Chapter 2-Capital Budgeting

Capital budgeting describes the process which companies use to make decisions on capital projects
i.e. projects with a lifespan of one year or more. It is a cost-benefit exercise which seeks to produce
end results and benefits which are greater than the costs of the capital budgeting efforts.

There are several steps involved in the capital budgeting process. The specificity of the procedures
adopted by a manager is, however, dependent on factors such as the manager’s level in the company,
the size and complexity of the particular project being evaluated, and the size of the company.

Capital Budgeting Process

The typical steps involved in the capital budgeting process are:

Step 1: Generate ideas – Generating good ideas is the most important step.

Step 2: Analyze individual proposals – Information is gathered which helps to forecast cash flows
for each project and then evaluate the project’s profitability.

Step 3: Plan the capital budget – This step involves looking at project timing, scheduling,
prioritizing, and coordinating.

Step 4: Monitor and post-audit – How the project is performing is assessed and actual results
(revenues, expenses, cash flows etc.) are compared with planned or projected results.

Categories of Capital Projects

Capital budgeting projects may be classified in a number of ways. One common classification is as
follows:

 Replacement projects – Sometimes capital budgeting decision involves replacing broken

down, worn out or older equipment with newer, more efficient equipment.
 Expansion projects – These increase the size of a company’s business activities, and
ultimately the size of the company.
 New products and services – capital budgeting projects which aim to increase a company’s
product and service offerings carry more uncertainty than expansion projects.
 Regulatory, safety, and environmental projects – These are usually undertaken due to a
requirement by a governmental agency, insurance company or some other external party. Oftentimes
they do not generate any revenue for the company, and it may actually be more prudent to shut down
that part of the business that is related to the project.
 Other – These projects tend to not be subject to the usual capital budgeting analysis, and
include, for example, pet projects of the company’s CEO.
 Basic Principles of Capital Budgeting

Since capital budgeting describes the process by which all companies make decisions on their capital
projects, it is not unusual for some fairly sophisticated techniques to be employed. Regardless of this,
capital budgeting relies heavily on just a few basic principles.

Principles of Capital Budgeting

Capital budgeting typically adopts the following principles:

 Decisions are based on cash flows and not on accounting concepts such as net income
 The timing of cash flows is critical
 Cash flows are based on opportunity costs. A comparison is made between the incremental
cash flows that occur with an investment and without the investment.
 Cash flows are analyzed on an after-tax basis. Taxes have to be fully reflected in capital
budgeting decisions.
 The financing costs are ignored. Financing costs are already reflected in the required rate of
return and therefore including them again in the cash flows and in the discount rate would lead to
double counting.
 The capital budgeting cash flows are not the same as accounting net income.

Capital Budgeting Concepts

In addition to the basic capital budgeting principles outlined above, there are several concepts which
capital managers should be aware of in the capital budgeting process. These include:

 Sunk costs – These are costs which have already been incurred.
 Opportunity cost – This refers to what a resource is worth if it is put to its next-best use.
 Incremental cash flow – This is the cash flow which is realized because of a decision.
 Externality – This refers to the effect of an investment on other things besides the investment
itself. If possible, these should be part of the investment decision. Cannibalization is one example of
an externality. This occurs when an investment results in customers and sales moving away from
another part of a company.(Impact of investment in sales of any other product or part of the business)
 Conventional cash flows versus nonconventional cash flows – A conventional cash flow
pattern is one which has an initial cash outflow followed by a series of cash inflows. Conversely, a
nonconventional cash flow pattern is one in which the initial cash outflow is not followed by cash
inflows only, but the cash flows can flip from positive to negative again (or even change signs
several times).

Mutually Exclusive Projects

Mutually exclusive projects are capital projects which compete directly with each other. For
example, if a manager has a choice to make between undertaking projects X and Y, and must choose
either of the two and not both, then projects X and Y are said to be mutually exclusive. This scenario
differs from independent projects which are those projects whose cash flows are independent of each
other and can, therefore, be undertaken together.

