CAPITAL BUDGETING

Capital Budgeting is a process used to determine and select the most profitable projects for a period
greater than one year.
That is a project, where the cash flow of the firm will be received over a period longer than a year.
Any corporate decision with an impact on future earning can be examined using this framework.
Decision about whether to buy a new machine, expanding the business in another geographical
area, move the corporate headquarters to another place, or replace a delivery truck, to name a few
can be examined using a capital budgeting analysis.
The capital budgeting process has four administrative steps:
STEP 1: Idea Generation
It is the most important steps in the capital budgeting process of generating a good project ideas.
Ideas can come from a number of sources including senior manager, functional divisions,
employees or outside the companies.
STEP 2: Analysing project proposal
Since the decision to accept or reject a capital project is based on the project’s expected future cash
flow, a cash flow forecast must be made for each product to determine its expected profitability.
STEP 3: Construct a capital budget for the firm
The firm must prioritize the profitable project according to the timing of the project’s cash flow,
available company’s resources and the company’s overall strategic plan. Many projects that are
attractive individually may not make sense strategically.
STEP4: Monitoring decision and constructing a post audit
It is important to follow up on all the capital budgeting decision. An analyst should compare the
actual result to the projected result and the project manager should explain why did the projections
did or did not match the actual performance. Since the capital budgeting process is only as good as
the estimates of the inputs into the model used to forecast cash flow, a post- audit should be used to
identify systematic errors in the forecasting process and improve the company operation.
 EXAMPLE of Capital Budgeting
1. An XYZ limited company looking to invest in one of the new projects and cost of that project is $10,000 before
investing company want to analyse that how long it will take a company to recovered invested money in a project?

SOLUTION: Let’s say in a year one and so on company recover a profit as listed in the table below.

So how long it will take the company to recover invested money from the above
table it shows 3 year and some months. But this is not the right way to find out a
payback period of initial investment because the base what company is considering
here is profit and it is not a cash flow so profit is not the right criteria so a company
should use here is cash flow. So, profit is arrived after deducting depreciation value
so to know the cash flows, we have to add depreciation in profit let say depreciation
value is $2,000 so net cash flows will be as listed in below table.

So from Cash flow analysis, company will recover initial

investment within 2 years. So, the payback period is
nothing but the time taken by cash inflows to recover the
investment amount.

PAYBACK PERIOD

The payback period is the time taken by cash inflows to recover the investment amount.

2. Calculate the Pay Back Period and Discounted Pay Back Period for the project which cost $270,000 and projects expected
to generate $75,000 per year for the next five years? Company required rate of return is 11 percent. Should the company go
ahead and invest in a project? The rate of Return 11%. Do we have to find here, PB? DPB? Should the project be purchased?

Solution: After adding cash flows of each year Balance will come as shown in below table.

From the table below the positive balance is in between 3 and 4 years so,

 PB= (Year – Last negative Balance)/Cash Flows

 PB= [3-(-45,000)]/75,000
 PB= 3.6 Years

Or

Positive Balance or Payback period= Initial

Investment/Annual Cash Flows

 PB= 270,000/75,000
 PB= 3.6 Years.
With the Discounted rate of return of 11% Present Value of Cash Flows as shown in below table.

 DPB= (Year – Last negative Balance)/Cash

Flows
 DPB= [(4-(37,316.57)/44,508.85)
 DPB= 4.84 Years

So, from above both capital budgeting method, it is

clear that the company should go ahead and invest in
the project as though both methods the company will
cover initial investment before 5 years.

3.XYZ limited company planning to buy some new production equipment which costs $240,000, but the
company has unequal net cash inflows during its life as shown in the table and $30,000 residual value at the end
of its life. Calculate the accounting rate of return?

Accounting Rate of Return technique of capital budgeting measures the average annual rate of return
over the assets life.

First, calculate Average Annual Cash Flows

 =Total cash Flows/Total Number of Year

 =360,000/6

Average Annual Cash Flows =$60,000

Calculate Annual Depreciation Expenses

=$240,000-$30,000/6

=210,000/6

Annual Depreciation Expenses =$35,000

Calculate ARR

 ARR=Average Annual net cash flows – Annual Depreciation Expenses/ Initial

Investment
 ARR=$60,000- $35,000/$240,000
  ARR=$25,000/$240,000 × 100
 ARR=10.42%

Conclusion – So if ARR is higher than the hurdle rate established by company

management than it will be considered and in vice versa it will be rejected.

Example #4 (Net Present Value)

MetLife Hospital is planning to buy an attachment for its X-ray machine, cost of attachment is $3,170 and
life of 4 years, Salvage value is zero and increase in cash inflows every year is $1,000. No investment is to be
made unless having annual of 10%. Will the MetLife Hospital invest in the attachment?

Solution:

Total Investment Recovered (NPV)= 3170

From the above table, it is clear that cash inflows of $1,000 during 4 years is sufficient to recover the initial
investment of $3,170 and to provide exactly 10% return on investment So MetLife Hospital can invest in X-ray
attachment.

Example #5

ABC limited company looking to invest in one of the Project cost that project is $50,000 and cash inflows and
outflows of a project during 5 years as shown in below table. Calculate Net Present Value and Internal Rate
of Return of the Project. An interest rate is of 5%.
Solution:

First to calculate net cash flows during that time period by Cash inflows – Cash outflows as shown in below table.

NPV= -50,000+15,000/(1+0.05)+12,000/(1+0.05)²+10,000/(1+0.05)³+ 10,000/(1+0.05)⁴+

14,000/1+0.05)5

NPV= -50,000+14,285.71+10,884.35+8,638.56+8,227.07+10,969.21

NPV= $3,004.84 (Fractional Rounding of)

Calculate IRR
Internal Rate of Return = 7.21%

If you take IRR 7.21% the net present value will be zero.

Points to Remember

 If IRR is > than Discount (interest) rate, then NPV is > 0

 If IRR is < than Discount (interest) rate, then NPV is < 0
 If IRR is = to Discount (interest) rate, then NPV is = 0
Positive Balance or Payback period= Initial Investment/Annual Cash Flows