Capital Budgeting

Capital Budgeting
• Non current assets
• Decisions are not as repetitive
• Large magnitude
• Have strategic implications
• Not reversible
 New Project
Generating
Revenue
Expansion of
Decisions
existing products
Reducing Costs

Independent Projects
• If accepted or rejected, do not affect cash flows of other projects

Mutually Exclusive Projects

• If accepted, prevent the acceptance of other competing projects
Capital Budgeting process
1. Ideating and generating options
2. Collecting relevant information
1. Estimating the quantity and timing of cash flows
3. Evaluating all options
1. Assess the risk of the investment
2. Consider the impact of the project on firm profits/ cashflows
4. Decision making
5. Post -audit
Evaluation Capital Budgeting Techniques
Capital
Budgeting
Techniques

Discounted
Traditional
Cash Flow
techniques
techniques

Accounting Payback Net Present Internal Rate Profitability

Rate Return period Value of Return Index
Rate of Return
• Crudest but simplest
• Appeals to the layman
• Profit/ Investment

• Higher the return, the better it is

Payback period
• Time required to recover initial investment
• Intuitive

• Lower the payback period, better it is

Net Present Value
• Scientific
• considers TIME VALUE OF MONEY
• Discounts future cash flows at the required rate of return/ cost of capital

• Considers CASH FLOWS and not accounting Profits

Net Present Value = Present Value of Cash Inflows – Present Value of

Cash Outflows
• Higher the NPV, better it is
Profitability Index
• Relative measure of NPV

• PV of Cash Inflows/ PV of Cash outflows

• Higher the PI, better it is

Internal Rate of Return
• That rate at which the Present value of cash inflows is equal to the
present value of cash outflows

• Is compared with the required rate of return / Cost of capital

• Higher the IRR, better it is