Capital Budgeting Techniques

Md. Nehal Ahmed,

Professor, BIBM

Capital Budgeting Techniques

 Capital Budgeting is the process of planning expenditures on assets whose cash flows
are expected to extend beyond one year.

 Capital budgeting refers to the investment decision involving fixed asset of a firm.

 The term capital refers to the fixed assets used in production and budget is a plan that
details projected inflows and outflows during some future periods.

 Thus capital budget in an outline of planned expenditures on fixed assets and capital
budgeting is the process of analyzing projects and deciding which are acceptable
projects.

Steps Involved in Capital Budgeting

(1) Determine the cost, or purchase price, of the asset.

(2) Estimate the cash flows expected from the asset.
(3) Evaluate the risking of the projected cash flows to determine the appropriate rate of
return to use for the present value of the estimated cash flows.
(4) Compute the PV of the expected cash flows.
(5) Compare the present value of the expected cash inflows with initial investment, or
cost, regard to acquire the asset.
 If a firm invests in a project with a present value greater than its cost, the value
of the firm will increase.
 The more effective the firm’s capital budgeting procedures, the higher the
price of its stock.

Time Value of Money

Time value of money refers to the fact that money received soon is worth more than money
expected in the distant future, because the sooner money is received, the sooner it can be
invested to earn a positive return. The trade-off between money now and money later thus
depends on, among other things, the rate that can earn by investing.

Future Value: The amount an investment is worth after one or more periods.
Compounding: The process of accumulating interest on an investment over time to
earn more interest.
Present value: The current value of future cash flows discounted at the appropriate
discount rate.
Discount: Calculate the present value of some future amount.

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Example: Future Value

Suppose you deposited Tk. 100 in a savings account that pays 10% interest per year. How
much would you have at the end of one year?

FV  100  10  100  100  10%  100 1  10%  PV1  i 

If the total amount after one year is deposited for another year with same interest rate then

FV  PV1  i   110  1.1  100  1.1  1.1  100  (1.1  1.1)  100  (1.1) 2  PV(1  i) 2

So future value of the investment for n periods at a rate i percent per period is
FV  PV1  i 
n

The expression (1 + i)n is sometimes called future value interest factor for Tk.1 invested at i
percent for t periods and can be expressed as FVIF(i, n).

Problem: PV = Tk 1000; i = 8%; n = 10 years; FV = ?

Answer: FV10 = 1000 (1 + 0.08)10 = 10002.15892 = Tk. 2158.92

Example: Present Value

The present value of a cash flow due n years if it were on hand today, would grow to equal
the future amount. Finding PV is called discounting. It is simply the reverse of compounding.
FV
PV 
1  i n
the term [1/(1 + i)n] is often called discount factor or present value interest factor for Tk.1
invested at i percent for t periods and can be expressed as PVIF(i, n).

Problem: What is the present value of Tk. 2158.90 be paid at the end of year 10, if i = 8% p.a.

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Answer: PV  2858 .92   2158 .92  0.4632  Tk.1000 .00
1  0.08 10

Capital Budgeting Evaluation Techniques

The basic methods we will discuss are:

(1) Payback period (PBP)
(2) Discounted Payback period (DPBP)
(3) Net Present Value (NPV)
(4) Benefit Cost Ratio (BCR)
(5) Internal Rate of Return (IRR).

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Payback Period (PBP)

 Payback period is defined as the length of time or expected member of years required
to recover the original investment.
 To compute a projects pay back period, simply add up the expected each flows for
each year until the commutative value is equal to the total amount initially invested.

Example:

Cash flows for projects A and B are as follows. Calculate the payback period for projects A
and B
Year Expected cash flows (CFs)
Project A Project B
0 Tk. (3,000) Tk. (3,000)
1 1,500 400
2 1,200 900
3 800 1,300
4 300 1,500
Project A:

Year 0 1 2 3 4
Net cash flow -3,000 1,500 1,200 800 300
Cumulative net cash flow -3,000 -1,500 -300 500 800

Project B:

Year 0 1 2 3 4
Net cash flow -3,000 400 900 1,300 1,500
Cumulative net cash flow -3,000 -2,600 -1,700 -400 1,100

The exact period can be found using the following formula:

 Years before full re cov ery   Unre cov ered cos t at start of full re cov ery year 
Payback      
 of original investment   Total cash flow during full re cov ery year 

300
For Pr oject A, Payback  2   2.4 years
800
400
For Pr oject B, Payback  3   3.27 years
1500

In general, a project is considered to be acceptable if its payback is less than the maximum
cost recovery time established by the farm. For example if the firm requires projects to have a
payback of three years or less, Project A would be acceptable but Project B would note.

