Capital Budgeting

Capital Budgeting
• Net Present Value
• Internal Rate of Return
• Profitability Index
• Payback Period
Capital Budgeting
• Finding out whether or not to invest money in a project
Capital Budgeting Techniques
• Investment decisions are generally called Capital budgeting decisions
• How do you decide – whether you should invest in Project A or
Project B?
• How do you make informed decisions?
• This is what we are going to learn in today's lecture
Criteria
• Capital Budgeting Techniques uses the following Criteria to make informed
decisions
• Net Present Value (NPV) – What is the value of investment
• NPV - At a higher level NPV tells us what is the value of the return on investment
• Internal Rate of Return (IRR) - % of Return of Investment
• It tells us the percentage of return on investment
• Profitable Index (PI) – Profit ration for every shilling spent
• Determines, for every shilling that we spend on a project, how much are we getting back
• Payback period – Time to recover your investments
• Tells us the break even point to recover our investment.
• It tells us what time or what period we can recover the investment made into the
project
Financial Management Overview

• Capital budgeting
techniques falls
under the umbrella
of financial
management
• It is important to
know where in
financial
management these
capital budgeting
techniques fall into.
Opportunity cost
• Opportunity cost is something that you would give up in order to get
something else
• Why would people consider opportunity cost – Because people think
rationally, they would weigh the pros and cons of each activity before
they do it and choose the best alternative available at the point in
time
Example
• Invest in a Bank - Bank Annual Returns: 8%
• Invest in a Project - Project Annual Returns : 10%
• What is the opportunity cost if you invest in the Bank?
• What is the opportunity cost if you invest in the Project?
Cash Flows
• Discounted Cash Flow
• Non-Discounted Cash Flow
 Discounted Cash Flow
• Discounted Cash flow is nothing but the Opportunity Cost. (It is a financial
word for Opportunity Cost)
• Rate of return that an organization could have earned on the investment,
if not invested in the current project.
• In other words, it’s the rate of return that an organization is willing to lose
in an expectation to earn more by investing in this project.
• It is the lost opportunity on the capital that is being invested in the
projects.
• Other names for Discounted cash flow
• Opportunity Cost of Capital
• Cost of Capital
Discounted Cash Flow
• Let’s say If an organization earns 10% interest per annum on its
capital by putting the money in bank instead of investing in the
project.

• What is the opportunity cost of the capital ?

• Since it is the minimum that an organization could have earned if

invested the money in the bank
Non-Discounted Cash Flow

• In Non discounted cash flow, the interest rate, opportunity cost or

Discounted cash flow is not taken into consideration
Consideration for Capital budgeting

Discounted • NPV - Net present Value

• IRR - Internal Rate of Return
Cash Flow • PI – Profitability Index

Non-
• Payback period (Payback period is usually calculated
Discounted considering the Non discounted cash flow.
Cash flow
Time Value of Money
A Shilling sitting in your wallet is worth more today than the same Shilling tomorrow.

Can you tell Why?

• Depreciation.

• Money grows over time when it earns interest.

So, the time value of money brings us to the concept of

• Future Value of Money.

• Present Value of Money.
Relationship between FV & PV
• Future Value of Money (let’s call it FV)

• Present Value of Money (let’s call it PV)

FV = PV (1 + K) n

FV = Future Value
PV = Present Value
K = Discounted Rate in %
n = Number of Years
Relationship between FV & PV
Example – Calculate Future Value
• If Shs. 100M is invested in a Bank today, it may earn 8% per year
• What is the future value of 100M for the 1st , 5th and 15th year?
Example – Calculate Present Value
• If 100M is to be received after 1 year, what is the present value of
100M today?
Exercise - Calculate Present Value
• If 100M is to be received after 5 years, what is the present value of
100M today?
• If 100M is to be received after 15 years, what is the present value of
100M today?
 A quick recap so far…
So far we learned about

• Dicounted Cash flow (Opportunity cost)

• Non Discounted Cash flow
• Future Value
• Present Value
Let’s now do the calculations
Net Present Value
Capital Budgeting

