1. Capital Budgeting and its Techniques
Chapter 5
Capital Budgeting and its Techniques

2. The Capital Budgeting Decision Process
Capital Budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth.
Capital expenditure- an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year.
Operating expenditure- An outlay of funds by the firm resulting in benefits received within 1 year.
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3. MOTIVES FOR CAPITAL EXPENDITURE
Capital expenditures are made for many reasons. The basic motive for capital expenditures are to expand, replace or renew fixed assets or to obtain some other less tangible benefit over a long period.
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4. Motives for Capital Expenditures
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5. Steps in the capital budgeting Process
Proposal Generation
Review and Analysis
Decision Making
Implementation
Follow-up
Our Focus
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6. proposal generation: Proposals are made at all levels within a business organization and are reviewed by finance personnel.
Review and Analysis: Formal review and analysis is performed to assess the appropriateness of proposals and evaluate their economic viability.
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7. 3. Decision Making: Firms typically delegate capital expenditure decision making on the basis of funds limits. Generally the board of directors must authorize expenditures beyond a certain limit.
4. Implementation: Following approval, expenditures are made and projects implemented. Expenditures for a large project often occur in phases.
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8. 5. Follow up: Results are monitored, and actual costs and benefits are compared with those that were expected. Action may be required if actual outcomes differ from projected ones.
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9. Basic Terminology: Independent versus Mutually Exclusive Projects
Independent Projects- Projects whose cash flows are unrelated or independent of one another. The acceptance of one does not eliminate the others from further consideration.
Mutually Exclusive Projects- projects that compete with one another, so that the acceptance of one eliminates from further consideration of all other projects that serve a similar function.
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10. Basic Terminology: Unlimited Funds versus Capital Rationing
Unlimited funds- The financial situation in which a firm is able to accept all independent projects that provide an acceptable return.
Capital rationing- The financial situation in which a firm has only a fixed amount available for capital expenditures and numerous projects compete for this resource.
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11. Basic Terminology: Accept-Reject versus Ranking Approaches
The accept-reject approach involves the evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criteria.
The ranking approach involves the ranking of capital expenditures on the basis of some predetermined measure, such as the rate of return.
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12. TECHNIQUES FOR CAPITAL INVESTMENT APPRAISAL
The following are the important techniques used for capital investment appraisal:
Pay back period
Net Present Value
Internal Rate of Return

13. Payback Period
The payback method- The amount of time required for a firm to recover its initial investment in a project.
THE DECISION CRITERIA
If the payback period is less than the maximum acceptable payback period, accept the project.
If the payback period is greater than the maximum acceptable payback period, reject the project.
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14. Pros and Cons of Payback periods
The payback period method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. Its popularity results from its computational simplicity and intuitive appeal. The major weakness of payback period is that the appropriate payback period is merely a subjectively determined number.
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15. Pay back period calculation
AL RASHID company, a software developer, has two investment opportunities, X and Y. Data for X and Y are given in the following table.
Project X
Project Y
Initial investment
10,000
Year
Operating cash
Flows 1
5,000
3,000 2
4,000 3
1,000 4
100 5
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16. Solution: The pay back period for project X is 2 years and for project Y is 3 years. Strictly adhering to Pay back approach suggests that project X is preferable to project Y.
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17. Net Present Value (NPV)
Net Present Value (NPV): NPV is found by subtracting a project’s initial investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital.
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18. (Cfo) = A project’s initial investment (CFt) = Present value of its cash inflows which is discounted at a rate equal to the firm’s cost of capital. (k) = Cost of capital
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19. NPV DECISION CRITERIA
When NPV is used to make accept-reject decisions, the decision criteria are as follows:
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
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20. If NPV is greater than 0, the firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV
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21. INTERNAL RATE OF RETURN (IRR)
The internal rate of return (IRR) is probably the most widely used sophisticated capital budgeting technique. However it is considerably more difficult than NPV to calculate by hand.
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22. Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows.
The IRR is the project’s intrinsic rate of return.
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23. Internal Rate of Return (IRR) (cont.)
When IRR is used to make accept-reject decisions, the decision criteria are as follows:
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
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24. These criteria guarantee that the firm will earn at least its required return. Such an outcome should increase the market value of the firm and therefore the wealth of the owners.
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25. Capital Budgeting Techniques
Chapter Problem
Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 9.1 and depicted on the time lines in Figure 9.1.
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26. Capital Budgeting Techniques (cont.)
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27. Capital Budgeting Techniques (cont.)
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28. Calculation of payback period
Project A-Initial investment-$42000
Year Accumulated
cash inflows
$14000
$ 28000
$ 42000
$ 56000
The year in which accumulated cash inflows is equal to initial investment is year 3.Hence the payback period is 3 years
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29. Calculation of payback period
Project B-Initial investment-$45000
Year Accumulated
cash inflows
$28000
$40000
$ 50000
At the end of year 3, $50000 is recovered. Only 50% of cash flow($10000 )is required to complete the payback of initial investment $ The payback period of Project B is 2.5 years.(2 years + 50% of year 3)
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