Capital Budgeting

Capital budgeting (or investment appraisal) is the process of determining the viability to long-
term investments on purchase or replacement of property plant and equipment, new product line
or other projects.
Capital budgeting consists of various techniques used by managers such as:
1. Net Present Value
2. Payback Period
3. Discounted Payback Period
4. Accounting Rate of Return
5. Internal Rate of Return
6. Profitability Index

All of the above techniques are based on the comparison of cash inflows and outflow of a project
however they are substantially different in their approach.
A brief introduction to the above methods is given below:
 Payback Period measures the time in which the initial cash flow is returned by the
project. Cash flows are not discounted. Lower payback period is preferred.
 Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash
inflows. Higher NPV is preferred and an investment is only viable if its NPV is positive.
 Accounting Rate of Return (ARR) is the profitability of the project calculated as
projected total net income divided by initial or average investment. Net income is not discounted.
 Internal Rate of Return (IRR) is the discount rate at which net present value of the
project becomes zero. Higher IRR should be preferred.
 Profitability Index (PI) is the ratio of present value of future cash flows of a project to
initial investment required for the project.

Net Present Value (NPV)

Net present value (NPV) of a project is the potential change in an investor's wealth caused by that
project while time value of money is being accounted for. It equals the present value of net cash
inflows generated by a project less the initial investment on the project. It is one of the most
reliable measures used in capital budgeting because it accounts for time value of money by using
discounted cash flows in the calculation.
Net present value calculations take the following two inputs:
 Projected net cash flows in successive periods from the project.
 A target rate of return i.e. the hurdle rate.
Where,
Net cash flow equals total cash inflow during a period, including salvage value if any, less cash
outflows from the project during the period.
Hurdle rate is the rate used to discount the net cash inflows. Weighted average cost of capital
(WACC)is the most commonly used hurdle rate.
Calculation Methods and Formulas
The first step involved in the calculation of NPV is the estimation of net cash flows from the
project over its life. The second step is to discount those cash flows at the hurdle rate.
The net cash flows may be even (i.e. equal cash flows in different periods) or uneven (i.e.
different cash flows in different periods). When they are even, present value can be easily
calculated by using the formula for present value of annuity. However, if they are uneven, we
need to calculate the present value of each individual net cash inflow separately.
Once we have the total present value of all project cash flows, we subtract the initial investment
on the project from the total present value of inflows to arrive at net present value.
Thus we have the following two formulas for the calculation of NPV:
Examples
Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an
initial investment of $243,000 and it is expected to generate a cash inflow of $50,000 each month
for 12 months. Assume that the salvage value of the project is zero. The target rate of return is
12% per annum.
Solution
We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%
Net Present Value
= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000
≈ $562,754 − $243,000
≈ $319,754
Example 2: Uneven Cash Inflows: An initial investment of $8,320 thousand on plant and
machinery is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824
thousand and $2,065 thousand at the end of first, second, third and fourth year respectively. At
the end of the fourth year, the machinery will be sold for $900 thousand. Calculate the net
present value of the investment if the discount rate is 18%. Round your answer to nearest
thousand dollars.

Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158
The rest of the calculation is summarized below:
Year 1 2 3 4
Net Cash Inflow $3,411 $4,070 $5,824 $2,065
Salvage Value 900
Total Cash Inflow $3,411 $4,070 $5,824 $2,965
× Present Value Factor 0.8475 0.7182 0.6086 0.5158
Present Value of Cash $2,890.68 $2,923.01 $3,544.6 $1,529.31
Flows 7

Total PV of Cash Inflows $10,888

− Initial Investment − 8,320
Net Present Value $2,568 thousand

Strengths and Weaknesses of NPV

Strengths
Net present value accounts for time value of money which makes it a sounder approach than
other investment appraisal techniques which do not discount future cash flows such payback
period and accounting rate of return.
Net present value is even better than some other discounted cash flows techniques such as IRR.
In situations where IRR and NPV give conflicting decisions, NPV decision should be preferred.
Weaknesses
NPV is after all an estimation. It is sensitive to changes in estimates for future cash flows,
salvage value and the cost of capital.
Net present value does not take into account the size of the project. For example, say Project A
requires initial investment of $4 million to generate NPV of $1 million while a competing
Project B requires $2 million investment to generate an NPV of $0.8 million. If we base our
decision on NPV alone, we will prefer Project A because it has higher NPV, but Project B has
generated more shareholders’ wealth per dollar of initial investment ($0.8 million/$2 million vs
$1 million/$4 million).
Payback Period
Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest investment
appraisal techniques.
Formula
The formula to calculate payback period of a project depends on whether the cash flow per
period from the project is even or uneven. In case they are even, the formula to calculate payback
period is:

