F2

CRI SL Cer t i f i ed Fi nanci al Anal y st ( CCFA) Pr ogr am
Level : 1 Fundament al s of Fi nanci al Management ( F2)

Module # 5: Capit al Budget ing Techniques Page 1 of 9
Ex pect ed Lear ni ng Out come
Different Capi t al Budget i ng Techni ques
Payback Peri od
I nt ernal Rat e of Ret urn
Net Present Val ue
NPV Profil e
Profit abili t y I ndex
Capit al Rat ioning Problems
Pract ical Problems and Sol ut ions
CRISL Certified Financial Analyst Program
Level: 1 (Fundamental)
F2: Fundamentals of Financial Management
Module-5
Topic: Capital Budgeting Techniques
By
Khaled Mahmud Raihan

CAPI TAL BUDGETI NG TECHNI QUES:
1.0 Pr oj ect Eval uat i on and Sel ect i on: Al t er nat i v e Met hods
We usually use four alt ernat i ve met hods of proj ect evaluat ion and select ion in capi t al budget ing:
1. Payback Period
2. I nt ernal Rat e of Ret urn
3. Net Present Value
4. Profit abilit y I ndex
The first is a simple addit ive met hod ( Non- discount ed cash flow t echnique) for assessing t he wort h of
a proj ect . The remaining met hods are more complicat ed discount ed cash flow ( DCF) t echniques. For
simplicit y, we assume t hroughout t hat t he expect ed cash flows are realized at t he end of each year. I n
addit ion, we carry over our assumpt ion t hat t he accept ance of any invest ment proposal would not
change t he t ot al business risk complexion of t he firm. This assumpt ion allows us t o use a single
required rat e of ret urn in j udging whet her or not t o accept a proj ect under t he various discount ed cash
flow t echniques.
Non Di scount ed Cash Fl ow Techni que
1.1 Pay back Per i od:
The payback period ( PBP) of an invest ment proj ect t ells us t he number of years required t o recover
our init ial cash invest ment based on t he proj ect s expect ed cash flows. Suppose t hat we wish t o
det ermine t he payback period for a part icular firm. We assume t hat for an init ial cash out flow of Tk.
100, 000, t he firm is expect ed t o generat e net cash flows of Tk. 34, 432, Tk. 39, 530, Tk. 39, 359, and
Tk. 32, 219 over t he next 4 years. Recording t he cash flows in a column, and following a few simple
st eps, will help you calculat e t he payback period.
YEAR CASH FLOWS CUMULATI VE I NFLOWS
0 ( Tk. 100, 000) ( - b)
1 34, 432 Tk. 34, 432
2( a) 39, 530 73, 962( c)
3 39, 359( d) 113, 321
4 32, 219 145, 540
Not e: PBP = a + ( b- c) / d = 2. 66 years.
St eps:
1. Accumulat e t he cash flows occurring aft er t he init ial out lay in a cumulat ive inflows column.
2. Look at t he cumulat ive inflows column and not e t he last year ( a whole figure) for which t he
cumulat ive t ot al does not exceed t he init ial out lay.
3. Comput e t he fract ion of t he following years cash inflow needed t o payback t he init ial cash
out lay as follows: Take t he init ial out lay minus t he cumulat ive t ot al from st ep 2, and t hen
divide t his amount by t he following years cash inflow.
4. To get t he payback period in years, t ake t he whole figure det ermined in st ep 2, and add t o it
t he fract ion of a year det ermi ned in st ep 3.
Accept ance Cr i t er i on:
I f t he payback period calculat ed is less t han some maximum accept able payback period, t he proposal
is accept ed; if not , it is rej ect ed. I f t he required payback period were t hree years, our proj ect would
be accept ed.

