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Capital Budgeting�

what long-term investments should the firm make?
decisions where :

(1) there is commitment of large funds at present while

(2) benefits expected from the decision are to accrue over a long

period of time.

What are some examples of capital budgeting decisions?
There are some popular investment tools : NPV, IRR, Payback ratio, AAR

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Payback Period

How long does it take to get the initial cost back in a nominal sense?
Computation

Estimate the cash flows
Subtract the future cash flows from the initial cost until the initial investment has been recovered

Decision Rule – Accept if the payback period is less than some preset limit

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Assume we will accept the project if it pays back within two years.

Year 1: 165,000 – 63,120 = 101,880 still to recover
Year 2: 101,880 – 70,800 = 31,080 still to recover
Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3

Do we accept or reject the project?

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Discounted Payback

Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis
Compare to a specified required period
Decision Rule - Accept the project if it pays back on a discounted basis within the specified time

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Net Present Value (NPV) Analysis

How much value is created from undertaking an investment?

The first step is to estimate the expected future cash flows.
The second step is to estimate the required return for projects of this risk level.
The third step is to find the present value of the cash flows and subtract the initial investment.

If the NPV is positive, accept the project

A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.
Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

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Internal Rate of Return (IRR)

This is the most important alternative to NPV
It is often used in practice and is intuitively appealing
It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere
Definition: IRR is the return that makes the NPV = 0
Decision Rule: Accept the project if the IRR is greater than the required return

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NPV vs IRR

NPV directly measures the increase in value to the firm
Whenever there is a conflict between NPV and another decision rule, you should always use NPV
IRR is unreliable in the following situations

Nonconventional cash flows
Mutually exclusive projects

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IRR and Nonconventional �Cash Flows

When the cash flows change sign more than once, there is more than one IRR
When you solve for IRR you are solving for the root of an equation, and when you cross the x-axis more than once, there will be more than one return that solves the equation
If you have more than one IRR, which one do you use to make your decision?

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Example – Nonconventional Cash Flows

Suppose an investment will cost $90,000 initially and will generate the following cash flows:

Year 1: 132,000
Year 2: 100,000
Year 3: -150,000

The required return is 15%.
Should we accept or reject the project?

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NPV = – 90,000 + 132,000 / 1.15 + 100,000 / (1.15)² – 150,000 / (1.15)³ = 1,769.54

Calculator: CF₀ = -90,000; C01 = 132,000; F01 = 1; C02 = 100,000; F02 = 1; C03 = -150,000; F03 = 1; I = 15; CPT NPV = 1769.54

If you compute the IRR on the calculator, you get 10.11% because it is the first one that you come to. So, if you just blindly use the calculator without recognizing the uneven cash flows, NPV would say to accept and IRR would say to reject.

Another type of nonconventional cash flow involves a “financing” project, where there is a positive cash flow followed by a series of negative cash flows. This is the opposite of an “investing” project. In this case, our decision rule reverses, and we accept a project if the IRR is less than the cost of capital, since we are borrowing at a lower rate.

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The NPV is positive at a required return of 15%, so you should Accept
If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject
You need to recognize that there are non-conventional cash flows and look at the NPV profile

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IRR and Mutually Exclusive Projects

Mutually exclusive projects

If you choose one, you can’t choose the other
Example: You can choose to attend graduate school at either Harvard or Stanford, but not both

Intuitively, you would use the following decision rules:

NPV – choose the project with the higher NPV
IRR – choose the project with the higher IRR

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Capital Budgeting in Islamic Perspective

In an Islamic framework the concern is now two-fold.

(1)like in conventional finance, one must identify the investments or

projects that not only create but maximize value and hence wealth

of the shareholders.

(2)the investments must not only be acceptable in Shariah, but seek

to achieve highest possible levels of Islamic ethics.

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Capital Budgeting in Islamic Perspective

If Islam condemns riba, hence zero interest rate, then should there be zero discount rate?

Answer: It depends on what we use as discount rate! The idea is it is n opportunity cost. So as long as it is not interest on debt, the concept is fine

What about “compound interest tables”?

It just shows the periodic growth of certain sums.

Discounting can be used as an evaluation tool, but not as a consideration tool.

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Remember time value of money:

2000 today is better than 2000 after a year because the 2000 today can be utililized and get 500 in a year. This is permissible in Islam.
What is prohibited is if one prefers 2000 a year later because guaranteed profit of 2000. so 500 is a consideration against 2000 .

What about discounting?

It is treated in the same way. If discounting is being used as an evaluation tool then Islam allows it. If discounting is taken as consideration then it would be haram in Islamic perspective.
So discounting to evaluate the projects for comparison and to make a decision regarding accepting or rejecting the project is permissible. But discounting the bills e.g. bill of exchange is prohibited because discounting is taken as a consideration which is Riba.

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If we accept time value of money and discounting as an evaluation concept , then we also accept the NPV and IRR as an evaluation tool for investments, with a few adjustments:

The rates of compounding (and discounting) for cash inflows are

their respective reinvestment rates. If reinvestment rare is zero for a given period, the corresponding cash inflow would be compounded at zero rate.

2. The rate of compounding (and discounting) for cash outflows is the cost of capital.

3. cost of capital is not same as rate of interest, but cost of permissible sources of funding, such as, equity

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The discount rate is under the assumption that there is another investment opportunity that exists. But sometimes there are situations when discounting cannot be used such as:
No other investment opportunity exists
when the output of a proposed investment is not conceptually exchangeable into investable resources. Example by Zarqa(1988):

• a mosque where the number of people attending or praying is one measure of output,

• a health unit whose output is the number of people relieved from a certain pain,

• a road improvement to reduce fatal accidents (i.e. save so many lives per year).

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