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Financial Management ­ MGT201
VU
Lesson 08
CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES
Learning Objective:
After going through this lecture, you would be able to have an understanding of the following concepts.
·  Capital Budgeting
·
Techniques of Capital Budgeting
Today, we will discuss Capital Budgeting--one of the most important topics in financial
management.
Capital budgeting is about investment in fixed assets. In addition, another type of investment could
be in working capital, which we would study later. Fixed assets are the part of long-term assets in the
balance sheet and working capital is net position of current assets and current liabilities on the balance
sheet.
We need to understand why capital budgeting is so important and why do we have to invest in fixed
assets? The answer is simple; the equipment or machinery and other fixed assets depreciate over a
period, they lose their productivity and get obsolete after sometime. These assets need to be replaced
with new assets. This replacement involves investment in fixed assets.
Moreover, if a company intends to start a new project, Capital Budgeting techniques are employed
to assess the financial viability of the project. Suppose, for instance, a company wants to introduce a
new soap and launching of the new product demands changes in the manufacturing process, the
company will have to purchase new equipment in the form of fixed assets. Capital budgeting is a
technique used to evaluate the value of investment and projects in fixed assets. It is also used to assess
the working capital requirements. Combined together it helps the company management to decide
whether the new venture should be taken up or not.
Capital budgeting is a decentralized function. In big corporations, this function is not an individual's
job, rather, different departments and teams are assigned to work on different aspects of capital
budgeting. Department managers prepare the budget for fixed assets in coming years, which is quite
helpful in capital budgeting. Besides, there are project managers who make the budget for a new project;
the cost accountants `count the cost' and assess the expenses to be incurred; the market researches
provide their input about the consumer psychology and sales potential. There may be as many
departments involved in capital budgeting, as there are present in an organization.
The biggest challenge in capital budgeting is to keep finding the valuable projects, i.e., projects that
may add to the value of the firm. You must be familiar with the basic objective of financial management
by now, which is to maximize shareholders' wealth. This is possible only by investing in the projects,
which have positive net present value, which in effect will increase the shareholders' wealth.
Most of the developed companies operate in an efficient market environment. We will discuss
efficient markets at length after studying the concept of risk akin to financial decisions. However, to
give you an idea, efficient markets can be described as highly competitive markets where good
business ideas are taken up immediately.
For instance, in Pakistan, about ten to fifteen years ago there was a video game craze. It was initially
a good business idea, as it required a very low-level investment, good profit margins, and short payback
periods. However, since the markets in Pakistan are quite efficient, the information about the business
spread quickly. More and more people started entering into the business and as a result, the profit
margins started shrinking and the lucrative business opportunity faded out in three or four years.
The same situation comes across the departmental heads of different companies. They may start a
new lucrative project, which may sound more than feasible at a given time. However, the competitors
get to know the new business opportunity, and because of market efficiency, those lucrative profits do
not remain lucrative anymore.
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Financial Management ­ MGT201
VU
Techniques of capital budgeting:
Capital budgeting is a mathematical concept in the sense that we have to use different
quantitative investments criteria to evaluate whether an opportunity is worth investing in or not.
Some of these techniques of capital budgeting are as under
1. Pay back period
2. Return on investment (ROI)
3. Net Present Value (NPV)
4. Profitability Index (PI)
5. Internal Rate of Return (IRR)
We will assume that the interest rate, or the discount rate, or the required of return, which we use in
calculating the net present value is given, later on, when we will discuss the concept of risk, we would
see how the discount rate is calculated .
For now, let us talk about the pay back period.
Pay back period:
In this technique, we try to figure out how long it would take to recover the invested capital
through positive cash flows of the business.
Reverting back to the cafe example, an initial investment of Rs. 200,000 is required to start the
business; Rs 10,000 per month are expected to be earned for the first year, and Rs 20,000 would be
earned every month in the second year.
Now according to the aforementioned assumptions, in the first year, you earn Rs.10, 000 per
month, which make Rs. 120,000 for the year (twelve months). Since you had invested Rs. 200,000
initially of which Rs. 120,000 have been recovered in the first year, you are still Rs.80, 000 short of
recovering your initial investment. In the second year, you would be earning Rs. 20,000 per month, so
the remaining Rs. 80,000 can be recovered in the next four months. We can say that the initial invested
capital can be recovered in 16 months, or the payback period for this investment is 16 months. The
shorter the payback period of a project, the more an investor would be willing to invest his money in the
project.
While the payback period is a simple and straightforward method for analyzing a capital
budgeting proposal, it has certain limitations. First and the foremost problem is that it does not take into
account the concept of time value of money. The cash flows are considered regardless of the time in
which they are occurring. You must have noticed that we have not used any interest rate while making
calculation.