Pr obl ems:
1. A maj or short coming of t he payback met hod is t hat it fails t o consider cash flows occurring aft er t he
expirat ion of t he payback period; consequent ly, it can not be regarded as a measure of profit abilit y.
Two proposals cost ing Tk. 10, 000 each would have t he same payback period if t hey bot h had annual
net cash inflows of Tk. 5, 000 in t he first t wo years, whereas t he ot her might be expect ed t o provide
cash flows of Tk. 5, 000 in each of t he next t hree years. Thus, t he payback met hod can be decept ive
as a yardst ick of profit abi lit y.
2. I n addit ion t o t his short coming, t he met hod ignores t he t ime value of money. I t simply adds cash
flows wit hout regard t o t he t iming of t hese flows. Finally, t he maximum accept able payback period,
which serves as t he cut off st andard, is a purely subj ect ive choice.
Alt hough a poor gauge of profit abilit y, t he payback period does give a rough indicat ion of t he liquidit y
of a proj ect . Many managers also use i t as a crude measure of proj ect risk; but as we shall see, ot her
analyt ical approaches for a much bet t er j ob of capt uring risk. The payback period may provide useful
insight s, but it is best employed as a supplement t o discount ed cash flow met hods.
Di scount ed cash f l ow ( DCF) :
Any met hod of invest ment proj ect evaluat ion and select ion t hat adj ust s cash flows over t ime for t he
t ime value of money.
Because of t he various short comings in t he payback met hod, it is generally felt t hat discount ed cash
flow met hods provide a more obj ect ive basis for evaluat ing and select ing invest ment proj ect s. These
met hods t ake account of bot h t he magnit ude and t he t iming of expect ed cash flows in each period of a
proj ect s life. St ockholders, for example, place a higher value on an invest ment proj ect t hat promises
cash ret urns over t he next five years t han on a proj ect t hat promises ident ical cash flows for years 6
t hrough 10. Consequent ly, t he t iming of expect ed cash flows i s ext remely i mport ant in t he i nvest ment
decision.
Discount ed cash flow met hods enable us t o capt ure differences in t he t iming of cash flows for various
proj ect s t hrough t he discount ing process. I n addit ion, t hrough our choice of discount ( or hurdle rat e) ,
we can also account for proj ect risk. The t hree maj or discount ed cash flow met hods are t he I nt ernal
Rat e of Ret urn ( I RR) , t he Net Present Value ( NPV) , and t he Profit abilit y I ndex ( PI ) . We consider each
met hod in t urn.
1.2 I nt er nal Rat e of Ret ur n:
The I nt ernal Rat e of Ret urn ( I RR) for an invest ment proposal is t he discount rat e t hat equat es t he
present value of t he expect ed net cash flows ( CFs) wit h t he init ial cash out flow ( I CO) . I f t he init ial
cash out flow or cost occurs at t ime 0, it is represent ed by t hat rat e, I RR, such t hat

I CO=
n
n
IRR
CF
IRR
CF
IRR
CF
) 1 (
.......
) 1 ( ) 1 (
2
2
1
1
+
+ +
+
+
+
Thus, I RR is t he int erest rat e t hat discount s t he st ream of f ut ure net cash flows CF
1
t hrough CF
n
t o
equal in present value t he init ial cash out flow ( I CO) at t ime 0. I n our previous example, t he problem
can be expressed as-
Tk. 100, 000=
4 3 2 1
) 1 (
219 , 32 .
) 1 (
359 , 39 .
) 1 (
530 , 39 .
) 1 (
432 , 34 .
IRR
Tk
IRR
Tk
IRR
Tk
IRR
Tk
+
+
+
+
+
+
+