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Net Present Value

Net Present Value (NPV) = “Present Value of all cash inflows – Present Value of
all cash outflow”

Example: Salary Slip

Net Salary = Gross Salary – Deductions

Similarly, The Present Value of all cash inflows is the Gross Present Value
and if you deduct cash outflows it becomes your Net Present Value.
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Net Present Value

Criteria
If NPV > 0 (NPV is +ve, Accept the Project)

If NPV < 0 (NPV is –ve, Reject the Project)

If NPV = 0 (Accept the Project, considering other non tangible

benefits)

Greater the NPV, Better the Prospects

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Example1: Calculating NPV
A sum of $ 400,000 dollars invested today in an IT project may give a series of below cash inflows in future:

$ 70,000 in year 1
$ 120,000 in year 2
$ 140,000 in year 3
$ 140,000 in year 4
$ 40,000 in year 5

If Opportunity cost of capital is 8% per annum, then should we accept or reject the project?

Solution:
Step 1: Calculate the PV value of year 1, year2, year3, year4, and year5
Step 2: Sum up the PV of all years
Step3: NPV = Present value of all cash inflows – Present value of all cash outflow.
Step 4: If NPV is positive, Accept the project, if not Reject the project.
Example1: Calculating NPV

Cash Inflow of all Present Values is : $ 408,959

Present value of Cash outflow is : $400,000

Net Present Value 🡺 PV of Cash inflows – PV of Cash Outflows

🡺 ($408959 – $400000) = $8959 dollars.

Since NPV is positive, (i.e., $8959, This project can be accepted)

Example2: Calculating NPV
Same example: Calculating NPV however with Discount rate or Opportunity cost of capital at 15%
A sum of $ 400,000 dollars invested today in an IT project may give a series of below cash inflows in future:

$ 70,000 in year 1
$ 120,000 in year 2
$ 140,000 in year 3
$ 140,000 in year 4
$ 40,000 in year 5

If Opportunity cost of capital is 15% per annum, then should we accept or reject the project?

Solution: Calculating NPV

Step 1: Calculate the PV value of year 1, year2, year3, year4, and year5
Step 2: Sum up the PV of all years
Step3: NPV = Present value of all cash inflows – Present value of all cash outflow.
Step 4: If NPV is positive, Accept the project, if not Reject the project.
Example2: Calculating NPV

N.B: Though we have the

same inflow & outflow of cash
as in the previous example,
the NPV value changed with
the change in the Discount
rate of interest.
Therefore, NPV is very much
dependent on the Discount
rate or in other words the
opportunity cost of the capital
Cash Inflow of all Present Values is : $ 343591 value.
Present value of Cash outflow is : $400,000

Net Present Value 🡺 PV of Cash inflows – PV of Cash Outflows

🡺 ($343591 – $400000) = $ -56408 dollars.
(negative 56408 dollars)

Since NPV is Negative, (i.e., - $56408, This project should be rejected)

Internal Rate of Return
Capital
Budgeting

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Internal Rate of Return (IRR)
• IRR 🡪 % of Return on investment.
• To put it simple: It is the percentage of Return of your investment.
• How do we calculate IRR?
• If you remembr from NPV example, we mentioned that the NPV is dependent on
Discounted rate
• If we increase the discount rate the NPV value decreases
• We need to increase /decrease the discount rate to a level where NPV becomes zero
• The discount rate at which NPV becomes zero is infact the Internal rate of return
• In other words, IRR is the opportunity cost at which the NPV becomes Zero.

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IRR
Let’s say at 8%, Discount rate, the NPV is 5000

Discoun And
t Rate
Let’s say at 12%, Discount rate, the NPV is 0

Net Then 12% is the return, we are getting from the

Presen project
t Value
And

This 12% is called the IRR.

Internal Rate of Return (IRR)
Note:
• For Constant rate of Cash inflow for every year, Internal Rate of Return can be calculated with the help of a formula.
• For Uneven rate of Cash inflows for every year, IRR can be calculated by little trail & error adjustments.

Accept the project when Internal rate of return > Discount rate or Opportunity cost of capital.

Reject the project when Internal rate of return < Discount rate or Opportunity cost of capital.