Now, let us talk about the next budgeting criteria called return on investment.
Return on Investments:
The concept of return on investment loosely defined, as there are a number of ratios that can be
used to analyze return on investment. However, in capital budgeting it implies the annual average cash
flow a business is making as a percentage of investment. In other words, it is an average percentage of
investment recovered in cash every year.
The formula for return on investment is as follows:
ROI= (CF/n)/IO
Dividing the average annual cash flow by the initial investment, we can calculate the return on
investment.
Example:
Taking the same example of a café, the initial investment of Rs.200,000, Rs 10,000 per month
profit in the 1st year in Rs 20,000 per month profit for the second year, we can easily calculate the ROI.
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Financial Management ­ MGT201
VU
ROI= ((120,000+240,000)/2)/200,000= 0.90 = 90%
Where, Rs 120,000=cash flow for 1st year at Rs 10,000 per month
Rs 240,000=cash flow for the 2nd year at Rs 20,000 per month.
n=2 years
Return on Investment is also very easy to calculate, but like payback period, it does not take into
account the time value of money concept.
A high ROI ratio is considered better and 90% is a very good rate of return but before
deciding whether or not this project should be taken up, we should compare this project with the
alternative opportunities on hand. It is also important to take into consideration the prevailing rate of
inflation in the country so that the returns could be adjusted accordingly. However, we would talk about
the inflation rate and market interest rate in more detail later.
The next and the most important criteria for evaluating a capital budgeting proposal is net present value.
Net Present Value (NPV):
NPV is a mathematical tool which uses the discounting process, something that we have found
missing in the aforementioned capital budgeting techniques. Net Present Value is defined as the value
today of the Future Incremental After-tax Net Cash Flows less the initial investment.
The formula for calculating NPV is as follows:
NPV=-IO+CFt/ (1+i)  t
Where,CFt=cash flows occurring in different time periods
-IO= Initial cash outflow
i=discount /interest rate
t=year in which the cash flow takes place
Initial cash outflow, being an outflow, is always expressed as a negative figure.
NPV is considered one of the most popular capital budgeting criteria. The disadvantage with the
NPV is that it is difficult to calculate since these calculations are based on too many estimates.
In order to calculate the NPV we need to forecast the future cash flows and sales; the discount factor is
also an estimate. If the NPV of a project is more than zero, it should be accepted. If two or more projects
under contemplation, then the one with the higher NPV, should be accepted. When a company invests in
projects with positive NPV, they raise the shareholders' wealth or company's value. This would also
increase the market value added and the economic value added for the firm.
Example:
Taking the same example of a café, an initial investment of Rs.200, 000, Rs 10,000 per month
profit in the 1st year in Rs 20,000 per month profit for the second year. However, for the calculation of
the NPV we would be requiring another important input--the discount rate. Assume the discount rate is
10 percent. Ten percent is what you at least expect to earn from the business. This is the rate of return,
which you can get by simply putting your money with a bank. If the business cannot yield more than 10
percent, then it is pointless to take unnecessary headache of setting up a business and running it, since
ten percent can be earned with a no-sweat-effort of placing the money with a bank.
Where,CFt=cash flows occurring in different time periods, i.e., Rs 120,000 in the first year and Rs
240,000 in the second year
-IO= Initial cash outflow = -200,000
i=discount /interest rate = 10 percent
t= 2 years
Putting in the values in the formula
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Financial Management ­ MGT201
VU
NPV=-IO+CF/i
=-200,000+120,000/(1+0.10)+240,000(1+0.10)2
= - 200,000 +
109,091
+
198,347
=+Rs.107438
At the end of 2nd year, the NPV is +ve, you can also solve this example by monthly
compounding if you want to have a more precise answer.
The cash flows at the end of the first year and second year will have to be brought back to the present.
The present value of the cash flows occurring at the end of the first year can be calculated by dividing
the cash flows by 1 plus discount factor as under.
120000/(1+0.10) = 109,091
The cash flow occurring at the end of the second year can be calculated by dividing the cash
flow by one plus discount factor squared.
240,000/1+(0.10)2 = 198,347
NPV=-2000000+120000/(1+0.10)+240000/(1+0.10)2
=-200000+109091+198347
=+Rs.107438 at the end of second year NPVis +ve
In other words, according to your cash flow forecast and required return, two years of running this
business is worth Rs 107,438 in cash to you today. The following diagram can explain the point further.
