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Capital Budgeting: Important Problems and Solutions

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Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on January 30, 2024

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The cost of a project is $50,000 and it generates cash inflows of $20,000, $15,000, $25,000, and $10,000 over four years.

Required: Using the present value index method, appraise the profitability of the proposed investment, assuming a 10% rate of discount.

The first step is to calculate the present value and profitability index.

Total present value = $56,175

Less: initial outlay = $50,000

Net present value = $6,175

Profitability Index (gross) = Present value of cash inflows / Initial cash outflow

= 56,175 / 50,000

Given that the profitability index (PI) is greater than 1.0, we can accept the proposal.

Net Profitability = NPV / Initial cash outlay

= 6,175 / 50,000 = 0.1235

N.P.I. = 1.1235 - 1 = 0.1235

Given that the net profitability index (NPI) is positive, we can accept the proposal.

A company is considering whether to purchase a new machine. Machines A and B are available for $80,000 each. Earnings after taxation are as follows:

Required: Evaluate the two alternatives using the following: (a) payback method, (b) rate of return on investment method, and (c) net present value method. You should use a discount rate of 10%.

(a) Payback method

24,000 of 40,000 = 2 years and 7.2 months

Payback period:

Machine A: (24,000 + 32,000 + 1 3/5 of 40,000) = 2 3/5 years.

Machine B: (8,000 + 24,000 + 32,000 + 1/3 of 48,000) = 3 1/3 years.

According to the payback method, Machine A is preferred.

(b) Rate of return on investment method

According to the rate of return on investment (ROI) method, Machine B is preferred due to the higher ROI rate.

(c) Net present value method

The idea of this method is to calculate the present value of cash flows.

Net Present Value = Present Value - Investment

Net Present Value of Machine A: $1,04,616 - $80,000 = $24,616

Net Present Value of Machine B: $1,03,784 - 80,000 = $23,784

According to the net present value (NPV) method, Machine A is preferred because its NPV is greater than that of Machine B.

At the beginning of 2024, a business enterprise is trying to decide between two potential investments .

Required: Assuming a required rate of return of 10% p.a., evaluate the investment proposals under: (a) return on investment, (b) payback period, (c) discounted payback period, and (d) profitability index.

The forecast details are given below.

It is estimated that each of the alternative projects will require an additional working capital of $2,000, which will be received back in full after the end of each project.

Depreciation is provided using the straight line method . The present value of $1.00 to be received at the end of each year (at 10% p.a.) is shown below:

Calculation of profit after tax

(a) Return on investment

(b) Payback period

Payback period = 2.9 years

Payback period = 3.5 years

(c) Discounted payback period

(d) Profitability index method

Capital Budgeting: Important Problems and Solutions FAQs

What are some examples of capital budgeting.

Examples of capital budgeting include purchasing and installing a new machine tool in an engineering firm, and a proposed investment by the company in a new plant or equipment or increasing its inventories.

What is the process of capital budgeting?

It involves assessing the potential projects at hand and budgeting their projected cash flows. Once in place, the present value of these cash flows is ascertained and compared between each project. Typically, the project that offers the highest total net present value is selected, or prioritized, for investment.

What are the primary capital budgeting techniques?

The primary capital budgeting techniques are the payback period method and the net present value method.

What are the capital budgeting sums?

The capital budgeting sums are the amounts of money involved in capital budgeting.

What are the capital budgeting numericals?

The capital budgeting numericals are the various types of numbers used in applying different capital budgeting techniques.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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BUS202: Principles of Finance

capital budgeting techniques solved problems

Introduction to Capital Budgeting Exercises

  • The decision rule should consider all relevant cash flows
  • The decision rule should recognize the riskiness of the relevant cash flows
  • The decision rule should recognize the time value of money
  • The decision rule should rank the projects so that those projects that increase the firm's value the most are ranked the highest.

Note that rule four can not be shortened to rank projects. Any decision rule will rank the projects, but we want our "optimal" decision rule to rank by value added. Also, a decision rule that does not meet all four criteria is not necessarily worthless. Instead it means that it has some obvious flaws that must be recognized.

The Payback Period

  • may not consider all relevant cash flows,
  • does not consider TVM,
  • does not rank by value added, and
  • has an arbitrary decision rule.

Consider each in order. First, consider two projects as follows:

According to PP, we would prefer project A as it has a shorter PP. However, clearly Project B is superior. The problem is that we fail to consider any cash flows that come in after the PP. Now consider another two projects.

According to PP, we would prefer project B as it has a shorter PP. However, Project A is superior (NPV A = $41,681 vs. NPV B = $33,199 when k=12%). The problem is that PP fails to recognize the advantage of getting $98,000 in year 1 as opposed to $99,000 in year 2. Because of TVM, the $98,000 is much more valuable. The third problem does not need an example. Our goal is to maximize value not get our initial investment back as soon as possible. Following PP distracts us from our primary goal and can lead to bad decision making. Finally, consider the arbitrary cutoff point. Lets say management chooses 3 years for the cutoff. What is special about 3 years vs. 2.5 or 3.5? Nothing really. There is no theoretical basis for any specific cutoff level.

The second part of the question is why bother with PP since it has so many flaws? The answer is twofold. First, one recent survey estimates that over 50% of firms (see Ch. 8) use PP either always or often in their capital budgeting process. Since so many firms use this decision rule, it is important to know how to calculate PP and what it is telling us. It is also important to know its flaws so we know its limitations as a decision rule. The second reason to know PP is that there are two specific situations where PP can be useful. One is for extremely risky projects where there is a significant chance that the project life will be shorter than anticipated. Under this scenario a quick payback may be critical. That way even if the firm has to kill the project early it may still be able to recover most (or all) of their costs. Two, firms that are extremely weak financially may pay extra attention to PP. If the project has a high NPV, but will not start generating positive cash flows for several years it may not be appropriate to firms in financial distress. They need projects that pay off quickly in order to stay in business.

Yes, when projects are independent NPV and IRR will make the same accept/reject decision. The reason for this can be thought of mathematically or intuitively. Mathematically, IRR is the discount rate at which NPV is equal to zero. Any higher discount rate causes NPV to be less than zero and any lower discount rate would cause NPV to be positive. Thus at all positive NPVs, the IRR is higher than the required return and at all negative NPVs the IRR is lower than the required return. Intuitively we can consider that the IRR tells us the expected return on our initial investment. If the expected return is greater than the required return we should be adding value (and vice-versa). Thus, whenever the IRR is higher than the required return the NPV will be positive and whenever the IRR is less than the required return the NPV will be negative. Because IRR and NPV make the same accept reject decision, either can be used for independent projects. It is only for mutually exclusive projects where we will have problems due to different rankings of which project is best.

The first two IRR problems are both ranking issues. One (the size problem) has to do with the initial investment sizes and the second (the reinvestment rate problem) has to do with cash flow timing issues. Before I go into explaining these problems, it is important to note that both are ONLY problems with mutually exclusive projects. For independent projects, they will alter the ranking of projects, but not the accept/reject decision and are therefore irrelevant. Let's start with the size problem. If we must choose only one project from a list of projects, we want to make sure we select the one that adds the most to firm value. Typically it is easier to do this with a larger project. Consider the following two projects (both with a 15% required return):

Project A looks better according to IRR and has a higher return. However, if we can choose only one, we'd rather earn a little lower percentage return on a lot larger investment. Project B will increase firm value by over $10,000 more than project A would. The difference in sizes for the initial investment leads to different rankings. The second ranking issue with IRR is the reinvestment rate problem. The calculation process of the IRR assumes that all intermediate cash flows will get to be reinvested at the IRR. For projects with high IRRs, this can distort the true return. For instance, in project A above, it assumes that we can reinvest each of the $6000 cash flows and earn over 36% on those investments. It is unlikely that we will be able to do so. This reinvestment rate problem shows up primarily in projects that have significantly different cash flow timing issues. For instance, front-loaded projects (where a large % of cash flows come in early) are more susceptible to the reinvestment rate problem than are back-loaded projects. Again, consider two projects (both with a 13% required return):

According to IRR, Project A looks better but Project B increases firm value by around $7000 more than Project A. This is because the IRR calculation assumes that the $80,000 cash flow in year 1 will be reinvested at 30% for two years which is unlikely. Since most of the cash flows in Project B are at the end of the time, they are not greatly affected by the reinvestment rate assumption. We know that this problem is due to reinvestment and not size as the initial investments are the same, but the timing of cash flows is different.

The third IRR problem is relatively rare. It is referred to as the Multiple IRR (or Crossover) Problem and occurs when the cash flows change signs more than once. For each sign change (from negative to positive or from positive to negative) there will be a unique IRR. Therefore, for a project that has two sign changes (crossovers) there are two IRRs. Three crossovers mean 3 IRRs. When this happens, the IRR is unreliable and shouldn't be used.

The final issue is why know about IRR given its flaws? The answer is that it is commonly used in practice (more than 75% use IRR according to the survey mentioned in the Ch. 8). The reason it is so commonly used is twofold. First, it is easily understood. Since many people involved in capital budgeting may not be finance people it is important to be able to communicate the results in a manner that is easy to follow. Most people are comfortable with rate of return analysis and intuitively understand what a 25% IRR means. On the other hand, without some training fewer people understand a $3567 NPV. This in itself is not enough reason to use IRR – five minutes can explain the basic NPV framework. However, in most cases IRR is sufficient. As long as the projects are not mutually exclusive and there is no crossover problem, IRR and NPV will give the same results. So NPV is only needed when a problem exists.

PP – increase T for low risk projects and decrease T for high risk projects.

IRR, NPV – decrease k for low risk projects and increase k for high risk projects.

No, it does not mean the process is flawed. Capital budgeting analysis gives us a framework for analyzing the value of long-term investment projects. However, two important problems remain. First, the results can only be as good as the inputs into the calculations. If we don't have reasonable forecasts of the cash flows associated with a new project, the expected lifespan, and the risk involved, then the NPV analysis is not helpful. This would be a case of "Garbage In, Garbage Out". Our calculated values are only as good as our inputs. However, we can still have reasonable forecasts and bad results. Anytime we are forecasting future cash flows, we need to remember that they are only forecasts. If we KNEW the outcomes with certainty, life would be a lot easier (but much more boring). Any tool for making decisions about the future (such as NPV analysis) is going to include error. However, it is still useful. If we have a good process, we will be right more often than we are wrong. As an analogy, assume you must pick a basketball player to make one basket. Player A makes 90% of his shots and Player B makes 20%. If you pick Player A and he misses, does that mean you made a bad choice? No! Given the available information, IN THE LONG RUN, you will do far better by choosing Player A. However, in any specific trial, there is a large random factor. Judging your decision process based on short-term results is results-oriented thinking and can lead to a major problem. If we have a good process for estimating cash flows, project life, and risk, then NPV will allow us to accept projects that OVER TIME will add value to our firm. While we may have a few bad outcomes, the process will lead to us being right more than we are wrong.

PP A = 2.89 years PP B = 3.26 years PP C = 2.33 years PP D = 3.39 years

IRR A = 9.99% IRR B = 15.40% IRR C = 17.07% IRR D = 12.94%

NPV A = -$71,051 NPV B = $38,622 NPV C = $28,259 NPV D = -$14,437

If Independent

Choose Projects B and C as both have positive NPVs. While the PP exceeds T for project B, unless the company has significant financial problems and/or is severely concerned about the project lasting the four years. NPV is the best decision rule, so when the decision rules give conflicting results, go with NPV.

If Mutually Exclusive

Choose Project B as it has the highest NPV. The higher IRR for project C is irrelevant and is caused by the different sizes of the projects. Again, when there are conflicts among the rules always follow NPV.

We identify the size problem by looking for different initial investments. Projects AC, AD, BC, and BD all are pairs with different initial investments. However, we also want to find a pair of projects without the reinvestment rate problem. Since A and C are both frontloaded while B and D are both backloaded, they should not suffer from the reinvestment rate problem. Therefore, you could select either AC or BD as an answer for a pair of projects that could suffer from the size problem, but not the reinvestment rate problem.

When looking for pairs of projects that might suffer from the reinvestment rate problem, we have AB, AD, BC, and CD. However, we also want to find a pair of projects without the size problem. Since both AB and CD have the same initial investments, they will not suffer from the size problem. Therefore, you could select either AB or CD as an answer for a pair of projects that could suffer from the reinvestment rate problem, but not the size problem.

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Justifying Investments With the Capital Budgeting Process

For a business manager, choosing what to invest in should not be an exercise of instinct. With capital budgeting methods, managers can appraise various projects simultaneously, with the end result indicating which one will have the highest impact on company value.

Justifying Investments With the Capital Budgeting Process

By David Bradshaw

David is an expert in planning asset acquisitions, managing projects of up to $100m across the financial, real estate and consumer space.

Years of Experience

Executive summary.

