CAPITAL BUDGETING

(INVESTMENT APPRAISAL
TECHNIQUES)
By
Name: Parmanand Sunda
CRO 0272758
Roll no. 19
Batch no. 343
Lab no. 4
 Objectives
• Understand the key motives for capital
expenditure and the steps in the capital
Budgeting Process.
• Define Basic Capital Budgeting
terminology
• Explain the various forms of investment
appraisal techniques
 Objectives (Contd)
• Calculate the initial investment associated
with a proposed capital expenditure
 What is Capital Budgeting?
• Capital Budgeting is the process of
selecting, financing and controlling capital
expenditures in order to maximize the
value of the firm.
• Capital Budgeting is the process of
evaluating and selecting long-term
investments that are consistent with the
maximizing of owner’s wealth
 Core Activity
• The core activity of the process of capital
budgeting is capital expenditure analysis
and the end-goal of this analysis is to
determine the course of action that will
minimize the inherent risk of the
investment project.
• The profitability, growth, competitiveness
and even the survival of a firm depend to a
large extent on how the capital budgeting
is carried out in the firm
THE NATURE OF CAPITAL
BUDGETING.
What are Capital Expenditures?
• Capital Expenditures are investments in
long – term assets that contribute to the
earning power of a firm over an extended
period of time.
• It involves spending an amount of cash in
the present with the expectation of future
cash return extending to more than one
year.
• The cash return could be revenues from
the sales of a new product and sales in a
new market, significant savings in labour
costs, and even bond interest received.
• It follows that the more effective a firm’s
capital budgeting is, the higher its growth
potential and consequently, the price of its
stock will perceivably be higher.
• EXAMPLES OF CAPITAL
EXPENDITURES
 EXAMPLES OF CAPITAL
EXPENDITURES
• Acquisition of Land
• Building
• Equipment (required to expand the
business)
• Machines (to replace equipment that is
wearing out) or becoming technically
obsolete.
• Advertising Campaign
 EXAMPLES OF CAPITAL
EXPENDITURES (Contd)

• Research and development programmes

• Major improvements required by safety or
environmental laws eg gas fraying in the
oil sector.
• Event Training programme (that could
have an impact beyond one year are
within the purview of capital expenditures.
 CAPITAL EXPENDITURES VS
OPERATING EXPENDITURES
• Returns from capital expenditure are
expenditure are expected to occur over a
period of years
• While returns from operating (or current)
expenditures are planned to occur within a
year
 CRITICAL POINT

• Decision-making for capital expenditures

involve more uncertainty and risk,
moreover, the principles and procedures
followed in budgeting capital expenditures
basically differ from those used in
budgeting operating expenditures.
• REASONS FOR CAPITAL
EXPENDITURES
 REASONS FOR CAPITAL
EXPENDITURES
• A capital expenditure is usually incurred for each
or combinations of the following purposes:
• To replace worn-out or seriously damaged
equipment and/or facilities so as to maintain the
business operation.
• To replace current equipment or facilities with
one that is technically advanced in order to
reduce cost of production including labour and
material costs.
• To provide for compliance with new, or usually
more stringent, safety and environmental
requirements of industry and or governments.
 REASONS FOR CAPITAL
EXPENDITURES (Contd)
• To expand the market for current product lines
or service
• To increase production capacity for the current
product
• To produce and market new product (s):
and/or to carry our research and development,
or exploration.
• PHASES IN CAPITAL
EXPENDITURE
 The Formulation Phase

• Identifying capital expenditure

opportunities
• Generating the Capital Expenditure
proposal
• Screening the proposals for consistency
with corporate strategies.
 The Selection Phase

• Evaluate the capital expenditure proposals

• Ranking and selecting the Capital
expenditure project(s)
• Securing funds to finance the project(s)
 The Follow-up Phase

• Monitoring or post audit of the capital

expenditures
• CAPITAL BUDGETING
DECISIONS
 CAPITAL BUDGETING
DECISIONS

• In general, capital budgeting decisions are

made in the following financial analysis
flow:
• Demand forecasts
• Cost forecasts
• Cashflow forecasts
• Demand Forecasts
• The future demand defines whether or not there is
opportunity for capital expenditures. For example
production equipment is not replaced unless demand for
its output will continue into the future – at least during the
life the replacement.
• A declining demand for a product will not justify the
replacement or updating of capital expenditures.

