Capital

Capital BudgetingBudgetingTechniques
Techniques
Usefulness
Usefulness
Chetan Palta - H040
Anurag Priyadarshan - H041
13-1

Which technique is superior?

13-2

NPV is a 'Decision variable', shows addition of value

to shareholders wealth, thus our decision should be
based on NPV, but each technique contributes in its
own way

IRR is a 'Efficiency variable, measure of safety

margin in a project. Higher IRR means more safety
margin in the projects estimated cash flows

Payback period is a rough Measure of Riskiness.

The longer the payback period, more risky a project is

PI is a Measure of Cost-Benefit Analysis. How much

NPV for every dollar of initial investment

Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Types
Soft

Rationing - the firm itself limits

Hard
13-3

Rationing - forced by external factors

Example
Julie Miller must determine what investment
opportunities to undertake for Basket
Wonders (BW). She is limited to a maximum
expenditure of $32,500 only for this capital
budgeting period.

13-4

Available Projects for BW

Project
A
B
C
D
E
F
G
H
13-5

ICO
$

500
5,000
5,000
7,500
12,500
15,000
17,500
25,000

IRR
18%
25
37
20
26
28
19
15

NPV

PI

50
6,500
5,500
5,000
500
21,000
7,500
6,000

1.10
2.30
2.10
1.67
1.04
2.40
1.43
1.24

Choosing by IRRs for BW

Project
C
F
E
B

ICO

IRR

NPV

PI

$ 5,000
15,000
12,500
5,000

37%
28
26
25

$ 5,500
21,000
500
6,500

2.10
2.40
1.04
2.30

Projects C, F, and E have the

three largest IRRs.
The resulting increase in shareholder wealth
is $27,000 with a $32,500 outlay.
13-6

Choosing by NPVs for BW

Project
F
G
B

ICO
$15,000
17,500
5,000

IRR

NPV

PI

28%
19
25

$21,000
7,500
6,500

2.40
1.43
2.30

Projects F and G have the

two largest NPVs.
The resulting increase in shareholder wealth
is $28,500 with a $32,500 outlay.
13-7

Choosing by PIs for BW

Project
F
B
C
D
G

ICO

IRR

NPV

PI

$15,000
5,000
5,000
7,500
17,500

28%
25
37
20
19

$21,000
6,500
5,500
5,000
7,500

2.40
2.30
2.10
1.67
1.43

Projects F, B, C, and D have the four largest PIs.

The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
13-8

Summary of Comparison
Method Projects Accepted
PI

F, B, C, and D

Value Added
$38,000

NPV

F and G

$28,500

IRR

C, F, and E

$27,000

PI generates the greatest increase in

shareholder wealth when a limited capital
budget exists for a single period.
13-9