CHAPTER

7 Introduction to Capital
Budgeting
 OVERVIEW OF CAPITAL BUDGETING

 Capital budgeting relates to the total funds employs in an enterprise as a whole, and budgeting

indicates a detailed quantified planning which guides future activities of an enterprise towards the

achievement of its goals.

 Capital budgeting can be defined as process of evaluating and selecting long-term

investment projects or expenditures that involve significant financial resources, typically

with a focus on assets that will generate returns over an extended period.

 Capital budgeting serves as a structured and methodical approach to making long-term

investment decisions in a business.

 REASONS FOR CAPITAL BUDGETING

A. Efficient Resource Allocation: Capital budgeting helps organizations allocate their

financial resources effectively by evaluating and prioritizing investment projects. This
ensures that the company's funds are directed toward initiatives that offer the best
potential returns.

B. Maximizing Shareholder Wealth: One of the primary objectives of capital budgeting is to

maximize the wealth of shareholders. By selecting projects with positive net present value
(NPV) or high internal rate of return (IRR), a company can increase the value of its
shares and attract investors.
 REASONS FOR CAPITAL BUDGETING

C. Risk Assessment: Capital budgeting involves a comprehensive analysis of the risks

associated with each investment opportunity. This risk assessment helps companies
make informed decisions and manage potential downsides.

D. Long-term Planning: It enables businesses to plan for the long term and align their
investments with strategic goals and objectives. This ensures that the company's
investments support its vision for the future.

E. Performance Evaluation: After investment projects are completed, capital budgeting

provides a basis for evaluating their actual performance against initial projections. This
assessment helps in refining future budgeting and decision-making processes.
 IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting is significant in the financial management of organizations/ business for

several reason:
a. Long-term Planning: Capital budgeting allows businesses to plan for the long term. It helps in
identifying and prioritizing investment opportunities that align with the company's strategic goals and
vision.
b. Resource Allocation: It aids in the efficient allocation of financial resources. By evaluating and
selecting the most promising investment projects, organizations can optimize their use of capital
and avoid wasteful spending on less profitable ventures.
c. Risk Management: Capital budgeting helps assess the risks associated with different investment
options. This risk analysis enables companies to make informed decisions and consider potential
downsides, minimizing the likelihood of making poor investment choices.
 IMPORTANCE OF CAPITAL BUDGETING

d. Maximizing Shareholder Value: The primary goal of capital budgeting is to maximize shareholder
wealth. By selecting projects that offer a positive net present value (NPV) or a high internal rate of
return (IRR), companies can enhance the value of their shares and attract investors.
e. Capital Efficiency: Effective capital budgeting ensures that resources are used efficiently, and that
the capital invested generates the highest possible returns. This efficiency is essential for sustaining
and growing the business.
f. Performance Evaluation: Once investment projects are completed, capital budgeting provides a
basis for evaluating their actual performance against the initial projections. This assessment helps
in refining future budgeting and decision-making processes.
 Overview (cont.)

 Two groups of project for decision making process:

– Independent project—which cash flows are unrelated
to one another. A decision to accept one project will
not affect the decision to accept another.
– Mutually exclusive projects—decision to choose only
one project from the many projects evaluated.
 Accept one project and reject the others
 CAPITAL BUDGETING
TECHNIQUE

CAPITAL
BUDGETING
TECHNIQUE

DISCOUNT INTERNAL
PAYBACK NET PRESENT PROFITIBALITY
PAYBANK RATE OF
PERIOD VALUE INDEX
PERIOD RETURN
 Payback Period

 Payback period is a financial metric used in capital budgeting to assess the time it takes for
an investment or project to generate sufficient cash flows to recover its initial investment cost.
In other words, it measures the time it takes for an organization to "break even" on its
investment.

 In practice, businesses often prefer payback period method because the shortest time taken
to recoup capital investment.

 Therefore, the general rule is that when comparing projects, the preferred choice will be the
one that shows the shortest time to pay back the capital invested.
 FORMULA PAYBACK PERIOD

 If the cash inflow is equal in each year (even cash flow)

PBP = Initial Investment/ Annual Cash Inflow

 If the cash flows are mixed stream (uneven cash flow) , the yearly cash inflows must be
accumulated until the initial investment is recovered :
 EXAMPLE 1
(EVEN CASH FLOW)

The Delta company is planning to purchase a machine known as machine X. Machine X

would cost $25,000 and would have a useful life of 10 years with zero salvage value. The

expected annual cash inflow of the machine is $10,000 and the company’s maximum desired

payback period is 4 years. Compute payback period of the investment and advise whether the

company should accept or reject the purchase?