May accept the project when Internal rate of return = Discount rate or Opportunity cost of capital.

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Relationship between IRR, Discount rate and NPV

If IRR > Discount rate or Opportunity cost of capital 🡺 The NPV is always Positive.

If IRR < Discount rate or Opportunity cost of capital 🡺 The NPV is always
Negative.

If IRR = Discount rate or Opportunity cost of capital 🡺 The NPV is Zero.

Note: As long as the NPV is Positive, the project is financially viable.

The moment that NPV becomes Negative, the Project is NOT financially viable.
Calculating Internal Rate of Return
Example:

The cost of a project is $1000. It has a time horizon of 5 years and the expected year wise incremental cash flows are:

Year 1 : $200
Year 2 : $300
Year 3 : $300
Year 4 : $400
Year 5 : $500

Compute IRR of the project. If opportunity cost of Capital is 12%, And tell us, should we accept the project?

Solution:
Step 1: Take “K” as 12% and calculate NPV value.
Step 2: If NPV < 0 then Project is NOT financially viable at 12% discount rate.
Step 3: If NPV > 0 then Project is financially viable at 12% however we need to know the actual IRR value,
so we need to increase the K value to and calculate the NPV, continue it till you reach a point where the
NPV becomes zero or close to zero.

Step 4: The “K” value at which NPV becomes Zero or “Near Zero” is the actual IRR (Internal Rate of
Return)
Calculating Internal Rate of Return

At Discount Rate of 12%, the NPV is 169 (positive)

At Discount Rate of 17.7%, the NPV is 0 (Zero), there fore the IRR is 17.7%

Since IRR > Discount rate, Project can be accepted

Profitability Index (PI)
Capital
Budgeting
Criteria
If PI > = 1, Accept the Project.
If PI < 1, Reject the Project.

For every dollar spent, how much are we getting back

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 Profitability Index
A sum of $ 25,000 invested today in a project may give a series of cash inflows in future as described below:
• $ 5000 in year 1
• $ 9000 in year 2
• $ 10,000 in each of year 3
• $ 10,000 in each of year 4
• $ 3000 in year 5
If the required rate of return is 12% pa,
what is the Profitability Index?

Profitability Index is 1.07 and since it

is greater than 1, we can accept the
project.

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Payback Period
Capital
Budgeting

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Payback Period
The time it takes for the project to generate money to pay for itself.

Payback period is the number of years required to recover the cash outflow invested in the
project.

The project would be accepted if its payback period is less than the maximum or standard
payback period set by Industry, Senior Leadership.

In terms of Projects ranking, it gives highest ranking to the project with the shortest payback
period.

Note: In general, the discounted cash flow is not considered for Pay back period. Some do, but
most don’t!

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Payback Period
A sum of $25,000 invested today in an IT project, may give a series of cash inflows in future as described below.

$ 5,000 in year 1
$ 9,000 in year 2
$ 10,000 in each of year 3
$ 10,000 in each of year 4
$ 3,000 in year 5

What is the Payback Period (Non-discounted)?

Payback Period (Non-discounted) = In between 3 years 1 month and 3 years 2 months

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Important: Few tips to Remember

✔ Always choose projects with highest NPV.

✔ If NPV is same for the given projects, choose the project with highest IRR.
✔ If NPV, IRR remains the same for the given projects, choose the projects
with early pay back period.
✔ NPV = All Cash Inflows – Cash Outflows
✔ PI = All Cash Inflows / Cash Outflows
✔ IRR = Discount rate at which the NPV becomes zero, this tell us what is the
percent of return for the project.
✔ Payback period is a major consideration for every project, business or
organization, it tells us how soon we can recover our investment and this
investment can be utilized for other business needs/projects later on.
Quick Recap – Concepts Learned

• Opportunity Cost / Discounted Cash flow

• Time Value of Money
• Calculating Future value
• Calculating Present value

Based on the above concepts, we learnt how to solve

• Capital Budgeting techniques.

✔ Net Present Value - NPV

✔ Internal Rate of Return - IRR
✔ Profitability Index – PI
✔ Payback Period - PBP