CAPITAL BUDGETING

 Capital refers to long term assets used in production

 Budget is a plan that outlines projected expenditures during a future period.
 Capital budget is a summary of planned investments of assets that will last for more than one
year.
 Capital Budgeting is the whole process of analyzing projects and deciding which to accept and
include in the capital budget.
 Types of Projects:
 Independent projects – if the cash flows of one are unaffected by the acceptance of the other.
 working on two entirely different types of projects
 Mutually exclusive projects – if the cash flows of one can be adversely impacted by the
acceptance of the other.
 Working on similar type of projects

PROJECTS

 Analysis of potential additions to fixed assets.

 Replacement of existing machinery with a new one to reduce cost
 Long-term decisions; involve large expenditures.
 Very important to firm’s future.
 How is this Done
 Estimate CFs (inflows & outflows).
 Determine the appropriate cost of capital.


Criteria of assessment of project(s)

 Payback Period
 Discounted Payback Period
 NPV
 IRR
 Modified IRR
 Profitability Index
Period Project S Project L

0 (10,000) (10,000)

1 5,000 1,000

2 4,000 3,000

3 3,000 4,000

4 1,000 6,750

Cost of Capital 10% (this is rate of return)

Payback period: The total time period to recover the total investment

Project S

Year 1. At the end of period total recovery is 5,000 Left over amount is 10,000-5,000= 5,000

Year 2. At the end of year2, the recovery is 4,000 Left over amount is 5000-4000 = 1,000

Year 3. Period for collecting 1,000 out of 3,000 = 1,000/3,000=0.333

That is total time period for collecting back 10,000 = 2.33 years

Cash collected in future time period is not same as what it is today, so first we compute the
discounted amount of future period and then calculate the payback period

Period Project S PVIF @10% PV of Cash flow

0 (10,000) 1 (10,000)

1 5,000 1/1.1 =0.909 4,545

2 4,000 1/(1.1)2 = 0.8264 3,304

3 3,000 1/(1.1)3 = 0.7513 2,254

4 1,000 1/(1.1)4 =0.6830 683

2. Discounted Payback Period

Year 1 = 10,000-4,545 = 5,455

Year 2 = 5,455-3,304 = 2,151

Year 3 period = 2,151/2,254 = 0.95

Total pertod require to recover your investment of 10,000 is = 2.95 years

3. NPV = Present value of cash inflows – Investment = (4545+3304+2254+683) – 10,000

Net Present Value = NPV =10,786 – 10,000 = 786

Since NPV is positive, so this project is feasible

4. Internal Rate of return

At 10%, NPV is 786

Now we find NPV at 12%

Period Project S PVIF @12% PV of Cash flow

0 (10,000) 1 (10,000)

1 5,000 1/1.12 =0.893 4,465

2 4,000 1/(1.12)2 = 0.797 3,188

3 3,000 1/(1.12)3 = 0.712 2,136

4 1,000 1/(1.12)4 =0.636 636

NPV at 12% = (4,465+3,188+2,136+636)–10,000 =10,425–10,000= 425 (again Positive)

We have to go for another rate let it be 15%

Period Project S PVIF @15% PV of Cash flow

0 (10,000) 1 (10,000)

1 5,000 1/1.15 =0.870 4,350

2 4,000 1/(1.15)2 = 0.756 3,024

3 3,000 1/(1.15)3 = 0.658 1,974

4 1,000 1/(1.15)4 =0.571 571

NPV at 15% = (4350+3024+1974+571) – 10,000 = 9919-10,000 = -81

Now we have +ve N PV at 12% and –ve NPV at 15%

IRR = Lower Rate+[ NPV at lower Rate/(NPV at Lower rate– NPV at upper rate)]* change in rate

IRR = kL +[ NPVL/(NPVL-NPVu)] *(change in rate)

IRR = 0.12 + [425/{425 –(-81)}]*0.03 IRR = 14.51%

5. Modified IRR

First future values of cash flows from yea 1 to year 4 is determined

Period Project S FVIF @10% FV of Cash flow

1 5,000 (1.1)3 =1.331 6,655

2 4,000 (1.1)2 = 1.21 4,840

3 3,000 (1.1) 3,300

4 1,000 1 1,000
FV for 4 years = 15,795 PV = 10,000

Keeping these two values, we find out k for 4 years.

