Financial Management

Capital Budgeting

This topic introduces you to the practice of capital budgeting which was briefly introduced in
your previous finance core subject. In Topic 1 we saw that increasing the value of the company’s
shares is the goal of the finance manager. This topic will introduce you to the techniques that tell
you whether a particular investment will achieve that goal or not. This topic reviews a variety of
techniques along with the Net present value (NPV) rule for capital budgeting. Other methods to
assess investments such as the payback period, the book or accounting rate of return and the
internal rate of return (IRR) are discussed. These methods have a number of shortcomings and
therefore, the NPV method comes out on top. It is shown that NPV is the most appropriate
method, so long as the objective is to maximize value. Discounted payback and modified IRR
methods are also discussed briefly. The discussion ends with an overview of capital rationing
and the profitability index (PI).

Payback Period
This part describes the payback and discounted payback rules. A widely used technique is the
payback on a proposed investment, which is the length of time it takes to recover the initial cash
cost of an investment, often called the payback period. The payback period rule is that an
investment is acceptable if its calculated payback period is less than the specified cut-off period.
The payback period calculation is easy, but it also has the shortcoming that the time value of
money is completely ignored. The arbitrary nature of the cut off period is a problem, as it is
ignoring the cash flows after payback. These problems can lead to ‘wrong’ investment decisions;
namely, rejecting projects that are value increasing in the longer term, or accepting projects that
are value decreasing in the longer term. The payback period method does not always promote
value maximization.

You are considering three independent projects A, B, and C. Given the following cash flow
information, calculate the payback period for each project:

Year Project A Project B Project C

0 -$900 -$9,000 -$7,000
1 600 5,000 2,000
2 300 3,000 2,000
3 200 3,000 2,000
4 100 3,000 2,000
5 500 3,000 2,000
Discounted Payback Period
The length of time until the accumulated discounted cash flows from the investment equal or
exceed the original cost. We will assume that cash flows are generated continuously during a
period. An investment is accepted if its calculated discounted payback period is less than or
equal to some pre-specified number of years.
Example: Consider the previous investment project analyzed with the NPV rule. The initial
cost is Rs600 million. The discounted payback period is 3 years. The appropriate discount rate
for these cash flows is 20%. Using the discounted payback rule, should the firm invest in the
new product?

Discounted
Accumulated
Year Cash Flow Present Value
Cash Flow
Factor

1 Rs200.00 0-833 167

2 Rs220.00 0.694 320

3 Rs225.00 0.578 450

4 Rs210.00 0.482 551

Net Present Value

The net present value (NPV) of an investment project is the present value of the cash inflows less
the present value of the cash outflows. By assigning negative values to cash outflows, it
becomes:

C1 C2 C3
NPV = −C 0 + + + + . .. .. . .. .. . .. .. .. . .. .
(1+r) (1+r ) 2
(1+r )3

Where Co = the initial cash outlay or investment amount

Ci = the cash flow in time period i
 r = the required rate of return / appropriate discount rate / cost of capital
1. The relevant criteria are:
o accept if NPV > 0
o reject if NPV < 0

The merits of this approach are that it takes the time value of money into consideration, it deals
with cash flows and not book returns, it is consistent with the goal of wealth maximization and it
emphasizes the importance of the value-added property.

Calculation of NPVs for XYZ Company’s Capital Expenditure Alternatives

Project A Project B
0 (Rs.42,000) (Rs.45,000)
1 Rs.14,000 Rs.28,000
2 Rs.14,000 Rs.12000
3 Rs.14,000 Rs.10,000
4 Rs.14,000 Rs.10000
5 Rs.14,000 Rs.10,000
If the cost of capital is 10%
NPV=PV of cash inflow – PV of cash outflow
For Project A:
NPV= 14000 [{1-(1+0.1)^-5} / (0.1)] -42000 = 11071
For Project B:
NPV =
{(28000/1.1)+(12000/1.1^2)+(10000/1.1^3)+(10000/1.1^4)+(10000/1.1^5)} – 45000 = 10924

Internal Rate of Return

The IRR method is a discounted cash flow method. It considers the time value of money.
Calculating the IRR is similar to calculating the yield to maturity on a bond. The IRR rule can
give the correct accept-reject signal if used carefully. IRR is defined as the discount rate that
makes NPV equal to zero.
The IRR may be regarded as the rate of return or implicit interest rate that is earned or generated
by a project. Mathematically, it is the discount rate that equates the present value of the project's
future net cash flows with the project's initial outlay. Thus, the IRR can be represented in the
equation below:
 C1 C2 C3 Ct
NPV = C0 + + + + . . .. .. .. . .. .. . .. .. . .. =0
(1+IRR ) (1+ IRR )2 (1+IRR )3 (1+IRR)t

The acceptance-rejection criteria are:

 accept if IRR > required rate of return
 reject if IRR < required rate of return

The required rate of return is often taken to be the firm's cost of capital.
There are three ways to calculate the IRR: 1) graphical method, 2) trial and error method, and 3)
using financial calculators. You accept a project if IRR > opportunity cost of capital. All
methods for finding the IRR can be time-consuming; however, financial calculators can be used
to make it less time consuming. The merits of this method are similar to the NPV method.
IRR= [P+ {(N-P) x p/p-n}]
P= Positive % of NPV
N= Negative % of NPV
p= positive amount of npv
n= negative amount of npv

Profitability Index
Simple capital rationing problems can be solved by trial and error or by ranking projects using
the PI
PI = Net present Value/investment
The PI can be used to rank competing projects and thus, facilitate a choice of value adding
projects subject to the capital budget.
The textbook distinguishes between “soft” and “hard” rationing and discusses whether value
maximization remains the appropriate objective if hard rationing is encountered. Linear
programming methods are useful in solving multi-period capital constraints.
The application of capital budgeting includes:

1. Capital Expenditure Planning: Capital budgeting helps businesses in planning and allocating
capital expenditure on long-termprojects such as plant and machinery, research and
development, and real estate. It helps them to identify the most profitable and viable projects that
can provide the maximum returns on investment.

2. Project Evaluation: Capital budgeting helps businesses to evaluate the feasibility ofprojects
such as purchasing new equipment, construction of new facilities, and investment in new
projects. The planning process involves identifying potential projects, evaluating their viability,
estimating their costs and benefits, and selecting the most profitable project to invest in.

2. Investment Decision Making: Capital budgeting helps businesses in making informed

investment decisions by evaluating potential projects and their expected returns. This involves
analyzing the project's cash flows, payback period, net present value, and internal rate of return.

3. Risk Management: Capital budgeting helps businesses in evaluating and managing risks
associated with long-term projects. By analyzing the potential risks and uncertainties involved in
a project, businesses can make informed decisions regarding the expected return on investment
and the level of risk associated with the project.

4. Resource Allocation: Capital budgeting helps businesses in allocating resources effectively

by identifying and prioritizing projects with the highest expected returns. It helps businesses to
allocate resources efficiently and effectively.

5. Performance Evaluation: Capital budgeting helps businesses in evaluating the performance

of their investment decisions by comparing actual results with the estimated results. It provides
feedback that can help managers make better investment decisions in the future.