• Cost Forecasts.
• The cost of operation is determined.

• Cashflow Forecasts
• The demand and cost are integrated to estimate the
desirable optimum level of output. Then cashflow
analysis is done based on this level of output.
•Investment
Appraisal
Techniques
 Investment Appraisal

• Is concerned with the evaluating the

financial viability of investment
opportunities.
• Such opportunities include investment in
capital projects as well as investment in
securities and other financial instruments,
 Introduction
• We use compound interest as a platform
for introducing and explaining commonly
referred to as discounted cash flow (DCF).
• DCF is the technique commonly used to
evaluate investment projects which involve
cash flow arising at different times and in
different amounts.
 Compound Interest
• Interest as a financial concept is widely
known and understood.
• It is concerned with the fact that a sum of
money can be invested for one or more
time periods in order to earn a return.
• A time period can be any convenient and
practical length of time eg a day, week,
month, quarter, half-year or a year
 Compound Interest Contd
• The return earned represents the premium
demanded by the investor for foregoing
the opportunity of spending the money
immediately.
• The Premium is known as interest and is
usually calculated as a percentage of the
principal
• The principal is the original sum of money
which is invested.
 Definition
• Compound interest is earned when the
interest earned in one period from an
investment is reinvested at the same rate
as the original investment
• Any succeeding period’s interest is then
calculated on the total of the original
investment and the reinvested interest.
 Illustration
• If $1000 is invested at an interest rate of 10% per
annum, it will grow to $1100 in one’s year time.
The surplus of $100 is the interest earned on the
principal of $1000.
• If the total of $1100 is reinvested for a further year
the investment will grow to a total of $1,210.
• This is true only if the first year’s interest is
reinvested at the same rate as the principal.
• This process of reinvestment of principal
and accumulated interested can be
continued for a third, fourth, fifth and as
many years as one wishes.
 Table 1
Year (a) Balance at start (b) Interest earned during yearrt of (c) Balance at end of
of year year = (a) X 10/100 year = (a) + (b)

1 1000 100 1100

2 1100 110 1210

3 1210 121 1331
4 1331 131.1 1462.1
5 1464.1 146.41 1610.51

FV = P x (1+ r)n
Types of investment appraisal:

• Payback Period
• Accounting Rate of Return (ARR)
• Internal Rate of Return (IRR)
• Profitability Index
• Net Present Value (discounted cash flow)
 Payback Period (PBP)
– Payback period is the amount of time required for a
firm to recover its initial investment in a project, as
calculated from cash inflows.

– This method is based on the assumption that the earlier

the cost of investment can be recouped from cash flows
the greater the attractiveness of the investment.

– The reasoning is based on the idea that as all the future

earnings can only be guessed at, then the higher the
probability of early recovery of the cost of the
investment the more comfortable management can feel
about undertaking it
Payback Period – Decision Criteria

• When the PBP is used to make accept –

reject decision, the following decision
criteria apply:
• If the PBP is less than the maximum
acceptable PBP, accept the project
• If the PBP is greater than the maximum
acceptable PBP, reject the project
 Table 2. Capital Expenditure Data
for International Bank Plc
Project A Project B
$42,000 $45,000
Year
1 14000 28000
2 14000 12000
3 14000 10000
4 14000 10000
5 14000 10000
• We can calculate the PBP for International Bank
Plc projects A and B using the data in Table 2
above. For project A which is an annuity, the
PBP is 3.0 years ($42000 initial investment -:-
$14000 annual cash inflow)
• Because project B generates a mixed stream of
cash inflows, the calculation of its PBP is not as
clearcut. In the year 1, the firm will recover
$28000 of its $45000 initial investment. By the
end of year 2, $40000 ($28000 from year 1 +
$12000from year 2) will have been recovered.
At the end of year 3 , $50000 will have been
recovered. Only 50% of the year-3 cash inflow
of $10000 is needed to complete the PBP of the
initial $45,000. The PBP for project B is
therefore2.5 years
• If the Bank’s maximum acceptable PBP
were 2.75 years, project A would be
rejected and project B would be accepted.
• If the maximum PBP were 2.25 years,
both projects would be rejected.
• If the projects were being ranked, B would
be preferred over A, because it has a
shorter PBP.
 Accounting Rate of Return
• The Accounting Rate of Return (ARR) as
defined as follows:

