Unit No.

10

Capital Budgeting

NPV

BCR

Unit 10 Roadmap

IRR

Non-Discounting Criteria

Discounting Criteria

Payback Period

Accounting Rate of Return

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Financial Decision Making (MGT434)

Unit 10

CAPITAL BUDGETING
The process of identifying, analyzing and selecting investment project whose returns (Cash Flows) are expected to extend beyond one year

10. Capital Budgeting Techniques

There are different methods of evaluating capital investment projects Broadly, there are two alternative methods of project evaluation and selection used in Capital Budgeting

Capital Budgeting

Non-Discounting Criteria

Discounting Criteria

PBP

ARR

NPV

BCR

IRR

10.1 Non-Discounting Criteria Non-discounting techniques take into account magnitude and not timing of the expected cash flow (ignoring TVM) Following are different non-discount techniques.

10.1.1 Payback Period The Payback Period is the length of time required to recover the initial cash outlay on project The payback period of the investment tells us the number of years required to cover our initial cash outflow The major short coming of the payback period is that it fails to consider the cash flows after the payback period

Example 10.1: Calculate the Payback Period? Cash Outflow Cash inflow 1st year Cash inflow 2nd year Cash inflow 3rd year Cash inflow 4th year Cash inflow 5th year Solution: Rs. (600,000) 150,000 100,000 150,000 200,000 120,000

Payback Period is 4 year (150,000 + 100,000 + 150,000 + 200,000 = 600,000)

If Cash inflow is constant than we can apply this equation

Payback Period

Cash Outflow /

Constant Cash Inflow

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Example 10.2: If Cash Outflow is Rs. 200,000 and constant cash inflow will be Rs. 50,000 per year what will be Payback Period? Solution:

Payback Period Payback Period

Cash Outflow /

Constant Cash Inflow = 4 years

= 200,000 / 50,000

Example 10.3: Which one of the following Investment is best? Year 0 1 2 3 4 5 6 Cash Flow of A Rs. (100,000) 50,000 30,000 20,000 10,000 10,000 -----Cash Flow of B Rs. (100,000) 20,000 20,000 30,000 40,000 50,000 60,000

(Acceptance Criterion: The shorter the Payback Period, the more desirable the project) Solution:

Payback for A = (50,000 + 30,000 + 20,000) Payback for B = (3 + 30,000/40,000)

= =

3 years 3.75 years

Project A is best according to payback period criterion

10.1.2 Accounting Rate of Return: The accounting rate of return, also called the average rate of return is defined as

ARR =

Profit after Tax / Book value of the investment

Example 10.4: Find out Accounting Rate of Return overall and individual in order to decide which year is best? Year 1 2 3 4 Book Value of Investment Rs. 90,000 80,000 70,000 60,000 Profit after Tax Rs. 20,000 22,000 24,000 26,000

5 50,000 28,000 (Acceptance Criterion: The higher the accounting rate of return the better the project)

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Solution:

ARR = ARR (0verall) =

Profit after Tax / Book value of the investment

(20,000 + 22,000 + 24,000 + 26,000 + 28,000) / (90,000 + 80,000 + 70,000

+ 60,000 + 50,000) = 34 % ARR (1) = 20,000 / 90,000 = 0.22 ARR (2) = 22,000 / 80,000 = 0.28 ARR (3) = 24,000 / 70,000 = 0.34 ARR (4) = 26,000 / 60,000 = 0.43 ARR (5) = 28,000 / 50,000 = 0.56 i.e. i.e. i.e. i.e. i.e. Year 5th is best 22 % 28 % 34 % 43 % 56 %

Example 10.5: Which one of the following project is best using Non-Discounting Criteria? X
Year Book Value Profit After Tax Cash Flow Book Value

Y
Profit After Tax Cash Flow

0 1 2 3 4 Solution:

Rs. 100,000 75,000 50,000 25,000 0

0 Rs. 40,000 30,000 20,000 10,000

Rs. (100,000) 65,000 55,000 45,000 35,000

Rs. 100,000 75,000 50,000 25,000 0

0 Rs. 10,000 20,000 30,000 40,000

Rs. (100,000) 35,000 45,000 55,000 65,000

X Payback = 1 + (35,000 / 55,000) ARR = 100,000 / 250,000 = = 1.64 years 40%

Y Payback = 2 + (20,000 / 55,000) ARR = 100,000 / 250,000 Project X is best = = 2.36 years 40%