I nt er pol at i on:
Solving for t he I nt ernal Rat e of Ret urn, I RR, somet i mes involves a t rial- and- error procedure using
present value t ables. Fort unat ely, t here are comput er programs and programmed calculat ors for
solving for t he int ernal rat e of ret urn. These aids eliminat e t he arduous comput at ions involved in t he
t rail- and- error procedure. St ill, t here are t imes when, by necessit y, one must resort t o t he t rial- and-
error met hod. To illust rat e, again consider our example. We want t o det ermine t he discount rat e t hat
set s t he present value of t he fut ure net cash- flow st ream equal t o t he init ial cash out flow. Suppose
t hat we st art wit h a 15 percent discount rat e and calculat e t he present value of t he cash- flow st ream.
For t he appropriat e present value int erest fact ors, we use Table value.
We could make repeat ed use of t he equat ion PVI F
i , n
= 1/ ( 1+ i)
n
.
YEAR NET CASH FLOWS PVI F AT 15% PRESENT VALUES
1 Tk. 34, 432 0. 870 = Tk. 29, 955. 84
2 39, 530 0. 756 = 29, 884. 68
3 39, 359 0. 658 = 25, 898. 22
4 32, 219 0. 572 = 18, 429. 27
Tk. 104, 168. 01
A 15 percent discount rat e produces a result ing present value for t he proj ect t hat is great er t han t he
init ial cash out flow of Tk. 100, 000. Therefore, we need t o t ry a higher discount rat e t o furt her
handicap t he fut ure cash flows and force t heir preset value down t o Tk. 100, 000. How about a 20
percent discount rat e?
This t ime t he discount rat e chosen was t oo large. The result ing present value is less t han t he hoped-
for Tk. 100, 000 figure. The discount rat e necessary t o discount t he cash- flow st ream t o Tk. 100, 000
must , t herefore, fall somewhere bet ween 15 and 20 percent .
Present value at 15%> I CO > Present value at 20%
Tk. 104, 168. 01> Tk. 100, 000 > Tk. 94, 434. 10
To approximat e t he act ual rat e, we int erpolat e bet ween 15 and 20 percent as foll ows:
. 05 ( 91 . 733 , 9 . ) 01 . 168 , 4 .
10 . 434 , 94 . 20 .
00 . 000 , 100 .
01 . 168 , 104 . 15 .
Tk Tk
TK
IRRTk
Tk
X
0214 .
91 . 733 , 9 .
) 01 . 168 , 4 . ( ) 05 (.
,
91 . 733 , 9 .
01 . 168 , 4 .
05 .
=
=
=
Tk
Tk
X Therefore
Tk
Tk X
YEAR NET CASH FLOWS PVI F AT 20% PRESENT VALUES
1 Tk. 34, 432 0. 833 = Tk. 28, 681. 86
2 39, 530 0. 694 = 27, 433. 82
3 39, 359 0. 579 = 22, 788. 86
4 32, 219 0. 482 = 15, 529. 56
Tk. 94, 434. 10

And I RR = . 15 + X = . 15 + . 0214 = . 1714, or 17. 14 percent . ( Solving for I RR by comput er yields
17. 04 percent , which in t his case is very close t o our approximat e answer) .
The Problems can also be solved in t he following way:
I RR= a+ [ c/ ( c- d) ] * ( b- a)
= . 15+ [ 4168. 01/ ( 4168. 01+ 5565. 9) ] * ( 0. 20- 0. 15)
= 17. 14%
I f t he cash- flow st ream is a uniform series of inflows ( an annuit y) and t he i nit ial out flow occurs at t ime
0, t here is no need for a t rial and error approach. We simply divide t he init ial cash out flow by t he
periodic receipt and search for t he nearest discount fact or in a t able of present value int erest fact ors
of an annuit y ( PVI FAs) . This is because for a net cash- flow st ream t hat is an annuit y, we have
I CO = ( PVI FA
I RR, n
) ( periodic cash flow)
And, rearranging t erms reveals-
( PVI FA
I RR, n
) = I CO / ( periodi c cash flow)
Modifying our example, let s assume t hat t he init ial cash out flow of Tk. 100, 000 was followed by four
annual receipt s of Tk. 36, 000. We divide Tk. 100, 000 by Tk. 36, 000, obt aining 2. 778. The nearest
discount fact or on t he four- period row is 2. 798, and t his figure corresponds t o a discount rat e of 16
percent . I n as much as 2. 778 is less t han 2. 798, we know t hat t he act ual rat e lies bet ween 16 and 17
percent , and we would int erpolat e accordingly if a more precise answer were required. As we have
seen, when t he cash flow st ream is an uneven series t he t ask i s more di fficult . I n such a case we must
resort t o t rail and error. Wit h pract ice, a person can become surprisingly close in select ing discount
rat es from which t o st art .
The accept ance crit erion generally employed wit h t he int ernal rat e of ret urn met hod is t o compare t he
int ernal rat e of ret urn t o a required rat e of ret urn, known as t he cut off or hurdle rat e. We assume for
now t hat t he required rat e of ret urn is given. I f t he required rat e of ret urn is 12 percent in our
example problem and t he int ernal rat e of ret urn met hod is employed, t he invest ment proposal will be
accept ed. I f t he required rat e of ret urn is t he ret urn i nvest ors expect t he firm t o earn on t he proj ect ,
accept ing a proj ect wit h an int ernal rat e of ret urn in excess of t he required of ret urn should result in
an increase in t he market price of t he st ock. This is because t he firm accept s a proj ect wit h a ret urn
great er t han t hat required t o maint ain t he present market price per share.
1.3 Net Pr esent Val ue:
Like t he int ernal rat e of ret urn met hod, t he net present value met hod is a discount ed cash flow
approach t o capit al budget ing. The net present value ( NPV) of an invest ment proposal is t he present
value of t he proposal s net cash flows less t he proposals init ial cash out flow. I n formula form we
have-
NPV= ICO
k
CF
K
CF
K
CF
n
n
+
+ +
+
+
+ ) 1 (
. ..........
) 1 ( 1 ) 1 (
2
2 1
Where k is t he required rat e of ret urn and all t he ot her variables remain as previously defined.
I f an invest ment proj ect s net present value is zero or more, t he proj ect is accept ed; if not , it is
rej ect ed. Anot her way t o express t he accept ance crit erion is t o say t hat t he proj ect will be accept ed if
t he present value of cash inflows exceeds t he present value of cash out flows. The rat ionale behind t he
accept ance crit erion i s t he same as t hat behind t he int ernal rat e of ret urn met hod. I f t he required rat e

