Capital Budgeting

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Capital Budgeting
Investment decision or capital expenditure decision are known as capital budgeting decision.

A capital budgeting decision can be defined as firms decision to invest its current funds most efficiently in the long term assets in application of an expected flow of benefit over a series of years.
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Types of investment decision

Investment usually include: Expansion Acquisition Modernization

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Importance of investment decision

Growth Risk Funding Irreversibility Complexity

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Steps involved in evaluation of investment

Estimation of cash flow Estimation of required rate of return Application of decision rule for making the choice. Note: decision rules may be referred to as capital budgeting technique.
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Capital budgeting technique

1. 2. 3. 1. 2. Discounted cash flow (DCF) technique: Net present value (NPV) Internal rate of return (IRR) Profitability Index Or Benefit cost ratio Non-discounted cash flow technique: Payback method Accounting rate of return (ARR) method
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Net present value method

Cash flow of investment project should be forecasted on realistic assumptions. Appropriate discounting rate/opportunity cost of capital should be identified NPV can be can be calculated by subtracting cash inflow and outflow.

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Properties of NPV
If there are two projects A & B then NPV of combined investment is :

NPV(A+B) = NPV(A) + NPV(B)

The value of firm can be expressed as the sum of present value of projects in place as well as the net present value of prospective projects. When a firm terminates an existing project which has ve NPV based on its expected future cash flow the value of the firm increases by that amount.
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NPV Acceptance Rule

NPV > 0, Accept NPV < 0, Reject NPV = 0, May accept

Limitations
1. NPV is expressed in absolute term not in relative term. 2. It does not consider the life of the project.
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Internal rate of return

Internal rate of return of a project is discount rate which makes its NPV equals to ZERO Internal Rate of Return can be defined as that rate which equates investment outlays with present value of inflow received certain period. Acceptance Rule If IRR > Cost of capital, accept the project. If IRR < Cost of capital, reject the project.
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Profitability Index
It is otherwise known as benefit-cost (B/C) ratio . Profitability index(PI) is equal to: PV of cash inflow Initial cash out lay

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Acceptance rule for profitability index(PI)

If PI > 1, Accept If PI < 1, Reject If PI = 1, May accept

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Non-Discounted cash flow technique

Payback Method
It is the length of time required to recover the initial cash outlay on the project.

Acceptance Rule
If the payback period calculated for a project is less than maximum or standard payback period set by management, it would be accepted. If not it would rejected.
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Advantages of payback method

It is simple both in concept and application. It is rough and ready method of dealing with risk. It is cost effective.

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Disadvantages of payback method

It does not take into consideration the cash flow after the payback period.
It ignores time value of money. It is measure of projects capital recovery not the profit.

It does not include liquidity position of the firm as a whole.

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Accounting Rate of Return

It is also known as average rate of return. ARR is the ratio between avg income and average investment. Avg. income Avg. investment Or Profit after tax Book value of investment
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Acceptance rule
This method will accept all those projects whose ARR is higher than minimum rate established by management. Advantages of ARR It is simple to calculate. It is based on accounting information which is readily available. It consider the benefit of entire life of project.
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Disadvantages of ARR
It is based on accounting profit, not cash flow. It does not consider the time value of money.

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