The payback method is very simple but ignores the time value of money. The cash flows
beyond the payback period are also ignored. A project may have greater cash flow in later
years, which would make it more preferable.

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Discounted Payback Period (DPBP)

The discounted payback period is the length of time until the sum of discounted cash flows is
equal to the initial investment. Based on the discounted payback rule, an investment is
acceptable if its discounted payback is less than some pre-specified number of years.

Example:

Calculate the discounted payback period for projects A with discount rate 10%

Year 0 1 2 3 4
Cash Flow -3,000 1,500 1,200 800 300
Discounted Cash Flow -3,000 1363.64 991.74 601.05 204.90
Cumulative net cash flow -3,000 -1636.36 -644.62 -43.57 161.33

43.57
For Pr oject A, Discounted Payback  3   3.2 years
204 .90

Discounted payback is better than the ordinary payback because it considers time value. The
ordinary payback does not take this into account. But discounted payback period rule has a
couple of other significant drawbacks. The biggest one is that the cutoff still has to be
arbitrary and cash flows beyond that point are ignored.

Net Present Value (NPV)

Net present value (NPV) is a measure of how much value is created or added today by
undertaking an investment. Given our goal of creating value for the shareholders, the capital
budgeting process can be viewed as a search for investments with positive net present values.

NPV relies on discounted cash flow (DCF) techniques, which is the process of valuing an
investment by discounting its future cash flows. NPV is computed using the following
equation:

n
CF1 CF2 CFn CFt
NPV       I0    I0
1  k  1
1  k 2
1  k n
t 1 1  k t
I0 = Initial Investment
CFt = Expected net cash flow at period t
k= Rate of return required by the firm (generally the firm’s cost of capital ) to invest in
the project
n= The projects duration in years

An NPV of zero signifies that the project’s cash flow are just sufficient to repay the
investment capital and to provided the required rate of return on that capital, which is k.

If a project has a positive NPV, then it generates a return that is greater than is needed to pay
for the funds provided by investors. Therefore the firm’s value will be improved.

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Example:

Considering project A when k = 10%

0 K = 10% 1 2 3 4

(3,000) 1,500 1,200 800 300

Cash flow 1,363.64
991.74
601.05
204.90
NPVA = Tk. 161.33

Using the formula:

1,500 1,200 800 300
NPVA      3000  Tk.161 .33
1.1
1
1.1 2
1.1
3
1.14

Similarly, project B’s NPVB = Tk. 108.67

Decision Criteria

If NPV >0, the project should be accepted.

If NPV <0, the project should be rejected.
If NPV = 0, the firm would be indifferent to the project.
NPV >0, if DCF > CFo.

Benefit Cost Ratio (BCR)

Another tool used to evaluate projects is called the profitability index (PI) or benefit cost
ratio. This index is defined as the present value of the future cash flows divided by the initial
investment. More generally, if a project has a positive NPV, then the present value of the
future cash flows must be bigger than the initial investment. The profitability index would
thus be greater than 1 for positive NPV investment and less than 1 for a negative NPV
investment.
PV of Cash Inflow
PI 
Initial Investment

For example project A costs Tk.3000 and the present value of its future cash flows is
3166.33, the profitability index value would be 3166.33/3000 = 1.06

Profitability index measures the value created for per taka invested. In our example, PI is
1.06. This tells us that, investing Tk.1 the value created is Tk.1.06

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Internal Rate of Return (IRR)

The internal rate of return (IRR) is defined as the discount rate that equates the present value
of the initial investment outlays to the present value of the future cash inflows. In other
words, IRR is the discount rate that equates the NPV of an investment opportunity with zero.
IRR is calculated as follows.
CF1 CF2 CF3 CFn
      Initial Investment (I 0 )
1  IRR  1  IRR  1  IRR 
2 3
1  IRR n
n
CFt
  I0  0
t 1 1  IRR t
IRR from the above mentioned formula requires a “trial and error” solution for investment
projects whose cash flows are received over a period of years. The computational procedure
is as follows
 Given the cash flow and investment outlay, choose a discount rate at random and
calculate the project’s NPV.
 If the NPV is positive, choose a higher discount rate and repeat the procedure.
 If the NPV is negative, choose a lower discount rate and repeat the procedure.
 Find the discount rate, which makes the NPV = 0 is the IRR.

