CAPITAL BUDGETING

Group Members

Adeel AkbarTaimoor ShahzadaMoqeet Ahmad Muhammad Shoaib

What is Capital Budgeting?

“Capital Budgeting is the process of identifying, Analyzing and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.”

What is Capital Budgeting?

“Capital Budgeting is the process of planning expenditures on assets with cash flows that are expected to extend beyond one year”

Functions of Capital Budgeting

FunctionsGenerating Investment projects

proposals consistent with firm’s strategy.

Estimating after tax operating cash flows for investment projects.

Evaluating project cash flows.Selecting a project based on

Value-Maximizing criteria.

Our Focused Area

Selecting a project based on Value-Maximizing criteria.

Techniques

PBP NPV

IRR PI

Pay Back Period (PBP)

“The Length of time required for an investment’s net Revenues to cover its cost.”

Can be Calculated as:

PBP= a + (b-c) d

Project with Minimum PBP will be Accepted.

Net Present Value (NPV)

“The Present value of an investment project’s is net cash flows minus the Project’s initial cash outflow.”

NPV=Present value of cash flows – Initial Investment

NPV= cf1+ cf2 + …….. + cfn -

ICO

(1+r)1 (1+r)2 (1+r)n

Where: cf = Cash flow r = Interest rate ICO= Initial Cash out flow

Project with +ve NPV will be selected

Internal Rate of Return (IRR)“The discount Rate that equates the

present value of the future net cash flows from an investment project’s initial cash out flow.”

If IRR > Given Rate, project will b accepted.

Formula

IRR = LDR + diff b/w NPV of LDR

two rates sum of both NPVs

where:

LDR = Lower Discount Rate

Profitability Index (PI)

“The Ratio of the present value of a project’s future net cash flow to the project’s initial cash out flow”

Example

ABC company has two projects Project A and Project B, the maximum pay back period and interest rate for both projects is 4years and 12% respectively, cash flows of different years for both projects is given. Evaluate both projects on the basis of four capital budgeting techniques and decide which project is beneficial for the company.

Cash Flows:Project A Project B

Years Cash Flow

1 15,000

2 20,000

3 30,000

4 35,000

5 40,000

Years Cash Flow

1 12,000

2 14,000

3 30,000

4 25,000

5 20,000

Initial Investment 70,000

Initial Investment 90,000

Calculation of PBP

Initial Investment = 70,000Years Cash Inflow Cumulative Cash Inflow

1 15,000 15000

2 20,000 (15000+20000) 35,000

3 30,000 (35000+30000) 65,000

4 35,000 (65000+35000) 1,00,000

5 40,000 (100000+40000) 1,40,000

a = 3 , b = 70,000 , c = 65,000 , d = 35,000

Project A

Calculation of PBP

Initial Investment 90,000Years Cash Inflow Cumulative Cash Inflow

1 12,000 12,000

2 14,000 (12,000+14,000) 26,000

3 30,000 (26,000+30,000) 56,000

4 25,000 (56,000+25,000) 81,000

5 20,000 (81,000+20,000) 1,01,000

Project B

a = 4 , b = 90,000 , c = 81,000 , d = 20,000

Pay Back Period (PBP)

Project APBP =3 + 70,000 – 65,000

30,000

= 3+ 5,000

30,000

= 3+ 0.14

= 3.14

3 Year,1 Month & 20 days

Project BPBP = 4 + 90,000 – 81,000

20,000

= 4 + 9,000

20,000

= 4 + 0.45

= 4.45 Years

4 Years, 5 Months & 12 days

Calculation Of Net Present Value

Initial Investment = 70,000Year

sCash

InflowPVIF PVCI

1 15,000 0.893 (0.893 ˣ 15,000) 13,395

2 20,000 0.791 (0.791 ˣ 20,000) 15,940

3 30,000 0.712 (0.712 ˣ 30,000) 21,360

4 35,000 0.636 (0.636 ˣ 35,000) 22,260

5 40,000 0.567 (0.567 ˣ 40,000) 22,680

Total Present Value 95,635

Project A

Calculation Of Net Present Value

Initial Investment = 90,000Year

sCash

InflowPVIF PVCI

1 12,000 0.893 (0.893 ˣ 12,000) 10,716

2 14,000 0.791 (0.791 ˣ 14,000) 11,158

3 30,000 0.712 (0.712 ˣ 30,000) 21,360

4 25,000 0.636 (0.636 ˣ 25,000) 15,900

5 20,000 0.567 (0.567 ˣ 20,000) 11,340

Total Present Value 70,474

Project B

Net Present Value (NPV)