 EXAMPLE 1
(EVEN CASH FLOW)

The Delta company is planning to purchase a machine known as machine X. Machine X

would cost $ 25,000 and would have a useful life of 10 years with zero salvage value. The
expected annual cash inflow of the machine is $10,000 and the company’s maximum desired
payback period is 4 years. Compute payback period of the investment and advise whether the
company should accept or reject the purchase?
PBP = Initial Investment/ Annual Cash Inflow

25,000 / 10,000 = 2.5 years @ 2 years and 6 month

 EXAMPLE 2
(UNEVEN CASH FLOW)
An investment of $200,000 is expected to generate the following cash inflows in six years
Year 1: $70,000
Year 2: $60,000
Year 3: $55,000
Year 4: $40,000
Year 5: $30,000
Year 6: $25,000

Compute payback period of the investment. Should the investment be made if management
wants to recover the initial investment in 3 years or less?
 EXAMPLE 2
(UNEVEN CASH FLOW)
 An investment of $200,000 is expected to generate the following cash inflows in six years
Year 1: $70,000 Year Cash Inflow Balance
Year 2: $60,000 0 - - 200,000
(+)
Year 3: $55,000 1 70,000 - 130,000
(+)
Year 4: $40,000
2 60,000 (+) -70,000
Year 5: $30,000
3 55,000 (+) -15,000
Year 6: $25,000
4 40,000 (+) 25,000
5 30,000 (+) 55,000
6 25,000 80,000
PBP = 3 + (15,000/40,000) = 3 + 0.38 = 3.38 years
 PRO AND CONS OF PAYBACK PERIOD
ADVANTAGES DISADVANTAGES
Simplicity: The payback period is easy to understand Ignoring the Time Value of Money: The most significant
and calculate, making it accessible to a wide range of drawback of the payback period is that it does not
users, including non-financial professionals. Its simplicity consider the time value of money. It treats all cash flows
allows for quick initial assessments of investment as if they have the same value, ignoring the fact that a
projects. dollar received in the future is worth less than a dollar
received today.
Liquidity Focus: The payback period emphasizes the Neglecting Cash Flows Beyond the Payback Period:
speed at which the initial investment is recouped. This is The payback period only measures the time it takes to
particularly relevant for projects where maintaining recoup the initial investment and doesn't account for the
liquidity or cash flow is a primary concern cash flows that occur beyond that period. This means it
doesn't provide a complete picture of the project's long-
term profitability.
Decision Making: In some cases, a company may have Risk Assessment Limitations: While the payback period
strict payback period requirements or guidelines for can help assess the risk of not recovering the initial
project selection, which can help in decision-making by investment, it doesn't provide insight into the overall
providing clear criteria return on investment (ROI) or the potential for profit after
the payback period.
 Discounted Payback Period

 The discounted payback period is a variation of the traditional payback period used
in capital budgeting.
 While the traditional payback period measures the time it takes to recover the initial
investment cost without considering the time value of money, the discounted
payback period accounts for the time value of money by discounting future cash
flows to their present value.
 This makes it a more sophisticated and financially rigorous method for evaluating
investment projects.
 Discounted Cash Flow (DCF)

If Extra Mart are considering an investment project that requires an initial investment of
$10,000. The project is expected to generate cash flows of $3,000 at the end of year 1, $4,000
at the end of year 2, $5,000 at the end of year 3, and $3,000 at the end of year 4.

If Extra Mart assume discount rate of 8% annually, compute payback period of the investment.
Should the investment be made if Extra Mart wants to recover the initial investment in 4 years
or less?
 Discounted Cash Flow (DCF)

If Extra Mart are considering an investment project that requires an initial investment of $10,000. The
project is expected to generate cash flows of $3,000 at the end of year 1, $4,000 at the end of year 2,
$5,000 at the end of year 3, and $3,000 at the end of year 4. If Extra Mart assume discount rate of 8%
annually, compute payback period of the investment. Should the investment be made if Extra Mart wants
to recover the initial investment in 4 years or less?
Year Cash Cash Calculation Present Cumulative discounted
Inflow Outflow (r= 8% @ 0.08) value cash flows
 Discounted Cash Flow (DCF)

If Extra Mart are considering an investment project that requires an initial investment of $10,000. The
project is expected to generate cash flows of $3,000 at the end of year 1, $4,000 at the end of year 2,
$5,000 at the end of year 3, and $3,000 at the end of year 4. If Extra Mart assume discount rate of 8%
annually, compute payback period of the investment. Should the investment be made if Extra Mart wants
to recover the initial investment in 4 years or less?
Year Cash Cash Calculation Present Cumulative discounted
Inflow Outflow (r= 8% @ 0.08) value cash flows
0 - 10,000 - (10,000)
1 3,000 - [3000 / (1.08)^1] 2,777.78 (7,222.22)
2 4,000 [4000 / (1.08)^2] 3,231.48 (3,459.41)