  • The funds that businesses have to invest are finite by nature, yet there are always ample opportunities for how to invest them. The capital budgeting formula allows managers to allocate scarce capital to such investments in the most value accretive manner.
  • Money also has a time value component to it. $1.00 now is worth more than $1.00 received in five years' time. Why? Because the money received now can be invested and grown within that five-year time scale.
  • Ascertain exactly how much is needed for investment in the project
  • Calculate the annual cash flows received from the project
  • At the end of the project's life (if there is one), what will be the residual value of the asset?
  • Using the weighted average cost of capital, cash flows are discounted to determine their value in today's terms
  • If an NPV for a project is positive, it means that the project generates value, because it returns more than it costs. Yet this value should be stress tested, by applying sensitivity analysis to the project's inputs
  • When purchasing a portfolio of assets, an NPV analysis provides an aggregate view of its total value. With relevant stress tests made on the cash flow and discount rate assumptions, a valuable tool is then gained for pricing negotiations with the seller.
  • For new business units that are being launched inside a company, the first financial step is often accountancy-based budgeting. Augmenting this with capital budgeting will help to demonstrate whether the new venture will actually generate value for the parent.
  • Be sure to account for all sources of cash flow from a project. Aside from revenues and expenses, large projects may impact cash flows from changes in working capital, such as accounts receivable, accounts payable, and inventory. Calculating a meaningful and accurate residual or terminal value is also critical.
  • Don't blindly assume that a seller's projections are gospel.
  • Net income is not a cash flow.
  • Be careful not to overestimate a residual or terminal value. Using an ambitious, but unrealistic, IPO target as a residual value could be the game changer between a positive and negative NPV.

The funds available to be invested in a business either as equity or debt, also known as capital, are a limited resource. Accordingly, managers must make careful choices about when and where to invest capital to ensure that it is used wisely to create value for the firm. The process of making these decisions is called capital budgeting . This is a very powerful financial tool with which the investment in a capital asset, a new project, a new company, or even the acquisition of a company, can be analyzed and the basis (or cost justification) for the investment defined and illustrated to relevant stakeholders.

Essentially, capital budgeting allows the comparison of the cost/investment in a project versus the cash flows generated by the same venture. If the value of the future cash flows exceeds the cost/investment, then there is potential for value creation and the project should be investigated further with an eye toward extracting this value.

Far too often, business managers use intuition or “gut feel” to make capital investment decisions. I have heard managers say, “It just feels like the best move is to expand operations by building a new and better factory.” Or perhaps they jot down a few thoughts and prepare a “back of an envelope” financial analysis. I have seen investors decide to invest capital based on the Payback Period or how long they think it will take to recover the investment (with everything after being profit). All of these methods alone are a recipe for disaster. Investing capital should not be taken lightly and should not be made until a full and thorough analysis of the costs (financial and opportunity) and outcomes has been prepared and evaluated.

In this article, I will describe the objectives of capital budgeting, delineate the steps used to prepare a capital budget, and provide examples of where this process can be applied in the day to day operations of a business.

capital budgeting process steps and the time value of money concept

The Capital Budgeting Process and the Time Value of Money

The capital budgeting process is rooted in the concept of time value of money , (sometimes referred to as future value/present value) and uses a present value or discounted cash flow analysis to evaluate the investment opportunity.

Essentially, money is said to have time value because if invested—over time—it can earn interest. For example, $1.00 today is worth $1.05 in one year, if invested at 5.00%. Subsequently, the present value is $1.00, and the future value is $1.05.

Conversely, $1.05 to be received in one year’s time is a Future Value cash flow. Yet, its value today would be its Present Value, which again assuming an interest rate of 5.00%, would be $1.00.

The problem with comparing money today with money in the future is that it’s an apples to oranges comparison. We need to compare both at the same point in time. Likewise, the difficulty when investing capital is to determine which is worth more: the capital to be invested now, or the value of future cash flows that an investment will produce. If we look at both in terms of their present value we can compare values.

Net Present Value

The specific time value of money calculation used in Capital Budgeting is called net present value (NPV) . NPV is the sum of the present value (PV) of each projected cash flow, including the investment, discounted at the weighted average cost of the capital being invested (WACC) .

If upon calculating a project’s NPV, the value is positive, then the PV of the future cash flows exceeds the PV of the investment. In this case, value is being created and the project is worthy of further investigation. If on the other hand the NPV is negative, the investment is projected to lose value and should not be pursued, based on rational investment grounds.

Preparing a Capital Budgeting Analysis

To illustrate the steps in capital budgeting analysis, we will use a hypothetical example of the purchase of a truck to be used by AAA Trucking for making local, short haul deliveries. AAA plans to acquire the truck, use it for 4 years and the sell it for fair value on the resale market. It plans to use the sales proceeds as a down payment on a more modern replacement truck. It estimates the WACC at 14.00%.

Step 1: Determine the total amount of the investment.

The total investment represents the total cost of the asset being acquired, or the total investment necessary to fund the project. In the case of AAA, that would consist of:

image alt text

Step 2: Determine the cash flows the investment will return.

This step consists of determining the net cash flows that the investment will return, NOT the accounting earnings. Typically, investment cash flows will consist of projecting an income statement for the project. For AAA’s new truck, it has projected the following:

NPV sensitivity analysis 1

Step 3: Determine the residual/terminal value

Capital Budgeting requires there to be a finite number of future cash flows. In the case of AAA, it plans to sell the truck in four years time, thus the future cash flows are inherently finite in nature anyway. In such cases, the residual value is equal to the net sales proceeds to be received from disposition of the asset. (If the asset will be scrapped, this value can be 0)

Some investments do not have a projected ending. For example, if the investment is the initiation of a new business unit, it is likely that the business is assumed to continue indefinitely into the future. So in order to truncate the future cash flows and have a finite timeline to evaluate the cash flows and calculate the NPV, it is often assumed that such a venture is sold and the final cash flow is a residual value. This would be in a similar manner to how a financial investor would appraise deals it is investing in

However, another way to allow for continuing operations is to calculate a terminal value . A terminal value assumes that the cash flow in the final year of the projection will continue at that level indefinitely into the future. To calculate the terminal value, the last cash flow is divided by the discount rate. Using AAA cash flows and discount rate, a terminal value would be $27,286 ÷ 14.00% = $194,900. This terminal value is a proxy for all cash flows that will occur beyond the scope of the projection. Again, a terminal value is used only when the true operations of the investment are expected to continue indefinitely into the future.

Step 4: Calculate the annual cash flows of the investment

Calculating the annual cash flows is completed by incorporating the values from Steps 1 to 3 into a timeline. Cash outflows are shown as negative values, and cash inflows are shown as positive values. By aligning cash flows with the periods in which they occur and adding each periods’ cash flows together, the annual cash flow amounts can be determined.

NPV sensitivity analysis 2

Step 5: Calculate the NPV of the cash flows

The NPV is the sum of the PV of each year’s cash flow. To calculate the PV of each year’s cash flow, the following formula is used:

PV of Cash Flow = Cash Flow ÷ (1 + Discount Rate) Year

Below is the NPV for AAA’s new truck investment.

NPV example

The NPV is positive, therefore AAA has determined that the project will return value in excess of the investment amount and is worth further investigation. To put it bluntly, it is spending money to make more money, which is a fundamental catalyst for business growth.

Step 6: Run a sensitivity analysis

While a positive NPV on a base case projection is an indication that the project is worth further consideration, it should not be the sole basis for proceeding with an investment. Recall that all of the values in the analysis are based on projections, a process that itself is a complicated art. Therefore if a positive NPV is returned, don’t pop open champagne just yet; instead, start stress testing your work. Various “what if” analyses should be run. For instance, in our capital budgeting example involving AAA:

  • What if the actual cost of the truck is greater than $53,899?
  • What if the operating cash flows are less than anticipated?
  • What if the residual value is overstated?
  • What if the WACC is higher than estimated?

Below is a summary table of the impact to the NPV through altering the capital investment cost and holding all other assumptions the same. Note that an increase to 140% of the baseline estimate still results in a positive NPV.

image alt text

NPV will reduce as the residual value decreases, but we can see from this analysis that even if the residual value drops to $0, holding all other assumptions constant, the NPV is still positive.

image alt text

From just these two analyses, we can see the project is quite stable and robust. Even with errors in the base projections of these two variables, the project still warrants further consideration via a positive NPV.

By running various scenarios to determine the impact on NPV, the risk of the project is better defined. If the alternate outcomes continue to provide a positive NPV, the greater the confidence level one will have in making the investment.

NPV vs. IRR

As I have discussed previously , NPV as used in capital budgeting does not provide a return on investment value. NPV is simply describing whether or not the project provides sufficient returns to repay the cost of the capital used in the project. If a project’s return on investment is desired, then internal rate of return (IRR) is the calculation required. Essentially, IRR is the discount rate that will make the NPV equal exactly $0. It is the rate of return that is directly indicated by the project’s cash flows.

Capital Budgeting Applications

A capital budget can be used to analyze almost any type of investment from the purchase of a piece of capital equipment, to investing in expanded operations, to starting a new business, to purchasing existing business operations.

When Acquiring a Portfolio of Assets

When I worked at GE Commercial Finance, I held a role in business development (BD). My focus was on acquiring portfolios of existing commercial real estate and equipment loans from other lenders in our market space. Using the asking price for the portfolio, the cash flows from the loans and the return rate required (as a discount rate), the NPV could be determined. Further, by running sensitivity on the asking price (investment size), we could determine the price range within which the purchase could be justified. The key to this valuation was allowing the BD director to know what the ROI would be on the purchase at alternative prices, and the absolute maximum price that could be paid and still return an acceptable ROI. When I implemented this process, it improved purchase negotiations as the director could negotiate price in real time without the need to pause negotiations to rerun the numbers.

When Projecting Operations for New Ventures

Several consulting clients have asked me to project operational performance for new business ventures. Using capital budgeting techniques, the financial feasibility of the new venture can be determined. One client had developed a proprietary fitness equipment product, the capital budgeting analysis for that company is shown below. As operations were expected to continue beyond the 5-year projection, a terminal value was used in the analysis.

New business projections NPV

The sensitivity analysis showed that the NPV remained positive, so long as the capital investment was less than $2.6 million, and cash flow could drop to 87% of projected levels (with all other factors held constant).

Successful Capital Budgeting Rules to Follow

The key to capital budgeting is the accuracy of the projected cash flows. The total investment is often easy. However, making sure to account for all sources of cash flow can be all-encompassing. In addition to revenues and expenses, large projects may impact cash flows from changes in working capital, such as accounts receivable, accounts payable and inventory. Calculating a meaningful and accurate residual or terminal value is also important.

In my experience, failed attempts at using capital budgeting came from not using detailed projections of project cash flows. I worked with one company who attempted to evaluate the purchase of another company by using the target’s projected income statement as the sole basis of operating cash flows. It used net income, which is NOT cash flow. Further, it completely ignored the impact to cash flow from changes in working capital. Lastly it did not accurately allow for a residual value. This all seriously understated cash flow, leading to an apparent value (investment amount) less than the seller would accept, and which ultimately was less than the fair market value of the company.

One should also be careful not to overestimate a residual or terminal value. I have seen projections for starting a new venture where the residual value was the anticipated value to be received upon taking the company public. The IPO value was far above a reasonable amount, and without the high residual value the NPV would be negative. Placing too much of the NPV value in the residual can be a mistake.

The greater the amount of an investment, the greater the risk of error. Key to preparing a successful capital budgeting analysis is finding someone with the expertise and experience to calculate accurate and reasonable cash flows. If a business does not have a person like this on hand, it does become more of a passion play and less an exercise in critical business judgement.

Understanding the basics

What do you mean by capital budgeting.

Capital budgeting is the process of determining how to allocate (invest) the finite sources of capital (money) within an organization. There is usually a multitude of potential projects from which to choose, hence the need to budget appropriately

What is the process of capital budgeting?

It involves assessing the potential projects at hand and budgeting their projected cash flows. Once in place, the present value of these cash flows is ascertained and compared between each project. Typically, the project that offers the highest total net present value is selected, or prioritized, for investment.

How do you calculate net present value?

Net present value (NPV) requires the projected cash flows from a project to be calculated and then discounted back to present day using the weighted average cost of capital. When added back to the negative cost of investment, this will provide the overall NPV

What does the IRR tell you?

Internal rate of return (IRR) is the discount rate created by a set of cash flows that will goal seek to an NPV of 0. Hence, it is the isolate return on investment of a project

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Chapter Learning Objectives

After completing this chapter, students should be able to

  • Identify what a capital budgeting project is, provide an example, and discuss why the capital budgeting process is essential to maximizing shareholder wealth
  • Explain the difference between independent and mutually exclusive projects
  • Identify and explain the relevance of the four key capital budgeting criteria
  • Identify whether or not each of the criteria is met by each of the three decision techniques introduced in class (Payback Period, Internal Rate of Return, and Net Present Value)
  • Calculate and conceptually explain the concepts of Payback Period (PP), Internal Rate of Return (IRR), and Net Present Value (NPV)
  • Adjust for risk differences under PP, IRR, and NPV
  • Evaluate independent and/or mutually exclusive projects using each of the three decision techniques in isolation and as a whole
  • Explain the flaws and relevance of the PP
  • Explain the flaws and relevance of the IRR
  • Explain why NPV is the best model
  • Explain the concepts of the size problem, reinvestment rate problem, and crossover problem as well as identifying when these problems might be present
  • Explain the concept of the NPV profile
  • Discuss the survey results of how these methods are applied in practice.