of ret urn is t he ret urn invest ors expect t he firm t o earn on t he invest ment proposal ; and t he firm
accept s a proposal wit h a net present value great er t han zero, t he market value of t he st ock should
rise. I n fact , if t he required rat e of ret urn, or discount rat e, is chosen correct ly, t he t ot al market price
of t he firms st ock should change by an amount equal t o t he net present value of t he proj ect . Thus,
t alking a proj ect wit h a net present value equal t o zero should leave t he market price of t he firms
st ock unchanged.
I f we assume a required rat e of ret urn of 12 percent aft er t axes, t he net present value of our previous
example is
NPV= 000 , 100 .
) 12 . 1 (
219 , 32 .
) 12 . 1 (
359 , 39 .
) 12 . 1 (
530 , 39 .
) 12 . 1 (
432 , 34 .
4 3 2 1
Tk
Tk Tk Tk Tk
+
+
+
+
+
+
+
Or, alt ernat ively,
NPV = [ Tk. 34, 432( PVI F
12%
,
1
) + Tk. 39, 530( PVI F
12%
,
2
) + Tk. 39, 359( PVI F
12%
,
3
) + Tk. Tk. 32,
219( PVI F
12%
,
4
) ] - Tk. 100, 000
= [ Tk. 30, 748+ Tk. 31, 505+ Tk. 28, 024+ Tk. 20, 491] - Tk. 100, 000
= Tk. 10, 768.
Once again, t he problem can be solved by comput er, by calculat or, or by reference t o t he appropriat e
present value t able. I n as much as t he net present value of t his proposal is great er t han zero; t he
proposal should be accept ed, based on t he net present value met hod.
NPV Pr of i l e:
I n general, t he net present value and int ernal rat e of ret urn met hods lead t o t he same accept ance or
rej ect ion decision. I n figure we illust rat e graphically t he t wo met hods applied t o our example proj ect .
The graph, called an NPV profile, shows t he curvilinear relat ionship bet ween t he net present value for
a proj ect and t he discount rat e employed. When t he discount rat e is zero, net present value is simply
t he t ot al cash inflows less t he t ot al cash out flows of t he proj ect . Assuming a convent ional proj ect
one where t ot al inflows and where t he init ial out flow( s) is ( are) followed by inflows- t he highest net
present value will occur when t he di scount rat e is zero. As t he di scount rat e increases, t he net present
value profile slopes downward t o t he right .

