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Capital Budgeting Technique

The document discusses various capital budgeting techniques used to evaluate long-term investment projects. It provides examples of calculating net present value (NPV), profitability index (PI), payback period, and internal rate of return (IRR) for a sample capital project with an initial $100,000 investment and expected cash flows over 4 years. It demonstrates determining whether the project would be accepted or rejected based on the required rate of return and each method's acceptance criteria.

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Ahmad Zubair Hariq
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55 views

Capital Budgeting Technique

The document discusses various capital budgeting techniques used to evaluate long-term investment projects. It provides examples of calculating net present value (NPV), profitability index (PI), payback period, and internal rate of return (IRR) for a sample capital project with an initial $100,000 investment and expected cash flows over 4 years. It demonstrates determining whether the project would be accepted or rejected based on the required rate of return and each method's acceptance criteria.

Uploaded by

Ahmad Zubair Hariq
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Capital budgeting Techniques

chapter no
5
Capital budgeting

It is the planning process used to determine


whether a form’s long term investment. i.e.
new machinery, replacement of
machinery, new plants, research and
development project etc.

“Note only how much cash expected to


receive but also when and how”
Capital Budgeting Technique
Different capital budgeting technique are,

i. Net present value

ii.Profitability index

iii.Internal rate of return

iv.Pay back period


Net Present Value (NPV)
The present value of an investment project’s net cash flows
minus the projects initial cash outflow.

In formula form we have


 CF1 + CF2 + ………. + CFn
NPV= -ICO
 (1+i) 1 (1+i) 2 (1+i) n

CF= Cash Flow

I = Rate of return

ICO = Initial cash outflow


Practical question
Suppose that we wish to determine the Net Present
Value for a company. We determine, at that time,
that for an initial cash outflow of $100,000, the
company expected to generate net cash flows of $
34,432, $ 39,530, $39359, and $32,219 over the
next 4 years and rate of return is 12%.
Required :- To Calculate Net Present Value
SOLUTION

Years Cash Flow Present Value of Cash Flow

0 (100,000) (100,000)

1 34,432 30,743

2 39,530 31,513

3 39,359 28,015

4 32,219 20,475
NPV= 10,746
   CF 1 + CF2 + CF3 + CF4
NPV= -ICO
 (1+i)1 (1+i)2 (1+i)3 (1+i)4

NPV= 34,432 + 39,530 + 39,359 + 32,219- 100,000


(1+0.12)1 (1+0.12)2 (1+0.12)3 (1+0.12)4
NPV = 30,743 + 31,513 + 28,015 + 20,475 - 100,000

= NPV = 1,10,746 - 100,000


NPV = 10,746
Acceptance Criteria
NPV = Positive accept
NPV = Negative reject
Profitability Index
The profitability of a project is the ratio of present value of
future net cash flow to the initial cash outflow.
NPV is Preferred over the profitability index because NPV
expressed the absolute and economic contribution.
 In formula form we have

 CF1 + CF2 + ………. + CFn


 P.I = (1+i)1 (1+i)2 (1+i)n ICO
Practical question
Suppose that we wish to determine the Profitability
Index for a company. We determine, at that time,
that for an initial cash outflow of $100,000, the
company expected to generate net cash flows of $
34,432, $ 39,530, $39359, and $32,219 over the
next 4 years and rate of return is 12%.
Required :- To Calculate Profitability Index
SOLUTION

Years Cash Flow Present Value of Cash Flow

0 (100,000) (100,000)

1 34,432 30,743

2 39,530 31,513

3 39,359 28,015

4 32,219 20,475
= 1,10,746
 CF1 + CF2 + CF3 + CF4
P .I= ICO
(1+i) 1 (1+i)2 (1+i)3 (1+i)4

34,432 39,530 + 39359 + 32,219


P .I=
+
100,00
(1+O.12)1 (1+0.12)2 (1+O.12)3 (1+0.12)4 0

P .I = 30,743 + 31,513 + 28,015 + 20,475 / 100,000

P .I =1,10,746 / 100,000
P .I = 1.12
Acceptance Criteria
Whenever profitability Index is greater than 1 you accepted and
if is less than 1 you rejected.

P .I 1 Accept
P .I 1 Reject
Pay Back Period
The pay back period of a investment project tell us the
number of year required to recover over initial cash
investment based on the project, expected cash flow.
In formula form we have

P.B.P = a + (b – c) d
Practical question
Suppose that we wish to determine the Pay Back
Period for a company. We determine, at that time,
that for an initial cash outflow of $100,000, the
company expected to generate net cash flows of $
34,432, $ 39,530, $39359, and $32,219 over the
next 4 years and rate of return is 12%.
Required :- To Calculate Pay Back Period
SOLUTION

Years Cash Flow Cumulative Cash Flow

0 b (100,000)

1 34,432 34,432

a 2 39,530 c 73,962

3 d 39,359 1,13,321

4 32,219 1,45,540
P.B.P = a + (b – c) d
P.B.P = 2 + (100,000 – 73,962) / 39359
P.B.P = 2 + 26,038 / 39359
P.B.P = 2 + 0.661
P.B.P = 2.7 years
Acceptance Criteria
If the pay back period calculated is less than the same
maximum expectable pay back period, proposal will
be accepted otherwise voice versa.
Internal Rate of Return
The internal rate of return for an investment proposal is the
discount rate that equates the present value of the future net cash
flows from an investment project with the project’s initial cash
outflow.
In formula form we have
 CF1 + CF2 + ………. + CFn
 (1+i)1 (1+i)2 (1+i)n
 ICO =
 IRR= Represented by i
SOLUTION

Years Cash Flow P.V of C.F 15% P.V of C.F 20%

0 (100,000)

1 34,432 29941 28693

2 39,530 29890 27451

3 39,359 25879 22777

4 32,219 18421 15538


1,04,131 94,459
 CF1 + CF2 + CF3 + CF4
ICO=
(1+i) 1 (1+i)2 (1+i)3 (1+i)4

34,432 + 39,530 + 39359 + 32,219


(1+O.15)1 (1+0.15)2 (1+O.15)3 (1+0.15)4
ICO=
ICO = 29941 + 29890 + 25879 + 18421
ICO = 1,04,131
34,432 + 39359 + 32,219
39,530 +
(1+0.2)1 (1+0.2)2 (1+O.2)3 (1+0.2)4
ICO = 28693 + 27451 + 22777 + 15538
ICO = 94,459
ICO=
Present value of C.F 15% = 1,04,131
Present value of C.F 20% = 94,459
ICO = 100,000
1,04,131 – 100,000 = 4131
1,01,131 – 94,459 = 9,672
X = 4131
0.05 9672
X
= 0.42
0.05
X = 0.42 * 0.05
X = 0.021
IRR = 0.15 + x IRR = 0.20 + X
IRR = 0.15 + 0.021 IRR = 0.20 + 0.021
IRR = 0.171 IRR = 0.221
IRR = 17% IRR = 22 %
Acceptance Criteria
IRR > I Accept = IRR < I Reject
17% > 12% Accept 22% > 12% Accept
17% < 20% Reject 22% > 15% Accept

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