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CAPITAL BUDGETING. Group Members. Adeel Akbar Taimoor Shahzada Moqeet Ahmad Muhammad Shoaib. What is Capital Budgeting?. “Capital Budgeting is the process of identifying, Analyzing and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.”.

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Group members
Group Members

Adeel Akbar

Taimoor Shahzada

Moqeet Ahmad

Muhammad Shoaib


What is capital budgeting
What is Capital Budgeting?

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


What is capital budgeting1
What is Capital Budgeting?

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



Functions
Functions

  • Generating Investment projects proposals consistent with firm’s strategy.

  • Estimating after tax operating cash flows for investment projects.

  • Evaluating project cash flows.

  • Selecting a project based on Value-Maximizing criteria.


Our focused area
Our Focused Area

Selecting a project based on Value-Maximizing criteria.


Techniques

PBP

NPV

IRR

PI


Pay back period pbp
Pay Back Period (PBP)

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


Can be Calculated as:

PBP= a + (b-c)

d

Project with Minimum PBP will be Accepted.


Net present value npv
Net Present Value (NPV)

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

NPV=Present value of cash flows – Initial Investment


NPV= cf1 + cf2 + …….. + cfn - ICO

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

Where:

cf = Cash flow

r = Interest rate

ICO= Initial Cash out flow

Project with +ve NPV will be selected


Internal rate of return irr
Internal Rate of Return (IRR)

“The discount Rate that equates the present value of the future net cash flows from an investment project’s initial cash out flow.”

If IRR > Given Rate, project will b accepted.


Formula
Formula

IRR = LDR + diff b/w NPV of LDR

two rates sum of both NPVs

where:

LDR = Lower Discount Rate


Profitability index pi
Profitability Index (PI)

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


Example
Example

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


Cash flows
Cash Flows:

Project A

Project B

Initial Investment 70,000

Initial Investment 90,000


Calculation of pbp
Calculation of PBP

Project A

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


Calculation of pbp1
Calculation of PBP

Project B

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


Pay back period pbp1
Pay Back Period (PBP)

Project A

Project B

PBP = 4 + 90,000 – 81,000

20,000

= 4 + 9,000

20,000

= 4 + 0.45

= 4.45 Years

4 Years, 5 Months & 12 days

PBP =3 + 70,000 – 65,000

30,000

= 3+ 5,000

30,000

= 3+ 0.14

= 3.14

3 Year,1 Month & 20 days




Net present value npv1
Net Present Value (NPV)

Project A

Project B

NPV = Total Present Value – Initial Investment

= 70,474 – 90,000

= -19,526

NPV = Total Present Value – Initial Investment

= 95,635 – 70,000

= 25,635


Steps for calculation of irr
Steps for Calculation of IRR

  • Calculate average cash flow

  • Divide Initial Investment by answer of above step

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

  • Calculate total present value with the help of above found rate

  • Get another total present value with another supposed rate.

  • Apply the formula


Calculation of avg cash flow
Calculation of Avg. Cash Flow

Project A

Project B


Step 1 average cash inflow
Step 1 : Average Cash Inflow

Project A

Project B

Average = Total Cash Inflow

No. of Years

= 1,01,000

5

= 20,200

Average = Total Cash Inflow

No. of Years

= 1,40,000

5

= 28,000


Step 2 division
Step 2: Division

Project A

Project B

Divide Initial Investment by answer of previous step.

= 90,000

20,200

= 4.45

Divide Initial Investment by answer of previous step.

= 70,000

28,000

= 2.5


Step 3 see the table
Step 3 : See The Table

Project A

Project B

28%

4%


Project A

Project B


Step 4 5 calculate npv
Step 4 & 5: Calculate NPV

Project A

Project B

Present value with 4%

= 88,979 – 90,000

= -1021

Present value with 2%

=94,694 – 90,000

= 4694

Present value with 28%

= 62,920 – 70,000

= -7080

Present value with 23%

= 71020 – 70000

= 1020


Step 6 apply the formula
Step 6: Apply The Formula

Project A

Project B

IRR= 2%+2% 4694

4694 + 1021

=2%+2% 4694

5715

= 2% + 2% ( 0.8213)

= 2% + 1.64%

= 3.64%

IRR = 23%+5% 1020

1020 + 7080

=23%+5% 1020

8100

= 23%+5% (0.125925)

= 23% + 0.63%

= 23.62%


Profitability index
Profitability Index

Project A

Project B

PI = Net Present Value

Initial Investment

= 70,474

90,000

= 0.78

PI = Net Present Value

Initial Investment

= 95,635

70,000

= 1.36


Conclusion
Conclusion

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



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