Calculate PBP and NPV.

• Which project or projects Should be accepted if they are independent?

• Which project should be accepte4d if they are mutually exclusive?

Expected Net Cash Flows

Year Project X Project Y

0 $(10,000) $(10,000)

1 6500 3500

2 3000 3500

3 3000 3500

4 1000 3500

ZULFIQAR HASAN 29

Profitability Index (PI)

–PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow.–The profitability index is the same as the NPV, except that we divide the PVCF by the initial outlay

<< OR >>

CF1 CF2 CFn (1+i)1 (1+i)2 (1+i)n

+ . . . ++ CFCF00PI =

CF

NPV 1 PI

0

ZULFIQAR HASAN 30

PI Decision Rule

1. For independent projects, if PI > 1.0, then accept the project; otherwise reject it.

2. For mutually exclusive projects, accept the project with the highest PI. However, the PI ignores the scale of investment. Therefore, like the IRR, use of the PI can still lead to conflicts when ranking investments.

ZULFIQAR HASAN 31

Example 03: Profitability Index

Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outflow (investment) will be $40,000. Calculate Profitability index (@ 13%).

PI for the Basket Wonders: PI for the Basket Wonders:

PIPI = $38,572 / $40,000 =0 .9643

Should this project be accepted?No! The PI is less than 1.00. This means that the project

is not profitable. [Reject as PI < 1.00 ]

Should this project be accepted?No! The PI is less than 1.00. This means that the project

is not profitable. [Reject as PI < 1.00 ]

ZULFIQAR HASAN 32

Practice 05

Suppose the expected cash flows for projects L and S are as follows:

Year Project L Project S

0 -$100 -$100

1 $10 $70

2 $60 $45

3 $80 $20

At a discount rate of 10%, what is the profitability index for Project L and S?

ZULFIQAR HASAN 33

PI Strengths and Weaknesses

Strengths• Same as NPV• Allows comparison of different scale projects

Strengths• Same as NPV• Allows comparison of different scale projects

Weaknesses1.Same as NPV2.Provides only relative profitability3.Potential Ranking Problems

ZULFIQAR HASAN 34

IRR Acceptance Criterion

• No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR < Hurdle Rate ]

The Internal Rate of Return (IRR) of a Capital Budgeting project is the discount rate at which the Net Present Value (NPV) of a project equals zero. The IRR decision rule specifies that all independent projects with an IRR greater than the cost of capital should be accepted. When choosing among mutually exclusive projects, the project with the highest IRR should be selected (as long as the IRR is greater than the cost of capital).

The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type.

Should this project be accepted?

ZULFIQAR HASAN 35

IRR Strengths and Weaknesses

StrengthsStrengths 1. Accounts for TVM2. Considers all Cash flows3. Less subjectivity

StrengthsStrengths 1. Accounts for TVM2. Considers all Cash flows3. Less subjectivity

WeaknessesWeaknesses1. Assumes all cash flows reinvested at the IRR

2. Difficulties with project rankings and Multiple IRRs

ZULFIQAR HASAN 36

Importance & Limitations of capital Budgeting

Importance• Profit earning capacity• Acceptance of long term

proposal• Steps of reducing risk• Effect of Cost structure• Advanced plan for Fund

collection• Competitions• Exchangeability• Legibility of fixed assets

Limitations• Lack of sufficient information• Reliability of information• Problem of measuring future

uncertainty• Problem of selecting different

time• Problem of quantitative

measurement