Project Sequencing
The purpose of project sequencing is to arrange projects in a logical order for completion. It enables
a project manager to determine the order of project completion which best manages the time and
resources that are available.

Through project sequencing, investing in one project may create the option to invest in future
projects. For example, a manager may invest in one project today and then invest in another project
in a year’s time if the financial results of the first project or new economic conditions are favorable.

Capital Rationing
Capital rationing is the act of placing restrictions on the amount of new investments or projects
that a company can undertake. It may occur either through the imposition of a higher cost
of capital for investment consideration or by the establishment of a ceiling on specific portions of a
budget.

Capital rationing is more frequent whenever a company has a fixed amount of funds available
to invest. If however the company has more profitable projects than it has funds available for,
then it will be forced to allocate these scarce funds in a manner which achieves maximum
shareholder value subject to the funding constraints.

The opposite of capital rationing occurs whenever unlimited funds are available to a company. In this
situation, a company can raise the required funds for all profitable projects simply by paying the
required rate of return.

Measures of profitability
Several important decision criteria are used to evaluate capital investments. The two most
comprehensive and well-understood measures of whether or not a project is profitable are the net
present value (NPV) and internal rate of return (IRR) measures. Other measures include the payback
period, discounted payback period, average accounting rate of return (AAR), and the profitability
index (PI)

Net Present Value (NPV)

The Net Present Value (NPV) of a project is the potential change in wealth resulting from the project
after accounting for the time value of money.  The NPV for a project with one investment outlay
made at the start of the project is defined as the present value of the future after-tax cash flows minus
the investment outlay.
Where:

CFt = after-tax cash flow at time t

r = required rate of return for the investment

Outlay = investment cash flow at time zero

Many projects have cash flow patterns in which outflows occur not only at the start of the project (at
time = 0) but also at future dates. In these instances, a better formula to use is:

The decision rule for the NPV is: Invest in the project if NPV > 0; do not invest in the project if NPV
< 0; and stay indifferent if NPV = 0.

In other words, positive NPV investments are wealth increasing, while negative NPV investments are
wealth decreasing.

NPV Example
Example 1

Suppose Company A is considering an investment of $100 million in a capital expansion project that
will return after-tax cash flows of $20 million per year for the first 3 years and another $33 million in
year 4, the final year of the project. If the required rate of return for the project is 8%, what would the
NPV be and should company undertake this project?

NPV = 18.519 + 17.147 + 15.877 + 24.256 – 100 = -$24.201 million

Since the NPV < 0, the project should not be undertaken.

Example 2

Gerhardt Corporation is considering an investment of $50 million in a capital project that will
return after-tax cash flows of $16 million per year for the next four years plus another $20
million in year five. The required rate of return is 10 percent.

Solution

EXAMPLE-Z Ltd. has two projects under consideration A & B; each costing$ 6 million .The
projects are mutually exclusive. Life for project A is 4 years & project B is 3 years. Tax Rate
33.99%. Cost of Capital is 15%.Calculate NPV

EBITD ( 00000)

At the end of the year Project A Project B P.V. @ 1 5%

1 60 100 0.870

2 110 130 0.756

3 120 50 0.685

4 50 — 0.572

Solution :
Computation of Net Present V alue of the Projects.

Project A

Yr1 Yr. 2 Yr. 3 Yr. 4

1. Net Cash Inflow 60.00 110.00 120.00 50.00

2. Depreciation 15.00 15.00 15.00 15.00

3. PBT (1–2) 45.00 95.00 105.00 35.00

4. Tax @ 33.99% 15.30 32.29 35.70 11.90

5. PAT (3–4) 29.70 62.71 69.30 23.10

6. Net Cash Flow 44.70 77.71 84.30 38.10

(PAT+Deprn)

7. Discounting Factor 0.870 0.756 0.685 0.572

8. P.V. of Net Cash Flows 3 8.89 58.75 57.75 21.79

9. Total P.V. of Net Cash Flo w = 177.18

10. P.V. of Cash outflow (Initial Investment) = 60.00

Net Present Value = 117.18

Project B

Yr. 1 Yr. 2 Yr. 3

1. Net Cash Inflow 1 00.00 130.00 50.00

2. Depreciation 20.00 20.00 20.00

3. PBT (1–2) 80.0 110.00 30.00

4. Tax @ 33.99% 27.19 37.39 10.20

5. PAT (3–4) 52.81 72.61 19.80

6. Next Cash Flow 72.81 92.61 39.80

(PAT+Dep.)

