CAPITAL BUDGETING

Financial Management

By- Tanya Sanjeev Joseph

20020033
C A P I TA L B U D G E T I N G I S A P L A N N I N G P R O C E S S T H AT D E T E R M I N E S
W H E T H E R A C O M PA N Y ' S L O N G - T E R M I N V E S T M E N T S , S U C H A S N E W
M AC H I N E RY, R E P L AC E M E N T M AC H I N E RY, N E W FAC I L I T I E S , N E W
PRODUCTS, AND RESEARCH AND DEVELOPMENT PROJECTS, ARE
WO RT H T H E C O M PA N Y ' S C A P I TA L I Z AT I O N S T RU C T U R E F U N D I N G
( D E B T , E Q U I T Y O R R E TA I N E D E A R N I N G S ) .
 Create and establish long-
term strategic objectives

WHY IS CAPITAL
BUDGETING Seek out new investment
IMPORTANT? projects

Estimate and forecast future

cash flows and facilitate
information transfer.
 Identifying investment
opportunities

Evaluating investment
CAPITAL proposals
BUDGETING
PROCESS Choosing a profitable
investment

Capital Budgeting and

Apportionment

Performance Review
 Net Present Value (NPV) Internal Rate of Return
(IRR)

METHODS AND
IMPLEMENTATION Payback Period Discounted Payback
Period

Average Accounting Rate of Profitability Index (PI)

Return (AAR)
 NET PRESENT VALUE (NPV)

Net present value is a widely used method of capital budgeting that determines costs. Firms should always
ensure that their rate of return of their investment is always higher than their cost of capital and the premium
that they place on the risk of the investment.This concept is known as the hurdle rate.

𝑅𝑡 𝑅𝑡 =Net cash inflow- outflows during a single period “t”

NPV= i =Discount rate or return that could be earned in
(1+𝑖)𝑡 alternative investments
t =Number of timer periods

Decision Rule: If a project's NPV is zero, accept it only if it has a positive NPV, reject it if it has a negative NPV, and keep
indifferent between accepting and rejecting if it has a negative NPV. Accept the project with the larger NPV in the case of
mutually exclusive projects (i.e., competing projects).
 INTERNAL RATE OF RETURN (IRR)

Internal rate of return (IRR) is a sophisticated capital planning technique. The internal rate of return is the
discount or interest rate that brings an investment's income stream to a halt. An investment's revenue
stream is computed by aggregating the project's total cash flows. The initial cash outflow is negative, but
the interest, or benefits, received each year is positive.

𝑁𝑃𝑉 𝑜𝑓 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒

Lower Interest Rate+ x (Higher rate – lower rate)
𝑁𝑃𝑉 𝑜𝑓 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 − 𝑁𝑃𝑉 𝑜𝑓 ℎ𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒

Decision Rule : Only accept a project if its internal rate of return is greater than the target internal rate of return.
When two or more mutually exclusive projects are compared, the project with the highest IRR value should be
chosen.
 PAYBACK PERIOD

The simplest technique of capital planning is the payback period.The primary assumption of this strategy is to
figure out how long it will take to repay the money spent on a capital project or equipment purchase. Payback
period does not account for the time worth of money, and so may not accurately reflect the full picture when
evaluating a project's cash flows. Because the payback time focuses on short-term profit, a worthwhile project
may be disregarded if the payback period is the only factor considered.

𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑙𝑎𝑦𝑠 (𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)

Payback Period = 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠

Decision Rule: Accept the project only if it has a shorter payback term than the target payback period.
 DISCOUNTED PAYBACK PERIOD

This method was created to address the drawbacks of the payback period method. When saving is not flat, it is preferable to
compute the payback period using the present value of cash inflows. The discounted payback method aids in calculating the
present value of all cash inflows and outflows at a suitable discount rate. The discounted pay-back period is the time period
during which the total present value of cash inflows equals the total present value of cash outflows.
𝐵
Discounted Pay-back period = A +
𝐶
A= last period with a negative discounted cumulative cash flow
B= Absolute value of discounted cumulative cash flow end of period A
C= Discounted cash flow during the period after A

Decision Rule: Accept the project if the discounted payback term is smaller than the goal term.
 AVERAGE ACCOUNTING RATE OF
RETURN (AAR)

During the life of the project, AAR is determined using average net income and average book value. The AAR
also ignores the time value of money, and there is no theoretically coherent cutoff for the AAR that divides
lucrative from unprofitable ventures.

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

Average Rate of Return = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒

Decision Rule: Accept the project only if the ARR matches or exceeds the statutory accounting rate of return.
Accept the project with the highest ARR if two projects are mutually exclusive.
 PROFITABILITY INDEX (PI)

The profitability index (PI) is calculated by dividing the present value of future cash flows by the initial
investment. The NPV and PI are inextricably linked. The PI is the ratio of future cash flow PV to initial
investment, whereas the NPV represents the difference between future cash flow PV and initial investment. The
PI will be more than 1.0 if the NPV is positive, and less than 1.0 when the NPV is negative.
𝑃𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠
PI = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑁𝑃𝑉
= 1 + 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Decision Rule : Accept a project if the profitability index is greater than 1, ignore it if the profitability index is
zero, and reject it if the profitability index is less than one. Profitability index, also known as benefit-cost ratio, is
useful in capital rationing because it allows projects to be ranked according to their per-dollar return.
 CONCLUSION

The Discounted Cash Flow Methods like NPV,

IRR and PI are all useful. Allow us to accept or
reject investment projects for capital
budgeting.
Our scope concentrated mostly on the
operating budget and less on the capital
budget due to the complexity and numerous
challenges associated to the operating
budget.
Given the challenges of construction
funding, planning, and management, the
general process of producing requests and
allocating monies for capital projects
appears to work well.
THANK YOU