Capital Budgeting Decisions

Capital Budgeting: The process of planning expenditures on assets whose cash flows are
expected to extend beyond one year.
IMPORTANCE OF CAPITAL BUDGETING:
A number of factors combine to make capital budgeting perhaps the most important function
financial managers and their staffs must perform.
1. Since the results of capital budgeting decisions continue for many years, the firm loses
some of its flexibility.
2. If it has inadequate capacity, it may lose market share to rival firms, and regaining lost
customers requires heavy selling expenses, price reductions, or product improvements, all
of which are costly.
3. Timing is also important—capital assets must be available when they are needed.
Effective capital budgeting can improve both the timing and the quality of asset
acquisitions.
4. Capital budgeting typically involves substantial expenditures, and before a firm can
spend a large amount of money, it must have the funds lined up— large amounts of
money are not available automatically. Therefore, a firm contemplating a major capital
expenditure program should plan its financing far enough in advance to be sure funds are
available.
Steps in Capital Budgeting process:
1. Identifying and evaluate potential opportunities. The process begins by exploring
available opportunities.
2. Estimate cost of operating and implementation.
3. Estimate cash flow or benefit.
4. Assess risk.
5. Implement.
Project Classifications:
Mutually Exclusive Projects:
Mutually exclusive means that if one project is taken on, the other must be rejected. For
example, the installation of a conveyor- belt system in a warehouse and the purchase of a fleet of
forklifts for the same warehouse would be mutually exclusive projects—accepting one implies
rejection of the other.
Independent Projects:
Projects whose cash flows are not affected by the acceptance or non-acceptance of other projects.
Capital Budgeting Techniques or Tools:
Capital Budgeting Decisions

Five key methods are used to rank projects and to decide whether or not they should be accepted
for inclusion in the capital budget:
(1) payback, (2) discounted payback,
(3) net present value (NPV), (4) internal rate of return (IRR),
and (5) modified internal rate of return (MIRR).
1. Payback Period: The length of time required for an investment’s net revenues to cover
its cost.
Unrecovered cost at start of year
Paybacks= Year before full recovery +
Cash flow during year
2. Discounted Payback Period: The length of time required for an investment’s cash
flows, discounted at the investment’s cost of capital, to cover its cost.
3. Net Present Value (NPV) Method: A method of ranking investment proposals using the
NPV, which is equal to the present value of future net cash flows, discounted at the
marginal cost of capital.
CF 1 CF 2 CFn
NPV = CF0+ + +……..+
(1k )1 (1k )2 (1k )n
n
CFt
=∑
t =1 (1k )t

4. Internal Rate of Return (IRR) Method: A method of ranking investment proposals

using the rate of return on an investment, calculated by finding the discount rate that
equates the present value of future cash inflows to the project’s cost.
5. Modified IRR (MIRR): The discount rate at which the present value of a project’s cost
is equal to the present value of its terminal value, where the terminal value is found as the
sum of the future values of the cash inflows, compounded at the firm’s cost of capital.

Hurdle Rate: The discount rate (cost of capital) that the IRR must exceed if a project is to be
accepted.
COMPARISON OF THE NPV AND IRR METHODS:
In many respects the NPV method is better than IRR, so it is tempting to explain NPV only, to
state that it should be used to select projects, and to go on to the next topic. However, the IRR
method is familiar to many corporate executives, it is widely entrenched in industry, and it does
have some virtues. Therefore, it is important for you to understand the IRR method but also to be
able to explain why, at times, a project with a lower IRR may be preferable to a mutually
exclusive alternative with a higher IRR.
Net Present Value Profile: A graph showing the relationship between a project’s NPV and the
firm’s cost of capital.
Crossover Rate: The cost of capital at which the NPV profiles of two projects cross and, thus, at
which the projects’ NPVs are equal.
Capital Budgeting Decisions

Reinvestment Rate Assumption: The assumption that cash flows from a project can be
reinvested (1) at the cost of capital, if using the NPV method, or (2) at the internal rate of return,
if using the IRR method.

11-8:
Edelman Engineering is considering including two pieces of equipment, a truck and an overhead
pulley system, in this year’s capital budget. The projects are independent. The cash outlay for the
truck is $17,100, and that for the pulley system is $22,430. The firm’s cost of capital is 14
percent. After-tax cash flows, including depreciation, are as follows:
YEAR TRUCK PULLEY
1 $5,100 $7,500
2 5,100 7,500
3 5,100 7,500
4 5,100 7,500
5 5,100 7,500
Calculate the IRR, the NPV, and the MIRR for each project, and indicate the correct
accept/reject decision for each.
Answer:
For Truck:
NPV= 17100-(5100×PVAF@14% for 5 years) or 17100-(5100×3.4331) =?
C
IRR=L+ ×(H-L)
C−D
Where, L = lower discounting rate
H = Higher discounting rate
C= NPV at lower discounting rate
D = NPV at higher discounting rate
MIRR:
PV costs = 17100
FV inflows= 5100×FVAF@14% for 5 years or 5100 ×4.9211 or

For Pulley:
Capital Budgeting Decisions

NPV =22430(7500×PVAF@14% for 5 years) or 22430-(7500×3.4331) =?

