Capital Budgeting Techniques and Applications

This assignment delves into the realm of capital budgeting, examining a diverse range of techniques used to evaluate investment opportunities. It encompasses discussions on Net Present Value (NPV), Internal Rate of Return (IRR), and other methods, highlighting their strengths, limitations, and practical applications in real-world scenarios.

Running Head: Stock Valuation and Capital Budgeting Techniques
Financial Studies

Stock Valuation and Capital Budgeting Techniques 1
QUESTION 1
Part A:
Current Year Dividend 20p
Earliest Year Dividend 13p
Latest Year Dividend 20p
Growth Rate 9.00%
Cost Of Equity 14.5%
Share Price (£) 32.71
Growth rate is calculated using excel:
Formula:
(End Value/Start Value) ^ (1/Periods) -1
Share price is to be calculated using the Gordon’s model in excel:
Fair price of the share= D1
Ke- g
Part B:
If the cost of equity is changed to 15.4% from 14.5%, the new fair price of the share will be as
follows:
As per Dividend discount Model:
Growth Rate 9%
Cost Of Equity 15.4%
Share Price (£) 28.11

Stock Valuation and Capital Budgeting Techniques 2
Part C:
Dividend Growth Model or Dividend Discount Model is the financial model used to determine
the value of firm’s stock. Stock valuation is required to be undertaken to estimate the value of the
firm for various decision making purposes. The said model was developed by Sir Gordon and
hence it is also known as Gordon’s Model (Arnold, 2013). It uses dividend as the base to
measure the share prices and therefore it is also called as dividend discount model. Under this
model the stock valuation is done using the aggregate of present values of dividend payment that
are expected to be made by the company in all the years in future. The company’s stock is thus
priced on the basis of net present values of expected dividend payments. Though, the dividend
growth model proves to be very useful approach in stock valuation, it suffers some of the
limitations which often makes it unreasonable to be practically employed. These problems are
discussed as below:
 As while making stock valuation only dividend factor is considered under dividend
growth model, the other non-dividend factors are being ignored by this model. The non-
dividend factors like brand loyalty, tangible assets ownerships and customer retention
have direct or indirect influence on the firm’s value (Olweny, 2011).
 Moreover, dividend growth model also assumes that the firm’s dividend growth rate
remain constant and known as well (Hiebert & Sydow, 2011).
 Also, the Gordon’s growth model asserts that the share price of the company is
hypersensitive to the chosen growth rate of dividend and the dividend growth rate in any
case cannot be greater than the cost of equity which does not hold true in every situation.
 There is difficulty in making the appropriate projections regarding the dividend payments
to be made by the company (Lazzati & Menichini, 2015).
 While the dividend discount model can be used effectively in the cases where firm
distributes its profits as dividend, the same model is unsuitable to the companies paying
no dividend.
 Further, the price appreciation of shares contributing to capital gains is also ignored under
this model.
 Another problem with the dividend growth model is the use of several flawed
assumptions. Even the slightest error in the assumptions and projections can lead to under
or overvaluation of the company’s stock.

Stock Valuation and Capital Budgeting Techniques 3
 It is also argued that the dividend growth rate model also ignores the stock buyback
effects whereas these effects can bring vast differences in the stock valuation. This
indicates that the model is being over conservative in its approach of estimation of stock
prices.
Therefore, it can be concluded that even when dividend growth model proves to be a reliable
method, there are some problems that are generally faced in its practical implementation.
QUESTION 3
Part 1:
a) PAYBACK PERIOD
Discounted payback period:
YEAR CASH FLOWS CASH FLOWS
DCF
@12%
PRESENT VALUES OF
CASHFLOWS
CUMULATIVE
PRESENT
VALUES OF
CASH FLOWS
0 Initial Investment -£ 275,000.00 1 -£ 275,000.00 -£275,000.00
1 Cash Inflows £ 72,500.00 0.893 £ 64,732.14 -£2,10,267.86
2 Cash Inflows £ 72,500.00 0.797 £ 57,796.56 -£1,52,471.30
3 Cash Inflows £ 72,500.00 0.712 £ 51,604.07 -£1,00,867.23
4 Cash Inflows £ 72,500.00 0.636 £ 46,075.06 -£ 54,792.17
5 Cash Inflows £ 72,500.00 0.567 £ 41,138.45 -£ 13,653.73
6 Cash Inflows £ 72,500.00 0.507 £ 36,730.76 £ 23,077.03
6
Salvage Value
Inflow £ 41,250.00 0.507 £ 20,898.53 £ 43,975.56
Payback period= 5 + (-13,653.73)
36,730.6
= 5.37 Years
Note: since the cost of capital is given in the question it is more preferable to calculate the
discounted payback period in place of normal payback period as it would offer more appropriate
payback period.

