Seminar in Finance

Report on
Capital Budgeting

Submitted to:
Anum Zulfiqar

Submitted by:
M.Kashif Qadeer (MBLE-13-01)
Khizar Hayat (MBLE-13-02)
Naveed Nazar (MBLE-13-05)
Shahid Ul Haq (MBLE-13-06)
Riaz Hussain (MBLE-13-14)
Abdul Jabar (MBLE-13-15)
Asad Mehood (MBLE-13-18)
Imran Khan (MBLE-13-23)
Imran Muhi U Din (MBLE-13-29)
M.Adeel Khan (MBLE-13-39)
Class:

Evening 6 th Semester

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BUSINESS & ADMNISTRATION DEPARTMENT BZU BHADUR SUB CAMPUS

LAYYAH

Table of Content

01 Capital budgeting or investment appraisal 03

02 Capital budgeting process 03

03 Capital Budgeting Techniques 04

04 06

Kinds of Capital Budgeting Decisions

05 The Capital Budgeting Process 07

06 The Importance of Capital Budgeting 10

07 Constructing a Capital Budget 12

08 Advantages of Capital Budgeting 16

09 Disadvantages of Capital Budgeting 17

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10 Factors Influencing Capital Budgeting 18

Capital budgeting or investment appraisal

Is the planning process used to determine whether an organization's long term investments such as new
machinery, replacement machinery, new plants, new products, and research development projects are
worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings)?
It is the process of allocating resources for major capital, or investment, expenditures. One of the
primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.

Capital budgeting process involves the following

1. Project generation:

Generating the proposals for investment is the first step. The investment proposal may fall into one of
the following categories:

Proposals to add new product to the product line,

proposals to expand production capacity in existing lines

Proposals to reduce the costs of the output of the existing products without altering the scale of
operation.

Sales campaigning, trade fairs people in the industry, R and D institutes, conferences and
seminars will offer wide variety of innovations on capital assets for investment.

2. Project Evaluation:

It involves two steps

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Estimation of benefits and costs: the benefits and costs are measured in terms of cash flows.
The estimation of the cash inflows and cash outflows mainly depends on future uncertainties.
The risk associated with each project must be carefully analyzed and sufficient provision must
be made for covering the different types of risks.

Selection of appropriate criteria to judge the desirability of the project: It must be consistent
with the firms objective of maximizing its market value. The technique of time value of
money may come as a handy tool in evaluation such proposals.

3. Project Selection:

No standard administrative procedure can be laid down for approving the investment proposal.
The screening and selection procedures are different from firm to firm.

4. Project Evaluation:

Once the proposal for capital expenditure is finalized, it is the duty of the finance manager to
explore the different alternatives available for acquiring the funds. He has to prepare capital
budget. Sufficient care must be taken to reduce the average cost of funds. He has to prepare
periodical reports and must seek prior permission from the top management. Systematic
procedure should be developed to review the performance of projects during their lifetime and
after completion.

Capital Budgeting Techniques:

Many formal methods are used in capital budgeting, including the techniques such as

Payback Period

The payback period is the most basic and simple decision tool. With this method, you are basically
determining how long it will take to pay back the initial investment that is required to undergo a
project. In order to calculate this, you would take the total cost of the project and divide it by how much
cash inflow you expect to receive each year; this will give you the total number of years or the payback
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period. For example, if you are considering buying a gas station that is selling for $100,000 and that
gas station produces cash flows of $20,000 a year, the payback period is five years.

As you might surmise, the payback period is probably best served when dealing with small and simple
investment projects. This simplicity should not be interpreted as ineffective, however. If the business is
generating healthy levels of cash flow that allow a project to recoup its investment in a few short years,
the payback period can be a highly effective and efficient way to evaluate a project. When dealing with
mutually exclusive projects, the project with the shorter payback period should be selected.

