Capital Budgeting
Capital budgeting is the process by which
investors determine the value of a
potential investment project. The three
most common approaches to project
selection are payback period (PB), internal
rate of return (IRR), and net present value
(NPV).
Payback period is the time required to
recover the initial investment. A firm is
always interested in knowing the amount
of time required to recover its
investment.
When cash flows are equal:
Payback period = initial investment/annual cash
inflow
When cash in flows are uneven:
PBP= A+ B/C
Where is A: year before the full recovery
B: unrecovered cost at the start of the year
C: cash inflow during the year
Note: before using these values we must find the
cumulative cash inflow. Cumulative net cash inflow
is the sum of inflows to date minus the initial
outflow
Example: Even Cash Flows:
Company A is planning to undertake a project requiring
initial investment of P105M. The project is expected to
generate 25M per yr in net cash inflow for 7 years.
Calculate the payback period.
Given: Initial investment = P105M
Cash inflow=25M
Solution: Payback period = initial investment/annual
cash inflow
= 105M/25M
= 4.2 years
Example: A Delta Company is planning to purchase a machine
known as machine X. Machine X would cost $25,000 and would
have a useful life of 10 years with salvage value. The expected
annual cash inflow of the machine is $10,000.00.
Required: Compute the payback period of machine X and
conclude whether or not the machine would be purchased if the
maximum desired payback period of Delta company is 3 years.
Given: ?
Cash Inflow? Equal or uneven?
Desired payback period : 3 years
Payback period : $25,000 /$10,000 = 2.5 years.
Example 4: Due to increase in demand, the management of Maximus
Storage Company is considering to purchase a new equipment to
increase the production and revenues. The useful life of the equipment
is 10 years and the company’s maximum desired payback period is 4
years. The inflow and outflow of cash associated with the new
equipment is given below:
Initial cost of equipment: $ 37,500.00
Annual cash inflow sales: $ 75,000.00 Given:?
Annual cash outflows :
Cost of ingredients : $45,000
Salary expenses :$13,500 Equal or
Maintenance Expenses: $1,500 uneven ?
Depreciation expense: $5,000
Requirement: Should Maximus Storage Company purchase the new
equipment? Use payback method .
Example 4 Solution:
Step 1: Get the net annual cash inflow:
Cash Inflow: $ 75,000.00
Less: Cash out flow
Cost of ingredients : $45,000
Salary expenses : $13, 500
Maintenance Expenses: $1, 500
========= 60,000.00
==========
$15,000.00
Payback period: 37,500/ 15,000 = 2.5 years
Note: Depreciation is non cash expense and has therefore been
ignored in calculating the payback period of the project.
Example5. A project costs $ 18,000.
The estimated annual cash inflows
during its 3 year life are $ 8,000, $
7,000 and $ 6,000 respectively. Find
out pay-back period.
Example5. A project costs $ 18,000. The estimated annual
cash inflows during its 3 year life are $ 8,000, $ 7,000 and
$ 6,000 respectively. Find out pay-back period.
Solution:
Year cash inflow cumulative cash inflow
1 8000 8000
2 7000 15000
3 6000 21000
PBP= A+ B/C =2 + 3000/6000 =.5 yr
2.5 yr
6.) Each of the following projects requires a cash outlay of
$10,000. You are required to suggest which project should
be accepted if the standard pay-back period is 5 Years .
Year Cash inflows for
Project X Project Y Project Z
1 2500 4000 1000
2 2500 3000 2000
3 2500 2000 3000
4 2500 1000 4000
5 2500 ---- ----
Solution:
Project X cash inflows are equal so PBP =I/C
=10000/2500 =4 years
Project Y cash inflows are not equal , so cumulate
cash inflow ie, 4000+3000+2000+1000 = 10000 so
PBP is 4 years
Project Z cash inflows are not equal , so cumulate
cash inflow ie, 1000+2000+3000+4000 = 10000 so
PBP is 4 years So pay back period of all three
project are 4 years
