CAPITAL BUDGETING DECISIONS

LEARNING OBJECTIVES
nature and importance of investment decisions
Process of capital budgeting
Developing cash flows data
Explain the methods of calculating net present value (NPV)
and internal rate of return (IRR)
Describe the non-DCF evaluation criteria: payback and
accounting rate of return
 Illustrate the computation of the discounted payback
 Compare and contrast NPV and IRR and emphasize the
superiority of NPV rule
Capital Budgeting
 Meaning: The process of decision making with respect
to investments in fixed assets—that is, should a
proposed project be accepted or rejected.
 It is easier to “evaluate” profitable projects than to
“find them”

© 2011 Pearson Prentice Hall. All rights reserved. 10-3

DEFINITION:
 “Capital budgeting is long term planning for making
and financing proposed capital outlays.” -----
Charles T.Horngreen-------------
 “Capital budgeting consists in planning development
of available capital for the purpose of maximizing the
long term profitability of the concern” – Lynch---
Nature of Investment Decisions
The investment decisions of a firm are generally known as the
capital budgeting, or capital expenditure decisions.

The firm’s investment decisions would generally include expansion,

acquisition, modernisation and replacement of the long-term
assets. Sale of a division or business (divestment) is also as an
investment decision.

Decisions like the change in the methods of sales distribution, or

an advertisement campaign or a research and development
programme have long-term implications for the firm’s expenditures
and benefits.
Features of Investment Decisions
The exchange of current funds for future benefits.

The funds are invested in long-term assets.

The future benefits will occur to the firm over a series of

years.
Types of Investment Decisions
One classification is as follows:
 Expansion of existing business
 Expansion of new business
 Replacement and modernisation
Yet another useful way to classify investments is as
follows:
 Mutually exclusive investments
 Independent investments
 Contingent investments
 CAPITAL BUDGETING PROCESS
 Step 1 & 2 = Project
generation

 Step3 = Project evaluation

 Step4 & 5 =project

selection

 Step 6 = project execution.

Investment Evaluation Criteria
Two steps are involved in the evaluation of an
investment:

Estimation of • Cash inflow(cost)

cash flows • Cash outflow(returns)

Application of
a decision rule
for making the • Take decision
choice
DEVOLOPING CAH FLOW DATA
(CASH INFLOW AND CASH
OUTFLOW)
 Suppose, we must estimate the cash flows both current
and future associated with it.
Calculation of CASH OUTFLOW
 Cost of project/asset xxxx
 Transportation/installation charges xxxx
 Working capital(2m) xxxx
Cash outflow xxxx
Calculation of CASH INFLOW
 Sales xxxx
 Less: Cash expenses xxxx
 PBDT xxxx
 Less: Depreciation xxxx
 PBT xxxx
 Less: Tax xxxx
 PAT xxxx
 Add: Depreciation xxxx
CASH INFLOW p.a xxxx
 Investment Decision Rule
It should maximise the shareholders’ wealth.
 It should consider all cash flows to determine the true profitability of the
project.
It should provide for an objective and unambiguous way of separating
good projects from bad projects.
It should help ranking of projects according to their true profitability.
It should recognise the fact that bigger cash flows are preferable to
smaller ones and early cash flows are preferable to later ones.