What is Capital Budgeting?

Capital budgeting is the process of deciding which long-term projects the firm should undertake. Examples may include:

  • The decision to purchase a new printing press.
  • The decision to build a new warehouse.
  • The decision to open or establish a second location on the other side of town.
  • The decision to update an airline fleet.

Mutually Exclusive vs. Independent Projects

Mutually exclusive projects.

Mutually exclusive projects are any set of projects in which choosing one makes the other projects no longer possible. For example, we are considering upgrading our printing press and have the choice of two alternatives. The first is a low-cost model that will need replaced in 3-years and the second is a more expensive model that will need replaced in 5-years. We can only choose one of these options, so they are mutually exclusive. When we have mutually exclusive projects, our decision rule needs to not only decide if a project is good or bad, but needs to be able to rank which project is the best.

Independent Projects

Independent (sometimes called stand-alone) projects are any set of projects in which choosing one has no impact on our decision to choose another project from that set. For example, McBurger Inc. may have the following capital budgeting projects to consider. The first is a new deep frying system for their french fries. The second is a new order placement system for the drive-thru. McBurger could choose to take the new deep fryer or the new order placement, or it could choose both. Taking one project does not influence the other, so they are independent. When we have independent projects, our decision rule does not need to rank which project is the best, but merely identify if the project is good or bad.

Many decisions made by the firm are neither independent nor mutually exclusive, but are instead interdependent. In this case, the decision to take one project impacts our decision to take another, but they are not mutually exclusive. For example, VideogamesPlus may decide to introduce a new video game machine along with some games for the new system. The two projects are not independent (the game machine will sell better with more games available) nor mutually exclusive (producing the games does not preclude producing the game machine). However, they are interdependent in that each project will perform better if both are produced. Some interdependent projects are compliments (like the example above) in which the cash flows from both projects taken together are greater than the cash flows from each project on a standalone basis. Other interdependent projects are substitutes in which the cash flows from both projects taken together are less than the cash flows from each project on a standalone basis. While we will not be evaluating interdependent projects in this class, the procedure is to look at each project individually as well as in combination.

Capital Budgeting Decision Criteria

Whatever capital budgeting decision rule we undertake should meet the following criteria:

Capital Budgeting Decision Criteria

The decision rule should consider all relevant cash flows

Some decision rules (such as the Payback Period) stop considering cash flows after a certain cutoff point. This may result in us making a poor decision, especially when trying to choose between two or more mutually exclusive projects. We also should note that it is important to be careful about evaluating relevant cash flows. For instance, consider your decision to attend college as a capital budgeting decision. It is easy to underestimate the cost if you do not acknowledge that you could be earning income during the time you spend in class and on homework. This is an opportunity cost and is just as important as actual dollars spent.

The decision rule should acknowledge the time value of money concept

Since capital budgeting projects are long-term investments, the cash flows which they generate are likely to take place years into the future. If a firm spends $1000 today and receives back $100 per year over the next 10 years, they have not broken even. Instead, the project has caused a significant reduction in firm value. This is because the present value of $100 per year for 10 years is worth far less than the $1000 spent today.

The decision rule should consider the riskiness of cash flows

As we have discussed since chapter one, investors are risk averse. Therefore, the riskier the projects that the firm invests in, the higher the rate of return they must earn to satisfy stockholders. If we don’t adequately address risk in the capital budgeting process, we will find firms over investing in high risk projects and under investing in low risk projects.

The decision rule should always rank projects so that those projects that add the most to the value of the firm are ranked highest

This is something to be careful about. All decision rules will rank projects in some manner. However, if we are going to focus on maximizing shareholder wealth, then we want to rank projects based on how they add value to the firm. The more value the project generates, the more wealth is generated for our shareholders.

Capital Budgeting Process

It is reasonable to argue that capital budgeting is the most important factor in maximizing shareholder wealth. Good capital budgeting decisions can generate hundreds of millions (or even billions) of dollars for shareholders as often a successful project lays the foundation for many more on top of the original. Poor capital budgeting decisions can destroy wealth almost as quickly (especially if the firm does not recognize failure quickly enough and continues to throw good money after bad). While we will focus only on a small portion of the process (making the decision), it is worthwhile to look at the process as a whole.

Capital Budget Process

Generating ideas

The process starts by generating potential ideas for capital budgeting projects. These may be projects to improving existing processes within the firm (such as updating current manufacturing equipment or introducing new software to streamline our distribution) or it could be developing new product lines.

Gathering information and making cash flow estimates

A challenging and critical component to capital budgeting is the process of trying to forecast the relevant cash flows. This typically involves input from many areas of the firm (marketing may estimate sales levels and pricing of a new product, accounting may help with cost estimates, operations will discuss feasibility and labor demands, etc.). Here we must estimate how much it will cost us to initially purchase and implement new equipment, the life span of the project, the marginal revenue it will generate each year, the marginal costs associated with the project each year, etc. While there is a lot of subjectivity and forecasting involved here, the better we do at getting things right in this stage, the better our results will be. If this stage is done poorly, the rest of our analysis will not be very useful (garbage in, garbage out).

Make decision

This is where we focus our attention for this class. Given what we know about the cash flow estimates above, we evaluate whether or not the project will help us add value for shareholders. If yes, we pursue the project. If not, we reject it.

Evaluate/review

This is an important (and difficult) part of any decision-making process …evaluating the results. What makes this difficult is we need to avoid falling into the “Results Oriented Thinking” trap. For instance, consider a project that has a 25% chance of making $50 million and a 75% chance of losing $10 million. On average, we will make $5 million for taking the project (it is a good project). However, if we lose $10 million, does that mean we shouldn’t have invested? No! Taking the project is a good decision with a bad outcome. Unfortunately in practice this is harder to evaluate as it is hard to distinguish between bad forecasts and bad outcomes. Therefore, in evaluation we should evaluate the process for biases (do we tend to underestimate risk or overestimate projected revenues) instead of just focusing on the outcome itself.

Capital Budgeting Decision Techniques

There are three capital budgeting techniques:

Capital Budgeting Decision Techniques

Note: There are many other additional capital budgeting decision techniques as well, but these are the primary models. Also, be careful about confusing concepts in this chapter as we have introduced (A) four key capital budgeting criteria , (B) a four-part capital budgeting p rocess , and (C) three capital budgeting decision techniques . Oftentimes we will see students mix these up on tests or homework.

A capital budgeting criteria refers to a specific issue we would like the capital budgeting decision process to factor into the decision.  For example, the decision rule should consider all relevant cash flows is a criteria.

A capital budgeting process is the set of procedures we want to follow throughout the analysis of a potential capital budgeting process.  For example, generating ideas is part of the process.

A capital budgeting technique refers to the way we evaluate whether or not the capital budgeting project being evaluated should be accepted or not.  For example, net present value is a technique.

Payback Period

The Payback Period measures the amount of time it would take to earn back the initial investment in the project. Management then decides how long they are willing to wait to recover their investment (critical acceptance level — T) and compares the calculated payback period to the critical acceptance level.

The decision rule for independent projects is to accept all projects that have a payback period less than the critical acceptance level (T). For mutually exclusive projects, the project with the lowest payback period would be chosen (assuming it is below the critical acceptance level)

For example, let’s assume that Jim’s Printing is considering the purchase of a new printing press. The press will cost $2000 to produce and will generate cash flows of $900 per year for 3 years. What is the payback period for this press? If Jim’s assigns a critical acceptance level of 2.0 years, should they accept the project?

  • In year one, we earn back $900 and have $1100 of our initial investment to recover
  • In year two, we earn back another $900 and still have $200 of our initial investment to recover
  • In year three, we will earn more than our initial investment and therefore we know that the payback period is more than two years, but less than three years
  • Since we will pay off our initial investment between the 2nd and 3rd year, we divide the amount remaining to be paid off at the start of the 3rd year ($200) by what we will receive in the 3rd year ($900) and find out that it will take us two full years plus 2/9ths (0.22) of the 3rd year to recover our initial investment.
  • Therefore, our payback period is 2 + 0.22 years (2.22 years).

Since the Payback Period = 2.22 years which is greater than 2.0 years (our T), we should reject the project.

How well does the payback period meet our 4 criteria? Very poorly. It ignores the time value of money and it may not consider all relevant cash flows (ignoring all cash flows that are after the payback period). Also, the decision rule is arbitrary – what is an acceptable payback period? It also ranks by time instead of shareholder wealth. Because of these flaws, the payback period does not always pick the best project. Despite this, many corporations still calculate the payback period (although usually not as the primary decision tool). Does this mean corporations are stupid? Probably not. What are some situations that you can think of in which the payback period may provide critical information in making a capital budgeting decision? Think about this for a minute before reading further.

There are two primary situations when payback period can be helpful. The first is when the distant cash flows are highly uncertain. For instance, we may project a 6-year life span for the project and find out after two years that the technology behind it has become obsolete and the project must end prematurely. In a situation like this, it would be extremely helpful to have had the entire project paid back by the end of the second year. That way even if we didn’t make as much as planned, we at least recovered our investment. The second situation where Payback Period is extremely helpful is when our firm is facing significant financial problems. Consider a highly profitable long-term investment that has very low cash flows in the first couple years and high cash flows in the later years. Can we afford to undertake such an investment if we are having financial problems? Probably not, there is too much of a chance that we will end up bankrupt and out of business before we can get to the part of the project with the high cash flows. For firms suffering from financial distress, projects having a quick payback are important.

Video Capital Budgeting Part One -Introduction and Payback Period

Internal Rate of Return

The Internal Rate of Return calculates the average annualized rate of return that we can earn over the lifetime of the project. The acceptance rule for independent projects is to accept all projects where the IRR is above the required return (hurdle rate) for those projects. If projects are mutually exclusive, accept the one with the highest IRR (assuming it is above the hurdle rate). Let’s look at the IRR of our printing press example

CLEAR WORKSHEET CF0 = -2000 CF1 = 900 CF2 = 900 CF3 = 900 SOLVE FOR IRR AND GET 16.65%

This is the process we used in Chapter Three Time Value of Money to find the discount rate. Here is a quick review for each calculator:

Calculator Steps to Compute IRR

Should we accept the project? Let’s assume that the project had a required return of 10%. Given this information, we would accept the project because the IRR is greater than the required return (or hurdle rate). This means that we are earning more than we need to compensate us for the risk we are assuming when we undertake the project.

How well does the IRR meet our 4 criteria? Very well if projects are independent. If projects are mutually exclusive, not so well. IRR incorporates the time value of money and considers all relevant cash flows. We can adjust for risk by adjusting our hurdle rate (the minimum acceptable rate of return for the project). If projects are independent (and there is no crossover problem – see below), the IRR will always make the right decision. However when projects are mutually exclusive, it will not always rank the projects correctly (again, see below). Despite this flaw, is used quite frequently as a capital budgeting techniques (although few firms use it in isolation).

Video Capital Budgeting Part Two -Calculating Internal Rate of Return

Crossover (Multiple IRR) Problem

If cash flows for a project crossover more than once (go from negative in one period to positive in the next or vice-versa) then the IRR will have more than one mathematically valid solution. For projects with a crossover problem, the IRR cannot be used. For instance, consider a project with the following cash flow stream:

CF0 = -$100 CF1 = $180 CF2 = $0 CF3 = $0 CF4 = $0 CF5 = $0 CF6 = $0 CF7 = -$100

The project has two IRR’s (4.9% and 76.7%). With two solutions, it is unclear whether to accept or reject the project, so we use NPV analysis instead. IRR is unreliable in this situation.

Size Problem and Reinvestment Rate Problem

If projects are mutually exclusive, the IRR can provide invalid rankings due to two problems. First, if the projects are of different sizes (the size problem). Second, if the timing of cash flows is vastly different (one project has cash flows come in evenly throughout the payback period and the other generates low cash flows early on and high cash flows near the end – or other such differences). This is referred to as the reinvestment rate problem. I will explain each of these in detail below, however, it is important to note that these two problems are only relevant when dealing with mutually exclusive projects. If we are dealing with independent projects, they may still impact the rankings but they will not cause us to make an incorrect accept/reject decision.

