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    Chapter 12 - Capital Budgeting

    Uploaded by

    Samin Haque
    Capital budgeting refers to evaluating proposed long-term investment projects. This document outlines various capital budgeting methods including payback period, net present value (NPV), profitability index, and internal rate of return (IRR). It provides examples of calculating each method and comparing two hypothetical projects (A and B). Based on the NPV and IRR calculations shown, Project B has a higher NPV and IRR than Project A, so Project B would be accepted while Project A is rejected.

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    Chapter 12 - Capital Budgeting

    Uploaded by

    Samin Haque
    59 views26 pages
    Capital budgeting refers to evaluating proposed long-term investment projects. This document outlines various capital budgeting methods including payback period, net present value (NPV), profitability index, and internal rate of return (IRR). It provides examples of calculating each method and comparing two hypothetical projects (A and B). Based on the NPV and IRR calculations shown, Project B has a higher NPV and IRR than Project A, so Project B would be accepted while Project A is rejected.

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    Chapter-12_Capital-Budgeting

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    Capital budgeting refers to evaluating proposed long-term investment projects. This document outlines various capital budgeting methods including payback period, net present value (NPV), profitability index, and internal rate of return (IRR). It provides examples of calculating each method and comparing two hypothetical projects (A and B). Based on the NPV and IRR calculations shown, Project B has a higher NPV and IRR than Project A, so Project B would be accepted while Project A is rejected.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    59 views26 pages

    Chapter 12 - Capital Budgeting

    Uploaded by

    Samin Haque
    Capital budgeting refers to evaluating proposed long-term investment projects. This document outlines various capital budgeting methods including payback period, net present value (NPV), profitability index, and internal rate of return (IRR). It provides examples of calculating each method and comparing two hypothetical projects (A and B). Based on the NPV and IRR calculations shown, Project B has a higher NPV and IRR than Project A, so Project B would be accepted while Project A is rejected.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
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    At a glance
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    The key takeaways are the different methods of evaluating capital budgeting projects including payback period, net present value, internal rate of return, and profitability index. Investors should consider factors like the future potential and risk of projects in addition to the financial analyses.

    The different methods of capital budgeting discussed are payback period, net present value (NPV), internal rate of return (IRR), and profitability index (PI). NPV discounts all future cash flows to determine if a project has a positive present value while IRR finds the discount rate that sets NPV to zero.

    Investors should consider factors like the future potentiality and risk of projects in addition to the results of financial analyses. The industry and specifics of each project also impact which methods may be most appropriate. Future courses will cover additional factors.

    Chapter 12

    Capital Budgeting
    Outline
    • What is Capital Budgeting ?
    • Importance of Capital Budgeting.
    • Calculation techniques of different methods of
    capital budgeting for proposed project.
    • Advantages and Limitations of different methods
    • Practice
    What is Capital Budgeting ?

    • Process that relates to the evaluation of


    several alternative proposed investment
    projects for a firm.

    - Example ?
    Importance of Capital Budgeting

    ✔ Involves commitment of large amount of funds for long


    term.
    ✔ Essential for evaluating future events which are
    uncertain.
    ✔ Ensure the selecting the right source of financing at the
    right time.
    Capital Budgeting
    Methods

    ❑Payback Period (PBP)

    ❑Net present value (NPV)

    ❑Profitability Index (P.I)

    ❑Internal Rate of Return (IRR)


    Payback Period

    ⦿Payback Period: Length of time require to


    recover the amount of initial investment.

    • Minimum Acceptance Criteria


    - Set by management

    • Ranking Criteria:
    - Lowest is better
    Example
    Time Project A Project B
    0 (10,000) in taka. (10,000) in taka.
    1 3,500 500
    2 3,500 500
    3 3,500 4,600
    4 3,500 10,000

     
    Project B
    Year Cash Flow Cumulative
    Cash flow
    0 (10,000) (10,000)
    1 500 (9,500)
    2 500 (9,000)
    3 4,600 (4,400)
    4 10,000 5,600

      [ Project A, 2.9 years] H.W

    Accept Project ‘A’ & Reject project ‘B’


    Payback
    Advantages & Limitations

    ▪ Advantages
    ▪ Easy to understand
    ▪ Provides a good ranking of projects in terms of liquidity

    ⮚Limitations:
    ⮚ Ignores the time value of money
    ⮚ Ignores cash flows after the payback period

    (Ahmed, 2012)
    Net Present Value
    (NPV)

    • Net Present Value (NPV) : Present value of all the costs and
    benefits of a project.