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10.2 Discounting Criteria

Discounting cash flow method provide more objective basis for evaluating and selecting projects This method take into account both magnitude and timing of the expected cash flow in each period of projects life Following are some important techniques used under Discounting Criteria

10.2.1 Net Present Value (NPV) The Net Present Value (NPV) of a project is the sum of all present values of cash inflows that are expected to occur over the life of project minus present values of all cash outflows So we can say that Net Present Value is difference between Cash Inflow and Cash Outflow If NPV > 0 the investment would add value to the firm the project may be accepted NPV < 0 the investment would subtract value from the firm the project should be rejected NPV = 0 the investment would neither profit nor lose value for the firm

Net Present Value

Present Value of Cash Inflow - Present Value of Cash Outflow

Or

NPV =

Cash Inflow t / (1 + i) t

Cash Outflow t / (1 + i) t

Example 10.6: Find the Net Present Value assuming cost of capital is 10 %? Year 0 1 2 3 4 5 Cash Flow Rs. (1,000,000) 200,000 200,000 300,000 300,000 350,000 (Acceptance Criterion: The higher the NPV the better the project) Solution:

Net Present Value Net Present Value

= =

Present Value of Cash Inflow

Present Value of Cash Outflow

[200,000 / (1+0.10)1 + 200,000 / (1+0.10)2 + 300,000 / (1+0.10)3 + [1, 000,000 / (1+o.10)0]

300,000 / (1+0.10)4 + 350,000 / (1+0.10)5] Net Present Value [1, 000,000] = 1,024,728.386 Net Present Value =

[181,818.18 + 165,289.266 +225,394.44 + 204,904.04 + 217,322.46]

Net Present Value

1, 000,000 = Rs. 24,728.386

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10.2.2 Benefit Cost Ratio (BCR) or Profitability Index (PI) Benefit Cost Ratio (BCR)of a project is the sum of all present values of cash inflows that are expected to occur over the life of project divided by present values of all cash outflows So we can say that Benefit Cost Ratio is ratio between Cash Inflow and Cash Outflow

BCR = Present Value of Cash Inflow (Benefits) / Present Value of Cash Outflow (Cost)
Accepted Criteria when BCR >1 =1 <1 Example 10.7: Find the BCR if cost of capital is 12 %? Initial Investment Year 1 benefit Year 2 benefit Year 3 benefit
th rd nd st

Rule is Accepted Indifference Rejected

Rs. (100,000) 25,000 40,000 40,000

Year 4 benefit 50,000 (Acceptance Criterion: The higher the BCR the better the project) Solution:

BCR = Present Value of Cash Inflow (Benefits) / Present Value of Cash Outflow (Cost) BCR / BCR BCR = 100,000 = = 22,321.43 + 31,887.76 + 28,471.21 + 31,775.90 114,456.3 / 100,000 BCR
10.2.3 Internal Rate of Return (IRR) o o The Internal Rate of Return of a project is the discount rate which makes it NPV to zero The IRR is compared with RRR or cost of capital. If the IRR exceeds the required return, the project is accepted; if not the project is rejected

25,000 / (1+0.12)1 + 40,000 / (1+0.12)2 + 40,000 / (1+0.12)3 + 50,000 / (1+0.12)4

100,000

1.14

Investment =

CFt / (1 + i) t

Example 11.8: Consider the following cash flows and calculate IRR. Year Cash Flow 0 1 2 3 (100,000) 30,000 30,000 40,000 (Acceptance Criterion: The higher the IRR the better the project) 4 45,000

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Solution:

Investment = 100,000 =

CFt / (1 + i) t

30,000 / (1 + i) 1 + 30,000 / (1 + i) 2 +40,000 / (1 + i) 3 +45,000 / (1 + i) 4

The calculation of IRR involves a process of trial and error. We try different values of i till we find the right-hand side of above equation is equal to 100,000. Let us, to begin with try i= 10 percent. We make the right-hand side equal to 100,000 = 30,000 / (1 + 0.10) 1 + 30,000 / (1 + 0.10) 2 + 40,000 / (1 + 0.10) 3 + 45,000 / (1 + 0.10) 4 100,000 = 27,272.7273 + 24,793.3884 + 30,052.5920 + 30,735.6055 100,000 = 112,854.31 This value is slightly higher our target value, 100,000. So we increase the value of i from 10 percent to 20 percent. The right hand side becomes 100,000 = 30,000 / (1 + 0.20) 1 + 30,000 / (1 + 0.20) 2 +40,000 / (1 + 0.20) 3 +45,000 / (1 + 0.20) 4 100,000 = 25,000 + 20,833.3333 +23,148.1482 +21,701.3889 100,000 = 90,682.87 Since the value is now less than 100,000, we conclude that the value of IRR lies between 10 percent and 20 percent. If more refine estimate of IRR is needed, use the following interpolation procedure.

10 % a IRR 20%

112,854.31 100,000 90,682.87 b c

Lower Rate = 0.10; a = 0.20 - 0.10 = 0.10; b= 112,854.31 - 100,000 = 12,854.31; c = 112,854.31 - 90,682.87 = 22,171.44

IRR =Lower Rate + [(a* b)] c IRR =0.10 + [0.10* 12,854.31] 22,171.44 IRR =0.10 + 0.058 IRR =15.8%

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END-OF-UNIT ASSIGNMENT (PROBLEMS & MULTIPLE CHOICE QUESTIONS)

Problem 10.1: You are financial analyst for the Hills Company. The director of capital budgeting has asked you to analyze two proposal capital investment. Project X and Y. Each project has a cost of Rs. 14,000, gross inflows have Rs. 21,000 and the cost of capital for each project is 12 percent. The projects expected cash flows are as follow.

Expected Cash Flows Year 0 1 2 3 4 Project X (14,000) 8,000 2,000 6,000 5,000 Project Y (14,000) 3,500 6,500 2,000 9,000

Requirement: Calculate each projects Payback, Net present value and Benefit-Cost Ratio then decided best project. Project X Payback Period = 2 + 4,000/6,000 = 2.67 Years Net Present Value Net Present Value (1+0.12)
0

= Present Value of Cash Inflow =

1

Present Value of Cash Outflow - 14,000 /

8,000 / (1+0.12) + 2,000 / (1+0.12)2 +6,000 / (1+0.12)3 +5,000 / (1+0.12)4

Net Present Value Net Present Value Net Present Value BCR BCR BCR = = =

= 7,142.86 + 1,594.39 +4,270.68 +3,177.59 - 14,000 = 16,185.52 = Rs. 2,185.52 14,000 / 14,000 14,000

8,000 / (1+0.12)1 + 2,000 / (1+0.12)2 +6,000 / (1+0.12)3 +5,000 / (1+0.12)4 / 16,185.52 1.16

Project Y Payback Period = 3 + 2,000/9,000 = 3.22 Years Net Present Value Net Present Value (1+0.12)
0

= Present Value of Cash Inflow =

1

Present Value of Cash Outflow - 14,000 /

3,500 / (1+0.12) + 6,500 / (1+0.12)2 +2,000/ (1+0.12)3 +9,000 / (1+0.12)4

Net Present Value Net Present Value Net Present Value BCR BCR BCR = = =

= 3,125 + 5,181.76+1,423.56 +5,719.66 = 15,449.98 = Rs. 1,449.98 14,000

- 14,000

3,500 / (1+0.12)1 + 6,500 / (1+0.12)2 +2,000/ (1+0.12)3 +9,000 / (1+0.12)4 / 15,449.98 1.10 (X IS BEST) / 14,000

14,000

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Problem 10.2: The cash stream for two mutually exclusive alternative investments; Project of Karachi and Project of Lahore are as follows with same cash inflow of Rs. 5,300 and outflows 2,300 at different points in project life cycle. You are required to calculate the Payback Period (PBP), Net Present Value (NPV) and Benefit Cost Ratio (BCR) if required rate of return is 5%. Which would you choose? Year 0 1 2 3 4 5 6 Project of Karachi 1. Payable Back Period Payback Period = 4 + 100/1,700 2. Net Present Value Net Present Value =
1

Project of Karachi Project of Lahore (1,500) (800) 700 1.200 500 2,200 (800) 1,900 1,000 (400) 1,700 (700) 1,400 (400) (For Calculation all figure are rounded to two decimal places)