Net Present Value (NPV)

The net present value decision tool is a more common and more effective process of evaluating a
project. Perform a net present value calculation essentially requires calculating the difference between
the project cost (cash outflows) and cash flows generated by that project (cash inflows). The NPV tool
is effective because it uses discounted cash flow analysis, where future cash flows are discounted at a
discount rate to compensate for the uncertainty of those future cash flows. The term "present value" in
NPV refers to the fact that cash flows earned in the future are not worth as much as cash flows today.
Discounting those future cash flows back to the present creates an apples to apples comparison between
the cash flows. The difference provides you with the net present value.

The general rule of the NPV method is that independent projects are accepted when NPV is positive
and rejected when NPV is negative. In the case of mutually exclusive projects, the project with the
highest NPV should be accepted.

Internal Rate of Return (IRR)

The internal rate of return is a discount rate that is commonly used to determine how much of a return
an investor can expect to realize from a particular project. Strictly defined, the internal rate of return is
the discount rate that occurs when a project is break even, or when the NPV equals 0. Here, the
decision rule is simple: choose the project where the IRR is higher than the cost of financing. In other

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words, if your cost of capital is 5%, you don't accept projects unless the IRR is greater than 5%. The
greater the difference between the financing cost and the IRR, the more attractive the project becomes.

The IRR decision rule is straightforward when it comes to independent projects; however, the IRR rule
in mutually-exclusive projects can be tricky. It's possible that two mutually exclusive projects can have
conflicting IRRs and NPVs, meaning that one project has lower IRR but higher NPV than another
project. These issues can arise when initial investments between two projects are not equal. Despite the
issues with IRR, it is still a very useful metric utilized by businesses. Businesses often tend to value
percentages more than numbers (i.e., an IRR of 30% versus an NPV of $1,000,000 intuitively sounds
much more meaningful and effective), as percentages are more impactful in measuring investment
success. Capital budgeting decision tools, like any other business formula, are certainly not perfect
barometers, but IRR is a highly-effective concept that serves its purpose in the investment decision
making process.

Kinds of Capital Budgeting Decisions

Capital budgeting refers to the total process of generating, evaluating, selecting and following up on
capital expenditure alternatives. The firm allocates or budgets financial resources to new investment
proposals. Basically the firm may be confronted with tress types of capital decisions: (i) the accept-
reject decision; (ii) the mutually exclusive choice decision; and (iii) the capital rationing decision.

The Accept-Reject Decision:

This is a fundamental decision in capital budgeting. If the project is accepted, the firm invests in it; if
the proposal is rejected, the firm does not invest in it. In general, all those proposals, which yield a rate
of return greater than a certain required rate of return or cost of capital is accepted and the rest, are
rejected. Under the accept-reject decision, all the independent projects that satisfy the minimum
investment criterion should be implemented.

Mutually Exclusive Project Decisions:

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Mutually exclusive projects are projects, which compete with other projects in such a way that the
acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually
exclusive and only one may be chosen. Suppose, a company is intending to buy a new folding machine.
There are three competing brands, each with different initial investment and operating costs. The three
machines represent mutually exclusive alternatives, as only one of the three machines can be selected.
Mutually exclusive investment decisions acquire significance when more than one proposal is
acceptable under the accept-reject decision. Then some techniques have to be used to determine the
best one. The acceptance of this best alternative automatically eliminates the other alternatives.

Capital rationing or ranking decisions:

In case the firm has various profitable investment proposals in that case the firm had only option to rank them as
per their profitability and then accept them.

The Capital Budgeting Process

Payback Period
Assume that two gas stations are for sale with the following cash flows:

According to the payback period, when given the choice between two mutually exclusive projects, Gas
Station B should be selected. Although both gas stations cost the same, Gas Station B has a payback
period of one year, whereas Gas Station A will payback in roughly one and half years. Payback analysis
is common to everyone in investment decisions, an example being the purchase of a hybrid car.

Net Present Value Method

As was mentioned earlier, the payback period is a very basic capital budgeting decision tool that
ignores the timing of cash flows. Since most capital investment projects have a life span of many years,
a shorter payback period may not necessarily be the best project.