50,000
40,000
30,000
20,000
10,000 IRR=17%
0
5 10 15 20
-10,000 DISCOUNT RATE (%)
N
E
T

P
R
E
S
E
N
T

V
A
L
U
E

(
T
k
.
)

At t he point where t he NPV curve int ersect s t he horizont al axis on t he graph, t he net present value of
t he proj ect is zero. By definit ion, t he discount rat e at t hat point represent s t he int ernal rat e of ret urn
t he discount rat e at which t he proj ect s net present value equals zero. For discount rat es great er t han
t he int ernal rat e of ret urn, t he net present value of t he proj ect is negat ive.
I f t he required rat e of ret urn is less t han t he int ernal rat e of ret urn, we would accept t he proj ect using
eit her met hod. Suppose t hat t he required rat e of ret urn was 12 percent . As seen in t he above figure,
t he net present value of t he proj ect is somewhat over Tk. 10, 000.
1.4 Pr of i t abi l i t y I ndex :
The profit abilit y index ( PI ) , or benefit - cost rat io, of a proj ect is t he rat io of t he present value of fut ure
net cash flows t o t he init i al cash out flow. I t can be expressed as
PI = ICO
k
CF
K
CF
K
CF
n
n
+
+ +
+
+
+ ) 1 (
......
) 1 ( ) 1 (
2
2
1
1
For our example problem,
PI = ( Tk. 30, 748+ Tk. 31, 505+ Tk. 28, 024+ Tk. 20, 491) Tk. 100, 000
= Tk. 110, 768 Tk. 100, 000
= 1. 11
Accept ance Cr i t er i on
As long as t he profit abilit y index is 1. 00 or great er, t he invest ment proposal is accept able. For any
given proj ect , t he net present value and t he profit abilit y index met hods give t he same accept - rej ect
signals. ( A profit abilit y index great er t han 1. 00 implies t hat a proj ect s present value is great er t han it s
init ial cash out flow which, in t urn, implies t hat net present value is great er t han zero. ) The net preset
value met hod, however, is oft en preferred over t he profit abilit y index met hod. The reason for t his is
t hat t he net present value t ells you whet her t o accept a proj ect or not and also expresses t he absolut e
dollar economic cont ribut ion t hat t he proj ect makes t o shareholder wealt h. I n cont rast , t he
profit abilit y index expresses only t he relat ive profit abilit y.
Capi t al Rat i oni ng
Capit al rat ioning occurs any t ime when t here is a budget ceiling, or const raint , on t he amount of funds
t hat can be invest ed during a specific period, or const raint , such as a year. Such const raint s are
prevalent i n a number of fi rms, part icularly in t hose t hat have a pol icy of i nt ernally financing all capit al
expendit ures. Anot her example of capit al rat ioning occurs when a division of a large company is
allowed t o make capit al expendit ures only up t o a specified budget ceiling, over which t he division
usually has no cont rol. Wit h a capit al rat ioning const raint , t he firm at t empt s t o select t he combinat ion
of invest ment proposals t hat will provide t he great est increase in t he value of t he firm subj ect t o not
exceeding t he budget ceiling const raint .
When capit al is rat ioned over mult iple periods, several alt ernat ive ( and rat her complicat ed) met hods
of handling const rained maximizat ion can be applied t o t he capit al rat ioning problem. These met hods
make use of linear, int eger or goal programming.
I f capit al is t o be rat ioned for only t he current period, t he problem is reduced t o select ing t hose
proj ect s t hat add t he great est increment in value per t aka of invest ment wit hout surpassing t he
budget ceiling. Assume, for example, t hat your firm faces t he following invest ment opport unit ies:

PROJECT I NI TI AL CASH OUTFLOWS I RR NPV PI
A Tk. 50000 15% Tk. 12000 1. 24
B 35000 19 15000 1. 43
C 30000 28 42000 2. 40
D 25000 26 1000 1. 04
E 15000 20 10000 1. 67
F 10000 37 11000 2. 10
G 10000 25 13000 2. 30
H 1000 18 100 1. 10
Table: 1
I f t he budget ceiling for init ial cash out flow during t he present period is Tk. 65, 000 and t he proposals
are independent of each ot her, you would want t o sel ect t he combinat ion of proposals t hat provides
t he great est increase in firm value t hat Tk. 65, 000 ( or less) can provide. Select ing proj ect s in
descending order of profit abilit y according t o t he various discount ed cash flow met hods unt il t he Tk.
65, 000 budget is exhaust ed reveals t he following:
Table: 2

