Capital Budgeting Analysis

Financial Policy and Planning

MB 29

Outline
Meaning of Capital Budgeting
Significance of Capital Budgeting Analysis
Traditional Capital Budgeting Techniques
Payback Period Approach
Discounted Payback Period Approach
Discounted Cash Flow Techniques

Net Present Value

Internal Rate of Return
Profitability Index
Net Present Value versus Internal Rate of Return

Meaning of Capital Budgeting

Capital budgeting addresses the issue of
strategic long-term investment decisions.
Capital budgeting can be defined as the
process of analyzing, evaluating, and
deciding whether resources should be
allocated to a project or not.
Process of capital budgeting ensure
optimal allocation of resources and helps
management work towards the goal of
shareholder wealth maximization.

Significance of Capital
Budgeting

Considered to be the most

important decision that a
corporate treasurer has to make.
So much is the significance of
capital budgeting that many
business schools offer a separate
course on capital budgeting

Why Capital Budgeting is so

Important?

Involve massive investment of

resources
Are not easily reversible
Have long-term implications for
the firm
Involve uncertainty and risk for
the firm

Due to the above factors, capital budgeting

decisions become critical and must be evaluated
very carefully.
Any firm that does not follow the capital
budgeting process will not be maximizing
shareholder wealth and
management will not be acting in the best
interests of shareholders.
RJR Nabiscos smokeless cigarette project example
Similarly, Euro-Disney, Concorde Plane, Saturn of
GM all faced problems due to bad capital
budgeting, while Intel became global leader due
to sound capital budgeting decisions in 1990s.

Techniques of Capital Budgeting

Analysis
Payback Period Approach
Discounted Payback Period
Approach
Net Present Value Approach
Internal Rate of Return
Profitability Index

Which Technique should we

follow?

A technique that helps us in selecting

projects that are consistent with the principle
of shareholder wealth maximization.
A technique is considered consistent with
wealth maximization if
It is based on cash flows
Considers all the cash flows
Considers time value of money
Is unbiased in selecting projects

Payback Period Approach

The amount of time needed to recover the
initial investment
The number of years it takes including a
fraction of the year to recover initial investment
is called payback period
To compute payback period, keep adding the
cash flows till the sum equals initial investment
Simplicity is the main benefit, but suffers from
drawbacks
Technique is not consistent with wealth
maximizationWhy?

Discounted Payback Period

Similar to payback period approach with one
difference that it considers time value of
money
The amount of time needed to recover initial
investment given the present value of cash
inflows
Keep adding the discounted cash flows till the
sum equals initial investment
All other drawbacks of the payback period
remains in this approach
Not consistent with wealth maximization

Net Present Value Approach

Based on the dollar amount of cash flows
The dollar amount of value added by a
project
NPV equals the present value of cash
inflows minus initial investment
Technique is consistent with the principle
of wealth maximizationWhy?
Accept a project if NPV 0

Internal Rate of Return

The rate at which the net present value of
cash flows of a project is zero, I.e., the
rate at which the present value of cash
inflows equals initial investment
Projects promised rate of return given
initial investment and cash flows
Consistent with wealth maximization
Accept a project if IRR Cost of Capital

NPV versus IRR

Usually, NPV and IRR are consistent with
each other. If IRR says accept the project,
NPV will also say accept the project
IRR can be in conflict with NPV if
Investing or Financing Decisions
Projects are mutually exclusive
Projects differ in scale of investment
Cash flow patterns of projects is different

If cash flows alternate in signproblem of

multiple IRR

If IRR and NPV conflict, use NPV approach

Profitability Index (PI)

A part of discounted cash flow family
PI = PV of Cash Inflows/initial investment
Accept a project if PI 1.0, which means
positive NPV
Usually, PI consistent with NPV
PI may be in conflict with NPV if
Projects are mutually exclusive
Scale of projects differ
Pattern of cash flows of projects is different

When in conflict with NPV, use NPV

Evaluating Projects with

Unequal Lives

Replacement Chain Analysis

Equivalent Annual Cost Method
If two machines are unequal in life,
we need to make adjustment
before computing NPV.

Which technique is superior?

Although our decision should be based on NPV,
but each technique contributes in its own way.
Payback period is a rough measure of
riskiness. The longer the payback period,
more risky a project is
IRR is a measure of safety margin in a project.
Higher IRR means more safety margin in the
projects estimated cash flows
PI is a measure of cost-benefit analysis. How
much NPV for every dollar of initial investment