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Consider the gas station example above under the NPV method, and a discount rate of 10%:

NPVgas station A = $100,000/(1+.10)2 - $50,000 = $32,644

NPVgas station B = $50,000/(1+.10) + $25,000/(1+.10)2 - $50,000 = $16,115

In our gas station example, the net present value tool illustrates the limitations of the payback period.
Under the payback period, the decision would have been to pick gas station B because it had the shorter
payback period. Under the NPV criteria, however, the decision favors gas station A, as it has the higher
net present value. In this particular case, the NPV of gas station A is more than twice that of gas station
B, which implies that gas station A is a vastly better investment project to undertake.
In the real world, however, sometimes managers will make decisions that don't necessarily agree with
the decision rules of the payback period, NPV or IRR methods. For example, suppose the NPV of gas
station A was only slightly higher than that of B, yet the buyer was worried about meeting his financial
obligations in year one. In that case, the choice may be made to take on the project with the quicker
upfront cash flows even it means a slightly lower return. When might something like this occur? It
could be that the buyer had to borrow a majority of the purchase price and really had a desire to pay
back the loan sooner, rather than later, to save on interest expense. In that case, a quicker payback
period may be more desirable than a slightly higher net present value project.

Do keep in mind, however, that all capital projects, in the case of for-profit enterprises, should be made
in the context of creating long-term shareholder value. In our above example, gas station A with the
higher NPV creates significantly more shareholder value than does gas station B. So even if the
decision was made based on a quicker payback period, the project with greatest net present value
would be the one that maximizes shareholder value. Generally speaking, accepting the project with the
lower net present value would be destroying shareholder value.

Internal Rate of Return

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The internal rate of return (IRR) method can perhaps be the more complicated and subjective of the
three capital budgeting decision tools. Similar to the NPV, the IRR accounts for the time value of
money. It is useful here to repeat the definition of the IRR:

The IRR of any project is the rate of return that sets the NPV of a project zero.
Since the general NPV rule is to only pick projects with an NPV greater than zero with the highest net
present value, the internal rate of return, by definition, is the breakeven interest rate. In other words, the
IRR decision criteria conceptually obvious:

Choose projects with an IRR that is greater than the cost of financing.
This rule is easy to understand: if your cost of capital is 10%, projects with an internal rate of return of
8% would destroy value, while projects with an internal rate of return of 15% with increase value.

While it's conceptually simple to understand the internal rate of return process, calculating IRR can be
a bit tricky. The calculation of a project's IRR is essentially a trial and error one. Consider the following
example of a project with the following cash flows:

There is no simple formula to calculate the IRR. It's either done by trial and error or a financial
calculator. Remember, however, that the IRR is that rate where NPV is equal to zero; the equation
would be set up like this:

CF0 + CF1/(1+IRR) + CF2/(1+IRR)2 + CF3/(1+IRR)3 = 0, or

-$1,000+ $100/(1+IRR) + $600/(1+IRR)2 + $800/(1+IRR)3 = 0

Believe or not, from here the next step is to guess a number for IRR, plug in and see if it equals zero.
When IRR = 20%, or .20, the result is a number greater than zero (you can try it yourself, just enter
"0.20" in place of "IRR." Performing a trial and error calculation here would be too cumbersome but
it's very simple and good practice, to try it yourself).

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Thus 20% is too big a number. The next step would be to try a lower number.
When IRR = 17%, the NPV is less than zero, so that IRR is too low.
The IRR of this particular project is 18.1%. That is the interest where the NPV of the above project is
zero. Plug it in and you should get zero or an insignificantly lower number that equates to zero.
Thus, if the cost of financing the above the project is below 18.1%, the project creates value under the
IRR calculation; if the cost of financing is greater than 18.1%, the project will destroy value.
Just as is the case with the payback method and NPV, the IRR decision will not always agree with the
NPV decision in mutually-exclusive projects. Again, this has to do with initial cash flow outlay and
timing of future cash flows. However, in the end, despite the its flaws, percentages are more intuitive
and useful in business, thus rendering value to the IRR method.
The Importance of Capital Budgeting

Capital budgeting is a step by step process that businesses use to determine the merits of an investment
project. The decision of whether to accept or deny an investment project as part of a company's growth
initiatives, involves determining the investment rate of return that such a project will generate.
However, what rate of return is deemed acceptable or unacceptable is influenced by other factors that
are specific to the company as well as the project. For example, a social or charitable project is often
not approved based on rate of return, but more on the desire of a business to foster goodwill and
contribute back to its community.

