CHAPTER

Capital
Budgeting
Techniques
WHAT IS CAPITAL BUDGETING?

The process of planning and evaluating
expenditures on assets whose cash flows

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are expected to extend beyond one year

Analysis of potential additions to fixed assets

Long-term decisions; involve large
expenditures

Very important to firm’s future
GENERATING IDEAS FOR CAPITAL
PROJECTS

A firm’s growth and its ability to remain
competitive depend on a constant flow of

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ideas for new products, ways to make
existing products better, and ways to
produce output at a lower cost.

Procedures must be established for
evaluating the worth of such projects.
PROJECT CLASSIFICATIONS

Replacement Decisions: whether to purchase
capital assets to take the place of existing assets to
maintain or improve existing operations

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Expansion Decisions: whether to purchase capital
projects and add them to existing assets to increase
existing operations

Independent Projects: Projects whose cash flows
are not affected by decisions made about other
projects

Mutually Exclusive Projects: A set of projects
where the acceptance of one project means the others
cannot be accepted
SIMILARITIES BETWEEN CAPITAL
BUDGETING AND ASSET VALUATION

Determine the cost, or purchase price, of the asset.

Estimate the cash flows expected from the project.

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Assess the riskiness of cash flows.

Compute the present value of the expected cash flows

to obtain as estimate of the asset’s value to the firm.

Compare the present value of the future expected cash
flows with the initial investment.
CAPITAL BUDGETING
Purpose

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Expansion

Improvement

Replacement

R&D
THE BASICS OF CAPITAL
BUDGETING

Should we
build this
plant?
IDEAL SELECTION METHOD
Will:-
 Select the project that maximises shareholders

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wealth

 Consider all cash flows

 Discount the cash flows at the appropriate

market determined opportunity cost of capital

 Will allow managers to consider each project

independently from all others
 CAPITAL BUDGETING PROCESS

1. Estimate
the cash flows.

2. Assess the riskiness of the cash
flows.

3. Determine the appropriate
discount rate.

4. Find the PV of the expected cash
flows.

5. Accept the project if PV of inflows
> costs.
SELECTION METHODS

Payback

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Internal Rate of Return (IRR)

Net Present Value (NPV)

Profitability Index
 PAYBACK PERIOD

FORMULA:-

For a project with equal annual receipts:

Where: I= initial investment

C =net annual cash inflow

Example 1:
Years 0 1 2 3 4 5

Project A 1,000,000 250,000 250,000 250,000 250,000 250,000

= 4 years
INTERNAL RATE OF RETURN

· The IRR is the discount rate at which the NPV

for a project equals zero. This rate means that
the present value of the cash inflows for the
project would equal the present value of its
outflows.

· The IRR is the break-even discount rate.

· The IRR is found by trial and error.

NET PRESENT VALUE METHOD

Discount cash inflows to their present
value and then compare with capital
outlay required by the investment

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Discount rate (hurdle rate or required
rate of return) - required minimum rate of
return given riskiness of investment

Proposal is acceptable when NPV is ≥ zero

The higher the NPV, the more attractive
the investment
NET PRESENT VALUE

DECISION RULE: Invest

in capital assets?

Is NPV positive? Is NPV negative?

Invest Do not invest

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.

PROFITABILITY INDEX (PI)

The profitability index, or PI, method compares the

present value of future cash inflows with the initial
investment on a relative basis. Therefore, the PI is the
ratio of the present value of cash flows (PVCF) to the
initial investment of the project.

PI= PVCF/Initial Investment

In this method, a project with a PI greater than 1 is

accepted, but a project is rejected when its PI is less
than 1
COMPARISON OF CAPITAL
BUDGETING MODELS

Method Strengths Weaknesses

Payback Easy to understand Ignores profitability
Based on cash flows and the time value
Highlights risks of money

NPV & Based on cash Difficult to

IRR flows, profitability & determine
time value of money discount rate
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