7. Discounting Factor 0.870 0.756 0.685

8. P.V. of Next Cash Flows 63.345 70.013 27.263

9. Total P.V. of Cash Inflows = 160.621

10. P.V. of Cash Outflows = 60.00

(Initial Investment)

Net Present Value = 100.621

As Project “A” has a higher Net Present Value, it has to be taken up.

Internal Rate of Return

The internal rate of return (IRR) is the discount rate which makes the net present value (NPV) of all
cash flows from a particular project equal to zero. For a project with one initial outlay, the IRR is the
discount rate which makes the present value of the future after-tax cash flows equal to the investment
outlay.

The IRR solves the equation –

It looks very much like the NPV equation except that the discount rate is the IRR instead of r, the
required rate of return. Discounted at the IRR, the NPV is equal to zero.

The decision rule for the IRR is to invest in the project if the IRR exceeds the required rate of return
for the project i.e. invest if IRR > r; do not invest if IRR < r.

In instances where the outlays for a project occur at times other than time 0, a more general form of
the IRR equation is:
IRR Example
Following on from the above NPV example, if company A is considering an investment of $100
million in a capital expansion project that will return after-tax cash flows of $20 million per year for
the first 3 years and another $33 million in year 4, the final year of the project, what is the IRR for
this project and should it be undertaken given that the required rate of return for the project is 8%?

Solve for IRR in the following equation –

The solution can be found by trial and error. However, a much simpler approach is to use a financial
calculator or spreadsheet software.

The IRR is computed to be -2.626%. Since -2.626% < 8%, the project should not be undertaken.

Example.

Project Cost $ 1,10,000

Year 1 2 3 4

Inflow 60000 20000 10000 50000

Calculate the Internal Rate of Return.

Year Cash Inflows P.V. @ 10% DCFAT P.V. @ 12% DCFAT

1 60,000 0.909 54,540 0.893 53,580

2 20,000 0.826 16,520 0.797 15,940

3 10,000 0.751 7,510 0.712 7,120

4 50,000 0.683 34,150 0.636 31,800

P.V. of Inflows 1,12,720 1,08,440

Less : Initial Investment 1,10,000 1,10,000

NPV 2,720 (1,560)

Example
We determined, at that time, that for an initial cash outflow of $100,000, the Faversham Fish Farm expected to
generate net cash flows of $34,432, $39,530, $39,359, and $32,219 over the next 4 years. Calculate IRR.
A 15 percent discount rate produces a resulting present value for the project that is greater than the initial cash
outflow of $100,000. Therefore, we need to try a higher discount rate to further handicap the future cash flows and
force their present value down to $100,000. How about a 20 percent discount rate?

Payback Period
The payback period refers to the number of years required to recover the original investment in a
project. It is very simple to compute and explain. It, however, ignores the time value of money and
the risk of a project by not discounting cash flows at the project’s required rate of return. It also
ignores cash flows that occur after the payback period is reached. It may be used as an indicator of a
project’s liquidity but not of its profitability.

Payback Period Example

The table below provides data on the cash flows of a project. How long would the project take to
recover the initial investment (payback period)?

Table 1 Payback Period Example

Year     0     1     2     3     4
Cash flow -5,000  1,500 3,500 4,000 4,000
Cumulative cash -5,000 -3,500     0 4,000 4,000
flow
 

After the first year, 1,500 of the initial investment of 5,000 is recovered, with 3,500 still unrecovered.
In year 2, the project earns 3,500, which means that the initial investment is now fully recovered. The
payback period is therefore 2 years. Payback period ignores the cash flows which occur in years 3
and 4.