Capital budgeting is important because it creates accountability and measurability. Any business that
seeks to invest its resources in a project, without understanding the risks and returns involved, would be
held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring
the effectiveness of its investment decisions, chances are that the business will have little chance of
surviving in the competitive marketplace.

Businesses (aside from non-profits) exist to earn profits. The capital budgeting process is a measurable
way for businesses to determine the long-term economic and financial profitability of any investment
project.
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Capital budgeting is also vital to a business because it creates a structured step by step process that
enables a company to:

1. Develop and formulate long-term strategic goals the ability to set long-term goals is
essential to the growth and prosperity of any business. The ability to appraise/value investment
projects via capital budgeting creates a framework for businesses to plan out future long-term
direction.

2. Seek out new investment projects knowing how to evaluate investment projects gives a
business the model to seek and evaluate new projects, an important function for all businesses
as they seek to compete and profit in their industry.

3. Estimate and forecast future cash flows future cash flows are what create value for
businesses overtime. Capital budgeting enables executives to take a potential project and
estimate its future cash flows, which then helps determine if such a project should be accepted.

4. Facilitate the transfer of information from the time that a project starts off as an idea to the
time it is accepted or rejected, numerous decisions have to be made at various levels of
authority. The capital budgeting process facilitates the transfer of information to the appropriate
decision makers within a company.

5. Monitoring and Control of Expenditures by definition a budget carefully identifies the

necessary expenditures and R&D required for an investment project. Since a good project can
turn bad if expenditures aren't carefully controlled or monitored, this step is a crucial benefit of
the capital budgeting process.

6. Creation of Decision when a capital budgeting process is in place, a company is then able to
create a set of decision rules that can categorize which projects are acceptable and which
projects are unacceptable. The result is a more efficiently run business that is better equipped to
quickly ascertain whether or not to proceed further with a project or shut it down early in the
process, thereby saving a company both time and money.

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Unlike other business decisions that involve a singular aspect of a business, a capital budgeting
decision involves two important decisions at once: a financial decision and an investment decision. By
taking on a project, the business has agreed to make a financial commitment to a project, and that
involves its own set of risks. Projects can run into delays, cost overruns and regulatory restrictions that
can all delay or increase the projected cost of the project.

In addition to a financial decision, a company is also making an investment in its future direction and
growth that will likely have an influence on future projects that the company considers and evaluates.
So to make a capital investment decision only from the perspective of either a financial or investment
decisions can pose serious limitations on the success of the project.

In December 2009 ExxonMobil, the world's largest oil company, announced that it was acquiring XTO
Resources, one of the largest natural gas companies in the U.S. for $41 billion. That acquisition was a
capital budgeting decision, one in which ExxonMobil made a huge financial commitment. But in
addition, ExxonMobil was making a significant investment decision in natural gas and essentially
positioning the company to also focus on growth opportunities in the natural gas arena. That acquisition
alone will have a profound effect on future projects that ExxonMobil considers and evaluates for many
years to come.
The significance of these dual decisions is profound for companies. Executives have been known to
lose jobs over poor investment decisions. One can say that running a business is nothing more than a
constant exercise in capital budgeting decisions. Understanding that both a financial and investment
decision is being made is paramount to making successful capital investment decisions.
Constructing a Capital Budget
Estimating Operating Cash Flows

The process for computing operating cash ows is shown below. Operating cash ows are usually
estimated for monthly, quarterly, or annual time periods. First, cash revenues are estimated. This
usually involves estimating the number of units sold during each time period and multiplying the
number by the selling price of the units.