Table: 4
Wit h capit al rat ioning, you would accept proj ect C, E, F and G, t ot aling Tk. 65000 in init ial out flows.
No ot her mix of available proj ect s will provide a great er t ot al net present value t han t he Tk. 76000
t hat t hese proj ect s provide. Because of t he budget const raint , you cannot necessaril y invest in all
proposals t hat increase t he net present value of t he firm; you invest in an accept able proposal only if
t he budget const raint allows such an invest ment . As you can see, select i ng proj ect s by descending
order of profit abilit y index ( t he rat io of t he present value of fut ure net cash flows over t he init ial cash
out flow) allows you t o select t he mix of proj ect t hat gives you t he biggest bang for t he buck
exact ly what ranking proj ect s by profit abilit y index reveals.
A budget ceiling carries a real cost when it bars us from t aking advant age of any addit i onal profit able
opport unit ies. I n our exampl e, a number of opport unit ies were forgone by t he imposit ions of t he Tk.
65000 budget ceiling. We were prohibit ed from t aking proj ect s A, B, D and H even t hough t hey would
have added Tk. 28100 ( Tk. 12000+ Tk. 15000+ Tk. 1000+ Tk. 100) in value t o t he firm.
PROJECT I RR NPV I NI TI AL OUTFLOW
F 37% Tk. 11000 Tk. 10000
C 28 42000 30000
D 26 1000 25000
Tk. 54000 Tk. 65000
PROJECT NPV I NI TI AL OUTFLOW
C Tk. 42000 Tk. 30000
B 15000 35000
Tk. 57000 Tk. 65000
PROJECT PI NPV I NI TI AL OUTFLOW
C 2. 40 Tk. 42000 Tk. 30000
G 2. 30 13000 10000
F 2. 10 11000 10000
E 1. 67 10000 15000
Tk. 76000 Tk. 65000
Table: 3

MODEL QUESTI ONS
Sect i on- A: Shor t Quest i ons
1. What are t he met hods of capit al budget ing t echniques?
2. Briefly describe t he problems of pay back period met hod?
3. Why discount ed cash flow met hod is popular t o non discount ed cash flow met hod?
4. What are t he accept ance crit eria of I RR met hod?
5. Define t he concept of Net Present Value ( NPV) .
6. How can you link t he concept of Net Present Value wit h I nt ernal rat e of Ret urn ( I RR) ?
7. Briefly explain t he capit al rat ioning problem.
Sect i on- B: Pr act i cal Pr obl ems
1. ABC Company is considering a new product line t o supplement it s range line. I t is ant icipat ed
t hat t he new product line will involve cash invest ment of Tk. 500, 000 init ially. Aft er t ax cash
inflows of t he proj ect are expect ed-

End of t he year Amount of cash flow ( in Tk. )
1 250, 000
2 175, 000
3 150, 000
4 225, 000
5 195, 000

Based on t hese informat ion answer t he following quest ions:
a) What is t he I nt ernal Rat e of Ret urn of t he Proj ect ?
b) I f t he required rat e of ret urn is 15%, will t he proj ect be accept ed?
c) What is t he proj ect s pay back period?

2. Two mut ually exclusive proj ect s have proj ect ed cash flows as follows:

Cash flows ( at t he end of year) Proj ect A ( in Tk) Proj ect B( in Tk)
1 ( 2000) ( 2000)
2 1000 0
3 1000 0
4 1000 0
5 1000 6000
a) Det ermine t he net present value for each proj ect at 10% discount rat e.
b) Which proj ect would you select ? Why? What assumpt ions are inherent in your decision?

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CRI SL Cer t i f i ed Fi nanci al Anal y st ( CCFA) Pr ogr am

Level : 1 Fundament al s of Fi nanci al Management ( F2)

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