3 5,000 [5000 / (1.08)^3] 3,762.81 303.4

4 3,000 [3000 / (1.08)^4] 2,574.83 2,878.23

 Net Present Value (NPV)

 This method calculates the net present value by

taking all discounted total cash inflows and
subtracting the total cash outflows from it, both
discounted at the discount rate, for the total number
of years of the project.
 The net figure will indicate either a positive or a
negative outcome that will be used as a basis for
recommending the decision.

20
 Net Present Value (NPV)

 A positive NPV means that the total discounted inflow

is greater than the total discounted outflow, therefore,
the project should be recommended.
 If the NPV is negative, the project should be rejected.
 The formula for the calculation of NPV is as follows:

NPV = - Cost + PV(Future Flows) Where,

NPV = - Cost + 
T
CF t Cost = Cost outflow
t
t =1 (1 + r ) CF = Cash Inflow
T
CF t r = discount rate
NPV = 
t =0 (1 + r )
t
t = year
 EXAMPLE 3
NET PRESENT VALUE (NPV)
 The management of Fine Electronics Company is considering to purchase
an equipment to be attached with the main manufacturing machine. The
equipment will cost $6,000 and will increase annual cash inflow by $2,200.
The useful life of the equipment is 6 years. After 6 years it will have no
salvage value. The management wants a 20% return on all investments.
Cash outflow/Initial outlay (cost) = RM 6,000
Years Cash flow Calculation Present Value (PV)
Cash inflow (CF) = RM 2,200/annually
Period of machine (t) = 6 years
0 -6000 - -6,000
Return rate (r)= 20% @ 0.2
1 2,200 2200/(1+0.2) 1,833.33
2 2,200 2200/(1+0.2)^2 1,527.78
3 2,200 2200/(1+0.2)^3 1,273.15
4 2,200 2200/(1+0.2)^4 1,060.96
5 2,200 2200/(1+0.2)^5 884.13
6 2,200 2200/(1+0.2)^6 736.78
NPV RM 1,316.13
 EXAMPLE 3
NET PRESENT VALUE (NPV)
 The management of Fine Electronics Company is
considering to purchase an equipment to be attached
with the main manufacturing machine. The equipment
will cost $6,000 and will increase annual cash inflow
by $2,200. The useful life of the equipment is 6 years.
After 6 years it will have no salvage value. The
management wants a 20% return on all investments.
 EXAMPLE 4
NET PRESENT VALUE (NPV)
 A project requires an initial investment of $225,000
and is expected to generate the following net cash
inflows
Year 1: $95,000
Year 2: $80,000
Year 3: $60,000
Year 4: $55,000
Compute net present value of the project if the minimum
desired rate of return is 12%.
 EXAMPLE 4
NET PRESENT VALUE (NPV)
 A project requires an initial investment of $225,000
and is expected to generate the following net cash
inflows
Year Cash Calculation Present value
Inflow
1 95,000 95,000/(1+0.12) 84,821.43
2 80,000 80,000/(1+0.12)^2 63,775.51
3 60,000 60,000/(1+0.12)^3 42,706.81
4 55,000 55,000/(1+0.12)^4 34,953.49
Total
 EXAMPLE 4
NET PRESENT VALUE (NPV)
 A project requires an initial investment of $225,000
and is expected to generate the following net cash
inflows
Year Cash Calculation Present value
Inflow
1 95,000 95,000 / (1+0.12)^1 84,821.43
2 80,000 80,000 / (1+0.12)^2 63,775.51
3 60,000 60,000 / (1+0.12)^3 42,706.81
4 55,000 55,000 / (1+0.12)^4 34,953.49
Total 226,257.24
NPV = -225000 + 226,257.24
NPV = RM 1,257.25
 Internal Rate of Return (IRR)

 IRR is a discount rate where the NPV equals zero. This is

similar in principle as in the case of Break-Even Point (BEP)
where the cost of investment is recouped at a particular rate
of return known as the IRR.
 The decision rule under this method is that if an investment
project shows that its IRR exceeds the cost of capital, or
the given discount rate, then the project should be
recommended.
 Internal Rate of Return (IRR)

 IRR is calculated either based on plotting the points of NPV

against the discount rates or by linear interpolation.
 The two extreme points of these variables must show one
negative NPV and one positive NPV at the two different rates.
 EXAMPLE 5
(IRR)

