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CAPITAL BUDGETING
Capital Budgeting
Is the process of allocating financial
resources to new long-term
investment projects,
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Importance of Capital Budgeting
Capital Budgeting Involves
investments of different amounts.
It limits a firm’s flexibility
It defines a firm’s strategic direction
It concern with the planning and
control investment.
To arrive at a long term investment decision,
the firm needs to identify the following:
1. Estimate Cash flow
a) Initial Investment
b) Annual cash returns
c) Terminal cash Flow
2. Estimated Cost of capital or Weighted
Average cost of Capital
3. Acceptance Criteria
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Framework of Capital Budgeting
*Present value of
expected cash
inflows *Required
*Cost saving Investment
*Expected rate *Cost of capital
of return
Capital Budgeting Techniques
Payback Period
Discounted Payback Period
Accounting Rate of Return
Net Present Value
Internal Rate of Return
Profitability Index
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Payback Period
It measured the length of time it takes to recover a
projects’ initial investment.
Decision Rule:
If the payback period is < required payback Accept
If the payback period is > required payback Reject
Payback Period
Example (even cash inflow):
Mr. Uy plans to purchase a piece of equipment which
amounts to 180,000 in accordance with an investment
proposal from a member of his staff. If the equipment is
bought, it is expected to generate an annual cash inflow
of 30,000. A five year pay back period is acceptable to Mr.
Uy.
𝒊𝒏𝒗𝒆𝒕𝒔𝒎𝒆𝒏𝒕 − 𝑺𝒄𝒓𝒂𝒑 𝒗𝒂𝒍𝒖𝒆
𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 =
𝑨𝒏𝒏𝒖𝒂𝒍 𝒂𝒇𝒕𝒆𝒓𝒕𝒂𝒙 𝒄𝒂𝒔𝒉 𝒔𝒂𝒗𝒊𝒏𝒈𝒔
𝟏𝟖𝟎, 𝟎𝟎𝟎
=
𝟑𝟎, 𝟎𝟎𝟎
= 𝟔 𝒚𝒆𝒂𝒓𝒔
Decision: reject the project ….
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Payback Period
Example (Uneven cash inflow):
Assume the same set of facts in the preceding
example for the annual cash inflows which have
now been changed as follows:
First year 20,000
Second year 30,000
Third year 40,000
Fourth year 50,000
Fifth year 50,000
Sixth year 40,000
Payback Period
Cash Inflows Balance Years
180,000
First year 20,000 160,000 1
Second year 30,000 130,000 1
Third year 40,000 90,000 1
Fourth year 50,000 40,000 1
Fifth year 50,000 40000/50000 0 .80
Sixth year 40,000 4.80 years
Decision: accept
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Payback Period
Advantages
It is simple to compute and easy to understand.
It handles investment risk well.
Disadvantage
It does not recognize the time value of money
It ignores the impact of cash inflows received after
the payback period.
There is a possibility of lower return
There is no rational way of determining the
payback period.
Discounted Payback Period
Examples:
Mr. Lee plans to put up a small stall in front of his house. The overall cost
of the construction is 150,000. The stall is expected to generate annual
cash inflows of 40,000 for 7 years. A four-year discounted payback
period is acceptable to Mr. Lee. The cost of Capital is at 12%.
Year Annual Cash Present Value Discounted Balance 5.29
Return (1+i)-n Amount
150,000
1 40,000 (1.12)-1 35714 114,286 1
2 40,000 (1.12)-2 31,888 82,398 1
3 40,000 (1.12)-3 28,471 53,927 1
4 40,000 (1.12)-4 25,421 28,506 1
5 40,000 (1.12)-5 22,697 5,809/20 1
265
6 40,000 (1.12)-6 20,265 .29
7 40,000 (1.12)-7 18,094
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Accounting Rate of Return
It is sometimes called the average rate of return.
𝐴𝑅𝑅 =
Examples:
Initial investment : 8,000
Estimate life : 20 years
Cash inflows per year: 1,000
Depreciation per year : 400
1000 − 400
𝐴𝑅𝑅 = = 7.5%
8,000
Accounting Rate of Return
In other variants of this method, the
investment is “average” by dividing the initial
investment by 2.
𝐴𝑅𝑅 = = 15%
,
Decision Rule:
If ARR is < required ARR Accept the project
If ARR is > required ARR Reject the project
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Accounting Rate of Return
Advantages
It is simple to compute and easy to understand.
It recognize the profitability factor.
Disadvantage
It does not recognize the time value of money
It uses accounting income instead of cash inflows
It difficult to determine the minimum acceptable
rate or return.
It does not take into account the amount of
investment.
Net Present Value
The NPV method is obtained by getting the present
value of all cash inflows using the cost of capital less the
initial investment.
The formula for even future cash flow is:
𝐼 − (1 − 𝑖)
𝑃𝑉 =
𝑖
The formula for uneven future cash flow is:
𝑃𝑉 = (1 + 𝑖)
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Net Present Value
Examples:
Z Corporation invested 6,854 in a 4-year project. Z
Corporation’s Cost of capital is 8%. Additional bits
of information on the project are as follows:
Year After –tax cash inflow of 1
1 2,ooo
2 2,200
3 2,400
4 2,600
Net Present Value
Year Annual Present Value Present value
Cash At 8%
Return
(1 + 𝑖)
1 2,ooo .926 1852
2 2,200 .857 1885
3 2,400 .794 1906
4 2,600 .735 1911
7,554
Less: 6,854
investment
NPV 700
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Internal Rate of Return
It is the rate of return that equates the present
value of all cash inflow to the initial
investment.
Decision Rule:
If IRR is < required IRR Accept the project
If IRR is > required IRR Reject the project
Internal Rate of Return
Example:
Assume that:
Initial investment 12, 950
Estimate life 10 years
Annual Cash Inflows 3,000
Answer : Trial Error
( . )
At 18% 3000 = 13,482.26
.
( . )
At 20% 3000 = 12,577.42
.
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Internal Rate of Return
by interpolation:
13,482.26 13,482.26 At 18%
12,950.00 Initial investment
12,577.42 At 20%
532.26 904.84 .2% 0.02
Y1+(X1-X)/(X1-X2)*(Y2-Y1)
IRR= .18+532.26 / 904.84(.02)
IRR= 19.18%
Internal Rate of Return
Advantages
It acknowledges the time value of money.
It is more exact and realistic than the ARR
It provides a decision similar to the NPV if the project
is independent.
Disadvantage
It requires a lot of time to compute especially when
the cash are not even
It provides multiple IRRs in situation where the
movement of cash flows is erratic.
Under mutually exclusive projects, the IRR may
provide results conflicting with the NPV.
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Profitability Index
The profitability index is the ratio of the total
PV of future cash inflows to the initial
investment.
If the profitability index is greater than 1, the
project is accepted.
A profitability ratio of 1 is logically the lowest
acceptable measure on the index.
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