    • Estimating NPV:
    – 1. Estimate future cash flows (CF)
    – 2. Estimate discount rate (K) / WACC
    – 3. Estimate initial investment / Cost

    NPV = Total PV of future CF’s - Initial Investment

    • Minimum Acceptance Criteria: Accept if NPV > 0

    • Ranking Criteria: Choose the highest NPV (If projects are qualified)
    NPV of Project ‘B:

     
     
    Project A, NPV

      A = 3,500
    I = 10%
    N =4
     

     
    * HW 16 & 10 B

    • Accept Project ‘B’ & Reject project ‘A’


    Why use Net Present Value (NPV)

    ▪ NPV uses all the cash flows of the project. (Not up to certain period)

    ▪ Consider the time value of money by discounting the cash

    flows properly.

    ▪ Accepting positive projects benefits the shareholders.

    (Rose, Westerfield & Jaffe, 2006)


    Profitability
    Index (P.I)

    P.I of Project ‘B:


     

    • Accept Project ‘B’ & Reject project ‘A’


    Internal Rate of Return
    (IRR)

    • IRR: The discount that sets NPV to zero.

    • Minimum Acceptance Criteria:


    – Accept if the IRR exceeds the WACC or required return.
    • Ranking Criteria:
    – Select alternative with the highest IRR (if projects are qualified)
    IRR of project B
    Step 1: Assume discount rate is 10%
    Step 2: calculate NPV by assuming K
    is 10%

    + 10 % 12% “ - 22% 30%


    + NPV 1154 0 - (2,207)
    IRR of project B L.D.R = Lower discount rate
    Step 3: H.D.R= Higher discount rate

     
    Here:
    L.D.R = 10%
    H.D.R= 22%
      NPV of L.D.R= 1,154
    NPV of H.D.R= (2,207)

     
    HW 19
     
    Assume, Discount rate/WACC 10% .
     
    Decision: IF IRR of project A is 12%,
    Accept Project ‘B’ &
    Reject project ‘A’
    Mutual exclusive vs Independent project
    Mutual exclusive : Disjoint if they cannot both occur at the same time.
    Example, a single coin toss, which can result in either heads or tails, but not both.

    Independent project: The occurrence of one event does not affect the occurrence


    of the other.

    If projects are If Independent


    A B projects , following
    mutually exclusive,
    following project project should be
    1) PBP 2 years 3.5 should be accepted accepted
    yeras
    2) NPV $3,200 $4,500 1 PBP = A 1 PBP = Depends
    3) NPV ($3,200) ($4,500) 2 NPV= B 2 NPV= Both

    4) IRR (Cost 12.4% 11 % 3 NPV = None 3 NPV = None


    10%) 4 IRR = A 4 IRR = A
    Yea CASH Cumulative
    r flow Cash flow • 409 pg ; 10
    Project B Cost of capital 10%. Calculate PBP,
    0 (10,000) (10,000) NPV
    1 12,000 2,000
    2 8,000 10,000
    3 6,000 16,000

       

     
    RANDOM math
    A) Calculate NPV, assume cost/K is 11% Year Project Project
    B) BASED on NPV which project should be IUB NSU
    selected
    C) Calculate the IRR of both project 0 (9,000) (8,000)
    D) BASED on IRR which project should be 1 12,000 9,500
    selected
    2 (0) (1,000)
    3 8,000 14,000

    C) IRR H.W
    &
    H.W 14
    Yea CASH flow • Pg 410/15:
    r
    Spend/invest 10,000 at the end of third year.
    0 (60,000)
    Cost of capital 10%. Calculate PBP, NPV & IRR
    1 15,000
    2 25,000 ✔ PBP as usual method.
    ✔ No impact for new investment [10,000]
    3 40,000

     
     
    IRR of the project L.D.R = Lower discount rate
    H.D.R= Higher discount rate

     
    Here:
    L.D.R = 3%
    H.D.R= 10%
      NPV of L.D.R= 5,583
    NPV of H.D.R= (3,188)

     
    **Few important facts

    ✔ Practice of any particular method varies industry to industry.

    ✔ Factors that investor should also consider


    - Future potentiality of project
    - Risk of the project

    ✔ In future finance course you will learn that part, In sha Allah.

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