Size Problem

The issue with the size problem is related to IRR’s focus on rate of return instead of value generation in terms of dollars. Consider a situation where you had the choice of two projects. Project A cost $1 today and would return $2 at the end of 1 year. Project B cost $1000 and will return $1500 at the end of 1 year. The first project has a 100% IRR while the second project only has a 50% IRR. At first glance, it appears that Project A is twice as good. However, if you could only take one of these two projects, which would be better? Clearly Project B is a better choice in that you will make $500 beyond your initial investment. If you took Project A, while you earned a higher return you would only make enough profit to visit the $1 menu at your local fast-food chain. When we can only choose one of the available projects, it is not important to identify which project generates the highest rate of return, but instead which project generates the most value. A high rate of return on a small investment is not likely to be as valuable as a moderate rate of return on a large investment. We can recognize the potential for a size problem in evaluating capital budgeting projects by looking at the initial investment. If initial investment sizes are very close, we likely will not encounter a size problem. If initial investments are vastly different, we need to be aware of the size problem and use NPV if dealing with mutually exclusive projects.

Reinvestment Rate Problem

The reinvestment rate problem is not as intuitive as the size problem. The reinvestment rate problem is a function of the process by which the IRR is generated mathematically. In order to calculate the IRR, the calculator assumes that all cash flows received throughout the projects life will be reinvested at the IRR. For instance, let’s assume that you have the following project

CF0 = -$1000 CF1 = $800 CF2 = $400 CF3 = $300

This gives us an IRR of 29.02% (in other words, we are expecting to earn an average rate of return of 29.02% per year over the next three years on our $1000 investment that we are making today). However, in order for this IRR to be realized, we will need to take the $800 that is generated at the end of year one and reinvest it somewhere for the remaining two years at 29.02%. Is this realistic? Well, how many investments do you know that pay nearly 30% rates of return? Probably not too many. As such, our average return is biased upwards (as we will likely earn much less than the 29% needed on reinvested cash flows). This bias will be greater for projects that are front loaded. The term front loaded refers to projects with higher cash flows early in the project life. The bias is greater here because the faulty reinvestment rate assumption has longer to impact our final answer. The bias is smaller for projects that are back loaded (cash flows coming in primarily later in the project life). Because of this difference in bias, front loaded projects are likely to have an artificially higher IRR than back loaded projects, which can potentially cause us to rank them incorrectly. If we are evaluating mutually exclusive projects with different timing (front loaded vs. back loaded), then we should be careful of the reinvestment rate problem and choose NPV as our decision tool.

Two last comments on the reinvestment rate problem. First, as with the size problem, it is only important when evaluating mutually exclusive projects. It will not distort accept/reject decisions for independent projects. Second, there is a process called Modified Internal Rate of Return (MIRR) that can be used to correct this issue. However, it is beyond the scope of this class and we will not be covering it.

Net Present Value

The Net Present Value measures the value added by investing in the project. Specifically, the NPV is equal to the present value of all cash flows less the initial investment.

The decision rule for independent projects is to accept all projects with a positive NPV.  For mutually exclusive projects, accept the project with the highest positive NPV.

Let’s consider the printing press example above, what is its NPV (assume the required return on the project is 10%, just like when we did the IRR analysis)?

CLEAR WORKSHEET CF0 = -2000 CF1 = 900 CF2 = 900 CF3 = 900 I/YR = 10 SOLVE FOR NPV AND GET $238.17

Calculator Steps to Compute NPV

Video Capital Budgeting Part Three -Calculating Net Present Value

How well does the NPV meet our 4 criteria? Perfectly. The NPV directly addresses the time value of money. It also considers all relevant cash flows. The riskiness of cash flows can be acknowledged by using a higher discount rate for high-risk projects and a lower discount rate for low-risk projects. The decision rule for NPV will always provide the correct decision. NPV is used by almost all firms as a key capital budgeting decision tool.

Video Capital Budgeting Part Four -Analysis of Decision

NPV Profile

NPV profile is a graph that shows the relationship between a project’s NPV and the required return on the project. To draw the NPV profile, we first need the project’s NPV at a number of different discount rates. Let’s stick with the example above, which requires an initial investment of $2,000 and generates $900 per year for the next three years. Instead of using a single required rate of return of 10%, I allow the rate to change within a range, say from 0% to 25%. For each discount rate, I would record the corresponding NPV value. The table to the right shows some of the results.

Next, we plot these values to create the NPV profile. Make sure to plot discount rates on the x-axis and NPV on the y-axis. For the project in this example, NPV declines as discount rate increases.

NPV Profile

One unique feature about the NPV profile is that it visualizes how IRR is related to NPV. Recall that the IRR of this project is 16.65%, and that is the exact discount rate at which the profile line crosses the horizontal axis. In other words, IRR is in fact the discount rate that makes the project NPV to equal zero.

Now consider two mutually exclusive projects. Project A and Project B require the same initial investment at time 0, but their cash flows in the following years differ.

The figure below shows two NPV profiles – one for A and one for B – and the following are worth noting:

When the discount rate increases, the NPVs from both projects decline.

Each project has only one fixed IRR. The IRR of Project A is lower than that of Project B, no matter what the discount rate is.

The two profiles crosses at a discount rate of 10.50%, which is considered as the crossover rate of the two projects. When the actual cost of capital is lower than the crossover rate, Project A should be taken because it has a higher NPV; when the actual cost of capital exceeds the crossover rate and as long as the NPV is positive, Project B should be accepted.

To find the crossover rate, I first need to compute the incremental cash flows as the difference in the two projects cash flows (see the last column of the table above), and then calculate the IRR based on the incremental cash flows.

NPV Profile for Project A and B

Capital Budgeting in Practice

While the data is starting to get dated, the most recent survey of capital budgeting techniques used in practice was conducted in 1999 and published in 2002 (Ryan and Ryan, 2002). This survey was based on Fortune 1000 firms and received 205 usable responses. Key findings include:

  • 85.1% of respondents use NPV either always or often
  • 76.8% of respondents use IRR either always or often
  • 52.6% of respondents use PP either always or often

This tells us that not only is NPV the preferred choice from a theoretical perspective, it is also the preferred choice of firms in practice. However, equally important is the concept that many firms rely on multiple techniques rather than merely choosing one when evaluating capital budgeting decisions. Even though there are flaws with IRR and PP (which have been discussed above), they are still used in practice. Possible reasons for this include that the marginal cost of performing the additional calculations is small and there may be reasons where the benefits of communicating the results or factoring in the concerns of financial distress possibilities make it worthwhile to include IRR and PP in the analysis, even if they are not a primary decision tool.

Key Takeaways

Capital budgeting refers to the practice of evaluating long-term investments that firms undertake, such as building a new warehouse, opening a new production facility, developing a new product, or replacing existing equipment. Since the firm is really just a collection of all its past and future capital budgeting projects, this is one of the key components associated with maximizing shareholder wealth. Capital budgeting projects can be thought of as independent projects (where we want to accept all good projects) or mutually exclusive projects (where we can only take one from the set so must choose the best project). When evaluating capital budgeting projects, we need to make sure that we consider all the relevant cash flows the project is expected to generate, acknowledge time value of money, control for the riskiness of the expected cash flows and choose the project that adds the most to firm value. While there are many different techniques for evaluating capital budgeting projects, the three most common are Payback Period, Internal Rate of Return, and Net Present Value. Of these three methods, all are used in practice by a significant percentage of firms. However, only NPV (which is used most frequently) meets all four of the criteria we designate as critical in choosing projects. Therefore, when making decisions, NPV should be our primary decision tool.

What are the four capital budgeting decision criteria?

Identify 4 flaws of the payback period? Given these flaws, why should you know the payback period method?

With independent projects that do not suffer from the crossover (multiple IRR) problem, will the IRR and NPV always give the same accept reject decision? Explain.

What are 3 potential problems with the IRR? Given these flaws, why should you know the IRR method?

How can we account for risk under each of the three methods (PP, IRR, NPV)?

Consider a situation where a firm carefully performs capital budgeting analysis and selects a project with a high, positive NPV. Three years later, the project is terminated early and the company has lost significant money on the project. Does this mean that their capital budgeting process is flawed? Explain.

Calculate the PP, NPV, and IRR of the following projects (assuming a 14% required return and critical acceptance level <T> of 3 years)

Which project(s) should we accept if they are independent? Mutually Exclusive?

In the problem above, identify a pair of projects that could suffer from the size problem, but not a reinvestment rate problem. Next, identify a pair of projects that could suffer from the reinvestment rate problem, but not the size problem.

Solutions to CH 8 Exercises

Capital Budgeting Part One -Introduction and Payback Period

Capital Budgeting Part Two-Calculating Internal Rate of Return

Capital Budgeting Part Three -Calculating Net Present Value

Capital Budgeting Part Four -Analysis of Decision

Ryan, P. A., & Ryan, G. P. (2002). Capital budgeting practices of the fortune 1000: How have things changed? Journal of Business and Management, 8(4), 355-364.

Business Finance Essentials Copyright © 2018 by Dr. Kevin Bracker, Dr. Fang Lin and Jennifer Pursley is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License , except where otherwise noted.

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What Is Capital Budgeting?

How capital budgeting works, discounted cash flow analysis, payback analysis.

  • Throughput Analysis
  • Capital Budgeting FAQs

The Bottom Line

  • Corporate Finance

Capital Budgeting: Definition, Methods, and Examples

capital budgeting techniques solved problems

Capital budgeting is a process that businesses use to evaluate potential major projects or investments. Building a new plant or taking a large stake in an outside venture are examples of initiatives that typically require capital budgeting before they are approved or rejected by management.

As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows to determine whether the potential returns it would generate meet a sufficient target benchmark. The capital budgeting process is also known as investment appraisal.

Key Takeaways

  • Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment. 
  • The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets a set benchmark.  
  • The major methods of capital budgeting include discounted cash flow, payback analysis, and throughput analysis.

Investopedia / Lara Antal

Ideally, businesses could pursue any and all projects and opportunities that might enhance shareholder value and profit. However, because the amount of capital any business has available for new projects is limited, management often uses capital budgeting techniques to determine which projects will yield the best return over an applicable period.

Although there are a number of capital budgeting methods , three of the most common ones are discounted cash flow, payback analysis, and throughput analysis.

Discounted cash flow (DCF) analysis looks at the initial cash outflow needed to fund a project, the mix of cash inflows in the form of revenue , and other future outflows in the form of maintenance and other costs.

These cash flows, except for the initial outflow, are discounted back to the present date. The resulting number from the DCF analysis is the net present value (NPV) . The cash flows are discounted since present value assumes that a particular amount of money today is worth more than the same amount in the future, due to inflation.

In any project decision, there is an opportunity cost , meaning the return that the company would have received had it pursued a different project instead. In other words, the cash inflows or revenue from the project need to be enough to account for the costs, both initial and ongoing, but also to exceed any opportunity costs.

With present value , the future cash flows are discounted by the risk-free rate such as the rate on a U.S. Treasury bond , which is guaranteed by the U.S. government, making it as safe as it gets. The future cash flows are discounted by the risk-free rate (or discount rate ) because the project needs to at least earn that amount; otherwise, it wouldn't be worth pursuing.

In addition, a company might borrow money to finance a project and, as a result, must earn at least enough revenue to cover the financing costs, known as the cost of capital . Publicly traded companies might use a combination of debt—such as bonds or a bank credit facility —and equity , by issuing more shares of stock. The cost of capital is usually a weighted average of both equity and debt. The goal is to calculate the hurdle rate or the minimum amount that the project needs to earn from its cash inflows to cover the costs. To proceed with a project, the company will want to have a reasonable expectation that its rate of return will exceed the hurdle rate.

Project managers can use the DCF model to decide which of several competing projects is likely to be more profitable and worth pursuing. Projects with the highest NPV should generally rank over others. However, project managers must also consider any risks involved in pursuing one project versus another.

Payback analysis is the simplest form of capital budgeting analysis, but it's also the least accurate. It is still widely used because it's quick and can give managers a " back of the envelope " understanding of the real value of a proposed project.

Payback analysis calculates how long it will take to recoup the costs of an investment. The payback period is identified by dividing the initial investment in the project by the average yearly cash inflow that the project will generate. For example, if it costs $400,000 for the initial cash outlay, and the project generates $100,000 per year in revenue, it will take four years to recoup the investment.

Payback analysis is usually used when companies have only a limited amount of funds (or liquidity ) to invest in a project, and therefore need to know how quickly they can get back their investment. The project with the shortest payback period would likely be chosen. However, the payback method has some limitations, one of them being that it ignores the opportunity cost.

Also, payback analysis doesn't typically include any cash flows near the end of the project's life. For example, if a project that's being considered involves buying factory equipment, the cash flows or revenue generated from that equipment would be considered but not the equipment's salvage value at the conclusion of the project. As a result, payback analysis is not considered a true measure of how profitable a project is, but instead provides a rough estimate of how quickly an initial investment can be recouped.

Salvage value

Salvage value is the value of an asset, such as equipment, at the end of its useful life .

Throughput Analysis 

Throughput analysis is the most complicated method of capital budgeting analysis, but it's also the most accurate in helping managers decide which projects to pursue. Under this method, the entire company is considered as a single profit-generating system. Throughput is measured as an amount of material passing through that system.