(a)When annual cash inflow are equal

Payback period = Original cost of the project (cash outlay)

Annual net cash inflow (net earnings)

Example-. A project cost$1, 00,000 and yields annual cash inflow of$20,000 for 8 years,
calculate payback period

(a) When annual cash inflow s are unequal

It is ascertained by cumulating cash inflows till the time when the cumulative cash
inflows become equal to initial investment.
 Year Cash inflow Cumulative cash inflow

1 2000 2000

2 4000 6000

3 3000 9000

4 2000 11000

The initial investment is recovered between the 3rd and the 4th year.

Pay back period =Y+ B = 3+ 1000 years = 3+ 1 years= 3year 6months

C 2000 2

Example

A project costing $2 million yields annually a profit of 300000 after depreciation @10% (straight line method) but
before tax 50%.

Solution

cash inflow = Profit after tax + Depreciation = 3,00,000 – Tax 1,50,000 + Depre. 2,00,000 = 350000 p.a.
2000000/350000=5.7

Discounted Payback Period

The discounted payback period refers to the number of years for the cumulative discounted cash
flows from a project to equal to the original investment. By factoring in a discount rate, the
discounted payback period is a slight improvement over the payback period. It, however, ignores
cash flows which occur after the discounted payback period is reached.

Discounted Payback Period Example

Following on from the example in Table 1 above, what would be the discounted payback period
assuming a discount rate of 10%?

Year 0 1 2 3 4
Cash flow (CF) -5,000  1,500.00 3,500.00 4,000.00 4,000.00
Cumulative CF -5,000 -3,500.00     0 4,000.00 4,000.00
Discounted CF -5,000  1,363.64 2,892.56 3,005.26 2,732.05
Cumulative -5,000 -3,636.36   -743.80 2,261.46 4,993.51
discounted CF
The discounted payback period is between 2 and 3 years. More precisely, it is two years plus (the
cumulative discounted  CF after 2 years divided by the discounted cash flow in year 3) i.e.  2 +
743.80/3,005.26 = 2.25 years.

Profitability Index (PI)

The profitability index (PI) refers to the present value of a project’s future cash flows divided by the
initial investment.

In the form of an equation, it is –

Whenever the NPV > 0, the PI will be greater than 1.0; conversely, whenever the NPV is negative,
the PI will be less than 1.0.

The decision rule for the PI is; Invest in the project if PI>1.0; do not invest in the project if PI<1.0.

PI Example
If company A has a project with an initial outlay of $100 million and an NPV of -$24.201 million,
the profitability index is computed as:

Since the PI < 1.0, undertaking the project would not be a profitable investment.

Accounting Rate of Return method or Average Rate of Return (A RR)

This method measures the rate in profit expected to result from investment.

It is based on accounting profits and not cash flows.

Example.

A project costing $1,000000. EBITD (Earnings before Depreciation, Interest and Taxes) during
the first five years is expected to be$2,50,000;$3,00,000,$3,50 ,000;$4,00,000 and 5,00,000.
Assume 33.99% tax and 30% depreciation on WDV Method.

YEARS 1 2 3 4 5
TOTAL

EBITD 2,50,0 00 3,00,000 3,50,000 4,00,000 5,00,000 3,60,000

Less : Depreciation 3,00, 000 2,10,000 1,47,000 1,02,900 7 2,030 1,66,386
EBIT (50,0 00) 90,000 2,03,000 2,97,100 4,27,970 1,93,614
Less : Tax @ 33.99% - 13,596 69,000 1,00,984 1,4 5,467 65,809
 Total (50,00 0) 76,404 1,34,000 1,96,116 2,8 2,503 1,27,805

ARR=127805/500000 X100=25.56%

Example

XYZ Company is considering investing in a project that requires an initial investment of

$100,000 for some machinery. There will be net inflows of $20,000 for the first two years,
$10,000 in years three and four, and $30,000 in year five. Finally, the machine has a salvage
value of $25,000.

Step Two: Calculate average investment

Average investment = ($100,000 + $25,000) / 2  = $62,500

Step 3: Divide profit into cost

ARR = 3,000/62,500 = 4.8%