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Faizan Ahmed
Financial ManagementSZABIST
Faizan Ahmed
SZABIST
Lecture 6Capital Budgeting Decision
The term capital refers to long-term assets used in production,
while a budget is a plan that details projected inflows and
outflows during some future period. Thus, the capital budget is
an outline of planned investments in fixed assets, and capital
budgeting is the whole process of analyzing projects and
deciding which ones to include in the capital budget.
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Faizan Ahmed
Financial ManagementSZABIST
The Role of the Financial ManagerThe Capital Budgeting
Decision…
• Recall lecture 1 and the role of the financial manager, until
now we have covered the financing decision of a financial manager.
Lets now turn our attention towards the other decision he or she
has to make ‘the Capital budgeting Decision’.
• Capital budgeting decision is the process of planning
expenditures on assets whose cash flows are expected to extend
beyond one year. There are two broad categories of assets which can
be acquired by the organization:
– Real Assets: These are the assets which are used to produce
goods or render services;
– Financial Assets: These are the assets which give the bearer
claims on the firm’s real assets and the cash those assets will
produce.
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Faizan Ahmed
Financial ManagementSZABIST
The Capital Budgeting DecisionProject Classifications…
• Every project being considered is unique in some sense,
however, depending upon the objective that is being targeted
projects can be classified into the following types:
– Replacement (Maintenance of Business): This category is
related to expenditures that are incurred to replace worn-out or
damaged equipment used in the production of products or rendering
of services;
– Replacement (Cost Reduction): This category includes
expenditures related to replace serviceable but obsolete equipment
with the intention of lowering the running costs;
– Expansion of Existing Products or Markets: The expenditures
which are undertaken to increase output of existing products or to
expand retail outlets or distribution facilities in markets now
being served;
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Faizan Ahmed
Financial ManagementSZABIST
The Capital Budgeting DecisionProject Classifications…
– Expansion into New Products or Markets: These are investments
to produce a new product or to expand into a geographic area not
currently being served;
– Safety and/or Environmental Projects: Expenditures necessary
to comply with government orders, labor agreements or insurance
policy terms fall into this category;
– Other: This catch-all category includes all those project
which cannot be categorized in either of the above
classifications.
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Faizan Ahmed
Financial ManagementSZABIST
The Capital Budgeting DecisionSimilarities With the Valuation of
Financial Assets…
• Once a potential capital budgeting project has been
identified, its evaluation involves the same steps that are used in
the valuation of financial assets:– First, the cost of the project
must be determined. This is similar to finding the price
that must be paid for the stock or bond;
– Next comes the estimation of expected cash flows from the
project which is synonymous to estimating the future dividend or
interest payment stream on a stock or a bond;
– The expected cash flows are then put on a present value basis
to obtain an estimate of the asset’s value. This is equivalent to
finding the present value of a stock’s expected dividends or a
bond’s future interest and principal payments;
– Finally, the present value of the expected cash inflows is
compared with the required outlay. If the PV of the cash flows
exceeds the cost, the project should be accepted. This is similar
to the comparison of the fair value of financial assets with its
market value.
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Faizan Ahmed
Financial ManagementSZABIST
The Capital Budgeting DecisionThe Mechanics…
• While undertaking any capital budgeting decision, two cardinal
rules are to be kept in mind:
– These decisions must be based on after-tax cash flows, not
accounting income;
– Only incremental cash flow are relevant.
• Incremental cash flows are the additional cash flows that the
company expects to generate if it goes ahead with the project under
consideration.
• Project cash flow is different from accounting income as it
reflects:
– Cash outlays for fixed assets;
– Tax shield provided by depreciation;
– Cash flows due to changes in net working capital;
– The impact of tax since after-tax cash flows are
considered.
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Faizan Ahmed
Financial ManagementSZABIST
The Capital Budgeting DecisionThe Mechanics…
• While determining incremental cash flows, there are certain
rules which must be kept in mind:
– Include All Externalities: You must forecast and include all
the indirect effects of accepting the project on the existing
business profile of the company. For example sales cannibalization
or acquisition of business synergies;
– Forget Sunk Costs: Sunk costs are outlays that have already
been incurred and that cannot be recovered regardless of whether
the project is accepted or rejected;
– Include Opportunity Costs: Resources are almost never free,
even when no cash changes hands. For example, the decision to
either use the land for manufacturing operation or selling it for
additional proceeds;
– Don’t Include Interest Payments: Interest payments are not
included while estimating incremental cash flows as their impact is
already reflected in the cost of capital used to discount the cash
flows.
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Faizan Ahmed
Financial ManagementSZABIST
The Capital Budgeting DecisionThe Mechanics…
• Following are the methods used to rank projects and decide
whether or not they should be accepted for inclusion in the capital
budget:
– The Payback Period;
– The Discounted Payback Period;
– Net Present Value (NPV);
– Internal Rate of return (IRR).
• Its foolish to assume that the above list is exhaustive as
modern theories involve new methodologies used to appraise the
projects.
• Moreover, it is never a good idea to make the capital
budgeting decision based on a single method rather it should be
based on a combination of several methodologies.
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting Decision RulesThe Payback Period…
• The payback period is the number of years required to recover
the original investment.
• Example: The projected cash flows from project X are:
The cost of the project is PKR 500. What is the payback period
for this investment?
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Year theDuring FlowCash
year theofStart at Cost dUnrecovereRecovery Full BeforeYear
PeriodPayback
Year 1 2 3 4
Cash Flow (PKR) 100 200 500 400
years 2.4500
2002PeriodPayback
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting Decision RulesThe Payback Period…
Decision Rule
In case of independent projects, an investment is acceptable if
its calculated payback period is less than some pre-specified
number of years.