The analysis assumes that nearly all costs are operating expenses , that a company needs to maximize the throughput of the entire system to pay for expenses, and that the way to maximize profits is to maximize the throughput passing through a bottleneck operation. A bottleneck is the resource in the system that requires the longest time in operations. This means that managers should always place a higher priority on capital budgeting projects that will increase throughput or flow passing through the bottleneck.

What Is the Primary Purpose of Capital Budgeting?

Capital budgeting's main goal is to identify projects that produce cash flows that exceed the cost of the project for a company.

What Is an Example of a Capital Budgeting Decision?

Capital budgeting decisions are often associated with choosing to undertake a new project that will expand a company's current operations. Opening a new store location, for example, would be one such decision for a fast-food chain or clothing retailer.

What Is the Difference Between Capital Budgeting and Working Capital Management?

Working capital management is a company-wide process that evaluates current projects to determine whether they are adding value to the business, while capital budgeting focuses on expanding the current operations or assets of the business.

Capital budgeting is a useful tool that companies can use to decide whether to devote capital to a particular new project or investment. There are several capital budgeting methods that managers can use, ranging from the crude but quick to the more complex and sophisticated.

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What is Capital Budgeting? Process, Methods, Formula, Examples

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‘Expansion and Growth’ are the two common goals of an organization's operations. In case a company does not possess enough capital or has no fixed assets , this is difficult to accomplish. It is at this point that capital budgeting becomes essential.

The capital budget is used by management to plan expenditures on fixed assets. As a result of the budgets, the company's management usually determines which long-term strategies it can invest in to achieve its growth goals. For instance, management can decide if it needs to sell or purchase assets for expansion to accomplish this.

Capital Busgeting

The purpose of capital budgeting is to make long-term investment decisions about whether particular projects will result in sustainable growth and provide the expected returns.

We shall learn about Capital Budgeting and all the details related to it in this article:

  • What is Capital Budgeting in detail
  • Features of capital budgeting
  • Understanding capital budgeting and how it works
  • Techniques/Methods of capital budgeting with Examples
  • Process of capital budgeting
  • Factors affecting capital budgeting
  • Limitations of capital budgeting

What is Capital Budgeting?

Capital Budgeting is defined as the process by which a business determines which fixed asset purchases or project investments are acceptable and which are not. Using this approach, each proposed investment is given a quantitative analysis, allowing rational judgment to be made by the business owners.

Capital asset management requires a lot of money; therefore, before making such investments, they must do capital budgeting to ensure that the investment will procure profits for the company. The companies must undertake initiatives that will lead to a growth in their profitability and also boost their shareholder’s or investor’s wealth.

Features of Capital Budgeting

Capital Budgeting is characterized by the following features:

  • There is a long duration between the initial investments and the expected returns.
  • The organizations usually estimate large profits.
  • The process involves high risks.
  • It is a fixed investment over the long run.
  • Investments made in a project determine the future financial condition of an organization.
  • All projects require significant amounts of funding.
  • The amount of investment made in the project determines the profitability of a company.

Understanding Capital Budgeting

While companies would like to take up all the projects that maximize the benefits of the shareholders, they also understand that there is a limitation on the money that they can employ for those projects. Therefore, they utilize capital budgeting strategies to assess which initiatives will provide the best returns across a given period. Owing to its culpability and quantifying abilities, capital budgeting is a preferred way of establishing if a project will yield results.

To measure the longer-term monetary and fiscal profit margins of any option contract, companies can use the capital-budgeting process. Capital budgeting projects are accepted or rejected according to different valuation methods used by different businesses. Under certain conditions, the internal rate of return (IRR) and payback period (PB) methods are sometimes used instead of net present value (NPV) which is the most preferred method. If all three approaches point in the same direction, managers can be most confident in their analysis.

How Capital Budgeting Works

It is of prime importance for a company when dealing with capital budgeting decisions that it determines whether or not the project will be profitable. Although we shall learn all the capital budgeting methods, the most common methods of selecting projects are:

  • Payback Period (PB)
  • Internal Rate of Return (IRR) and
  • Net Present Value (NPV)

It might seem like an ideal capital budgeting approach would be one that would result in positive answers for all three metrics, but often these approaches will produce contradictory results. Some approaches will be preferred over others based on the requirement of the business and the selection criteria of the management. Despite this, these widely used valuation methods have both benefits and drawbacks.

Investing in capital assets is determined by how they will affect cash flow in the future, which is what capital budgeting is supposed to do. The capital investment consumes less cash in the future while increasing the amount of cash that enters the business later is preferable.

Keeping track of the timing is equally important. It is always better to generate cash sooner than later if you consider the time value of money. Other factors to consider include scale. To have a visible impact on a company's final performance, it may be necessary for a large company to focus its resources on assets that can generate large amounts of cash.

In smaller businesses , a project that has the potential to deliver rapid and sizable cash flow may have to be rejected because the investment required would exceed the company's capabilities.

The amount of work and time invested in capital budgeting will vary based on the risk associated with a bad decision along with its potential benefits. Therefore, a modest investment could be a wiser option if the company fears the risk of bankruptcy in case the decisions go wrong.

Sunk costs are not considered in capital budgeting.  The process focuses on future cash flows rather than past expenses .

Techniques/Methods of Capital Budgeting

In addition to the many capital budgeting methods available, the following list outlines a few by which companies can decide which projects to explore:

#1 Payback Period Method

It refers to the time taken by a proposed project to generate enough income to cover the initial investment. The project with the quickest payback is chosen by the company.

Example of Payback Period Method:

An enterprise plans to invest $100,000 to enhance its manufacturing process. It has two mutually independent options in front: Product A and Product B. Product A exhibits a contribution of $25 and Product B of $15. The expansion plan is projected to increase the output by 500 units for Product A and 1,000 units for Product B.

Here, the incremental cash flow will be calculated as:

(25*500) = 12,500 for Product A

(15*1000) = 15,000 for Product B

The Payback Period for Product A is calculated as:

Product A = 100,000 / 12,500 = 8 years

Now, the  Payback Period for Product B is calculated as:

Product B = 100,000 / 15,000 = 6.7 years

This brings the enterprise to conclude that Product B has a shorter payback period and therefore, it will invest in Product B.

Despite being an easy and time-efficient method, the Payback Period cannot be called optimum as it does not consider the time value of money. The cash flows at the earlier stages are better than the ones coming in at later stages. The company may encounter two projections with the same payback period, where one depicts higher cash flows in the earlier stages/years. In such as case, the Payback Period may not be appropriate.

A similar consideration is that of a longer period, potentially bringing in greater cash flows during a payback period. In such a case, if the company selects the projects based solely on the payback period and without considering the cash flows, then this could prove detrimental for the financial prospects of the company.

#2 Net Present Value Method (NPV)

Evaluating capital investment projects is what the NPV method helps the companies with. There may be inconsistencies in the cash flows created over time. The cost of capital is used to discount it. An evaluation is done based on the investment made. Whether a project is accepted or rejected depends on the value of inflows over current outflows.

This method considers the time value of money and attributes it to the company's objective, which is to maximize profits for its owners. The capital cost factors in the cash flow during the entire lifespan of the product and the risks associated with such a cash flow. Then, the capital cost is calculated with the help of an estimate.

Example of Net Present Value (with 9% Discount Rate ):

For a company, let’s assume the following conditions:

Capital investment = $10,000

Expected Inflow in First Year = $1,000

Expected Inflow in Second Year = $2,500

Expected Inflow in Third Year = $3,500

Expected Inflow in Fourth Year = $2,650

Expected Inflow in Fifth Year = $4,150

Discount Rate = 9%

Net Present Value achieved at the end of the calculation is:

With 9% Discount Rate  = $18,629

This indicates that if the NPV comes out to be positive and indicates profit. Therefore, the company shall move ahead with the project.

#3 Internal Rate of Return (IRR)

IRR refers to the method where the NPV is zero. In such as condition, the cash inflow rate equals the cash outflow rate. Although it considers the time value of money, it is one of the complicated methods.

It follows the rule that if the IRR is more than the average cost of the capital, then the company accepts the project, or else it rejects the project. If the company faces a situation with multiple projects, then the project offering the highest IRR is selected by them.

We shall assume the possibilities exhibited in the table here for a company that has 2 projects: Project A and Project B.

Here, The IRR of Project A is 7.9% which is above the Threshold Rate of Return (We assume it is 7% in this case.) So, the company will accept the project. However, if the Threshold Rate of Return would be 10%, then it would be rejected as the IRR would be lower. In that case, the company will choose Project B which shows a higher IRR as compared to the Threshold Rate of Return.

#4 Profitability Index

This method provides the ratio of the present value of future cash inflows to the initial investment. A Profitability Index that presents a value lower than 1.0 is indicative of lower cash inflows than the initial cost of investment. Aligned with this, a profitability index great than 1.0 presents better cash inflows and therefore, the project will be accepted.

Assuming the values given in the table, we shall calculate the profitability index for a discount rate of 10%.

So, Profitability Index with 10% discount = $15,807/$10,000  = 1.5807

As per the rule of the method, the profitability index is positive for the 10% discount rate, and therefore, it will be selected.

Process of Capital Budgeting

The process of Capital Budgeting involves the following points:

Identifying and generating projects

Investment proposals are the first step in capital budgeting. Taking up investments in a business can be motivated by a number of reasons. There could be the addition or expansion of a product line. An increase in production or a decrease in production costs could also be suggested.

Evaluating the project

It mainly consists of selecting all criteria necessary for judging the need for a proposal. In order to maximize market value, it has to match the company's mission. It is crucial to consider the time value of money here.

In addition to estimating the benefits and costs, you should weigh the pros and cons associated with the process. There could be a lot of risks involved with the total cash inflows and outflows. This needs to be scrutinized thoroughly before moving ahead.

Selecting a Project

Since there is no ‘one-size-fits-all’ factor, there is no defined technique for selecting a project. Every business has diverse requirements and therefore, the approval over a project comes based on the objectives of the organization.

After the project has been finalized, the other components need to be attended to. These include the acquisition of funds which can be explored by the finance department of the company. The companies need to explore all the options before concluding and approving the project. Besides, the factors like viability, profitability, and market conditions also play a vital role in the selection of the project.

Implementation

Once the project is implemented, now come the other critical elements such as completing it in the stipulated time frame or reduction of costs. Hereafter, the management takes charge of monitoring the impact of implementing the project.

Performance Review

This involves the process of analyzing and assessing the actual results over the estimated outcomes. This step helps the management identify the flaws and eliminate them for future proposals.

Factors Affecting Capital Budgeting

So far in the article, we have observed how measurability and accountability are two primary aspects that achieve the center stage through capital budgeting. However, while on the path to accomplish a competent capital budgeting process, you may come across various factors that may affect it.

Let us move on to observing the factors that affect the capital budgeting process.

Objectives of Capital Budgeting

The following points present the objectives of the capital budgeting:

  • Capital Expenditure Control : Organizations need to estimate the cost of investment as it allows them to control and manage the required capital expenditures.
  • Selecting Profitable Projects : The company will have to select the most appropriate project from the multiple possibilities in front of it.
  • Identification of Source of funds : The businesses need to locate and select the most viable and apt source of funds for long-term capital investment. It needs to compare the various costs like the costs of borrowing and the cost of expected profits.

Limitations of Capital Budgeting

Although capital budgeting provides a lot of insight into the future prospects of a business, it cannot be termed a flawless method after all. In this section, we learn about some of the limitations of capital budgeting.

It is a simple technique that determines if an enhanced value of a project justifies the required investment. The primary reason to implement capital budgeting is to achieve forecasting revenue a project may possibly generate. The problem could be the estimate itself. All the upfront costs or the future revenue are all only estimates at this point. An overestimation or an underestimation could ultimately be detrimental to the performance of the business.

Time Horizon

Usually, capital budgeting as a process works across for long spans of years. While the shorter duration forecasts may be estimated, the longer ones are bound to be miscalculated. Therefore, an expanded time horizon could be a potential problem while computing figures with capital budgeting.

Besides, there could be additional factors such as competition or legal or technological innovations that could be problematic.

The payback period method of capital budgeting holds a lot of relevance, especially for small businesses. It is a simple method that only requires the business to repay in the predecided timeframe. However, the problem it poses is that it does not count in the time value of money. This is to say that equal amounts (of money) have different values at different points in time.

Discount Rates

The accounting for the time value of money is done either by borrowing money, paying interest, or using one’s own money. The knowledge of discount rates is essential. The proper estimation and calculation of which could be a cumbersome task.

Even if this is achieved, there are other fluctuations like the varying interest rates that could hamper future cash flows. Therefore, this is a factor that adds up to the list of limitations of capital budgeting.