Initial Investment
Payback Period =
Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period
and then use the following formula for payback period:

Payback Period = A B
+ C
In the above formula,
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.
Decision Rule
Accept the project only if its payback period is LESS than the target payback period.
Examples
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $105 million. The
project is expected to generate $25 million per year for 7 years. Calculate the payback period of
the project.
Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2 years

Example 2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50 million
and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3,
$19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.
Solution
(cash flows in Cumulative
millions) Cash Flow
Year Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 years
Advantages and Disadvantages
Advantages of payback period are:
1. Payback period is very simple to calculate.
 2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a
project's life are considered more uncertain, payback period provides an indication of
how certain the project cash inflows are.
3. For companies facing liquidity problems, it provides a good ranking of projects that
would return money early.
Disadvantages of payback period are:
1. Payback period does not take into account the time value of money which is a serious
drawback since it can lead to wrong decisions. A variation of payback method that
attempts to remove this drawback is called discounted payback period method.
2. It does not take into account, the cash flows that occur after the payback period.

Discounted Payback Period

One of the major disadvantages of simple payback period is that it ignores the time value of
money. To counter this limitation, an alternative procedure called discounted payback period
may be followed, which accounts for time value of money by discounting the cash inflows of the
project.

Formulas and Calculation Procedure

In discounted payback period we have to calculate the present value of each cash inflow taking
the start of the first period as zero point. For this purpose the management has to set a suitable
discount rate. The discounted cash inflow for each period is to be calculated using the formula:
Actual Cash Inflow
Discounted Cash Inflow = 
(1 + i)n
Where,
   i is the discount rate;
   n is the period to which the cash inflow relates.
Usually the above formula is split into two components which are actual cash inflow and present
value factor ( i.e. 1 / ( 1 + i )^n ). Thus discounted cash flow is the product of actual cash flow
and present value factor.
The rest of the procedure is similar to the calculation of simple payback period except that we
have to use the discounted cash flows as calculated above instead of actual cash flows. The
cumulative cash flow will be replaced by cumulative discounted cash flow.
Discounted Payback Period = A B
+  C
Where,
   A = Last period with a negative discounted cumulative cash flow;
   B = Absolute value of discounted cumulative cash flow at the end of the period A;
   C = Discounted cash flow during the period after A.
Note: In the calculation of simple payback period, we could use an alternative formula for
situations where all the cash inflows were even. That formula won't be applicable here since it is
extremely unlikely that discounted cash inflows will be even.
The calculation method is illustrated in the example below.

Decision Rule

If the discounted payback period is less that the target period, accept the project. Otherwise
reject.

Example

An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years.
Calculate the discounted payback period of the investment if the discount rate is 11%.
Solution

Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual
cash flows by present value factor. Create a cumulative discounted cash flow column.
Year Cash Flow Present Value Discounted Cash Cumulative
n CF Factor Flow Discounted
PV$1=1/(1+i)n CF×PV$1 Cash Flow
0 $ 1.0000 $ $
−2,324,000 −2,324,000 −2,324,000
1 600,000 0.9009 540,541 − 1,783,459
2 600,000 0.8116 486,973 − 1,296,486
3 600,000 0.7312 438,715 − 857,771
4 600,000 0.6587 395,239 − 462,533
5 600,000 0.5935 356,071 − 106,462
6 600,000 0.5346 320,785 214,323
Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years

Advantages and Disadvantages

Advantage: Discounted payback period is more reliable than simple payback period since it

accounts for time value of money. It is interesting to note that if a project has negative net
present value it won't pay back the initial investment.
Disadvantage: It ignores the cash inflows from project after the payback period.

Definition
Accounting Rate of Return, shortly referred to as ARR, is the percentage of average accounting
profit earned from an investment in comparison with the initial capital cost cost or average
accounting value of investment over the period.

Return on Capital Employed (ROCE)

ROCE is also known as accounting rate of return (ARR).
Formula
The formula for calculating ROCE is:

The initial capital cost could comprise any or all of the following:
 cost of new assets bought
 net book value (NBV) of existing assets to be used in the project
  investment in working capital
 capitalised R&D expenditure
Decision rule
The decision rule for ROCE is:
If the expected ROCE for the investment is greater than the target or hurdle rate (as decided by
management) then the project should be accepted.
Example using ROCE
A project requires an initial investment of $800,000 and then earns net cash inflows as follows:

In addition, at the end of the seven-year project the assets initially purchased will be sold for
$100,000.
Required:
Determine the project's ROCE using:
(a)initial capital costs
(b)average capital investment.