Problem 01:
BTCL is considering to purchase an equipment costing Tk. 40 lakh with an estimated life of 5
years after which expected salvage value of Tk. 5 lakh. Expected cash flows before depreciation
and tax are Tk. 15 lakh each in 1 st three years and Tk. 12 lakh in 4 th and 5th year. Corporate tax
rate is 30%. Calculate the net cash inflows of the equipment.
Answer: Given,
Net cash outflow (NCO) = 4000000
No of years (N)= 5 years
Tax rate = 30% or 0.30
Salvage value = 500000
Annual net cash inflow (NCF) =?
Cost−salvage value
Annual depreciation=
useful life
4000000−500000
= or 700000
5
Computation table:
Year CF Annual Earning before Tax at 30% NCF
(1) (2) depreciation tax (EBT) (5)= 4×30% (6)= (1-5)
(3) (4)=(2-3)
1 1500000 700000 800000 240000 1260000
2 1500000 700000 800000 240000 1260000
3 1500000 700000 800000 240000 1260000
4 1200000 700000 500000 150000 1050000
5 1200000 700000 500000 150000 1050000

11-1: Project K has a cost of $52,125, its expected net cash inflows are $12,000 per year for 8
years, and its cost of capital is 12 percent. What is the project’s payback period (to the closest
year)?
Answer: payback period= 52125/12000 or 4.3438 years.
Capital Budgeting Decisions

11-4: Refer to Problem 11-1. What is the project’s discounted payback period?

Computation table for discounted payback period

Year Annual cash flows Cash flow at PVIF @12% Cumulative cash flow
0 (52125) (521250) (52125)
1 12000 10714.29 (41410.71)
2 12000 9566.33 (31844.38)
3 12000 8541.36 (23303.02)
4 12000 7626.22 (15676.80)
5 12000 6809.12 (8867.68)
6 12000 6079.57 (2788.11)
7 12000 5428.19 2640.08
8 12000 4846.60 7486.68
2788.11
The discounted payback period is 6+ or 6.51 years
5428.19

11-12: Your Company is considering two mutually exclusive projects, X and Y, whose costs and
cash flows are shown below:
YEAR X Y
0 ($1,000) ($1,000)
1 100 1,000
2 300 100
3 400 50
4 700 50
The projects are equally risky, and their cost of capital is 12 percent. You must make a
recommendation, and you must base it on the modified IRR (MIRR). What is the MIRR of the
better project?
Answer:
Future value or Terminal value of project X:
FV/TV= 100(1+.12)1+300(1+.12)2+400(1+.12)3+700(1+.12)4
=
FV
Cost= n
(1+ MIRR)
Capital Budgeting Decisions

❑
1000= (1+ MIRR) 4

MIRR=

Future value or Terminal value of project X:

FV/TV= 1000(1+.12)1+100(1+.12)2+50(1+.12)3+50(1+.12)4
=
FV
Cost= n
(1+ MIRR)
❑
1000= (1+ MIRR) 4

MIRR=
Decision:
11-17: Sharon Evans, who graduated from the local university 3 years ago with a degree in
marketing, is manager of Ann Naylor’s store in the Southwest Mall. Sharon’s store has 5 years
remaining on its lease. Rent is $2,000 per month, 60 payments remain, and the next payment is
due in 1 month. The mall’s owner plans to sell the property in a year and wants rents at that time
to be high so the property will appear more valuable. Therefore, Sharon has been offered a “great
deal” (owner’s words) on a new 5-year lease. The new lease calls for zero rent for 9 months, then
payments of $2,600 per month for the next 51 months. The lease cannot be broken, and Ann
Naylor Corporation’s cost of capital is 12 percent (or 1 percent per month). Sharon must make a
decision. A good one could help her career and move her up in management, but a bad one could
hurt her prospects for promotion.
a. Should Sharon accept the new lease? (Hint: Be sure to use 1 percent per month.)
b. Suppose Sharon decided to bargain with the mall’s owner over the new lease payment. What
new lease payment would make Sharon indifferent between the new and the old leases? (Hint:
Find FV of the first 9 payments at t _ 9, then treat this as the PV of a 51-period annuity whose
payments represent the incremental rent during Months 10 to 60.)
c. Sharon is not sure of the 12 percent cost of capital—it could be higher or lower. At what
nominal cost of capital would Sharon be indifferent between the two leases? (Hint: Calculate the
differences between the two payment streams, and find the IRR of this difference stream.)
Answer:
Old lease terms are 5 years remaining, rent per month 2000, payments remaining 60 at the end of
each month.
Capital Budgeting Decisions

For new lease terms are: no payment for first 9 months and 2600 per month for (60-9) months
after first 9 months. Annual cost of capital is 12% or 1% per month.