In case of mutually exclusive projects, the project with the
lowest payback period gets selected.
Advantages & Disadvantages of the Payback Period Rule
Advantages Disadvantages
It is easy to understand Ignores time value of money
Adjusts for uncertainty of later cash flows Requires an
arbitrary cutoff point
Biased towards liquidity Ignores cash flows beyond the cutoff
date
Biased against long-term projects
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting Decision RulesThe Discounted Payback
Period…
• Discounted payback period is similar to the regular payback
period except that the expected cash flows are discounted by the
project’s cost of capital. Thus, it is defined as the number years
required to recover the investment from discounted cash flows.
• Example: Calculate the discounted payback period for project X
given that the project’s cost of capital is 14%.
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Year theDuring FlowCash of PV
year theofStart at Cost dUnrecovereRecovery Full BeforeYear
PeriodPayback Discounted
years 2.8337.49
258.392PeriodPayback Discounted
Year 1 2 3 4
Cash Flow (PKR) 100 200 500 400
PV of Cash Flows 87.72 153.89 337.49 236.83
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting Decision RulesThe Discounted Payback
Period…
Decision Rule
In case of independent projects, an investment is acceptable if
its calculated discounted payback period is less than some
pre-specified number of years.
In case of mutually exclusive projects, the project with the
lowest discounted payback period gets selected.
Advantages & Disadvantages of the Discounted Payback Period
Rule
Advantages Disadvantages
It is easy to understand May yield conflicting results
Adjusts for uncertainty of later cash flows Requires an
arbitrary cutoff point
Biased towards liquidity Ignores cash flows beyond the cutoff
date
Includes time value of money Biased against long-term
projects
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting Decision RulesNet Present Value (NPV)…
• The NPV method follows the discounted cash flow technique in
which a project’s NPV is equal to present value of future net cash
flows, discounted at the cost of capital.
• Example: Calculate the net present value of project X given
that the project’s cost of capital is 14%.
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(Outflows) PV(Inflows) PVNPV
Year 1 2 3 4
Cash Flow (PKR) 100 200 500 400
PV of Cash Flows 87.72 153.89 337.49 236.83
37.315NPV
00537.158NPV
(Outflows) PV(Inflows) PVNPV
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting Decision RulesNet Present Value (NPV)…
Decision Rule
In case of independent projects, an investment is acceptable if
its net present value is greater than zero i.e. positive.
In case of mutually exclusive projects, the project with the
highest net present value gets selected.
Advantages & Disadvantages of the Net Present Value Rule
Advantages Disadvantages
It is easy to understand Does not take into account the
project’s size
Includes time value of moneyDoes not signify anything in terms
of
project’s profitability
Takes into account all the cash flows
Biased towards liquidity
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting Decision RulesInternal rate of Return
(IRR)…
• The IRR method is a method of ranking investment proposals
using the rate of return, calculated by finding the discount rate
that equates the present value of future cash inflows to the
present value of cash outflows.
• That is, IRR is the rate of return at which:
• Example: Calculate the internal rate of return of project
X.
– The IRR of project X is 35.75%.
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(Outflows) PV(Inflows) PV
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting Decision RulesInternal Rate of Return
(IRR)…
Decision Rule
In case of independent projects, an investment is acceptable if
its internal rate of return is greater than its cost of
capital.
In case of mutually exclusive projects, the project with the
highest internal rate of return gets selected.
Advantages & Disadvantages of the Internal Rate of Return
Rule
Advantages Disadvantages
Easy to understand and communicateMay result in multiple answers
or no
answers because of its inability to handle nonconventional cash
flows
Closely related to NPV and often leading identical results
May lead to incorrect decisions in comparison of mutually
exclusive
investments
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting DecisionFood For Thought…
• If a project with conventional cash flows has a payback period
less than the project’s life,– Can you definitively state the
algebraic sign of the NPV? Why or why not?
– If you know that the discounted payback period is less than
the project’s life, what can you say about the NPV?
• Suppose a project has conventional cash flows and a positive
NPV. What do you know about its – Payback Period?
– Discounted Payback Period?
– IRR?
• Respond to the following comment, “Company X likes the IRR
rule. It can use it to rank projects without having to specify a
discount rate.”
• Unfortunately, your chief executive officer refuses to accept
any investments in plant expansion that do not return their
original investment in four years or less. That is, he insists on a
payback rule with a cutoff period of four years. As a result,
attractive long-lived projects are being turned down. The CEO is
willing to switch to a discounted payback rule with the same
four-year cutoff period. Would this be an improvement? Explain.
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting DecisionA Few Examples…
• Consider the following two mutually exclusive projects:
• Whichever project you choose, if any, you require a 15 percent
return on your investment.– If you apply the payback criterion,
which investment will you choose?
– If you apply the discounted payback criterion, which
investment will you choose?
– If you apply the NPV criterion, which investment will you
choose?
– If you apply the IRR criterion, which investment will you
choose?
– Based on your answers to the above four parts, which project
will you finally choose? Why?
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Year Cash Flow (Project A) Cash Flow (Project B)
0 -170,000 -18,000
1 10,000 10,000
2 25,000 6,000
3 25,000 10,000
4 380,000 8,000
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Faizan Ahmed
Financial ManagementSZABIST
Capital Budgeting DecisionFood For Thought…
• An investment has an installed cost of PKR 412,670 and has
annual cash inflows of PKR 153,408 for four years coming at the end
of the each year.
– If the discount rate is zero, what is the NPV of the
investment?
– If the discount rate is infinite, what is the NPV?
– At what discount rate is the NPV just equal to zero?
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