Example: Calculation of IRR for a Hypothetical Project

When discount rate is 10%

Year Net Cash Flow Discount Factor PV of Cash Flow
1 452 0.909 411
2 500 0.826 413
3 278 0.751 209
PV of Cash Inflow 1033
Less: Initial Investment - 1000
NPV + 33

When discount rate is 14%

Year Net Cash Flow Discount Factor PV of Cash Flow
1 452 0.877 396
2 500 0.769 385
3 278 0.675 188
PV of Cash Inflow 969
Less: Initial Investment - 1000
NPV - 31

When discount rate is 12%

Year Net Cash Flow Discount Factor PV of Cash Flow
1 452 0.893 403
2 500 0.797 399
3 278 0.712 198
PV of Cash Inflow 1000
Less: Initial Investment - 1000
NPV 0

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The above trail and error method can easily solved by using the following method

 Choose a discount rate at random which makes the NPV of the project positive. This
discount rate is known as lower discount rate (LDR).

 Choose a higher discount rate (HDR), which makes the NPV negative.

 Solve the following equation

 HDR  LDR 
NPV @ LDR
IRR  LDR 
NPV @ LDR  NPV @ HDR 
For the above example,

LDR = 10%, HDR = 14%, NPV @ 10% = + 33, NPV @ 14% = - 31

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IRR  10%   (14%  10%)  12%
(33  31)

Decision Criteria for IRR

 If IRR > Cost of Capital (k), accept the project.

 If IRR < Cost of Capital (k), reject the project.
 If IRR = Cost of Capital (k), the firm would be indifferent to the project.

For a project to be acceptable, the IRR must exceed or at least equal to the firm’s cost of
capital or opportunity cost.

Modified Internal Rate of Return (MIRR)

The IRR assumes that a project’s annual cash flows can be reinvested at the project’s internal
rate of return, which should be the project’s cost of capital. MIRR is the discount rate at
which the present value of a project’s cost is equal to the sum of the present value of its
future cash inflow, where the cash inflows are reinvested at the firm’s cost of capital. So
MIRR is more accurate measure for calculating the firms return.

Problems of Internal Rate of Return (IRR)

 Difficult to calculate - Trial and Error method

 Non-conventional cash flow – A double change in the sign of the cash flow gives two
solution for IRR, which is known as multiple IRR problem.
 Differences in the scale of investment - IRR ignores the size of the investment
because the result of the IRR method is expressed as a percentage.
 The IRR assumes that a project’s annual cash flows can be reinvested at the project’s
internal rate of return, which should be the project’s cost of capital. MIRR is an
alternative to address above-mentioned problem.

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Sensitivity Analysis

The most common method of evaluating projects source of risk is the sensitivity analysis.
The net cash flow from a project depends on many variables, each of which must be
estimated. Suppose we wish to calculate the net cash flow from a project to generate
electricity from industrial waste to replace power currently being purchased from the electric
utility. We must estimate the investment outlay, the amount of waste available for burning,
the costs of operating and maintaining the generating equipment, the amount of electricity
generated, and the probable price of the electricity if we continue to purchase it from the
electric utility rather than generate it.

Sensitivity analysis is a systematic way to determine which of the factors affecting project
cash flow are most important. The basic procedure is to recalculate the NPV using
assumptions that differ from those used to produce the original net cash flow estimates.

Purpose of Sensitivity Analysis

 The purpose of analysis is to assess how “sensitive” the NPV is to changes in

assumptions about the underlying economic factors.
 If a small error proves critical, in the sense that the NPV becomes negative, the
project is considered very risky since small estimation errors are likely to occur.

Example: Sensitivity Analysis of a Hypothetical Project

Description Estimate Description Estimate

(Original) (Original)
Initial Cost Tk.1,000,000 Power Generated / year (KWH) 1,000,000
Estimated Life (Years) 10 Price of Electricity / KWH Tk.0.25
Depreciation / year Tk.100,000 Tax Rate 40%
Operating Costs / year Tk.50,000 Discount Rate 9%

Calculation of Net Cash Flow

Income Statement Amount (Tk.)
Revenue (Electricity Savings) 250,000
Operating Expense 50,000
Depreciation Expense 100,000
Earning Before Tax 100,000
Taxes 40,000
Earning After Tax 60,000
Cash Flow Adjustments
Earning After Tax 60,000
+ Depreciation 100,000
Net Cash Flow 160,000

10
160 ,000
Results : PV of net cash Inflow =  (1.09)
t 1
t
=1,026,825, Cash Outflow = 1,000,000

NPV = 26825; BCR = 1.03; IRR = 9.61%

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The financial manager has to perform a sensitivity analysis by examining how sensitive the
estimated NPV is to an estimation error of 10% in the estimates of the economic factors
affecting the cash flow.