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Key Takeaways

Before we wrap up the post, let us peep into the important points with context to Capital Budgeting:

  • Capital Budgeting is defined as the process by which a business determines which fixed asset purchases are acceptable and which are not.
  • Capital budgeting leads to calculating the profitable capital expenditure.
  • Determining if replacing any existing fixed assets would yield greater returns is a part of capital budgeting
  • Selecting or denying a given project is based on its merits.
  • The process of capital budgeting requires calculating the number of capital expenditures.
  • An assessment of the different funding sources for capital expenditures is needed.
  • Payback Period, Net Present Value Method, Internal Rate of Return, and Profitability Index are the methods to carry out capital budgeting.
  • The process of capital budgeting involves the steps like Identifying the potential projects, evaluating them, selecting and implementing the projects, and finally reviewing the performance for future considerations.
  • Capital return, accounting methods, structures of capital, availability of funds, and working capital are some of the factors that affect the process of capital budgeting.

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8.2: Capital Budgeting and Decision Making

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Learning Objectives

  • Apply the concept of the time value of money to capital budgeting decisions.

Question: What is the difference between management decisions made in Chapter 7 and management decisions made in this chapter?

The types of decisions covered in this chapter and Chapter 7 are similar in that they require an analysis of differential revenues and costs. However, Chapter 7 involves short-run operating decisions (e.g., special orders from customers), while this chapter focuses on long-run capacity decisions (e.g., purchasing long-lived assets to increase capacity for many years).

Organizations make a variety of long-run investment decisions. The San Francisco Symphony invests in stage risers for its orchestra members. McDonald’s invests in new restaurants. Honda Motor Co. invests in new manufacturing facilities. Bank of America invests in new branches. These examples have one common feature: all of these companies are investing in assets that will affect the organization for several years.

Question : The process of analyzing and deciding which long-term investments to make is called a capital budgeting decision 1 , also known as a capital expenditure decision. Capital budgeting decisions involve using company funds (capital) to invest in long-term assets. How does the evaluation of these types of capital budgeting decisions differ from short-term operating decisions discussed in Chapter 7 ?

When looking at capital budgeting decisions that affect future years, we must consider the time value of money. The time value of money concept is the premise that a dollar received today is worth more than a dollar received in the future. To clarify this point, suppose a friend owes you $100. Would you prefer to receive $100 today or 3 years from today? The money is worth more to you if you receive it today because you can invest the $100 for 3 years.

For capital budgeting decisions, the issue is how to value future cash flows in today’s dollars. The term cash flow 2 refers to the amount of cash received or paid at a specific point in time. The term present value 3 describes the value of future cash flows (both in and out) in today’s dollars.

Business in Action 8.1

Capital Budgeting Decisions at JCPenney and Kohl’s

JCPenney Company has over 1,000 department stores in the United States, and Kohl’s Corporation has over 800. Both companies cater to a “middle market.” In October 2006, Kohl’s announced plans to open 65 new stores. At about the same time, JCPenney announced plans to open 20 new stores, 17 of which would be stand-alone stores. This was a departure from JCPenney’s typical approach of serving as an anchor store for regional shopping malls.

Figure 8.1BA.png

© Thinkstock

The decision to open new stores is an example of a capital budgeting decision because management must analyze the cash flows associated with the new stores over the long term.

Source: James Covert, “Chasing Mr. and Mrs. Middle Market: J.C. Penney, Kohl’s Open 85 New Stores,” The Wall Street Journal , October 6, 2006.

When managers evaluate investments in long-term assets, they want to know how much cash would be spent on the investment and how much cash would be received as a result of the investment. The investment proposal is likely rejected if cash inflows do not exceed cash outflows. (Think about a personal investment. If you would receive only $700 in the future from an investment of $1,000 today, you undoubtedly would not make the investment because you would lose $300!) If cash inflows are expected to exceed cash outflows, managers must consider when the cash inflows and outflows occur before taking on the investment. (Again, consider an investment of $1,000 today. If you expect to receive $1,050 in 20 years rather than at the end of 1 year, you would probably think twice before investing because it would take 20 years to make $50!)

Question : We use two methods to evaluate long-term investments, both of which consider the time value of money. What are these two methods?

The first is called the net present value (NPV) method , and the second is called the internal rate of return method . Before presenting these two methods, let’s discuss the time value of money (present value) concepts.

The Present Value Formula

Question : Suppose you invest $1,000 for 1 year at an interest rate of 5 percent per year, as shown in the following timeline. How much will you have at the end of 1 year (or what is the future value of the investment)?

Figure 8.1.1.png

You will have $1,050:

\[ \$ 1,050 = \$ 1,000 \times (1 + 0.05)\]

Question : Let’s change course and find the present value of the same future cash flow. If you receive $1,050 in 1 year, how much is that worth in today’s dollars assuming an annual interest rate of 5 percent?

Figure 8.1.2.png

The present value is $1,000, calculated as follows:

\[ \$ 1,000 = \frac{\$ 1,050}{(1 + 0.05)}\]

Question : Let’s go back to finding a future value. Assume you invest $1,000 today at an annual rate of 5 percent for 2 years. How much will you have at the end of 2 years?

Figure 8.1.3.png

At the end of 1 year, you will have $1,050 (= $1,000 × [1 + .05]). At the end of the second year, you will have $1,102.50, which is $1,050 × (1 + .05). The equation is

\[ \$ 1,102.50 = \$ 1,000 \times (1 + 0.05) \times (1 + 0.05)\]

\[ \$ 1,102.50 = \$ 1,000 \times (1 \ 0.05)^{2}\]

Question : Again, let’s change course and find the present value of the same future cash flow. If you receive $1,102.50 in 2 years, how much is that worth in today’s dollars assuming an annual interest rate of 5 percent?

Figure 8.1.4.png

\[ \$ 1,000 = \frac{\$ 1,102.50}{(1 + 0.05)^{2}}\]

These examples show that one equation can be used to find the present value of a future cash flow. The equation is

\[P = \frac{F_{n}}{(1 + r)^{n}}\]

\[\text{P = Present value of an amount}\]

\[F_{n} = \text{Amount received n years in the future}\]

\[\text{r = Annual interest rate}\]

\[\text{n = Number of years}\]

Question : Let’s use this formula to solve for the following: Assume $500 will be received 4 years from today, and the annual interest rate is 10 percent. What is the present value of this cash flow?

Figure 8.1.5.png

The present value is $341.51, calculated as follows:

\[\begin{split} P &= \frac{F_{n}}{(1 + r)^{n}} \\ &= \frac{\$ 500}{(1 + 0.10)^{4}} \\ &= \frac{\$ 500}{(1 + 0.10)^{4}} \\ &= \frac{\$ 500}{1.4641} \\ &= \$ 341.51 \end{split}\]

Present Value Tables

Question : Although most managers use spreadsheets, such as Excel, to perform present value calculations (discussed later in this chapter), you can also use the present value tables in the appendix to this chapter, labeled Figure 8.9 and Figure 8.10, for these calculations. Figure 8.9 simply provides the present value of $1 (i.e., F = $1) given the number of years (n) and the interest rate (r). How are these tables used to calculate present value amounts?

Let’s look at an example to see how these tables work. Assume $1 will be received 4 years from today (n = 4), and the interest rate is 10 percent (r = 10 percent). What is the present value of this cash flow? Look at Figure 8.9 in the appendix. Find the column labeled 10 percent and the row labeled 4. The present value is $0.6830, or $0.68 rounded. The table amount given is often called a factor . The factor in this example is 0.6830 (note that the formula to find this factor is shown at the top of Figure 8.9).

Now assume all the same facts, except that $500 rather than $1 will be received in 4 years. To find the present value, simply multiply the factor found in Figure 8.9 by $500, as follows:

\[\begin{split} \text{Present value} &= \text{Amount received in the future × Present value factor} \\ &= \$ 500 \times 0.6830 \\ &= \$ 341.50 \end{split}\]

Notice that this present value is the same as the one we calculated using the formula P = F n ÷ (1 + r) n , with the exception of a small difference due to rounding the factor in Figure 8.9. Next, we use present value concepts to evaluate projects with the NPV method.

Key Takeaway

Present value calculations tell us the value of future cash flows in today’s dollars. The present value of a cash flow can be calculated by using the formula P = F n ÷ (1 + r) n . It can also be calculated by using the tables in the appendix of this chapter. Simply find the factor in Figure 8.9 given the number of years (n) and annual interest rate (r). Then multiply the factor by the future cash flow, as follows:

\[\text{Present value = Amount received in the future × Present value factor}\]

REVIEW PROBLEM 8.1

For each of the following independent scenarios, calculate the present value of the cash flow described. Round to the nearest dollar.

  • You will receive $5,000, 5 years from today, and the interest rate is 8 percent.
  • You will receive $80,000, 9 years from today, and the interest rate is 10 percent.
  • You will receive $400,000, 20 years from today, and the interest rate is 20 percent.
  • You will receive $250,000, 10 years from today, and the interest rate is 15 percent.

Two approaches can be used to find the present value of a cash flow. The first requires using the formula P = F n ÷ (1 + r) n . The second requires using Figure 8.9 in the appendix to find the present value factor and inserting it in the following formula:

(from Figure 8.9)

We show both approaches in the following solutions.

  • Using the formula P = F n ÷ (1 + r) n , we get $$ \$ 3,403 = \$ 5,000 \div (1 + 0.08)^{5}$$Using Figure 8.9, we get $$\begin{split} \text{Present value} &= \text{Future value × Present value factor} \\ \$ 3,403 &= \$ 5,000 \times 0.6806 \end{split}$$
  • Using the formula P = F n ÷ (1 + r) n , we get $$ \$ 33,928 = \$ 80,000 \div (1 + 0.10)^{9}$$Using Figure 8.9, we get $$\begin{split} \text{Present value} &= \text{Future value × Present value factor} \\ \$ 33,928 &= \$ 80,000 \times 0.4241 \end{split}$$
  • The small difference between the two approaches is due to rounding the factor in Figure 8.9. Using the formula P = F n ÷ (1 + r) n , we get $$ \$10,434 = \$ 400,000 \div (1 + 0.20)^{20}$$Using Figure 8.9, we get $$\begin{split} \text{Present value} &= \text{Future value × Present value factor} \\ \$ 10,440 &= \$ 400,000 \times 0.0261 \end{split}$$
  • The small difference between the two approaches is due to rounding the factor Figure 8.9. Using the formula P = F n ÷ (1 + r) n , we get $$ \$ 61,796 = \$ 250,000 \div (1 + 0.15)^{10}$$Using Figure 8.9, we get $$\begin{split} \text{Present value} &= \text{Future value × Present value factor} \\ \$ 61,800 &= \$ 250,000 \times 0.2472 \end{split}$$
  • The process of analyzing and deciding which long-term investments (or capital expenditure decision) to make.
  • The amount of cash received or paid at a specific point in time.
  • The term used to describe future cash flows (both in and out) in today’s dollars.

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60 Important Capital Budgeting Questions and Answers [With PDF]

The 6th chapter of our finance learning course is “ Capital Budgeting .” In this article, we’ll learn the 60 most important capital budgeting questions and their answers.

It will help you quickly understand the important capital budgeting terms and their explanations.

By reading this post, you may quickly prepare for “finance” courses and for any competitive tests such as school and college exams, vivas, job interviews, and so on.

So let’s get started…

Capital Budgeting Questions and Answers   

The 60 important capital budgeting questions and answers are as follows:

Question 01: What is capital budgeting?

Answer: Capital budgeting is the process of finding, analyzing, and choosing investment projects with returns that are expected to last longer than one year. 

It is the process by which a company determines whether projects like building a new plant or investing in a long-term venture are worthwhile. 

Ideally, companies should pursue all projects and opportunities that increase shareholder value.

Question 02: What is another name for capital budgeting?

Answer: Another name for capital budgeting is “investment appraisal.”

Question 03: What is a project?

Answer: A project is a planned piece of work that has a distinct objective.

Question 04: What are the types of projects?

There are generally three types of projects that businesses will take on:

  •  Independent Project
  • Dependent Project
  • Mutually Exclusive Project

Question 05: What are the steps in the capital budgeting process?

Answer: The five steps of capital budgeting are as follows:

  • Generating Ideas
  • Analyzing individual proposals
  • Planning the capital budget
  •  Implementation
  •  Monitoring and follow up

Question 06: What are the fundamental principles of capital budgeting?

Answer: The following are the fundamental principles of capital budgeting:

  •  Cash flows are used to make decisions.
  • The timing of cash flow is critical.
  • Cash flows are calculated using opportunity costs.
  • After-tax cash flows are examined.
  • Financing costs (such as interest) are ignored.
  •  Sunk costs are not considered.
  •  Only incremental flows are taken into account.
  •  Inflationary effects are taken into account.

Question 07: What are the objectives of capital budgeting?

Answer: The following are the primary objectives of capital budgeting:

  • Select the most profitable project for the business enterprise.
  •  Assists the business in determining the most rational project for a business venture.
  • Aids businesses in forecasting their future revenue, cash flows, present value status of future investments, and net earnings.
  • Demonstrate the justification for new investment and abandon older investment projects.

Question 08: What are the benefits or importance of capital budgeting?