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The next step is to estimate the cash expenses associated with making the product. Cash expenses are
categorized as variable and xed cash expenses. Variable cash expenses are tied directly to the amount
of output produced. For example, if it takes 10 pounds of raw materials to make one unit of output, then
the cost of raw materials varies in direct proportion to the amount of output produced. Fixed cash
expenses are those that dont vary according to the amount of output produced. For example,
administrative expense is often a xed expense because it is constant regardless of the amount of output
produced.

Depreciation of the capital assets is computed next. Depreciation and cash expenses are then subtracted
from cash revenues to compute net income before taxes. The income tax rates are applied against the
net income before taxes to compute the amount of taxes. The taxes are subtracted from net income
before taxes to compute net income after taxes. Because depreciation is a non-cash expense, it is added
back to net income after tax to compute cash ow after tax.

Cash Flow, Not Portability

Capital budgeting is based on the projected cash ows of a project, not its projected portability. Al-
though closely related, cash ow and portability are different. Cash ow represents the cash inows
and outows from the business. Portability represents the income and expenses of the business.

You may think of cash ow as transactions that affect your business checkbook and portability as
items that impact your income tax return. For example, the purchase of capital assets results in
different transactions. Cash ows include the initial outlay for capital assets and their sale at the end of
the project, whereas portability expresses the cost of capital assets in a series of annual depreciation
expenses over the life of the assets.

Discount Rate

The discount rate used in the analysis should reect the cost of capital. If the project is nanced entirely
with debt capital, the discount rate will be the interest rate charged by the lender. If the project is
nanced entirely with equity capital, the discount rate may be the opportunity cost of the funds. For
example, the opportunity cost may be the rate of return the funds would have earned invested

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elsewhere. If both equity and debt are used, the interest charged on the borrowed money and the
opportunity cost rate of return may be blended in computing the discount rate.

If the discount rate is designed to represent the cost of capital for the business project, interest expense
should not be included as an operating cash ow. If it is, interest (the cost of capital) will be counted
twice.

Working Capital
Working capital represents the money required to fund the annual operating cash ow. When creating a
capital budget, it is important to allow for funds to provide adequate liquidity for operations. At the
beginning of the business project, working capital is a cash outow just like the purchase of capital
assets. At the end of the project, working capital is a cash inow just like the sale of the capital assets.
The amount of working capital remaining at the end of the project may not be the same as the working
capital invested at the beginning of the project.

A related issue is the capital needed to get the business project up and running. In many situations, the
time period from the initial purchase of equipment until the facility is completed and running at
capacity can be long. Funds are needed to bridge this time period.

Another issue is working capital in the form of contingency funds needed to cover any unexpected
occurrences. These can include cost overruns, under-performance of the facility, a market downturn,
and many other unexpected occurrences.

Lag Time in Converting Inputs to Outputs

In many traditional manufacturing and processing business projects, there is a relatively short time
between when inputs are purchased and outputs are produced. For example, corn can be converted into
ethanol rather quickly. Once production begins, outputs are produced in the same time period as inputs
are utilized.
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However, for many agricultural production business projects, there is a considerable lag time from the
time the input is utilized until output is produced. For example, it may take several months for a feeder
calf to be converted into a nished animal. From the time inputs (feeder calf) are purchased, outputs
(nished animal) may not emerge until the following year. In this situation, the rst time period will
generate cash outows (feeder calf purchase) but no cash inows (nished animal sale). Therefore,
additional working capital is needed to nance this lag time. Also, during the last year of the projects,
the situation is reversed because no inputs (feeder calf) are purchased but outputs (nished animal) are
produced.

Expansion versus Stand-alone Business Project

Business projects are primarily of two types the expansion of an existing business and the start-up of
a new stand-alone business. Expansion examples include an expansion of your main product line,
adding a new product line, making a component versus buying the component, and a host of other ways
of expanding a business. The other is a standalone business project. This is often a new start-up
business that has no direct connection to an existing business.

