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Capital Budgeting Process
Evaluation of Capital budgeting project involves six steps: First, the cost of that particular project must be known. Second, estimates the expected cash out flows from the project, including residual value of the asset at the end of its useful life. Third, riskiness of the cash flows must be estimated. This requires information about the probability distribution of the cash outflows. Based on project’s riskiness, Management find outs the cost of capital at which the cash out flows should be discounted. Next determine the present value of expected cash flows. Finally, compare the present value of expected cash flows with the required outlay. If the present value of the cash flows is greater than the cost, the project should be taken. Otherwise, it should be rejected. OR If the expected rate of return on the project exceeds its cost of capital, that project is worth taking.




Capital Budgeting Techniques
Cash Flow
Success of any business can be determined through its capacity to generate positive cash flows. Therefore, Cash inflow and outflow is considered as one of the most essential elements which gives us as idea Continued on Page 2
Page # 2 about the continued existence of a business in future. It is a useful capital budgeting technique for grading projects because it measures the value created by per unit of investment made by the investor. where does business invest those funds for generating more. The statement of cash flow. Therefore. Profitability Index Profitability index (PI) is the ratio of investment to payoff of a suggested project. how does business generate funds and second. This technique is also known as profit investment ratio (PIR). Objectives of a cash flow statement: The main objective of a cash flow statement is to assist users: In assessing the business’s ability to generate positive cash flow In assessing business’s ability to bridge the gap between out flow and inflow of funds. therefore. In assessing its ability to meet its short and long term obligations In assessing the rationale of differences between reported and related cash flows In assessing the effect on finances of major projects during the year. the stakeholders focus on two things while investing in business: first. The ratio is calculated as follows: Profitability Index = Present Value of Future Cash Flows / Initial Investment . shows increase and decrease in cash and cash equivalents rather than working capital. benefitcost ratio and value investment ratio (VIR).
etc. Continued on Page 3 Page # 3 Thus the Profitability Index for a project with positive NPV is greater than 1 and less than 1 for a project with negative NPV. The regular payback period for this project is exactly 2 year. But the discounted payback period will be more than 2 years because the first 2 years cumulative discounted cash flow of $8695. inflation.66 is not sufficient to cover the initial investment of $10000. 1) Discounted Payback Period One of the limitations in using payback period is that it does not take into account the time value of money.If project has positive NPV. it shows the breakeven after covering such costs. will take to cover the initial cost of the project. the PV of future cash inflows are cumulated up to time they cover the initial cost of the project. $2000. This technique may be useful when available capital is limited and we can allocate funds to projects with the highest PIs. Decision Rule of Discounted Payback: . discounted at project’s cost of capital. However. Thus. Discounted payback period is generally higher than payback period because it is money you will get in the future and will be less valuable than money today. 2 and 3 respectively. then the PV of future cash flows must be higher than the initial investment. Discounted payback period is how long an investment’s cash flows. This technique is somewhat similar to payback period except that the expected future cash flows are discounted for computing payback period. The cost of capital is 15%. In this approach. the discounted payback period solves this problem. It considers the time value of money. and $1000 in year 1. For example. assume a company purchased a machine for $10000 which yields cash inflows of $8000. future cash inflows are not discounted or adjusted for debt/equity used to undertake the project . The discounted payback period is 3 years.
3) Payback Period Payback period is the first formal and basic capital budgeting technique used to assess the viability of the project. One of the project requires a higher initial investment than the second project.If discounted payback period is smaller than some predetermined number of years then an investment is worth undertaking. Continued on Page 4 Page # 4 2) Internal Rate of Return Internal Rate of Return is another important technique used in Capital Budgeting Analysis to access the viability of an investment proposal. Suppose we have to evaluate two mutually exclusive projects. the investment should be accepted or should be rejected otherwise. However this is not true in case of mutually exclusive projects. Decision Rule of Internal Rate of Return: If Internal Rate of Return exceeds the required rate of Return. but a higher NPV and should thus be accepted over the second project (assuming no capital rationing constraint). the first project may have a lower IRR value. It is defined as the time period required for the investment’s returns to cover its cost. Under such circumstances IRR can be misleading. IRR is “The Discount rate at which the costs of investment equal to the benefits of the investment. widely used by investors. IRR must exceed Cost of Capital. NPV and IRR methods will always result identical accept/reject decisions for independent projects. For example. an investment of $5000 which returns $1000 per year will have a five year payback period. therefore. Shorter payback periods are more desirable for . The reason is that whenever NPV is positive . Payback period is easy to apply and easy to understand technique. This is considered to be most important alternative to Net Present Value (NPV). Or in other words IRR is the Required Rate that equates the NPV of an investment zero. The problem with IRR come about when Cash Flows are nonconventional or when we are looking for two projects which are mutually exclusive.
It is considered as a method of analysis with serious limitations and qualifications for its use. risk and other important considerations such as opportunity cost. .the investors than longer payback periods. Because it does not properly account for the time value of money.
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