Case-1 Case-2 Case-3

Case-4 Case-5
Present (Operating (Power (Price of the
Description (Tax rate (Project life
Assumption cost generation electricity
increased) decreased)
increased) decreased) decreased)
Operating Cost 50,000 55,000 50,000 50,000 50,000 50,000
Power Generation 1,000,000 1,000,000 900,000 1,000,000 1,000,000 1,000,000
Price of Electricity 0.25 0.25 0.25 0.225 0.25 0.25
Tax Rate 40% 40% 40% 40% 44% 40%
Project Life 10 10 10 10 10 9
NPV 26,825 7,572 -69,440 -69,440 1,155 -14,115
BCR 1.03 1.01 0.93 0.93 1.00 0.99
IRR 9.61% 9.17% 7.40% 7.40% 9.03% 8.65%
Decision Accept Accept Reject Reject Accept Reject

Sensitivity Analysis of the Project Assuming Different Estimation Error

Estimation Error Power Generation Operating Cost Tax Rate

-20% -165,704 65,331 78,166
-15% -117,572 55,075 65,331
-10% -69,440 46,078 52,496
-5% -21,307 36,452 39,661
0% 26,825 26,825 26,825
5% 74,958 17,199 13,990
10% 123,090 7,572 1,155
15% 171,223 -2,054 -11,681
20% 219,355 -11,681 -24,516

From the above data it is found that the major sources of risk in this project are uncertainties
in the future price of electricity, volume of power generated and life of the project. NPV is
most sensitive to errors in the forecasts of the volume of power generated, and the price of
electricity. At this point sensitivity analysis has made its contribution. Fluctuation in volume
of power generated is not very risky factor as the plant manager would be more efficient in
his assignment. Sensitivity analysis is a flexible method that provides useful information, but
it does not tell what decision should be made.

Reference:

 Capital Investment & Financial Decisions – Haim Levy & Marshall Sarnat
 Fundamental of Corporate Finance – Stephen A. Ross, Random W. Westerfield &
Bradford D. Jordan

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Exercise: Capital Budgeting Techniques: PBP, NPV, BCR and IRR

Problem 1:

Millat industry is in the process of choosing the better of two equal risk, mutually exclusive,
capital expenditure projects- M and N. The relevant cash flows for each project are shown in
the following table. The firm's cost of capital is 14%.

Project M Project N
Initial Investment Tk. 28,500 Tk. 27,000
Year Cash flows
1 Tk. 10,000 Tk. 11,000
2 Tk. 10,000 Tk. 10,000
3 Tk. 10,000 Tk. 9,000
4 Tk. 10,000 Tk. 8,000

a. Calculate each project’s payback period and discounted payback period.

b. Calculate the net present value for each project.
c. Calculate the benefit cost ratio for each project.
d. Calculate the internal rate of return for each project.
e. Summarize the preferences dictated by each measure calculated above, and
indicate which project you would recommend. Explain why?

Problem 2:

The Khaleque group is contemplating the purchase of a new milling machine. The machine
will cost Tk.6,00,000. The machine is expected to generate earnings before depreciation and
taxes of Tk.2,00,000 each year over its 5-year economic life. Mr. Khaleque is aware that the
tax law will most probably be changed before acquisition of the new machine. Proposed
changes would necessitate using five-year straight-line depreciation rather than the three-year
MACRS schedule. Khaleque's tax rates would increase to 40% instead of current 34%.
Khaleque's cost of capital is 12%.

Compute the NPV and IRR of the new machine under existing depreciation and tax
laws.

Problem 3:

A machine purchased six years ago for Tk.1,50,000 has been depreciated to a book value of
Tk. 90,000. It originally had a life of 15 years and zero salvage value. A new machine will
cost Tk.2,50,000 and result in an operating cost of Tk.30,000 per year for the next nine years.
The older machine could be sold for Tk.50,000. The cost of capital is 10%. The new machine
will be depreciated on a straight-line basis over 9-year life with Tk.25,000 salvage value. The
company's tax rate is 55%. Determine whether the old machine should be replaced.

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