CAPITAL BUDGETING
Capital Budgeting: The total process of generating, evaluating, selecting and following up on capital expenditure alternatives.
Capital Expenditure: An outlay made by a firm for a fixed or an intangible asset from which benefits are expected to be received over a period greater than a year.
Independent Projects: Capital expenditure alternatives that compete with each other, but in such a way that the acceptance of one project does not eliminate the other projects from further consideration.
Mutually Exclusive Projects: A group of capital budgeting projects that compete with one another in such a way that the acceptance of one eliminates all other in the group from further consideration.
Capital Rationing: The allocation of limited amount of funds to a group of competing capital budgeting process.
Ranking Approach: Evaluating the relative attractiveness of capital projects on the basis of some predetermined criterion.
Present Value: The value of a future sum or stream of dollars discounted at a specified rate. The process of finding present value is actually the inverse of the compounding process.
Future value: The value of a single sum or an annuity compounded at a given interest rate for a specified time period.
Importance of Capital Budgeting:
1. To achieve longterm goal of firm.
2. Huge Capital Investment.
3. Long Term Investment.
4. Risky Investment.
5. Balancing among liquidity, profitability and value of the firm.
6. Searching for alternative investment opportunities.
7. Ranking of projects and best use of limited capital.
Types of Capital Budgeting Decisions
1. AcceptReject Decision
2. Mutually Exclusive Projects Decision
3. Capital Rationing Decision
Capital Budgeting process:
1. Identification of investment projects
2. Evaluation of alternative investment projects
3. Selection of the best investment projects
4. Implementation of the projects
5. Continuous evaluation of the selected projects.
Application of Capital Budgeting:
1. Purchase of Fixed assets
2. Mechanization of production method
3. Selection from alternative equipments
4. Introduction of new product
5. Expansion of business
6. Modernization and replacement
7. Make or buy decision.
Related Issues in Capital Budgeting:
Prospective Investment proposals
1. Cost of the projects
2. Life of the projects
3. Cash inflows and outflows
4. Salvage value of the projects
5. Discounting rate
6. Techniques of evaluation
Capital Budget Techniques
1. Average/Accounting Rate of Return Methods of Capital Budgeting
Formula 1: Based on original investment
ARR = Net Profit After Tax X 100
Original Investment
Formula 2: Based on Average investment
ARR = Net Profit After Tax X 100
Average Investment
*Average investment
= Original
Investment – Salvage value +
Salvage value
2
2. Pay Back Period Methods of Capital Budgeting
Formula 1: When Annual Cash Flows are uniform
PBP
= Investment
Cash flow after tax
Formula 1: When Annual Cash Flows are uniform
PBP
= A +
NCO  C
D
Where,
A = Year in which the accumulated cash flows are nearer to NCO
NCO
= Net Cash Outlay
C = Accumulated cash outlay of the year ‘A’
D = Cash flow of the succeeding
year of the year ‘A’
FORMULA : IRR
IRR = A + × (BA)
Where, IRR
= Internal Rate of Return
A = Lower Discount Rate.
B = Higher Discount Rate.
C = NPV of Lower Discount Rate.
D = NPV of Higher Discount Rate
Capital
Budget Example (NPV)
ABC co. has two projects for consideration
Year

Cash flows


0
1
2
3
4
5
Salvage value

Project A

Project B

(50,000)
10,000
15,000
12,000
20,000
10,000
5,000

(50,000)
12,000
10,000
15,000
25,000
9,500
2,500

If the tax rate is 40% and the discount rate is 12%,
which of the two projects will be accepted ?
Capital Bedgeting Capital Budgeting
SOLUTION:
Depreciation = = = 9,000.
Year

CFBT

Dep.

EBT

Tax
40%

EAT

CFAT

Factor
12%

PV

1
2
3
4
5
S.V

10,000
15,000
12,000
20,000
10,000
5,000

9,000
9,000
9,000
9,000
9,000


1,000
6,000
3,000
11,000
1,000
5,000

400
2,400
1,200
4,400
400


600
3,600
1,800
6,600
600
5,000

9,600
12,600
10,800
15,600
9,600
5,000

.892
.797
.712
.635
.567
.567

8,563
10,042
7,690
9,906
5,443
2,835









44,479

NPV = PV of NCB – PV of NCO
= 44,479 – 50,000
= (5,521)
Depreciation = = 9,500
Year

CFBT

Dep.

EBT

Tax
40%

EAT

CFAT

Factor
12%

PV

1
2
3
4
5

12,000
10,000
15,000
25,000
9,500

9,500
9,500
9,500
9,500
9,500

2,500
500
5,500
15,500
0

1,000
200
2,200
15,500
0

1,500
300
3,300
9,300
0

11,000
9,800
12,800
18,800
9,500

.892
.797
.712
.635
.567

9,812
7,811
9,101
11,938
5,387









44,049

NPV = PV of NCB – PV of NCO
= 44,049 – 50,000
= (5,951)
Decision: Both
the companies have a negative NPV. So none of them would be considered for
investment.
FORMULA : IRR
IRR = A + × (BA)
Where, IRR
= Internal Rate of Return
A = Lower Discount Rate.
B = Higher Discount Rate.
C = NPV of Lower Discount Rate.
D = NPV of Higher Discount Rate
ILLUSTRATION:
(IRR)
The cost of a 3 year project is estimated as tk.
20,000. The estimated inflows for three years have been estimated as tk. 8,000
per year. If the cost of capital is 7% whether investment in the project is
worthy or not?
Calculation
of IRR
Year

CFAT

Factor 7%

PV

Factor 10%

PV

13
Less : NCO

8,000

2,624

20,992
20,000

2,486

19,888
20,000




992


112

IRR = A + × (BA)
= 7% + (107)%
= 7% + × 3%
= 7% + 2.695%
= 9.695% You can download here full articles