Stock Valuation and Capital Budgeting Techniques 4
Analysis: The payback period of 5.37 years is quite large and it indicates that the project will
take maximum time to cover its cost and only thereafter it will start to generate returns. So the
company must not consider the option of investing in the new machinery.
b) ACCOUNTING RATE OF RETURN
ARR = Average net income after depreciation and taxes
Average investment
= £ 33,542
£156,979
= 21.37% p.a.
The average accounting rate of return of the company is 21.37% p.a.
Analysis: Since the ARR is greater than the given cost of capital of the firm (assumed to be the
cut off rate). It must be accepted.
Working notes:
 As ARR is calculated on the basis of net earnings of the company, the depreciation
element has to be reduced from the actual cash flows to reach at the annual earnings of
the company.
 Depreciation per annum as per Straight Line Method:
= Cost of the asset- Residual value
Useful life of asset
= £ 275,000 - £ 41,250
6
= £ 38,958 per annum (rounded off)
 Earnings After Depreciation And Taxes (per year)
Cash Inflows £ 85,000
Less: Cash Outflows £ 12,500

Stock Valuation and Capital Budgeting Techniques 5
Less: Depreciation £ 38,958
Net Earnings After Depreciation £ 33,542
 Average Investment = Salvage Value + (Initial Investment- Salvage Value)/2
= £41,250 + (£ 275,000 - £ 41,250) /2
= £ 156,979
Note: Since earnings after depreciation and taxes are equal in all the years, per year earning
will be equal to the average of total net earnings after depreciation.
c) NET PRESENT VALUE
NPV CALCULATION TABLE:
YEAR CASH FLOWS CASH FLOWS DCF PV OF CASHFLOWS
0 INITIAL INVESTMENT -£ 275,000 1 -£ 275,000
1 CASH INFLOWS £ 72,500 0.893 £ 64,732.14
2 CASH INFLOWS £ 72,500 0.797 £ 57,796.56
3 CASH INFLOWS £ 72,500 0.712 £ 51,604.07
4 CASH INFLOWS £ 72,500 0.636 £ 46,075.06
5 CASH INFLOWS £ 72,500 0.567 £ 41,138.45
6 CASH INFLOWS £ 72,500 0.507 £ 36,730.76
6 SALVAGE VALUE £ 41,250 .507 £ 20,898.53
NPV £ 43,975.56
Note: Since the tax rate is not given in the question no impact of depreciation is given in the
above table as there is no outflow of depreciation expense.
The Net Present value of the company is £ 43,975.56.
Analysis: project plans with the higher and positive NPVs should be selected. Since in the
present case only one investment proposal is to be evaluate it must be accepted since the net
present value of the Lovewell Limited is positive. The decision of investing in the new
machinery would lead to the profitability by creating value for the firm.

Stock Valuation and Capital Budgeting Techniques 6
d) INTERNAL RATE OF RETURN
YEA
R PARTICULARS CASH FLOWS
DCF
@12%
PV OF
CASHFLOWS
DCF
@17%
PV OF
CASHFLOWS
DCF
@18%
PV OF
CASHFLOWS
0
Initial
Investment -£ 2,75,000.00 1 -£ 2,75,000.00 1.00 -£ 2,75,000.00 1 -£ 2,75,000.00
1 Cash Inflows £ 72,500.00 0.893 £ 64,732.14 0.855 £ 61,965.81 0.847 £ 61,440.68
2 Cash Inflows £ 72,500.00 0.797 £ 57,796.56 0.731 £ 52,962.23 0.718 £ 52,068.37
3 Cash Inflows £ 72,500.00 0.712 £ 51,604.07 0.624 £ 45,266.87 0.609 £ 44,125.74
4 Cash Inflows £ 72,500.00 0.636 £ 46,075.06 0.534 £ 38,689.63 0.516 £ 37,394.69
5 Cash Inflows £ 72,500.00 0.567 £ 41,138.45 0.456 £ 33,068.06 0.437 £ 31,690.42
6 Cash Inflows £ 72,500.00 0.507 £ 36,730.76 0.390 £ 28,263.30 0.370 £ 26,856.29
6
Salvage Value
Inflow £ 41,250.00 0.507 £ 20,898.53 0.390 £ 16,080.84 0.370 £ 15,280.30
NPV £ 43,975.56 £ 1,296.74 -£ 6,143.51
IRR FORMULA
=0.17+ 1296.74 x (0.18-0.17) = 17.17% p.a.
1296.74-(-6143.51)
=LOWER RATE + NPV AT LOWER RATE x (UPPER RATE – LOWER RATE)
NPV AT LOWER RATE- NPV AT UPPER RATE

