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CAPITAL BUDGETING
Presented By:
1. Introduction
2. Definition
It includes the cash required to acquire the new equipment or build the
new plant less any net cash proceeds from the disposal of the replaced
equipment. The initial outlay also includes any additional working
capital related to the new equipment. Only changes that occur at the
beginning of the project are included as part of the initial investment
outlay. Any additional working capital needed or no longer needed in a
future period is accounted for as a cash outflow or cash inflow during
that period.
Page 3 of 13
It includes the net cash generated from the sale of the assets, tax
effects from the termination of the asset and the release of net working
capital.
Although there are several methods used in Capital Budgeting, the Net
Present Value technique is more commonly used. Under this method a
project with a positive NPV implies that it is worth investing in.
A capital budgeting decision has its effect over a long time span and
inevitably affects the company’s future cost structure and growth. A
wrong decision can prove disastrous for the long-term survival of firm.
On the other hand, lack of investment in asset would influence the
competitive position of the firm. So the capital budgeting decisions
determine the future destiny of the company.
the firm from earning profit from other investments which could not be
undertaken.
Generally the business firms are confronted with three types of capital
budgeting decisions.
It includes all those projects which compete with each other in a way
that acceptance of one precludes the acceptance of other or others.
Thus, some technique has to be used for selecting the best among all
and eliminates other alternatives.
Problem:
Cost price of Assets: 540000 TK
Installation Charge: 50000
Salvage Value: 10000
Working Capital: 20000
Useful Life: 5years
Tax Rate: 40%
Depreciation: Straight Line
Cost of Capital: 10%
Now, Required:
(A) Pay back period (PBP)
(B) Average rate of return (ARR)
(C) Net present Value(NPV)
(D) Internal rate of return (IRR)
(E) Profitability index (PI)
(F) Discounted Pay back Period (DPBP)
(G) Comment on the acceptability of the project (based on DCF model)
Solution :
Working -1
C + I − SV
We know, Depreciation = L
(540000 + 50000 ) − 10000
=
5
590000 −10000
= 5
= 116000 TK
Working Table -1
Mainly the techniques of project evaluations are tow types and they
have such branch also. These are..
Page 9 of 13
If the cash flow is uniform, in this case the pay back period will:
NCO
PBP = (When Cash Flow will uniform)
NCB
And if the cash flow is not uniform, this case the pay back period will:
NCO − C
PBP = A+ (When Cash Flow will not uniform)
D
We know, Here,
NCO − C NCO = Tk.610000
PBP = A+
D A = The year at which CNCB is Nearer to
NCO=3
610000 - 499200
∴PBP =3+
124400 C = CNCB of year A=499200
110800 D = NCB of the year following the year
=3+
124400
= 3+0.89
= 3.89 Years
Page 10 of 13
AverageofN PAT
ARR = AverageInv estmetnt ×100
180000 ÷ 5
=
( 610000 + 10000 ) ÷ 2 ×100
36000
= ×100
310000
= 11.61
∴ARR = 11.61%
ARR including working capital
AverageofN PAT
ARR = AverageInv estmetnt ×100
180000 ÷ 5
=
( 590000 +10000 ) ÷ 2 + 20000 ×100
36000
= ×100
320000
= 11.25%
Net present value (NPV) gives explicit consideration to the time value
of money; it is considered a sophisticated capital budgeting technique.
All such techniques in one way or another discount the firm’s cash
flows at a specified rate. This rate—often called the discount rate,
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A1 A2 A3 A4 A5 + S
NPV = [ + + + +
(1 + R ) 1
(1 + R ) 2
(1 + R ) 3
(1 + R ) 4
(1 + R ) 5 ] - NCO
136400 196400 166400 124400 136400 + 10000 + 20000
[ + + + + ]
=
(1 + 0.1)1 (1 + 0.1) 2 (1 + 0.1) 3 (1 + 0.1) 4 (1 + 0.1) 5
- NCO
= [124000+162314+125019+84967+103321]-610000
= 599621 – 610000 = -10379
C
IRR = [A+ × (B-A)] ×100
C −D
IRR= Internal Rate of Return
A = Lower Discount Rate
B = Higher Discount Rate
C= Net Present Value (NPV) at lower discounting rate
D = Difference between the NPV at higher discounting rate and the
lower discounting rate.
Here,
NCO =610000 TK
A = Lower Discount Rate = 6% = 0.06
B = Higher Discount Rate = 10% = 0.10
C = NPV of HDR
= -10379
D = NPV of LDR
136400 196400 166400 124400 136400 + 10000 + 20000
NPV (6%)=[ ]
(1 + .06 )1 (1 + .06 ) 2 (1 + .06 ) 3 (1 + .06 ) 4 (1 + .06 ) 5
+ + + +
– NCO
Page 12 of 13
=[128679+174795+139713+98537+124346] -610000
=666070 - 610000 =56070
56070
∴IRR = [0.06 + 56070 − (−10379 )
× (0.10-0.06)] ×100
56070
= [0.06 + × 0.04] ×100 =(0.06 + 0.0338) ×100
66446
=0.0938×100 =9.38
∴IRR =9.38%
F. Profitability Index Method (PI)
PVCF
PI =
Initial Investment
599621
PI = =.98
610000
Under the DPBP method, the project should not be accepted due to its
required more than 5 years to pay back the net cash outlay.
(H)Comments: