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Capital-Budgeting

Capital Budgeting Concepts

Capital Budgeting involves evaluation of (and

decision about) projects. Which projects should be
accepted? Here, our goal is to accept a project which
maximizes the shareholder wealth. Benefits are
worth more than the cost.
The Capital Budgeting is based on forecasting.
Estimate future expected cash flows.
Capital Budgeting is the process of determining
which real investment projects should be
accepted and given an allocation of funds from
the firm.

Capital budgeting

Capital budgeting or investment appraisal is the

process of allocating resources for major capital, or
investment, expenditures. One of the primary goals
of capital budgeting investments is to increase the
value of the firm to the shareholders.

Capital Budgeting Concepts

Capital budgeting implies decision making on

investments which take time to mature.
This decision making has to be based on the returns
which the proposed investment will give.

Capital financing & Allocation

functions
Capital financing includes the amounts
funds needed from investors and lenders as
funds available from internal sources to
new capital projects.

of new
well as
support

The sum of these amounts as well as the ratio of

debt to equity capital must match with the financial
status of the firm and must be balanced with the
current and future capital investment requirements.

Capital financing
Allocation function
Capital financing or Sources of Capital funds
can be
1. Internal
2. External.

Sources of Funds
Sources of Funds
Internal Sources

Profit

Depreciation

External Sources

Sales of assets

Long-term:
Share Capital
Loan Capital

Short term:
Overdraft
Leasing
Credit card

Internal Sources of Funds

Profit

The after-tax profit earned

and retained by a business
which is an important and
inexpensive source of
finance, for example, the
retained earnings of the
business. A large part of
finance is funded from
profit.

Internal Sources of Funds

Profit
Depreciation

The financial provision for

the replacement of worn-out
machinery and equipment.
Nearly all businesses use
depreciation as a source of
funds.

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Internal Sources of Funds

Profit

Depreciation

Sales of Assets

Definition: The activity that

a business sells off assets to
raise funds for the business.
Reasons: When a business
can not raise finance from
banks or other sources, it
may be forced to sell some
assets, such as company
cars, land property; or even
subsidiary or associated
company to solve its urgent
financial problems (this
activity
is
called
divestment).

External Long-term Sources of

Funds

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Share capital:

The most important source of funds for a limited company. It is often

considered as permanent capital as it is not repaid by the business, but
the shareholder can have a share in the profit, called dividend.

Three types of shares are:

1. Ordinary shares: The most common types of shares, and the most
riskiest shares since no guaranteed dividend. Dividend depends on
how much profit is made by the firm. But all ordinary shareholders
have voting rights.
2. Preference shares: The share owners receive a fixed rate of return.
They carry less risk because shareholders are entitled to the dividend
before the ordinary shares. But they are not strictly owners of the
company.
3. Deferred shares: These shares are often held by the founders of the
company. Deferred shareholders only receive the dividend after the
ordinary shareholders have been paid.

External Long-term Sources of

Funds

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Loan capital
Definition:
Any money which is borrowed for a long period of
time by a business is called loan capital.
Types:
There are four major types of loan capital:
Debentures, Mortgage, Loan specialists funds,
Government assistance. See next page:

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External Long-term Sources of Funds

Types of loan capital:

1.Debentures: The holder of a debenture is a creditor of the company,

not an owner. Holders are paid with an agreed fixed rate of return, but
having no voting rights. The amount of money borrowed must be
repaid by the expiry date.
2.Mortgage: These are long-term bank loans (usually over one year
period) from banks or other financial institutions. The borrowers land
or property must be used as a security on such as a loan.
3.Loan specialists funds: These are venture capitalists or specialists
who provide funds for small businesses, especially for high tech
investment projects in their start-up stage. There are also individuals
who invest in such businesses, which are often called business
angels.
4.Government assistance: To encourage small businesses and high
employment, governments may be involved in providing finance for
businesses.

External Short-term Sources of

Funds

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Definition:
Short term sources of funds are usually the funds which
are less than one year for maturity. They are less stable
sources of funds for businesses.
Types:
The main types of external short term sources of funds
include:
1. Bank overdraft
2. Bank loan
3. Leasing
4. Credit card
5. Trade credit
See the next page for details:

External short-term sources of loans

Major types

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Main characteristics

Bank
overdraft

This is a short term financing from banks.

The amount to be overdrawn depends on the needs of the business at the
time and its credit standing.
Interest is calculated from the time the account is overdrawn..

Bank loan

This is a loan which requires a rigid agreement between the borrower

and the bank. The amount borrowed must be repaid over a certain period
or in regular installments.
Sometimes, banks change persistent overdrafts into loans, so borrowers
must repay at regular intervals.

Leasing

Leasing allows businesses to buy plant, machinery or equipment without

paying large sums of money immediately.
The leasing company or bank hires or buys the equipment and for the
use of the hire company for a certain period of time. If the user can never
owns the equipment, it is an operating lease, while if it is given the choice
to own the equipment at the expiry time, it is a finance lease.
Lease payments are made by the hire company yearly or monthly, etc.

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External Short-term Sources of Funds

Major types
Credit card

Trade credit

Main characteristics
Credit cards can be used to pay for hotel bills,
meals,
shopping and materials, etc. They are convenient,
and secure because it can avoid the use of cash and
the payment of interests within credit periods.
Cards may not be suitable for certain purchases,
especially a large sum of order because they have a
credit limit.
It is a common method for businesses to buy
materials and to pay for them at a later date, usually
between 30 and 90 days. Such trade credit given by
the seller is usually an interest free way of short
term financing.

Sources of Funds

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Debt capitalfunds obtained through borrowing.

Equity capitalfunds provided by the firms owners
when they reinvest earnings, make additional
contributions, or issue stock to investors.

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Comparison of Debt and Equity Capital

Capital Asset Pricing Model

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Relationship between risk and return

Unsystematic risk Firm specific, project specific risk,
diversifiable risk(the total risk of investing in a particular
share). This is diversifiable by holding a large portfolio of
shares
Systematic Risk Market risk (Risk borne by all companies)
When shares are not very sensitive to market fluctuations,
beta value becomes less than one (defensive share) whereas,
when shares are sensitive to market changes, beta value
becomes more than one (aggressive shares)

CAPM'

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The capital asset pricing model (CAPM) is a model that describes the
relationship between risk and expected return and that is used in the pricing of
risky securities.

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Capital Asset Pricing Model

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Risk premium = difference between market return and

return from the risk free asset
Beta = a measure of movements of a shares return to the
return on the market portfolio. (defensive and aggressive
shares)

WACC- Weighted Average Cost Of

Capital

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Overall return that a corporation must earn on its existing

assets and business operations(debt equity and equity
capital) in order to increase or maintain the current value
of the current stock.

Capital Budgeting Concepts

Cash Flows

Initial Cash Outlay - amount of capital spent to get

project going.

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Capital Budgeting Methods

Payback Period

Number of years needed to recover your initial

outlay.

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Payback Period
The payback period is the amount of time required
for the firm to recover its initial investment
If the projects payback period is less than the
maximum acceptable payback period, accept the
project
If the projects payback period is greater than the
maximum acceptable payback period, reject the project

Management determines maximum acceptable

payback period
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Pros And Cons Of Payback Method

Advantages of payback method:
Computational simplicity
Easy to understand
Focus on cash flow

Disadvantages of payback method:

Does not account properly for time value of
money
Does not account properly for risk
Cutoff period is arbitrary
Does not lead to value-maximizing decisions

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Discounted Payback Period

Discounted payback accounts for time value
Apply discount rate to cash flows during payback
period
Still ignores cash flows after payback period

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Payback Method

The Discounted payback method can correct this

shortcoming of the payback method.
To find the discounted pay back
(1) Find the PV of each cash flow on the time line.
(2) Find the payback using the discounted CF and
NOT the CF.

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Payback Method

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Also, the payback method is not a good method as it

does not consider the cash flows beyond the payback
period.

Capital Budgeting Methods

Methods that consider time value of money and all
cash flows
Net Present Value:
Present Value of all costs and benefits of a project.

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Capital Budgeting Methods

Net Present Value

Present Value of all costs and benefits of a project.

Concept is similar to Intrinsic Value of a security but
subtracts cost of the project.
NPV
NPV == PV
PV of
of Inflows
Inflows -- Initial
Initial Outlay
Outlay

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Capital Budgeting Methods

NPV Decision Rules

If projects are independent then

accept all projects with NPV 0.
If projects are mutually exclusive,
accept projects with higher NPV.

ACCEPT A & B
ACCEPT B only

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Pros and Cons Of Using NPV As

Decision Rule
NPV is the gold standard of investment decision
rules
Key benefits of using NPV as decision rule
Focuses on cash flows, not accounting earnings
Makes appropriate adjustment for time value of money
Can properly account for risk differences between
projects

Though best measure, NPV has some

drawbacks
Lacks the intuitive appeal of payback
Doesnt capture managerial flexibility (option value)
well
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Capital Budgeting Methods

Profitability Index
Very Similar to Net Present Value

PI = PV of Inflows
Initial Outlay

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Capital Budgeting Methods

Profitability Index
Very Similar to Net Present Value

PI = PV of Inflows
Initial Outlay

Instead of Subtracting the Initial Outlay from the PV

of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.

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Capital Budgeting Methods

Profitability Index
Very Similar to Net Present Value

PI = PV of Inflows
Initial Outlay

Instead of Subtracting the Initial Outlay from the PV

of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.

PI =

CF1
(1+ k )

CF2
(1+ k )2

IO

CF3
CFn
++
(1+ k )3
(1+ k )n

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Capital Budgeting Methods

Profitability Index Decision Rules

Independent Projects

Accept Project if PI 1

Mutually Exclusive Projects

Accept Highest PI 1 Project

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