If the project expected complete in one year and the beginning

cash outflow is RM 100,000 and the cash inflow after the project
is completed is RM 130,000. Given the that the rate of return is
8%. Find the
a.) Net Present Value (NPV) for this project
b.) Internal Rate of Return (IRR) for this project.
c.) Based on your answer at (a) and (b), should we accept this
project.
 EXAMPLE 5
(IRR)

If the project expected complete in one year and the beginning

cash outflow is RM 100,000 and the cash inflow after the project
is completed is RM 130,000. Given the that the rate of return is
8%. Find the
a.) Net Present Value (NPV) for this project
NPV = -100,000 + [130,000/(1.08)]
NPV = -100,000 + 120,370.37
NPV = RM 20,370.37
 EXAMPLE 5
(IRR)

If the project expected complete in one year and the beginning cash outflow is
RM 100,000 and the cash inflow after the project is completed is RM 130,000.
Given the that the rate of return is 8%. Find the
b.) Internal Rate of Return (IRR) for this project.
Set NPV to Zero (NPV=0)
0 = -100,000 + [130,000/ (1+R)]
100,000 = 130,000 / (1+R)
1+R = 130,000/100,000
R = 1.3 – 1
R = 0.3 @ 30%
 EXAMPLE 5
(IRR)

If the project expected complete in one year and the beginning

cash outflow is RM 100,000 and the cash inflow after the project
is completed is RM 130,000. Given the that the rate of return is
8%. Find the
c.) Based on your answer at (a) and (b), should we accept
this project.
We should ACCEPT this project due to NPV of this project is
positive and the IRR are higher than rate of return.
 EXAMPLE 6
(IRR)

Daizo Capital Venture intend to invest in one project known as Project

Xander. Below are the cash flow proposal for Project Xander :
Year 0: (RM 50,000)
Year 1: RM 33,000
Year 2 : RM 24,200
Compute the Internal Rate of Return (IRR) for this project. If the rate of return
is 11%, should Daizo Capital Venture accept this project.
 EXAMPLE 6
(IRR)

Daizo Capital Venture intend to invest in one project known as Project

Xander. Below are the cash flow proposal for Project Xander :
Year 0: (RM 50,000)
Year 1: RM 33,000
Year 2 : RM 24,200
Trial and error technique.

Let say the rate of return is 9%

NPV = - 50,000 + [33,000/1.09] + [ 24,200/(1.09)^2]
NPV = -50,000 + 30,275 + 20,369
NPV = RM 644
 EXAMPLE 6
(IRR)

Daizo Capital Venture intend to invest in one project known as Project

Xander. Below are the cash flow proposal for Project Xander :
Year 0: (RM 50,000)
Year 1: RM 33,000
Year 2 : RM 24,200
Trial and error technique. Let say the rate of return is 9.5%
NPV = - 50,000 + [33,000/(1.095)] + [24,200/(1.095)^2]
NPV = -50,000 + 30,137 + 20,183
NPV = RM 320
 EXAMPLE 6
(IRR)

Daizo Capital Venture intend to invest in one project known as Project

Xander. Below are the cash flow proposal for Project Xander :
Year 0: (RM 50,000)
Year 1: RM 33,000
Year 2 : RM 24,200
Trial and error technique. Let say the rate of return is 10%
NPV = - 50,000 + [33,000/(1.1)] + [24,200/(1.1)^2]
NPV = -50,000 + 30,000 + 20,000
NPV = RM 0.
This mean our IRR is 10% as the NPV already 0
If the rate of return is 11%, should Daizo Capital Venture accept this project.
10% < 11%
 EXAMPLE 6
(IRR)

Daizo Capital Venture intend to invest in one project known as Project

Xander. Below are the cash flow proposal for Project Xander :
Year 0: (RM 50,000)
Year 1: RM 33,000
Year 2 : RM 24,200
Compute the Internal Rate of Return (IRR) for this project. If the rate of return
is 11%, should Daizo Capital Venture accept this project.

Based on IRR, Daizo Capital Venture should REJECT this project as the
IRR this project is lower than rate of return (hurdle rate)
 Difference between NPV
and IRR

 NPV and IRR methods are both DCF methods of

evaluating capital investments that can be adopted before
deciding if a particular project is feasible financially.
 There could be cases where when two projects are
compared, the NPV and IRR methods might give
conflicting answers and affect our recommendation.
 NPV uses absolute numbers and measures the size of
the outcome in monetary value, whereas IRR accounts
for relative basis in a percentage measure.
 In this case, NPV relates to the size and timing of the
cash flows which IRR does not do.