Capital budgeting:

Capital budgeting In general To select the best project before investment is called capital budgeting. According to john j. Hampton, Capital budgeting describes the firms forms formal planning process for the acquisition & investment of capital. Capital Budgeting Techniques: When firms have developed relevant cash flows they then analyze them to assess whether a project is acceptable or to rank projects. There are a number of capital budgeting techniques available to an analyst. For our purposes, we will review payback period, net present value and internal rate of return. Payback period: Pay back period is the estimated time by which the original invested capital in a project can be recovered .In case of annuity, the payback period can be found by dividing the initial investment by the annual cash inflow. For a mixed stream of cash inflows, the yearly cash flows must be accumulated until the initial investment is recovered. The decision criteria: If the payback period is less than the maximum acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project. The length of the maximum acceptable payback period is determined by management. Formula for calculation of PBP: (1) PBP = NCO / NCB (for equal cash flow in every year) PBP = pay back period NCO = net cash out lay NCB = Net cash benefit / CFAT (Cash flow after tax). (2) PBP = A + (NCO C) / D (for unequal cash flow in every year) Example: 1 There are two investment proposals. Following data are available about these proposals Proposal A Proposal B Investment tk 42,000 tk 64,000 Expected life 6 years 6 years Annual cash flow each year tk 9,000 and 12,000 respectively. Compute PBP & comment which proposal should be accepted.

Solution: Proposal A =
NCO PBP = NCB / CFAT 42 ,000 = 9,000 = 4.67 < 6Years

[For equal cash flow] Where, PBP = Pay Back Period NCO = Net Cash outlay; 42,000 NCB = Net Cash Benefit; 9,000 CFAT = Cash Flow after Tax (Gross)

Proposal B =
PBP = NCO NCB / CFAT 64 ,000 = 12 ,000 = 5.33 < 6Years

[For equal cash flow] Where, PBP = Pay Back Period NCO = Net Cash outlay; 64,000 NCB = Net Cash Benefit; 12,000 CFAT = Cash Flow after Tax (Gross)

Proposal As payback period is less than proposal B. On the basis of Time Value of Money concept proposal A is more acceptable than proposal B. Example: 2 Hasan Co. Ltd is considering buying a machine. It will cost tk 82000. it economic life is 5 years. It wills income cash flow after tax as follows: Year CFAT 1 20000 2 25000 3 30000 4 34000 5 40000 What is the pay back period of the machine? Solution: Table for calculation of C.CFAT 1 2 3 Year CFAT C.CFAT
20,000 20,000 25,000 45,000 30,000 75,000(C) (D) 34,000 1,09,000 40,000 1,49,000 NCO C PBP = A + [Unequal ] D
82 ,000 75 ,000 34 ,000 7,000 =3 + 34 ,000 = 3 + 0.205 = 3.21Years =3 +

Hasan Co. Ltd.

Where, CFAT = Cash Flow after tax (Gross) C.CFAT = Cumulative Cash Flow After Tax (Gross)

1 2 3(A) 4 5

Where, PBP = Pay Back Period NCO = Net Cash Outlay; 82,000 A = The year in which the cumulative cash flow is nearer to Net Cash Outlay; 3 C = Cumulative Cash Flow of Year A; 75,000 D = Cash flow of succeeding year of A; 34,000

From the table we can see that to recover initial capital of TK. 82,000. It will take more than 3 years, but less than 5 years. Accounting rate of return (ARR): Accounting rate of return is the average after tax profit divided by the initial cash outlay. ARR techniques measure the profitability of the investment proposals. Decision Rule: If the calculated ARR> expected ARR; accept the project. If the calculated ARR< expected ARR; reject the project. If the calculated ARR= expected ARR; indifferent to choose. Example: 3 Abir Ltd wants to buy a machine. The machine will cost tk 50000. Its economic life is 5 years. The annual estimated income after Depreciation & tax are given below:
Years 1 2 3 4 5 Income after depreciation & tax 10000 8000 7000 6000 4000

Required: 1. Return on Investment (ROI) 2. Average Rate of Return (ARR) Solution: 1 Year
1 2 3 4 5

Abir Ltd. 2 NPAT/EAT

10,000 8,000 7,000 6,000 4,000 T.NPAT =35,000

Requirement: (1) CFAT = Income after Tax Return on Investment (ROI) =

NPAT = Income after depreciation and Tax

AverageNPA T TotalInves tment 7,000 = 50 ,000 =14 %

Where, A.NPAT =
TotalNPAT UsefulLife 35 ,000 = 5 = 7,000

Total Investment = 50,000

Requirement: (2) Average Rate of Return (ARR) = AverageInv estment

7,000 25 ,000 = 28 % =
AverageNPA T

NPV Method Net Present Value: In a word, NPV is the difference between present value of future cash inflow and the initial investment. NPV is a sophisticated capital budgeting technique; found by subtracting a projects initial investment from the present value of its cash inflows discounted at a rate equal to the firms cost of capital. NPV = Total Present value of cash inflows - Initial investment. By using NPV, both inflows and outflows are measured in terms of present dollars. The decision criteria: If the NPV is greater than $0, accept the project. If the NPV is less than $0, reject the project. Example: 4 Nabid Company Ltd is considering the purchase of a new machine. Two alternatives machines (X & Y) have been suggested. Each is costing of tk 400000. Cash flows after taxation are expected to be as follows: Year Cash flow Machine-X (tk) Machine-Y (tk)
1 2 3 4 5 40000 120000 160000 240000 160000 120000 160000 200000 120000 80000