FV = PV ( 1+ K)4 15,795 = 10,000( 1+ K)4

(1+ K)4=15,79/10,00 =1.5795 4 log(1+k)=log1.579 Log (1+k) = 0.1985/4 = 0.0496

With shift log 1+k = 1.12 K = 0.1211 = 12.11%

6. Profitability Index = Present values of cash inflows/investment

= 10,786/10,000 = 1.0786 positive

 It must be positive
 Similarly compute these six for L as well
 If these two are mutually exclusive projects, then choose the one where NPV is greater.
 If these are the independent projects, then we can choose both, if NPV is positive.
 Further projects having IRR greater than Cost of capital are selected.

Mutually Exclusive Projects with unequal lives

Which project is selected, if cost of capital is 9%

Period Project S Project L

0 (40,000) (20,000)

1 8,000 7,000

2 14,000 13,000

3 13,000 12,000

4 12,000

5 11,000

6 10,000

For analyzing two projects, the first point to consider is that the life of projects must be same

If these are not same, then we make the period same by repeating the same cash flows. Like

Period Project S Project L PVIF@9% PV(S) PV(L)

0 (40,000) (20,000) 1 (40,000) (20,000)

1 8,000 7,000 0.9174 7,339.2 6,421.8

2 14,000 13,000 0.8416 11,782.4 10,940.8

3 13,000 12,000 -20,000 0.7722 10,038.6 (6,177.6)

4 12,000 7,000 0.7084 8,500.8 4,958.8

5 11,000 13,000 0.6499 7,148.9 8,448.7

6 10,000 12,000 0.5963 5,963 7,155.6

NPV 10,772.9 11748.10

Here by comparing these two projects, project L generates more cash flows than Project S

Q1. Your division is considering two investment projects, each of which requires an up front expenditure of
$15 million. You estimate that the investments will produce the following net cash flows:

Year ProjectA ProjectB

1 $ 5,000,000 $20,000,000

2 10,000,000 10,000,000

3 20,000,000 6,000,000

What are the two projects’ net present values, assuming the cost of capital is 5%? 10%? 15%?

What are the two projects’ IRRs at these same costs of capital?

Q2. 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 indepen-dent. 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%. 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.

Q3. Davis Industries must choose between a gas-powered and an electric-powered forklift truck for moving
materials in its factory. Since both forklifts perform the same function, the firm will choose only one. (They are
mutually exclusive investments.) The electric-powered truck will cost more, but it will be less expensive to
operate; it will cost $22,000, whereas the gas-powered truck will cost $17,500. The cost of capital that applies
to both investments is 12%. The life for both types of truck is estimated to be 6 years, during which time the
net cash flows for the electric-powered truck will be $6,290 per year and those for the gas-powered truck will
be $5,000 per year. Annual net cash flows include depreciation expenses. Calculate the NPV and IRR for each
type of truck, and decide which to recommend.
Q4. The Ewert Exploration Company is considering two mutually exclusive plans for extracting

Oil on property for which it has mineral rights. Both plans call for the expenditure of $10million to drill
development wells. Under Plan A, all the oil will be extracted in 1 year, producing a cash flow at t = 1 of $12
million; under Plan B, cash flows will be $1.75 million per year for 20 years.

What are the annual incremental cash flows that will be available to Ewert Exploration if it undertakes Plan B
rather than Plan A?

If the company accepts Plan A and then invests the extra cash generated at the end of

Year 1, what rate of return (reinvestment rate) would cause the cash flows from reinvestment to equal the cash
flows from Plan B?

Q5. Shao Airlines is considering two alternative planes. Plane A has an expected life of 5 Years, will cost $100
million, and will produce net cash flows of $30 million per year.

Plane B has a life of 10 years, will cost $132 million, and will produce net cash flows of $25 million per year.
Shao plans to serve the route for only 10 years. Inflation in operating costs, Airplane costs, and fares is
expected to be zero, and the company’s cost of capital is 12%.

By how much would the value of the company increase if it accepted the better project (plane)? What is the
equivalent annual annuity for each plane?