NPV = Total Present Value – Initial Investment

= 95,635 – 70,000

= 25,635

NPV = Total Present Value – Initial Investment

= 70,474 –

90,000 = -19,526

Project A Project B

Steps for Calculation of IRR

1. Calculate average cash flow

2. Divide Initial Investment by answer of above step

3. Find the Answer of above step in table and see % of rate

4. Calculate total present value with the help of above found rate

5. Get another total present value with another supposed rate.

6. Apply the formula

Calculation of Avg. Cash Flow

Years Cash Inflow

1 15,000

2 20,000

3 30,000

4 35,000

5 40,000

Total 1,40,000

Project A Project B

Years Cash Inflow

1 12,000

2 14,000

3 30,000

4 25,000

5 20,000

Total 1,01,000

Step 1 : Average Cash Inflow

Average = Total Cash Inflow

No. of Years

= 1,40,000

5

= 28,000

Average = Total Cash Inflow

No. of Years

= 1,01,000

5

= 20,200

Project A Project B

Step 2: Division

Divide Initial Investment by answer of previous step.

= 70,000

28,000

= 2.5

Divide Initial Investment by answer of previous step.

= 90,000

20,200

= 4.45

Project A Project B

Step 3 : See The Table

Periods 27% 28% 29%

3 1.896 1.868 1.842

4 2.280 2.241 2.203

5 2.583 2.532 2.483

Periods 3% 4% 5%

3 2.829 2.775 2.723

4 3.717 3.630 3.546

5 4.580 4.452 4.329

Project A Project B

28% 4%Periods 28%

1 0.781

2 0.610

3 0.477

4 0.373

5 0.291

Periods 4%

1 0.962

2 0.925

3 0.889

4 0.855

5 0.822

With 28% With 23%

PVIF TPV PVIF TPV0.781 11,715 0.813 12,195

0.620 12,200 0.661 13,220

0.477 14,310 0.537 16,110

0.373 13,055 0.437 15,295

0.291 11,640 0.355 14,200

62,920 71,020

With 4% With 2 %

PVIF PV PVIF PV0.962 11,544 0.980 11,760

0.925 12,950 0.961 13,454

0.889 26,670 0.942 28,260

0.855 21,375 0.924 23,100

0.822 16,440 0.906 18,120

88,979 94,694

Project A Project B

Step 4 & 5: Calculate NPV

Present value with 28%

= 62,920 – 70,000

= -7080

Present value with 23%

= 71020 – 70000

= 1020

Present value with 4%

= 88,979 – 90,000

= -1021

Present value with 2%

=94,694 – 90,000

= 4694

Project A Project B

Step 6: Apply The Formula

IRR = 23%+5% 1020

1020 + 7080

=23%+5% 1020

8100

= 23%+5% (0.125925)

= 23% + 0.63%

= 23.62%

IRR= 2%+2% 4694

4694 + 1021

=2%+2% 4694

5715

= 2% + 2% ( 0.8213)

= 2% + 1.64%

= 3.64%

Project A Project B

Profitability Index

PI = Net Present Value

Initial Investment

= 95,635

70,000

= 1.36

PI = Net Present Value

Initial Investment

= 70,474

90,000

= 0.78

Project A Project B

Conclusion

Project A Project B

PBP 2 Y ,1M, 20 D 4Y ,5M, 12 D

NPV 25,635 (19,526)

IRR 23.62% 3.64%

PI 1.36 0.78

On the basis of above Techniques The Project B is Not Beneficial for Company ABC.

Thank you!!!