ARR = Total Revenues – Total Operating Cost

---------------------------------------- X 100%
Investment
 Illustration 1
• e.g.
• An investment is expected to yield cash flows of
£10,000 annually for the next 5 years
• The initial cost of the investment is £20,000
• Total profit therefore is: £30,000
• Annual profit = £30,000 / 5
= £6,000
ARR = 6,000/20,000 x 100
= 30%
 Illustration 2
• It is proposed to purchase a new machine for
production for $100,000. The machine is
expected to have a useful life of 5 years with no
residual value at the end of the 5 years.
Depreciation of the machine is expected to be
on a straight line basis. This means that the
cost of the machine would be spread equally
over the five years of its life. The annual
depreciation charge would therefore be one-fifth
of $100,000 which is $20,000.
 Illust. 2 Contd.
• Use of the new machine is expected to
generate the revenues, operating costs
and earnings shown below.
(Note: The annual depreciation charge is
included in the total operating costs)
Year Total Total Net
Revenues Operating Earnings
Costs
$ $ $
1 80,000 70,000 10,000
2 80,000 70,000 10,000
3 80,000 70,000 10,000
4 80,000 70,000 10,000
5 80,000 70,000 10,000
------------ ----------- -----------
400,000 350,000 50,000
========= ======= ======
• From our definition above

Net Earnings 50,000

ARR = ------------------ X 100 = --------- X 100
Investment 100,000

= 50% or ARR = 10% p.a

 Advantages of ARR
• As a method of measuring return, ARR is
both easy to understand and easy to
calculate.
• It offers a view on the overall profitability of
the project.
 Disadvantages of ARR
• The method involves the use of
accounting profit which, as we have seen
elsewhere, possesses inherent limitation.
• The method does not use cash flows and
therefore ignores the time value of money
• ARR could give the same result for two
projects which have significantly different
earnings streams.
 Net Present Value (NPV)
• This method overcomes the principal weakness
of other methods, namely the failure to
recognize the time value of money
• Time value of money means that time is literally
worth money. In other words, a sum of money
received today is worth more than the same sum
received in one year’s time.
• This is because a cash sum received today can
be invested to yield a higher amount in one
year’s time.
 NPV Contd,
• The initial investment of $100,000 is shown as
negative figure arising in year 0. A negative
cash flow is a way of depicting a cash outflow in
order to distingush it from a cash inflow which is
represented as a positive cash flow.
• Thus Year 0 is the start point of Year 1, Year 1 is
the start point of Year 2, Year 2 is the end point
of Year 2, Year 3 is the end point of Year 3 and
so on.
• Year 0 can be thought of as the start of the
project.
 NPV Contd.
• Lets assume a return of 12% on this
investment. This is therefore the rate
used to discount future cash flows to
arrive at their present values. See
spreadsheet
Year Net Discount Net
Cash Factor Present
Flow Value
$ $ $
0 (100,000) 1.0000 (100,000)
• 30,000 0.893 26,790
• 30,000 0.797 23,910
• 30,000 0.712 21,360
• 30,000 0.636 19,080
• 30,000 0.567 17,010
------------ -----------
150,000 8,150
========= ======
 Advantages of NPV
• It is based on the use of cash flows ratherr than
accounting profits. Cash flows are less
susceptible to manipulation than profits.
• It recognizes the time value of money.
• It offers a view on the overall profitability of the
project
• It takes account of all cash flows including those
beyond payback.
• It facilitates choice between alternative
investments.
 Disadvantages
• It is not that easy to understand and it is
less easy to calculate
• It requires the availability of a discount
rate. Determination of a discount rate is
not always straight forward as taking the
marginal cost of borrowing.
• Thank you