The purpose of the capital budgeting exercise for a business expansion is to determine if the expansion
will generate positive cash returns for the existing business. When computing cash ows for a business
expansion, only those cash inows and outows associated with the expansion are included. The cash
ows of the existing business need not be included. These additional cash ows are sometimes called
incremental cash ows because they often represent an increase is an existing cash ow (e.g. more
product sales, larger purchase of raw materials, more marketing expense, etc.). An expansion can lead
to new and additional cash ows that are difcult to detect. A careful assessment is required to identify
all cash ows.

The purpose of the capital budgeting exercise for a stand-alone business is to determine if the business
investments will generate a positive net cash return over the life of the project. When preparing a
capital budget, all of the cash inows and outows over the life of the business project need to be
included. This includes the initial cash outlays at the beginning of the project, the operating cash ows
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that occur annually over the life of the project, and the remaining cash value of assets at the end of the
project.

Assessing Risk
Because capital budgeting involves projecting cash ows several years into the future, there is consid-
erable risk as to the accuracy of these projections, especially for those years farthest into the future.
This variability of outcome can have a major impact on the outcome of the analysis and the resulting
feasibility of the business project. Several methods have been developed to assess this variability and
its impact on the analysis.

Advantages and Disadvantages

Capital budgeting revolves around capital expenditures which include large inflow and outflow of
money to finance investment projects. It is a process by which a company decides whether it should
invest in a project or not. We have tried to explains advantages and disadvantages of capital budgeting.

Capital budgeting is largely used for long term investment opportunities whose tenure is more than a
year and fetches returns over several subsequent years. These investment opportunities could be for
new plant & machinery, factory facility, construction of a building etc. Capital budgeting is a very
important tool in finance but it comes with its own merits and demerits.

Advantages of Capital Budgeting:

Capital budgeting helps a company to understand various risks involved in an investment

opportunity and how these risks affect the returns of company.
It helps the company to estimate which investment option would yield the best possible
return.
A company can choose a technique/method from various techniques of capital budgeting to
estimate whether it is financially beneficial to take on a project or not.
It helps the company to make long term strategic investments.
It helps to make an informed decision about an investment taking into consideration all
possible options.
It helps a company in a competitive market to choose its investments wisely.
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All the techniques/methods of capital budgeting try to increase shareholders wealth and give
the company an edge in the market.
Capital budgeting presents whether an investment would increase the companys value or
not.
It offers adequate control on expenditure for projects.
Also, it allows management to abstain from over investing and under investing.

Disadvantages of Capital Budgeting:

Capital budgeting decisions are for long term and are majorly irreversible in nature.
Most of the times, these techniques are based upon the estimations and assumptions as the
future would always remain uncertain.
Capital budgeting still remains introspective as the risk factor and the discounting factor
remains subjective to the managers perception.
A wrong capital budgeting decision taken can affect the long term durability of the company
and hence it needs to be done judiciously by professionals who understand the project well.
Payback Period

Advantages

1. Simple to compute
2. Provides some information on the risk of the investment
3. Provides a crude measure of liquidity

Disadvantages

1. No concrete decision criteria to indicate whether an investment increases the firm's value
2. Ignores cash flows beyond the payback period
3. Ignores the time value of money
4. Ignores the risk of future cash flows

Net Present Value

Advantages

1. Tells whether the investment will increase he firm's value

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2. Considers all the cash flows

3. Considers the time value of money
4. Considers the risk of future cash flows (through the cost of capital)

Disadvantages

1. Requires an estimate of the cost of capital in order to calculate the net present value.
2. Expressed in terms of dollars, not as a percentage.

Internal Rate of Return

Advantages

1. Tells whether an investment increases the firm's value

2. Considers the time value of money
3. Considers all cash flows of the project
4. Consider the risk of future cash flows (through the cost of capital in the decision rule)

Disadvantages

1. Requires an estimate of the cost of capital in order to make a decision

2. May not give the value-maximizing decision when used to compare mutually exclusive projects
3. May not give the value-maximizing decision when used to choose projects when there is capital
rationing

Factors influencing capital budgeting

Availability of funds

Structure of capital

Taxation policy

Government policy

Lending policies of financial institutions

Immediate need of the project

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Earnings

Capital return

Economical value of the project

Working capital

Accounting practice

Trend of earnings

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