Answer: The following are the benefits or importance of capital budgeting:

  • Capital budgeting assists in selecting the best project from a pool of potential investments.
  •  Analyzing capital budgeting techniques allows an investor to forecast future cash flows.
  • Capital budgeting allows a company to control costs and other unnecessary expenditures.
  • Capital budgeting assists businesses in calculating the venture’s future financial risks. It is cautious steeping to avoid future investment risk.
  • It is beneficial to choose a project investment that is not frequently changed.

Question 09: What are the features or characteristics of capital budgeting?

Answer: The following are the five most important features or characteristics of capital budgeting:

  • Cash flows are used to make capital budgeting decisions.
  • The timing of cash flows is critical in capital budgeting decisions.
  •  Cash flows are calculated using opportunity costs.
  • Capital budgeting ignores financing and sunk costs.
  • The cash flows are examined after taxes.

Question 10: What are the constraints or limitations of capital budgeting?

Answer: The top five constraints of capital budgeting are as follows:

  • Because major project decisions are based on forecasting, there is a chance that important project information will be overlooked.
  • This budgeting technique does not allow for the estimation of probable future risk.
  • Sometimes a country’s economic turmoil can have an impact on capital budgeting decisions for a future project.
  • Estimating the economic life of an investment is perhaps the most difficult task.
  • There are numerous unknown factors that cannot be predicted and cannot be controlled or avoided.

Question 11: What is the application of capital budgeting?

Answer: Capital budgeting is used in all aspects of long-term investment decisions. The following are some examples of popular capital budgeting applications:

  • Purchase of a fixed asset.
  • Business expansion with the goal of increasing production capacity.
  • Product differentiation
  • Modernization and replacement.

Question 12: What are the factors affecting capital budgeting decisions?

Answer: The following factors influence capital budgeting decisions:

  • Maturity of Project
  •  Cash flows
  • Present value factor

Question 13: What are the major cash flow components?

Answer: The following are the major cash flow components:

  • Initial cash outflow
  • Interim Incremental Net Cash Flows
  • Terminal Year Incremental Net Cash Flow

Question 14: What is an initial cash outflow?

Answer: The amount of money paid out or received at the start of a project or investment is referred to as the “initial cash outflow.”

Question 15: How do you calculate the initial cash outflow?

Answer: The initial cash flow is calculated in the following manner:

Initial cash flow = cost of the new asset – capitalized expenditures +/- increased or decreased level of net working capital +/- net proceeds from the sale of old assets +/- taxes (tax savings) from the sale of old assets

Question 16: What are the interim incremental net cash flows?

Answer: Interim incremental net cash flows are the extra operating cash flows that a company gets because it started a new project.

Question 17: How do you calculate the interim incremental net cash flows?

Answer: The interim incremental net cash flows are calculated as follows:

Incremental Net Cash Flow for the Period = Net increase (decrease) in operating revenue -/+ any net increase or decrease in operating expenses, excluding depreciation +/- Net increase or decrease in tax depreciation charges +/- Net increase or decrease in taxes +/- Net increase or decrease in tax depreciation charges

Question 18: How do you calculate the terminal-year incremental net cash flow?

Answer: The terminal year incremental net cash flow is calculated as follows:

Terminal year incremental net cash flow = Net increase or decrease in operating revenue -/+ any net increase or decrease in operating expenses, excluding depreciation +/- Net increase or decrease in tax depreciation charges +/- Net increase or decrease in taxes +/- Net increase or decrease in tax depreciation charges +/- initial salvage value of new assets -/+ Taxes or Tax savings due to sale or disposal of new assets +/- decreased or increased level of net working capital

Question 19: What are the types of capital budgeting decisions?

Answer: The following are the different types of capital budgeting decisions:

  •  Accept or reject decision
  • Mutually exclusive decision
  • Capital rationing decision
  • Ranking method
  • Non-discounted methods of capital budgeting
  • Discounted methods of capital budgeting

Question 20: What is an “accept or reject” decision?

Answer: This is an important decision in capital budgeting. The farm would invest in the project if it were accepted, but not if it were rejected. 

Most project proposals are accepted if their rates of return are higher than a certain minimum rate of return. 

Under the accept or reject decision, all separate products that meet the minimum investment criteria should be put into place.

Question 21: What are mutually exclusive decisions?

Answer: Projects that compete with each other but don’t affect each other’s chances of getting approved are said to be “mutually exclusive.” Only one of the options is allowable because they are mutually exclusive.

Question 22: What is a capital rationing decision?

Answer: If the business has no limits on how much money it can spend, any independent investment proposal with a return higher than a certain level could be accepted.

In reality, a business’s budget for project implementation is limited. There are many investment proposals competing for those limited funds. As a result, the business must ration them. 

The business allocates funds to projects in such a way that long-term returns are maximized. Capital rationing is a term for a business’s financial situation in which it only has a small amount of money to spend on capital investments.

Question 23: What is the ranking method?

Answer: Using different capital budgeting techniques, this method starts by figuring out how likely each project is to happen. 

The project with the highest return is then ranked first, followed by the project with the lowest return. The project with the highest ranking is chosen, and the investment decision is made.

Question 24: What are the non-discounted methods of capital budgeting?

Answer: The non-discounted methods of capital budgeting are as follows:

  • Payback Period (PBP)
  • Average Rate of Return (ARR)
  • Pay Back Reciprocal (PBR)

Question 25: What are the discounted methods of capital budgeting?

Answer: The discounted methods of capital budgeting are as follows:

  • Net Present Value (NPV)
  • Internal Rate of Return (IRR)
  • Profitability Index (PI)
  • Modified Internal Rate of Return (MIRR)
  • Discounted Pay Back Period (DPBP)

Question 26: What is a payback period (PBP)?

Answer: The payback period is the number of years it takes to get back the money you put into a project at the beginning.

The payback period is one of the most common and widely accepted ways to judge investment proposals. The PBP figures out how long it will take to get back the initial cash investment based on the expected cash flows.

Question 27: What is the average rate of return (ARR)?

Answer: When you divide the average annual net income after taxes by the average investment, you get the average rate of return. It considers both the amount invested and the profit generated. 

Question 28: What is the net present value (VPV)?

Answer: The net present value of a project is the sum of the present values of all expected future cash flows over the project’s life, less the initial cash outlay.

The net present value is the traditional economic method for assessing investment proposals. It is one of the most important ways to discount money that takes into account the value of time. 

It makes the right assumption that future cash flows from different time periods have different values and can’t be compared until their equivalent present values are known.

Question 29: What is an internal rate of return (IRR)?

Answer: Another method for discounting is the internal rate of return. A project’s IRR is the discount rate that equals its NPV.

It is the discount rate at which the present value of future cash flows is equal to the initial investment.

Question 30: What is a profitability index (PI)?

Answer: The profitability index is the ratio you get when you divide the present value of all future cash inflows by the present value of all cash outflows.

Question 31: What are the techniques or methods of capital budgeting?

Answer: The following are capital budgeting techniques or methods:

  • Discounted Payback Period (DPBP)

Question 32: What is the formula for NPV, and how do you calculate NPV?

Answer: The formula for calculating NPV is as follows:

CFt = After-tax cash flow at time t

R = Required rate of return for the investment

Outlay = Initial cash outflow or investment 

Calculation:

Let’s calculate the net present value (NPV) using a straightforward example.

ABC Corporation is thinking about investing $30,000 in a project that will generate after-tax cash flows of $12,000 per year for the next three years and an additional $20,000 in the fourth year. The required rate of return is 13%.

The NPV for ABC Corporation would be as follows, using the above formula:

NPV= 12/1.13+12/(1.13)+12/1.13+20/1.13-30

       =10.62+9.4+8.32+12.27-30

       =40.61-30

       =10.61

Since the NPV is positive, the investment will therefore be accepted.

Question 33: What are the NPV decision criteria?

Answer: The following are the NPV decision criteria:

  • Invest: If the NPV is greater than or equal to zero.
  • Do not make an investment: If the NPV is less than zero.

Question 34: What are the benefits of using the Net Present Value (NPV) method?

Answer: The net present value (NPV) method has the following benefits:

  • It recognizes the time value of money.
  • It calculates the project’s worth based on all cash flows that occur over the course of the project’s life.
  • The discounting process allows you to calculate cash flows in terms of present value.
  • The NPV Method can be modified to account for risk.
  • It took into account the risk of future cash flows (through the cost of capital).
  • The NPV method is always in line with the goal of maximizing shareholder wealth.

Question 35: What are the disadvantages of using the Net Present Value (NPV) method?

Answer: The following are the disadvantages of the net present value (NPV) method:

  • In comparison to PBP or ARR, it is difficult to understand, calculate, and use. 
  • The problem associated with NPVs involves calculating the required rate of return or cost of capital to discount the cash flows.
  • When comparing alternative projects with unequal life, use caution when using the NPV.

Question 36: What is the formula for IRR?

Answer: The internal rate of return (IRR) formula is: 

IRR = r = the discount rate that makes the net present value of the investment equal to zero.

Question 37: What are the IRR decision criteria?

Answer: The IRR decision criteria are as follows:

  • Invest: If the IRR is greater than or equal to the required rate of return.
  • Don’t invest: If the IRR is less than the required rate of return.

Question 38: What are the benefits of using the Internal Rate of Return (IRR) method?

Answer: The following are the benefits of using the Internal Rate of Return (IRR) method:

  • It takes into account the time value of money.
  • It considers total cash inflows and outflows.
  • For business executives, the IRR is simpler to grasp.
  • It is consistent with the overall goal of increasing shareholder wealth.
  • It takes into account the risks associated with future cash flows.

Question 39: What are the disadvantages of using the Internal Rate of Return (IRR) method?

Answer: The following are the disadvantages of the Internal Rate of Return (IRR) method:

  • It entails arduous and time-consuming calculations.
  • It may generate multiple rates, which can be perplexing.
  • IRR does not account for scale or amount.
  • If the project has a long duration, the trial and error process used to calculate the IRR can become unmanageable.

Question 40: What is the PBP formula?

Answer: The following is the formula for calculating the payback period (PBP):

PBP= a+((ICO-c)/d)

a= the year of the cumulative inflow closest to the year of the initial cash outflow

ICO= Initial Cash Outlay

c=Cumulative inflow of a year

d= Inflow of the year of recovery

Question 41: What are the PBP decision criteria?

Answer: The payback period decision criteria are as follows:

  • The proposal is accepted if the calculated payback period is less than some maximum acceptable payback period.
  • The project is rejected if the payback period exceeds the acceptable payback period.

Question 42: What are the benefits of using the Pay Back Period (PBP) method?

Answer: The Pay Back Period (PBP) method has the following benefits:

  • It is very simple to compute.
  • The method provides some information about the investment’s risks. When the payback period exceeds an acceptable payback period, the project becomes more uncertain.
  • This method does not provide a rough estimate of the project’s liquidity.

Question 43: What are the disadvantages of using the Payback Period (PBP) method?

Answer: The Payback Period (PBP) method has the following disadvantages:

  • There are no concrete decision criteria for determining whether an investment increases the firm’s value.
  • The method disregards cash flows that occur after the payback period.
  • It ignores the concept of the time value of money.
  • It also takes no account of the risk of future cash flows.
  • This method is an ineffective predictor of profitability.

Question 44: What is the Discounted Pay Back Period (DPBP) formula?

Answer: The following is the formula for calculating the discounted payback period (DPBP):

DPBP= a+((ICO-c)/d)

Question 45: What are the benefits of the Discounted Pay Back Period (DPBP) method?

Answer: The following are the benefits of the discounted payback period (DPBP) method:

  • The primary benefit of a discounted payback period is that it takes into account the time value of money.
  • It also takes into account the riskiness of the project’s cash flows (through the cost of capital).

Question 46: What are the disadvantages of using the Discounted Payback Period (DPBP) method?

Answer: The following are the disadvantages of the Discounted Pay Back Period (DPBP) method:

  • This method, like the payback period method, ignores cash flows after the discounted payback period is reached.
  • This method is still not a reliable indicator of profitability.
  • The maximum acceptable discounted payback period is entirely arbitrary.

Question 47: What is the formula of an average or accounting rate of return (ARR)?

Answer: The formula for figuring out an average or accounting rate of return (ARR) is as follows:

ARR = Average net income/Average Investment

Average Investment=(Initial Investment +Salvage Value)/2

Question 48: What are the ARR decision criteria?

Answer: The following are the ARR decision criteria:

  • Accept: If the actual ARR exceeds or equals the projected ARR.
  • Don’t accept: If the actual ARR is less than or equal to the projected ARR.

Question 49: What are the benefits of calculating the average rate of return (ARR)?

Answer: The following are the benefits of using the Average Rate of Return (ARR) method:

  • It is simple to comprehend, calculate, and apply.
  • The ARR method is easy to figure out from accounting data, and unlike the NPV and IRR methods, it doesn’t require any adjustments to get to the cash flows of the project.
  • It considers benefits over the project’s entire life cycle.
  • The ARR rule considers the entire income stream when calculating the project’s profitability.