Investment Criteria
N.P.V (Café Example ­ Cash Flow Diagram)
CF2 = Rs
240,000
Rs 198,347
CF1=Rs 120,000
Rs 109,091
NPV = Rs
107,438
i = 10%
i = 10%
Yr 0 (Today)
Yr 1
Yr 2
Io = Rs
200,000
The next criterion that we would talk about here is the profitability index, or the cost-benefit ratio.
Probability Index:
It is quite similar to the NPV in terms of concept and calculation. Profitability index
may be defined as the ratio of the present value of future cash flows to the initial investment.
The profitability index can be calculated using the following formula.
PI = [Σ CFt / (1+ i) t ]/ IO
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Financial Management ­ MGT201
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Those projects with a profitability index ratio of more than one (PI >= 1.0) are considered
acceptable. Here it is important to mention that those projects, which are ranked as acceptable using the
NPV method, would also be acceptable on the profitability index criteria.
Example: The profitability index for the café example can be calculated as under.
PI = [120,000]/ (1+ 0.1) + [240,000 / (1+ 0.1)2]/200,000
= (109,091 + 198,347) / 200,000 = 1. 54
PI = 1.54 > 1.0
Therefore, the project is acceptable. Notice that we have taken into consideration the annualized
return. The same can be calculated using the monthly returns with a slight adjustment in the formula as
we have studied in the previous lectures. If there were two or more projects that need ranking, the one
with the highest profitability index would be acceptable.
Let us now talk about the fifth and the final capital budgeting criteria of our course, known as Internal
Rate of Return (IRR).
Internal Rate of Return (IRR):
IRR is a widely used and an important measure, which is more common in practice than the
NPV. IRR, unlike NPV that is expressed in dollar amounts, is always quoted in terms of percentage,
which makes it comparable to the other market interest rates or the inflation rate.
RR calculation involves the same equation that we have earlier used for the calculation of NPV.
The only difference is that while calculating IRR we would set the value of NPV equal to zero and then
solve the equation for the value if `i'. In other words, the value of `i', at which the net present value of
the project equals zero would be considered as the internal rate of return of the project.
his is important to remember that unlike NPV calculation, the value of IRR is constant in every
year for the life of the project. While working out the NPV, we can change the discount rate for every
single, but for IRR you would come up with a rate that is constant and fixed for every single year in the
life of the project. Another simplistic explanation of IRR can be that it is the break-even rate of return.
In other words, at this rate of return, we would be able to recover the initial investment in project's
lifetime.
RR is calculated by a trial and error method or iteration. Finding the value of an unknown
variable may involve solving of higher degree polynomial equations and the easiest way to go about it is
to use trial and error method.
n a trial-and-error method, we tryout a value of `i', and see if the equation comes to the value of
zero; if it does not, try another value, even if the second value does not bring the equation down to zero
and so on. The higher the IRR, the better it is considered, however, which value of the IRR can be
considered as acceptable is difficult to measure. We would discuss more details of it in the coming
lectures.
Another important distinction needs to clarification here is that the internal rate of return is
different from the discounting rate that we use in the calculation of the NPV. In the NPV formula, we
used the discount rate as the required rate of return that we expected the project to generate. In case of
IRR, we used the existing cash flows to find the forecasted return. These two different interpretations of
`i' should be kept in mind while calculating NPV and IRR.
We can calculate the IRR for the café project in the following manner. Using the same formula of NPV,
we can put the values in the formula
IRR Equation:
NPV= -IO +CF1/ (1+IRR) + CF2/ (1+IRR) 2
= 0= -200,000 + 120,000/ (1+0.1) + 240,000/ (1+0.1)2
Solving the equation assuming IRR to be 10 percent, we have obtained a figure of 107,483, which was
calculated as our NPV for the café project. However, in order to bring the NPV down to zero, we need
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Financial Management ­ MGT201
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to apply a higher rate as an assumed IRR. If we assume IRR to be 50 percent the equation can be solved
as follows.
NPV= -IO +CF1/ (1+IRR) + CF2/ (1+IRR) 2
= 0= -200,000 + 120,000/(1+0.5) + 240,000/(1+0.5)2
The calculation gives us a figure of -13,333, which is lesser than zero. In order to bring the value equal
to zero we would use a rate lesser than 50 percent.
Trying out various IRR rates, we can finally reach a rate of 43.6 percent at which the value of
NPV would come down to -48 which is close to zero. If we try out IRR with more decimal places, we
can bring the value of NPV equal to zero. However, with approximation, 43.6 percent is the actual IRR
of the project.
Send you query to registrar.
More details about the IRR and the NPV would be discussed in the next chapter.
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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios