Capital Budgeting

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CAPITAL BUDGETING
Business administration (University of Central Punjab)
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Capital Budgeting
Assignment
Submitted by: Nibras Shair (0056)

BBA
2A
Submitted to: Prof. Hafiz Waqas

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CAPITAL BUDGETING
Capital budgeting (or investment appraisal) is the process of determining the viability to long-
term investments on purchase or replacement of property plant and equipment, new product line
or other projects.
Capital budgeting is the process most companies use to authorize capital spending on long‐term
projects and on other projects requiring significant investments of capital. Because capital is
usually limited in its availability, capital projects are individually evaluated using both
quantitative analysis and qualitative information. Most capital budgeting analysis uses cash
inflows and cash outflows rather than net income calculated using the accrual basis. Some
companies simplify the cash flow calculation to net income plus depreciation and amortization.
Others look more specifically at estimated cash inflows from customers, reduced costs, proceeds
from the sale of assets and salvage value, and cash outflows for the capital investment, operating
costs, interest, and future repairs or overhauls of equipment.
Capital budgeting consists of various techniques used by managers such as:
A brief introduction to the above methods is given below:

 Payback Period measures the time in which the initial cash flow is returned by the
project. Cash flows are not discounted. Lower payback period is preferred.
 Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash
inflows. Higher NPV is preferred and an investment is only viable if its NPV is positive.
 Accounting Rate of Return (ARR) is the profitability of the project calculated as
projected total net income divided by initial or average investment. Net income is not
discounted.
 Internal Rate of Return (IRR) is the discount rate at which net present value of the
project becomes zero. Higher IRR should be preferred.
 Profitability Index (PI) is the ratio of present value of future cash flows of a project to
initial investment required for the project.
PAYBACK PERIOD
Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest investment
appraisal techniques.
Formula
The formula to calculate payback period of a project depends on whether the cash flow per
period from the project is even or uneven. In case they are even, the formula to calculate payback
period is:

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Initial Investment
Payback Period
=
Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period
and then use the following formula for payback period:
B
Payback Period = A
+
C
In the above formula,

A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.
Accept the project only if its payback period is LESS than the target payback period.
Example 1: Even Cash Flows

Company C is planning to undertake a project requiring initial investment of $105 million. The
project is expected to generate $25 million per year for 7 years. Calculate the payback period of
the project.
Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2 years
Example 2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50 million
and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3,
$19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.
Solution

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(cash flows in Cumulative

millions) Cash Flow
Year Cash
Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 years
NET PRESENT VALUE (NPV)
Net present value (NPV) of a project is the potential change in an investor's wealth caused by that
project while time value of money is being accounted for. It equals the present value of net cash
inflows generated by a project less the initial investment on the project. It is one of the most
reliable measures used in capital budgeting because it accounts for time value of money by using
discounted cash flows in the calculation.
Net present value calculations take the following two inputs:
 Projected net cash flows in successive periods from the project.

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 A target rate of return i.e. the hurdle rate.
Where,
Net cash flow equals total cash inflow during a period, including salvage value if any, less cash
outflows from the project during the period.
Hurdle rate is the rate used to discount the net cash inflows. Weighted average cost of capital
(WACC)is the most commonly used hurdle rate.
Calculation Methods and Formulas
The first step involved in the calculation of NPV is the estimation of net cash flows from the
project over its life. The second step is to discount those cash flows at the hurdle rate.
The net cash flows may be even (i.e. equal cash flows in different periods) or uneven (i.e.
different cash flows in different periods). When they are even, present value can be easily
calculated by using the formula for present value of annuity. However, if they are uneven, we
need to calculate the present value of each individual net cash inflow separately.
Once we have the total present value of all project cash flows, we subtract the initial investment
on the project from the total present value of inflows to arrive at net present value.
Thus we have the following two formulas for the calculation of NPV:
When cash inflows are even:
1 − (1 + i)-n
NPV = R × − Initial Investment
I
In the above formula,

R is the net cash inflow expected to be received in each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate cash
inflows.
When cash inflows are uneven:

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R1 R2 R3
NPV = + + + ... − Initial Investment
(1 + i)1 (1 + i)2 (1 + i)3
Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...
Decision Rule
In case of standalone projects, accept a project only if its NPV is positive, reject it if its NPV is
negative and stay indifferent between accepting or rejecting if NPV is zero.
In case of mutually exclusive projects (i.e. competing projects), accept the project with higher
NPV.
Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an
initial investment of $243,000 and it is expected to generate a cash inflow of $50,000 each month
for 12 months. Assume that the salvage value of the project is zero. The target rate of return is
12% per annum.
Solution
We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%
Net Present Value

= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000
≈ $562,754 − $243,000
≈ $319,754

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Example 2: Uneven Cash Inflows: An initial investment of $8,320 thousand on plant and
machinery is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824
thousand and $2,065 thousand at the end of first, second, third and fourth year respectively. At
the end of the fourth year, the machinery will be sold for $900 thousand. Calculate the net
present value of the investment if the discount rate is 18%. Round your answer to nearest
thousand dollars.
Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158
The rest of the calculation is summarized below:
Year 1 2 3 4
Net Cash Inflow $3,411 $4,070 $5,824 $2,065
Salvage Value 900
Total Cash Inflow $3,411 $4,070 $5,824 $2,965
× Present Value Factor 0.8475 0.7182 0.6086 0.5158
Present Value of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.3

1
Total PV of Cash Inflows $10,888
− Initial Investment − 8,320

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Net Present Value $2,568 thousand

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lOMoARcPSD|4779556

Business administration (University of Central Punjab)

StuDocu is not sponsored or endorsed by any college or university

Submitted by: Nibras Shair (0056)

Downloaded by Zahid Zahid ([email protected])

A brief introduction to the above methods is given below:

Downloaded by Zahid Zahid ([email protected])

In the above formula,

Both of the above situations are applied in the following examples.

Example 1: Even Cash Flows

Example 2: Uneven Cash Flows

Downloaded by Zahid Zahid ([email protected])

(cash flows in Cumulative

NET PRESENT VALUE (NPV)

Net present value calculations take the following two inputs:

 Projected net cash flows in successive periods from the project.

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 A target rate of return i.e. the hurdle rate.

Calculation Methods and Formulas

When cash inflows are even:

In the above formula,

When cash inflows are uneven:

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Net Present Value

Downloaded by Zahid Zahid ([email protected])

The rest of the calculation is summarized below:

Net Cash Inflow $3,411 $4,070 $5,824 $2,065

Salvage Value 900

Total Cash Inflow $3,411 $4,070 $5,824 $2,965

× Present Value Factor 0.8475 0.7182 0.6086 0.5158

Present Value of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.3

Total PV of Cash Inflows $10,888

− Initial Investment − 8,320

Downloaded by Zahid Zahid ([email protected])

Net Present Value $2,568 thousand

Downloaded by Zahid Zahid ([email protected])

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