Cost of capital 10% you are required to calculate the net present value & comment on the result. Solution:
Year 1 2 3 4 5

Nabid Company
Machine-Y (tk) 2 PV@10% .9091 .8264 .7513 .6830 .6209

Calculation for the two alternatives machines (X and Y)s TPV:

Machine-X (tk) 1 2 3 CFAT/NCB PV@10% PV(12) 40,000 .9091 36,364 1,20,000 .8264 99,168 1,60,000 .7513 1,20,208 2,40,000 .6830 1,63,920 1,60,000 .6209 99,344 5,19,004 1 CFAT/NCB 1,20,000 1,60,000 2,00,000 1,20,000 80,000 3 PV(12) 1,09,092 1,32,224 1,50,260 81,960 49,672 5,23,208

Machine-Xs NPV (Net Present Value)

Where, TPV = Total Present Value; 5, 19,004 NCO = Net Cash Outlay; 4, 00,000

= TPV NCO = 5, 19,004 4, 00,000 = 1, 19,004 >0 Machine-Ys NPV (Net Present Value) = TPV NCO Where, = 5, 23,208 4, 00,000 TPV = Total Present Value; 5, 23,208 = 1, 23,208 >0 NCO = Net Cash Outlay; 4, 00,000 Since, the net Present value of machine Y is higher than machine X and 0. So, Machine Y should be considered to purchase. Profitability Index (PI): PI is the ratio of the present value of a projects future net cash inflows to the project initial cash outflow. Profitability Index (PI): Total Present Cash inflow Initial Investment

The decision criteria:

If the PI is greater than 1, accept the project. If the PI is greater than 1, accept the project. If the PI is equal to 1, indifferent to take the project.

Example: 5 Z and Z Construction firm has following three alternative projects: (1) Project A: To build water treatment plant. (2) Project B: To develop Dhaka Chittagong highway. (3) Project c: To develop 5 Storied Shopping complexes at Basundara Project. Initial cost and expected cash flow for the three 3 projects are as follows: Project A B C Initial cost 28,00,000 48,00,000 35,50,000 Year 1 10,00,000 20,00,000 15,00,000 Year 2 12,00,000 20,20,000 20,00,000 Year 3 15,00,000 20,50,000 10,00,000

The company has 1 Core tk and thinking for capital Rationing. If the cost of capital is 12% then make your decision using Profitability Index. Solution:
Year

Z and Z Construction Calculation for the three alternatives projects (A, B and C)s TPV:
1 CFAT/ NCB 20,00,000 20,20,000 20,50,000 Project B 2 3 PV@ PV(12) 12% .8929 17,85,800 .7972 16,10,344 .7118 14,59,190 48,55,334 1 CFAT/ NCB 15,00,000 20,00,000 10,00,000 Project C 2 PV@ 12% .8929 .7972 .7118 3 PV(12)
13,39,350 15,94,400 7,11,800 36,45,550

1 2 3

Project A 1 2 3 CFAT/ PV@ PV(12) NCB 12% 10,00,000 .8929 8,92,900 12,00,000 .7972 9,56,640 15,00,000 .7118 10,67,700 29,17,240

Profitability Index for the 3 alternative projects is as follows:

Project As Profitability Index (PI) =

TPV NCO 29,17,240 = 28 ,00 ,000 =1.04 >1.00

TPV NCO 48,55,334 = 48 ,00 ,000 =1.01 >1.00

Where, TPV = Total Present Value of cash inflow; 29, 17,240 NCO = Net Cash Outlay; 28, 00,000

Project Bs Profitability Index (PI) =

Where, TPV = Total Present Value of cash inflow; 48, 55,334 NCO = Net Cash Outlay; 48, 00,000

Project Cs Profitability Index (PI) =

TPV NCO 36,45,550 = 35 ,50 ,000 =1.03 >1.00

Where, TPV = Total Present Value of cash inflow; 36, 45,550 NCO = Net Cash Outlay; 35, 50,000

On the basis of Profitability Index, the three alternatives are as follows as their ranking order: 1st ----Project A 2nd----Project C 3rd-----Project B Decision: The Company will prefer project A first and the project C. it will not be able to invest to Project B because after investing in Project A and C. The company will have not available fund for Project B. Internal Rate of Return (IRR): The internal rate of return is the discount rate that equates the present value of cash inflows with the initial investment associated with a project. The IRR, in other words, is the discount rate that equates the NPV of an investment opportunity with $0. The decision criteria: If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project.

Calculating the IRR: The IRR can be found either by using trial-and-error techniques interpolation or with the aid of a sophisticated financial calculator or a computer. By using trial and error technique we have to find out the discount rate which will equate the present value of inflows with its initial investment. In that case we can use interpolation to find out the discount rate. Example:

Year Proje ct

Outflo w 0 $ 16,200

Inflow 1 $ 8,000 2 7,000 3 6,000

Example 6 A Company is interested to invest tk 50,000 in a project. It is expected that the project would have a life of five years. The cash flows from the project in different years would be in the following: Year Cash flows 1 20,000 2 18,000 3 25,000 4 27,000 5 28,000 Depreciation should be charged on straight line basis. The cost of capital is 20%.The Companys tax rate is 40%.Evalute the project on the basis of IRR.