Stock Valuation and Capital Budgeting Techniques 7
Part 2
Capital appraisal techniques are the financial techniques used to evaluate the appropriateness of
the capital expenditure or investment made by a firm (Ahmed, 2013). As capital expenditures
involves huge amount of company’s firm it is necessary to measure the risk and returns
associated with all the alternative investments plans so as to select the best suitable option which
generates higher returns for long run with acceptably low level risk. Capital appraisal techniques
are therefore considered as the most important tools while making capital budgeting decisions
(Jordan, 2014). As it involves the deployment of significant portion of company’s funds, it is
necessary to critically study and examine every alternative plan (Chai, 2011). All the capital
investment appraisal techniques uses different basis to identify the project or capital expenditure
worth. These techniques provides the business managers with the necessary and reliable
information that aids them in their decision making process regarding the capital investments to
be made in possible investments (Baker & English, 2011). Since all the techniques provides
different outputs and based on such outputs decisions are made by the managers, it is necessary
for them to understand the strengths and limitations of those capital budgeting techniques. The
detailed study of those techniques is given below:
a) Payback period:
Payback period is the technique used in capital budgeting in determining the time in which the
project will recover all the invested funds and start generating the expected returns from the
investments. It is usually measured in terms of years (Ghahremani, Aghaie & Abedzadeh, 2012).
When a business manager has to select one amongst two or more projects on the basis of
payback period, the project with shortest payback period will be selected. Many firms have their
predetermined maximum acceptable payback term. If the project is estimated to exceed that
maximum term in recovering its initial outlays, it is not accepted by the firm. Following are the
benefits and limitations of payback technique:

Stock Valuation and Capital Budgeting Techniques 8
Benefits:
 This method is very popular capital budgeting technique due to its simplicity. The
concept of payback period is easily understandable to the users.
 It is universally accepted for making capital budgeting decisions
 Payback method gives more emphasis to the liquidity while making decisions regarding
investment proposals (Daunfeldt & Hartwig, 2014).
 The short term perspective of payback period method is an added strength of this method
in evaluation of suitability of any capital expenditure.
 Moreover, payback period technique deals with the risks associated with the projects. It
implies the project with least payback period is less risky than the project having longer
payback period.
Limitations:
 Time value of money is ignored under this method in the calculation of payback period
which makes it unreliable in certain situations.
 The profitability factor is not given consideration whereas it highly focuses on the
liquidity aspect of an investment proposal.
 Payback technique only takes into account the cash flows prior to the payback period and
does not consider the cash flows inflows and outflows that arises after payback period.
 Salvage value of long term capital asset in not considered under this method. It also
ignores the cost of capital as one of the important factor which affects the investment
proposals selection (Burns & Walker, 2015).
b) Accounting Rate of Return:
 This technique of capital budgeting is used to determine the return that is generated from
the net income of the capital investment that is proposed to be undertaken. This rate of
return is also known as average rate of return. It measures the amount of return a firm can
expect from the proposed investment (Magni, 2010). This method is sometimes called as
financial statement method as it uses the accounting rate of return. Like all the other

Stock Valuation and Capital Budgeting Techniques 9
capital investment appraisal techniques accounting rate of return method also has its own
strengths and limitations which are described as below:
Benefits:
 This technique considers the earnings from the project investment over its entire life.
 ARR method is also easily understandable and also it is quite simplified to be followed
by the project managers (DeFusco et al., N.D.).
 As accounting rate of return is based on the accounting information, this method does not
require the use of special reports to determine ARR.
 As this technique is highly focused on the accounting profit, it helps the business
managers to measure the project profitability.
Limitations:
 This method also proves to be unreasonable in certain situations due to the ignorance of
time value of money under it.
 As ARR method uses the earnings to determine the rate of return, it does not take into
consideration the cash flows of any particular project.
 It is also criticized because it does not consider the project’s terminal value.
 Also, this technique cannot be used in the situations where a portion of capital investment
is to be made after the commencement of project.
 It also ignores the shrinkage of the original investment as it charges depreciation against
the project’s earnings (Maroyi & Poll, 2012).
c) Net present value
Net present value is the method used in identifying the appropriateness of the investment
decision. It takes into account all the possible cash outflows and inflows to determine the net
amount of cash flows of the company (Arshad, 2012). Once the possible cash flows are
estimated, the present values of those cash flows is calculated using the discounting rate
(Hanafizadeh & Latif, 2011). All the present values of net cash flows are then aggregated to
measure the net present value of any project. Following are the benefits and limitations of Net
Present Value Method:
Benefits:

Stock Valuation and Capital Budgeting Techniques 10
 The most obvious benefit of net present value method is that it gives effect to the basic
concept of time value of money i.e. the value of a dollar in future will be less than it’s
worth today (Schutt et al., 2012).
 This method helps the investors to identify whether the investment in a particular plan
will create will value or not, for the firm along with the quantum of such value creation.
Therefore it helps the managers in maximizing the value of a firm over a period of time
(Holopainen et al., 2010).
 Another strength of net present value method is that it duly considers the project’s cost of
capital and also the inherent risk associated with the making of future projections
(Pasqual, Padilla & Jadotte, 2013).
 This technique gives highest preference to the consideration of profitability and risk
factor of any investment plan in making the project selection.
Limitations:
 The practical implementation of net present value method is difficult as it involves
calculation of appropriate cost of capital of investment to ascertain the present values of
the cash inflows and outflows of a firm (Shinoda, 2010).
 It does not provide the accurate decision in the cases of unequal amounts invested in the
mutually exclusive projects.
 Even when the projects have different project life, this method proves to be inefficient in
providing the correct decision making information to the business managers for the
selection of one best suited project plan (Galperin, Fishman & Gibiansky, 2012).
d) Internal rate of return:
This technique is commonly used while making the decisions regarding capital
investments. It determines the profitability of the proposed investment. IRR is the rate
that equates the present values of cash inflows with that of cash outflows (Bierman &
Smidt, 2012). This is therefore the rate at which the net present value of the particular
project is zero. This technique also carries some benefits and limitations which are
mentioned below:
Benefits:

Stock Valuation and Capital Budgeting Techniques 11
 This technique considers the time value of money and hence it can be relied upon under
various situations.
 It also considers the profitability of the investment proposal over its economic life.
 This technique helps the business managers to meet the objective of maximizing their
welfare.
IRR technique provides the sophisticated and reliable method to evaluate the capital
investment proposals (Wiesemann, Kuhn & Rustem, 2010).
 This method is considered as most effective method as it offers uniform ranking. Along
with the ranking IRR also provides for quick comparisons of the relative efficiency of the
potential projects.
Limitations:
 The discounting of the cash flows using the cost of capital and other rates is quite
difficult to be undertaken as it involves complex calculations.
 The internal rate of return can be negative or sometimes one or multiple rates are also
offered under this method when the project has a series of changes in the signs of cash
flows. This feature makes it difficult to interpret the results.
 IRR method relies on the assumption that the project incomes are compounded
(reinvested) over the entire economic life of the project at the rate of return earned on the
investments. However, this assumption does not hold true in every situation. Rather, the
appropriateness of this assumption can only be illustrated in the situation when IRR is
close enough to the average rate of return generated on the total investments. In the cases
where IRR departs from the company’s typical rate of earnings, the results delivered by
the IRR technique would be misleading (Bennouna, Meredith & Marchant, 2010).
Apart from the above discussed capital appraisal techniques there are various other techniques
also that are commonly used in capital budgeting desion making. Those techniques are
profitability index method, modified internal rate of return, adjusted present value, equivalent
annuity discounted pay-back period method etc. But, from the above analysis it can be concluded
that each of the capital appraisal techniques has its own pros and cons. Though, the capital
budgeting techniques are useful enough in the decision making regarding the capital investments
to be made by the company to achieve higher returns, each of them suffers from some or the

Stock Valuation and Capital Budgeting Techniques 12
other limitations. Since, it is important for the project managers to critically analyze the
appropriateness of the project before investing the funds of the firm, the employment of most
appropriate ( best suitable and reasonable) capital investment appraisal method from the entire
set of given techniques is necessary. The selection of the suitable technique may require number
of factors to be considered.

Stock Valuation and Capital Budgeting Techniques 13

Stock Valuation and Capital Budgeting Techniques 14
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investment analysis.

Stock Valuation and Capital Budgeting Techniques 15
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Stock Valuation and Capital Budgeting Techniques 16
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