4.0588 Years 2

= Present Value of Cash Inflow

Present Value of Cash Outflow

[700 / (1+0.05) + 500 / (1+0.05) +1,000 / (1+0.05)4 +1,700 / (1+0.05)5 +1,400 /

(1+0.05)6] - [1,500 / (1+0.05)0 + 800 / (1+0.05)3] Net Present Value Net Present Value 3. BCR BCR BCR BCR = = = = = [666.67 + 453.51 + 822.70 + 1,331.99 + 1,044.70] - [1,500 + 691.07] = 4,319.57 - 2,191.07 I = Rs. 2,128.5

PVB /

[700 / (1+0.05)1 + 500 / (1+0.05)2 +1,000 / (1+0.05)4 +1,700 / (1+0.05)5 +1,400 / (1+0.05)6] / [1,500 / (1+0.05)0 +800 / (1+0.05)3] [666.67 + 453.51 + 822.70 + 1,331.99 + 1,044.70] / [1,500 + 691.07] [4,319.57 / 2,191.07] = 1.97

Project of Lahore 1. Payable Back Period Payback Period = 1 + 1,100/2,200 2. Net Present Value Net Present Value
1

1.5 Years 2

= Present Value of Cash Inflow

Present Value of Cash Outflow

= [1,200 / (1+0.05) + 2,200 / (1+0.05) +1,900 / (1+0.05)3] - [800 / (1+0.05)0 +400 / (1+0.05)4 +700 / (1+0.05)5 + 400 / (1+0.05)6]

Net Present Value Net Present Value 3. BCR BCR = =

= [1,142.86 + 1,995.46 + 1,641.29] - [800 + 329.08 + 548.47 + 298.49] = [4,779.61] - [1,976.04] I [800 / (1+0.05)0 +400 / (1+0.05)4 = Rs. 2,803.57

PVB /

[1,200 / (1+0.05)1 + 2,200 / (1+0.05)2 +1,900 / (1+0.05)3] / +700 / (1+0.05)5 + 400 / (1+0.05)6]

BCR BCR

= =

[1,142.86 + 1,995.46 + 1,641.29] / [800 + 329.08 + 548.47 + 298.49] [4,779.61] / [1,976.04] = 2.42

Project of Lahore is best on the basis of above criteria

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MULTIPLE CHOICE QUESTIONS (MCQs)

1. A project costs Rs.16,000.The estimated annual cash inflows during its 3 year life are Rs.8,000, Rs.7,000 and Rs.6,000 respectively. What will be the pay-back period? (a) 2 years 2. (b) 2.5 years (c) 3 years (d) 4 years

To estimate an unknown number that lies between two known numbers is knows as ___________? (a) Capital rationing (b) Capital budgeting (c) Interpolation (d) Amortization

3.

Decision criterion with respect to profitability index to accept project if? (a) Profitability index is equal to or less than 1 (c) Profitability index is less than or equal to 1 (b) Profitability index is greater than 1 (d) Profitability index is greater than 10

4.

A proposal is accepted if payback period falls within the time period of 4 years. According to the given criteria which of the following project will be accepted? Projects Project A Project B Project C (a) Project A (b) Project B Payback period 1.66 2.66 3.66 (c) Project C (d) Project A & B

5.

____________ of a project is the sum of all present values of all cash inflows minus present value of outflows? (a) Pay Back Period (b) Internal Rate of Return (c) Benefit Cost Ratio (d) NPV

6.

If you have to judge a project from its NPV, you will select the one with the______________? (a) Highest NPV (c) NPV cannot judge the project (b) Lowest NPV (d) Information is not enough

7.

Criteria that measures how quickly project will return its original investment is? (a) Accounting rate of return (c) Internal rate of return (b) Payback period (d) Benefit cost ratio

8.

Capital budgeting is the process of identifying analyzing and selecting investments project whose returns are expected to extend beyond ____________________? (a) 3 years (b) 2 years (c) 1 year (d) Months

9.

Indifference criteria when BCR (Benefit Cost Ratio)? (a) BCR > 1 (b) BCR = 1 (c) BCR < 1 (d) None of above

10. Criterion for IRR (Internal Rate of Return)? (a) Accept IRR > Cost of capital (c) Accept IRR = Cost of capital (b) Accept IRR < Cost of capital (d) none of the above

11. Process that involves decision making with respect to investment in fixed asset? (a) Valuation (b) Breakeven analysis (c) Capital budgeting (d) Material management decision

12. Criterion for benefit cost ratio? (a) Accept BCR > 1 (b) Accept BCR<1 (c) Accept BCR=1 (d) None of the above

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13. A capital budgeting technique that is not considered as discounted cash flow method is? (a) Internal rate of return (c) Net present value (b) Payback period (d) Profitability index