Solution:
Advantages and disadvantages of ROCE
Advantages of ARR
ARR provides a percentage return which can be compared with a target return
ARR looks at the whole profitability of the project
Focuses on profitability – a key issue for shareholders
Disadvantages of ARR
Does not take into account cash flows – only profits (they may not be the same thing)
Takes no account of the time value of money
Treats profits arising late in the project in the same way as those which might arise early

Profitability Index
Profitability index is an investment appraisal technique calculated by dividing the present value
of future cash flows of a project by the initial investment required for the project.
Formula:
Profitability Index
 Present Value of Future Cash Flows
= 
Initial Investment Required
 
Net Present Value
= 1 + 
Initial Investment Required
Explanation:
Profitability index is actually a modification of the net present value method. While present
value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profitability
index is a relative measure (i.e. it gives as the figure as a ratio).
Decision Rule
Accept a project if the profitability index is greater than 1, stay indifferent if the profitability
index is 1 and don't accept a project if the profitability index is below 1.
Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing
since it helps in ranking projects based on their per dollar return.
Example
Company C is undertaking a project at a cost of $50 million which is expected to generate future
net cash flows with a present value of $65 million. Calculate the profitability index.
Solution
Profitability Index = PV of future Cash Flows / Initial Investment Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Future Cash Flows − Initial Investment Required
Net Present Value = $65M-$50M = $15M.
The information about NPV and initial investment can be used to calculate profitability index as
follows:
Profitability Index = 1 + (Net Present Value / Initial Investment Required)
Profitability Index = 1 + $15M/$50M = 1.3

Advantages and Disadvantages

Easy to Understand
The profitability index is easily understood by people with minimal background knowledge in
finance, because it uses a simple formula of division. Calculating the profitability index only
requires initial investment figure and present value of cash flows figures. The decision to
undertake or reject a project relies on whether the profitability index is greater than or less than
1.
Time Value
Calculating present value of cash flows involves discounting the cash flows by the opportunity
costs. This takes into consideration time value of money. A dollar is more valuable now than in
the future because it can be invested to earn interest. Money value also is affected by inflation
with time, and therefore it is important to consider time value, in order to make profitable
investments.
Incorrect Comparisons
A major disadvantage of profitability index is that it may lead to incorrect decision when
comparing mutually exclusive projects. These are a set of projects for which at most one will be
accepted, the most profitable one. Decisions made out of profitability index do not show which
of the mutually exclusive projects has a shorter return duration. This leads to choosing a project
with longer return duration.

Estimates Cost of Capital

The profitability index requires an investor to estimate the cost of capital in order to calculate it.
Estimates may be biased and thus be inaccurate. There is no systematic procedure for
determining cost of capital of a project. Estimates are based on assumptions which may differ
between investors. This may lead to inconsistent decision making when the assumptions do not
hold in the future.

The Internal Rate of Return (IRR)

The IRR is another project appraisal method using DCF techniques.
The IRR represents the discount rate at which the NPV of an investment is zero. As such it
represents a breakeven cost of capital.

Calculating the IRR using linear interpolation

The steps in linear interpolation are:
(1)Calculate two NPVs for the project at two different costs of capital
(2)Use the following formula to find the IRR:
where:
L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest.
The diagram below shows the IRR as estimated by the formula.

Decision rule:
 projects should be accepted if their IRR is greater than the cost of capital.

EXAMPLE

Year Cash Flows  At 18% At 25%

0 -10000 – 10000.00 -10000

1 5000      4237.29 4000

 2 5000      3590.92 3200

3 5000      3043.15 2560

Total          871.36 – 240.00

Advantages and disadvantages of IRR

Advantages
The IRR has a number of benefits, e.g. it:
 considers the time value of money
 is a percentage and therefore easily understood
 uses cash flows not profits
 considers the whole life of the project
Disadvantages
 It is not a measure in absolute value.
 Interpolation only provides an estimate and an accurate estimate requires the use of a
spreadsheet programme.
 It is fairly complicated to calculate.
 Non-conventional cash flows may give rise to multiple IRRs which means the
interpolation method can't be used.