Question 50: What are the disadvantages of using the Average Rate of Return (ARR) method?

Answer: The following are the disadvantages of the Average Rate of Return (ARR) method:

  • It is calculated using accounting profit rather than cash flow.
  • It does not account for the time value of money.
  • The ARR does not account for any benefits that may accrue after the project is completed.
  • The ARR makes no distinction between the sizes of the investments needed for each project.

Question 51: What is the PI formula, and how is it calculated?

Answer: The following is the formula for calculating PI:

PI = PV of future cash flows/Initial investment

PI= 1+(NPV/Initial Investment)

The example below will show you how to calculate the Profitability Index (PI).

Assume ABC Corporation is considering a $42,000 investment in a capital project that will generate after-tax cash flows of $14,000 per year for the next five years. The cost of capital is 10%.

The estimated present value of future cash flows is $53,071.

PV of Future cash flows=$53,071

Initial Investment = $42,000

Profitability Index (PI)= (53,071/42000)= 1.26

Question 52: What are the PI Decision Criteria?

Answer: The following are the PI decision criteria:

  • If PI is greater than or equal to one, invest.
  • If the PI is less than one, do not invest.

Question 53: What are the advantages of the Profitability Index (PI) method?

Answer: In capital budgeting decision-making, the Profitability Index has the following advantages:

  • The PI meets almost all of the criteria for a sound investment.
  • It assesses all of the project’s cash flows.
  • It indicates whether or not an investment increases the firm’s value.

Question 54: What are the disadvantages of using the Profitability Index (PI) method?

Answer: The following are the Profitability Index’s disadvantages:

  • The calculation necessitates an estimate of the capital cost.
  • When used to compare mutually exclusive projects, it may not provide the correct decision.

Question 55: What is the difference between capital budgeting and capital rationing?

Answer: The three important differences between capital budgeting and capital rationing are as follows:

  • Capital budgeting is the process of generating, analyzing, and allocating long-term investments to the capital budget. “Capital rationing,” on the other hand, is a situation in which the amount of funding available is limited to the point where projects cannot be accepted.
  • Capital budgeting functions include project evaluation, selection, and implementation. On the other hand, the goal of capital rationing is to choose projects that will make the most money out of the limited amount of money.
  • To analyze projects, capital budgeting is used. Capital rationing, on the other hand, is used to accept or reject projects.

Question 56: What is the distinction between Net Present Value (NPV) and Internal Rate of Return (IRR)?

Answer: The following are the three important distinctions between the net present value (NPV) and the internal rate of return (IRR):

  • NPV is the present value of future cash flows discounted at the required rate of return minus the project’s initial investment. Whereas IRR is the rate of return that equates the present value of a series of cash inflows with the initial investment.
  • The NPV method’s goal is to compute the net value. The goal of the IRR method is to calculate the required rate.
  • The project is profitable if the NPV is positive. The project is profitable if the IRR is greater than the cost of capital.

Question 57: What is the distinction between Net Present Value (NPV) and Profitability Index (PI)?

Answer: The following are the three important distinctions between net present value (NPV) and profitability index (PI):

  • NPV is the present value of future cash flows discounted at the required rate of return minus the project’s initial investment. Whereas PI is the present value of future cash flows discounted at the required rate of return divided by the project’s initial investment.
  • The NPV method’s goal is to compute the net value. The goal of the PI method is to calculate the ratio.
  • The project is profitable if the NPV is positive. The project is profitable if the PI is greater than one.

Question 58: Which technique, NPV or IRR, is preferred and why?

Answer: It is difficult to choose between approaches. It is smart to look at NPV and IRR methods from both a theoretical and a practical point of view.

The theoretical point of view:  

Answer: NPV is the superior approach to capital budgeting for the following reasons:

  • The NPV user assumes that any intermediate cash inflows from an investment are reinvested at the firm’s cost of capital. whereas the use of IRR assumes that the IRR will reinvest any of these cash inflows. The cost of capital, on the other hand, is the realistic investment rate.
  • A project with an unusual cash flow may produce multiple IRR, whereas NPV does not have this issue.

The practical point of view: 

Answer: Even though the NPV method is better in theory, financial managers prefer the IRR method for the following reasons:

  • Rates of return are preferred by businesspeople over dollar returns. In this regard, IRR is preferable.
  • NPV is less intuitive to financial decision-makers because it does not measure benefits in relation to the amount invested.
  • There are several methods for avoiding the difficulty of the IRR.

Question 59: When is the profitability index better than the NPV?

Answer: In the following situations, it is thought that the profitability index is better than the net present value (NPV).

  • In terms of capital rationing decisions, the profitability index is thought to be better than the NPV.
  • If the initial investment is unequal and I am asked to accept or reject a decision, the profitability index will be a better technique than the NPV.
  • In the profitability index method, the net present value of the cash flows is calculated first, followed by the profitability index. As a result, the profitability index becomes preferable.

Question 60: What is the best way to figure out how much a capital expenditure or investment is worth?

Answer: There are two types of capital budgeting methods: traditional and discounted cash flow. The discounted cash flow method is the better option of the two.

I hope that by the end of this post, you will have a good understanding of the “ capital budgeting ” chapter.

You will gain a better understanding of the “ capital budgeting ” chapter if you read these “60 important capital budgeting questions and answers” on a regular basis.

You can read the first five chapters of our finance learning course here:

  • 25 Important Introduction to Finance Questions and Answers [With PDF]
  • 30 Important Time Value of Money Questions and Answers [With PDF]
  • 35 Important Short-Term and Mid-Term Financing Questions and Answers [With PDF]
  • 35 Important Long-Term Financing Questions and Answers [With PDF]
  • 35 Important Cost of Capital Questions and Answers [With PDF]

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Well researched and written, short and pricise, straight to the point notes. Very understandable when studying them.

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Capital Budgeting Techniques Solutions to Problems

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Both project A and project B have payback periods of exactly 4 years. (b) Based on the minimum payback acceptance criteria of 4 years set by John Shell, both projects should be accepted. However, since they are mutually exclusive projects, John should accept project B. (c) Project B is preferred over A because the larger cash flows are in the early years of the project. The quicker cash inflows occur, the greater their value.

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    Capital Budgeting Techniques Solutions Compute the (i) net present value and (ii) internal rate of return of the following capital budgeting projects. The firm's required rate of return is 12 percent. Projects Year 0 Zeta $(50,000) 20,000 15,000 30,000 Omega $(45,000) 42,000 9,000 1,850 Solutions to part (a) and (e): Year 0 CF

  3. Introduction to Capital Budgeting Exercises: Solutions

    Solutions Question 1 The decision rule should consider all relevant cash flows The decision rule should recognize the riskiness of the relevant cash flows The decision rule should recognize the time value of money The decision rule should rank the projects so that those projects that increase the firm's value the most are ranked the highest.

  4. Capital Budgeting: Important Problems and Solutions

    Problem 1 The price of a project the $50,000 and it generates cash inflows of $20,000, $15,000, $25,000, and $10,000 over four years. Required: Using the present value index select, rating the profitability of the proposed invest, assuming a 10% rank of discount. Solution The start tread is in calculate the past value and profitability index.

  5. Capital Budgeting Process Walkthrough and Use-cases

    Years of Experience 26 Executive Summary What Is the Capital Budgeting Process? How Can You Apply Capital Budgeting in Your Business? What Are Some Potential Pitfalls to Avoid? The funds available to be invested in a business either as equity or debt, also known as capital, are a limited resource.

  6. Chapter 8 -Introduction to Capital Budgeting

    8 Dr. Kevin Bracker, Dr. Fang Lin and Jennifer Pursley Chapter Learning Objectives After completing this chapter, students should be able to Identify what a capital budgeting project is, provide an example, and discuss why the capital budgeting process is essential to maximizing shareholder wealth

  7. 11.E: Capital Budgeting Decisions (Exercises)

    Mason, Inc., is considering the purchase of a patent that has a cost of $85, 000 $ 85, 000 and an estimated revenue producing life of 4 4 years. Mason has a required rate of return that is 12% 12 % and a cost of capital of 11% 11 %. The patent is expected to generate the following amounts of annual income and cash flows:

  8. Capital Budgeting: What It Is and How It Works

    Key Takeaways. Capital budgeting is the process by which investors determine the value of a potential investment project. The three most common approaches to project selection are payback period ...

  9. Capital Budgeting Techniques (List of Top 5 with Examples)

    #1 - Profitability Index Profitability Index is one of the essential techniques, and it signifies a relationship between the investment of the project and the payoff of the project. The formula of profitability index given by:- Profitability Index = PV of future cash flows / PV of initial investment Where PV is the present value.

  10. Capital Budgeting: Definition, Methods, and Examples

    The major methods of capital budgeting include discounted cash flow, payback analysis, and throughput analysis. Investopedia / Lara Antal How Capital Budgeting Works Ideally, businesses could...

  11. What is Capital Budgeting? Process, Methods, Formula, Examples

    Capital Budgeting is defined as the process by which a business determines which fixed asset purchases or project investments are acceptable and which are not. Using this approach, each proposed investment is given a quantitative analysis, allowing rational judgment to be made by the business owners. Capital asset management requires a lot of ...

  12. PDF Chapter 5 Capital Budgeting

    Chapter 5 Capital Budgeting 5-1 1 NPV Rule A firm's business involves capital investments (capital budgeting), e.g., the acquisition of real assets. The objective is to increase the firm's current market value. Decision reduces to valuing real assets, i.e., their cash flows. Let the cash flow of an investment (a project) be {CF 0,CF1 ...

  13. PDF CAPITAL BUDGETING TECHNIQUES (CHAPTER 9)

    Capital Budgeting Evaluation Techniques—in this section, the basic techniques that are used to make capital budgeting decisions are described. To illustrate the techniques, let's assume a firm is considering investing in a project that has the following cash flows: Year (t) 0

  14. PDF ACCY121 Appendix Capital Budgeting Practice Problems

    Required Calculate the removal costs of the existing equipment net of tax effects. Compute the depreciation tax shield. Compute the forgone tax benefits of the old equipment. Calculate the cash inflow, net of taxes, from the sale of the new equipment in year 10. Calculate the tax benefit arising from the loss on the old equipment.

  15. 8.2: Capital Budgeting and Decision Making

    The process of analyzing and deciding which long-term investments (or capital expenditure decision) to make. The amount of cash received or paid at a specific point in time. The term used to describe future cash flows (both in and out) in today's dollars. This page titled 8.2: Capital Budgeting and Decision Making is shared under a CC BY-NC ...

  16. [#2] Capital Budgeting Techniques

    [#2] Capital Budgeting Techniques | Discounted Payback Period Method | Solved problem by kauserwise® - YouTube Here is the video for Discounted payback period under capital...

  17. How to Overcome the Difficulties of Capital Budgeting

    How to Overcome the Difficulties of Capital Budgeting Overcome the conventional difficulties of capital planning management and see how cloud-based software allows you to streamline and...

  18. Capital Budgeting Practice Problems And Solutions

    Capital Budgeting Practice Problems And Solutions jan 14 2024 capital budgeting is a process that businesses use to evaluate potential major projects or investments building a new plant or taking a large stake in an outside venture are examples of learn about the different types of capital budgeting problems and how to solve them with our ...

  19. 60 Important Capital Budgeting Questions and Answers [With PDF]

    Answer: Capital budgeting is the process of finding, analyzing, and choosing investment projects with returns that are expected to last longer than one year. It is the process by which a company determines whether projects like building a new plant or investing in a long-term venture are worthwhile. Ideally, companies should pursue all projects ...

  20. Capital Budgeting Techniques Solutions to Problems

    Capital Budgeting Techniques Solutions to Problems Ilma Latansa See Full PDF Download PDF Related Papers FN-313 chapter 9 kuoy pheap Download Free PDF View PDF 2006 • Caroline Desbiens

  21. Solved PRACTICE PROBLEM ON CAPITAL BUDGETING TECHNIQUES: NPV

    PRACTICE PROBLEM ON CAPITAL BUDGETING TECHNIQUES: NPV AND IRR Suppose you have to choose between two mutually exclusive investment projects with the following cash flows (all numbers are in $1,000s): t=0 t=1 t=2 Project A -$400 $250 $300 Project. PRACTICE PROBLEM ON CAPITAL BUDGETING TECHNIQUES: NPV AND IRR.

  22. capital budgeting solved problems

    SOLVED PROBLEMS - CAPITAL BUDGETING. Problem 1 The cost of a plant is Rs. 5,00,000. It has an estimated life of 5 years after which it would be disposed off (scrap value nil). Profit before depreciation, interest and taxes (PBIT) is estimated to be Rs. 1,75,000 p. Find out the yearly cash flow from the plant. Tax rate 30%. Solution

  23. [#6] IRR

    [#6] IRR - Internal Rate of Return method in Capital Budgeting | Solved example | by kauserwise® - YouTube 0:00 / 6:37 Here is the video about IRR (Internal Rate of Return) under capital...