14. Ratio of present value of projects future net cash flows to projects initial cash flow is? (a) Profitability index (c) Net present value (b) Internal rate of return (d) Average rate of return

15. In non-discounting Techniques there are two methods; one is Accounting Rate of Return and the other is ______? (a) NPV (b) Internal Rate of Return (c) Benefit Cost Ratio (d) Pay Back Period

16. On the recommendations of the Finance Manager, the board of directors will accept the project if? (a) Benefit Cost Ratio is less than one (c) Internal Rate of Return is less than cost of capital 17. Internal Rate of Return is the Rate at which NPV=? (a) 0 (b) 1 (c) 2 (d) 3 (b) Net Present Value is greater than zero (d) Pay Back Period is greater than target period

18. The project is most desirable whose Payback period is? (a) More (b) Less (c) Time doesnt make any difference (d) None of the above

19. For a single project we take it if and only if? (a) NPV is positive (b) NPV is zero (c) NPV is negative (d) None

20. In order to compute the NPV of project we need to analyze? (a) Cash Flows (b) Discount rates (c) Both A & B (d) None of them

21. For mutual exclusive projects take the one with? (a) Positive & highest NPV (b) Positive & lowest NPV (c) Negative & lowest NPV (d) None

22. Which statement is true regarding Payback Period? (a) It ignores the cash flows after the payback period (c) Both A & B (b) It ignores discounting (d) None of them

23. The length of a time required for an investments net revenues to cover its cost is called? (a) NPV (b) PI (c) IRR (d) Pay Back Period

24. Projects whose cash flows are not affected by the acceptance or non acceptance of other projects are called? (a) Dependent projects (b) Independent projects (c) Mutually exclusive projects (d) None

25. Methods for ranking investments proposals that employ time value of money concept is called? (a) Discounted cash flow techniques (b) Pay Back Period (c) NPV (d) IRR

26. Mutually exclusive means that you can invest in _________ project(s) and having chosen ______ you cannot choose another? (a) Two; one (b) Two; two (c) One; one (d) Three; one

27. What are two major areas of capital budgeting? (a) Net present value, profitability index (c) Net present value; payback period (b) Net present value; internal rate of return (d) Payback period; profitability index

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28. Which of the following is not a cash outflow for the firm? (a) Depreciation (b) Dividends (c) Interest (d) Taxes

29. What is the most important criteria in capital budgeting? (a) Return on investment (b) Profitability index (c) Net present value (d) Payback period

30. The benefit we expect from a project is expressed in terms of? (a) Cash inflows 31. Capital budgeting focus on? (a) Non- discounting criteria (b) Discounting criteria (c) Both a & b (d) None (b) Cash outflows (c) Cash flows (d) None of the given option

32. Accounting rate of return is also known as? (a) Average rate of return (b) Equal rate of return (d) Market rate of return (d) None

33. What do we call a formal comparison of the actual costs and benefits of a project with original estimates? (a) Post-completion audit (c) Cost-benefit analysis 34. Why companies invest in projects with negative NPV? (a) Because there is hidden value in each project (c) Because they have invested a lot 35. A capital investment is one that? (a) Has the prospect of long term benefits (c) Applies only to investment in fixed assets (b) Has the prospect of short term benefits (d) All of the given options (b) Because they have chance of rapid growth (d) All of the given options (b) Feedback audit (d) Business scorecard report

36. The net present value (NPV) of an investment represents the amount by which the investment is expected to ______________________shareholder wealth? (a) Provide zero change to (b) Decrease (c) Increase (d) Provide zero change to or decrease

37. Which if the following refers to capital budgeting? (a) Investment in long-term liabilities (c) Investment in current assets 38. The capital budget for the year is approved by a company's? (a) Board of directors (b) Capital budgeting committee (c) Officers (d) Shareholders (b) Investment in fixed assets (d) Investment in short-term liabilities

39. Capital budgeting is the process? (a) Used in sell or process further decisions (c) Of making capital expenditure decisions (b) Of determining how much capital share to issue (d) Of eliminating unprofitable product lines

40. Which of the following methods of evaluating capital budgeting proposals rests on the assumption that income is uniform over the life of an investment? (a) Internal rate of return (b) Payback method (c) Net present value (d) Accounting rate of return

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