This action might not be possible to undo. Are you sure you want to continue?

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 .

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

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

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 .

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.Due to the above factors. RJR Nabisco’s smokeless cigarette project example Similarly. while Intel became global leader due to sound capital budgeting decisions in 1990s. Euro-Disney. . Concorde Plane. Saturn of GM all faced problems due to bad capital budgeting. capital budgeting decisions become critical and must be evaluated very carefully.

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. but suffers from drawbacks Technique is not consistent with wealth maximization—Why? . keep adding the cash flows till the sum equals initial investment Simplicity is the main benefit.

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 maximization—Why? Accept a project if NPV ≥ 0 .

. I.Internal Rate of Return The rate at which the net present value of cash flows of a project is zero. the rate at which the present value of cash inflows equals initial investment Project’s promised rate of return given initial investment and cash flows Consistent with wealth maximization Accept a project if IRR ≥ Cost of Capital .e.

NPV versus IRR Usually. use NPV approach . 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 sign—problem of multiple IRR If IRR and NPV conflict.

use NPV . 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.Profitability Index (PI) A part of discounted cash flow family PI = PV of Cash Inflows/initial investment Accept a project if PI ≥ 1. which means positive NPV Usually.0.

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

Sign up to vote on this title

UsefulNot useful- Capital Budgeting
- BIMIT (S.RANA)
- capitalbudgeting-slide16
- Capital Budgeting-Deepa
- PK10 Notes
- Capital Budgeting (5)
- CAPITAL+BUDGETING
- Capital Budgeting
- Capital Budgeting
- Capital Budgeting Techniques
- Capital Budgeting
- For Ibf Capt. Budgeting
- MANAGERIAL ECONOMICS - VI
- Capital Budgeting Techniques
- Capital Budgeting Technique (1)
- Capital Budgeting
- 33 - 11. Unit 10 (Solved)
- Chapter_21_s.v
- Jay's Portion of Mini Case
- Review Materials on Capital Budgeting
- Capital Budgeting ani
- Capital Budgeting (1)
- Financial Management - Chapter 11
- CH 10 Mini Case (Final)(1)
- CB
- MBALN-622
- Lecture 5 Capital Budgeting Stu
- Hansen Aise Im Ch13
- Financial Management
- NPV and IRR
- Capital Budgeting

Are you sure?

This action might not be possible to undo. Are you sure you want to continue?

We've moved you to where you read on your other device.

Get the full title to continue

Get the full title to continue reading from where you left off, or restart the preview.

scribd