Capital Budgeting

Assignment





Submitted to: Mr. Muntazir Hussain
By:
Adnan Rashid
M.Phil. II (Finance)
University of Lahore







Capital Budgeting
When one can look at the word capital budgeting, he can find a combination of two words
capital and budget. Where capital refers to the long term investment in assets for production
or shareholder maximization, and budgeting represents the planning for getting the maximum
income from such investment over the extended life of the investment. So, normally we can say
that Capital budgeting is a process or combination of steps that help the organization to evaluate
the long term investments, and enable them to invest in a bets suitable / optimal investment. It is
a process that contains several techniques through which organization as well as individual
investor can easily find the best suitable project for investment and also find out its future
performance. In capital budgeting, the decision of either acceptance of rejection is made on the
basis of cash generation capacity of the project.
The background of capital budgeting resembles with security valuation, but different from that
valuation in sense of difference between organization and individual investor.
The importance of capital budgeting process is not ignorable for an organization, because of its
involvement in the achievement of organization primary goal. This is because organization
manages finance to raise the wealth of the shareholders and in this regard, capital budgeting
techniques or process enable managers to effectively manage investments by raising
accountability and measurability. The importance of capital budgeting can also be observed from
the situation of the organization, who make investment in projects without consideration of risk
and return find less return and cannot fulfill the main objective of the organization.
As we discussed earlier that capital budgeting is a process, and this process contains several
stages that starts from analyzing the projects, creation of their lists and comes through an end of
investment in an project through evaluation stage, which shows the analysis of taxes, incremental
costs etc. So, in nutshell capital budgeting process is also somewhat similar to decision making
process. However there are certain factors that can affect the capital budgeting process of an
organization. Like any other process there are certain factors that influence the capital budgeting
process, and are as following:
Availability of Funds
Capital Structure of an organization
Urgency of investment
Exchange rate position and policy
Taxation and other governmental policies
Trends of risk and return adoption
Capital Budgeting Process:
- First, the cost of that particular project must be known.
- Second, estimates the expected cash out flows from the project, including residual value of
the asset at the end of its useful life.
- Third, riskiness of the cash flows must be estimated. This requires information about the
probability distribution of the cash outflows.
- Based on projects riskiness, Management find outs the cost of capital at which the cash out
flows should be discounted.
- Next determine the present value of expected cash flows.
- Finally, compare the present value of expected cash flows with the required outlay. If the
present value of the cash flows is greater than the cost, the project should be taken.
Otherwise, it should be rejected.
OR
- If the expected rate of return on the project exceeds its cost of capital, that project is worth
taking.

Capital Budgeting Techniques:
1) Profitability Index
Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful
capital budgeting technique for grading projects because it measures the value created by per unit
of investment made by the investor.

This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value
investment ratio (VIR).

The ratio is calculated as follows:
Profitability Index = Present Value of Future Cash Flows / Initial Investment

If project has positive NPV, then the PV of future cash flows must be higher than the initial
investment.
Thus the Profitability Index for a project with positive NPV is greater than 1 and less than 1 for a
project with negative NPV. This technique may be useful when available capital is limited and
we can allocate funds to projects with the highest PIs.

2) Discounted Payback Period
One of the limitations in using payback period is that it does not take into account the time value
of money. Thus, future cash inflows are not discounted or adjusted for debt/equity used to
undertake the project, inflation, etc. However, the discounted payback period solves this
problem. It considers the time value of money, it shows the breakeven after covering such costs.
This technique is somewhat similar to payback period except that the expected future cash flows
are discounted for computing payback period.
Discounted payback period is how long an investments cash flows, discounted at projects cost
of capital, will take to cover the initial cost of the project. In this approach, the PV of future cash
inflows are cumulated up to time they cover the initial cost of the project. Discounted payback
period is generally higher than payback period because it is money you will get in the future and
will be less valuable than money today.
For example, assume a company purchased a machine for $10000 which yields cash inflows of
$8000, $2000, and $1000 in year 1, 2 and 3 respectively. The cost of capital is 15%. The regular
payback period for this project is exactly 2 year. But the discounted payback period will be more
than 2 years because the first 2 years cumulative discounted cash flow of $8695.66 is not
sufficient to cover the initial investment of $10000. The discounted payback period is 3 years.

Decision Rule of Discounted Payback:
If discounted payback period is smaller than some pre-determined number of years then an
investment is worth undertaking.

3) I nternal Rate of Return
Internal Rate of Return is another important technique used in Capital Budgeting Analysis to
access the viability of an investment proposal. This is considered to be most important
alternative to Net Present Value (NPV). IRR is The Discount rate at which the costs of
investment equal to the benefits of the investment. Or in other words IRR is the Required Rate
that equates the NPV of an investment zero.
NPV and IRR methods will always result identical accept/reject decisions for independent
projects. The reason is that whenever NPV is positive , IRR must exceed Cost of Capital.
However this is not true in case of mutually exclusive projects.
The problem with IRR comes about when Cash Flows are non-conventional or when we are
looking for two projects which are mutually exclusive. Under such circumstances IRR can be
misleading.
Suppose we have to evaluate two mutually exclusive projects. One of the project requires a
higher initial investment than the second project; the first project may have a lower IRR value,
but a higher NPV and should thus be accepted over the second project (assuming no capital
rationing constraint).
Decision Rule of Internal Rate of Return:
If Internal Rate of Return exceeds the required rate of Return, the investment should be accepted
or should be rejected otherwise.
4) Payback Period
Payback period is the first formal and basic capital budgeting technique used to assess the
viability of the project. It is defined as the time period required for the investments returns to
cover its cost. Payback period is easy to apply and easy to understand technique; therefore,
widely used by investors.
For example, an investment of $5000 which returns $1000 per year will have a five year payback
period. Shorter payback periods are more desirable for the investors than longer payback periods.
It is considered as a method of analysis with serious limitations and qualifications for its use.
Because it does not properly account for the time value of money, risk and other important
considerations such as opportunity cost.
5) Net Present value:
Net present value among other techniques of capital budgeting simply tell us about the
contribution of a certain project to the shareholders wealth. The higher the addition of wealth by
the project, higher will be the shareholders wealth, which means the higher will be the share
price. A formal definition of this technique of capital budgeting defines it as a ranking methods
of projects, which rank the projects on the basis of their difference between outflow and present
value of inflows. Formula of this technique is as following:
NPV= present value of Inflow + Outflow
The higher the net present value of the project, higher will be the chances of profitability from
that project. Here we talk about chance of profitability because on the basis of prediction of
future. So, the decision criteria in this approach of capital budgeting is the selection of project
with a higher net present value.
For example, we find a project which requires an outflow of RS. 1000 and inflows of 500, 400,
300, 200 at the required rate of 10% for next 4 years. Is it project is feasible for investment.
NPV= -1000 + 500/(1.10)^4 + 400/(1.10)^3 +300/(1.10)^2 + 200/(1.10)^1
NPV= -1000 + 1071.785
NPV= 71.785
As the Net present value of this project is positive, so we can conclude that the investment in
this project is feasible and result in profitable investment.