CAPITAL BUDGETING

Overview of Capital Budgeting

 Capital budgeting is the process of evaluating and
selecting long-term investments that are consistent
with the firm’s goal of maximizing owner wealth.
 A capital expenditure is an outlay of funds by the
firm that is expected to produce benefits over a
period of time greater than 1 year.
Overview of Capital Budgeting:
Steps in the Process

1. Proposal generation. Proposals for new

investment projects are made at all levels within
a business organization and are reviewed by
finance personnel.
2. Review and analysis. Financial managers
perform formal review and analysis to assess the
merits of investment proposals
3. Decision making. Firms typically delegate
capital expenditure decision making on the basis
of dollar limits.
4. Implementation. Following approval,
expenditures are made and projects
implemented. Expenditures for a large project
often occur in phases.
5. Follow-up. Results are monitored and actual
costs and benefits are compared with those that
were expected. Action may be required if actual
outcomes differ from projected ones.
Payback Period
The payback method is the amount of time required
for a firm to recover its initial investment in a project,
as calculated from cash inflows.
Decision criteria:
 The length of the maximum acceptable payback period is
determined by management.
 If the payback period is less than the maximum acceptable
payback period, accept the project.
 If the payback period is greater than the maximum
acceptable payback period, reject the project.
Payback Period: Pros and Cons of
Payback Analysis
 The payback method is widely used by large firms to evaluate
small projects and by small firms to evaluate most projects.
 Its popularity results from its computational simplicity and
intuitive appeal.
 By measuring how quickly the firm recovers its initial
investment, the payback period also gives implicit
consideration to the timing of cash flows and therefore to the
time value of money.
 Because it can be viewed as a measure of risk exposure, many
firms use the payback period as a decision criterion or as a
supplement to other decision techniques.
Payback Period: Pros and Cons of
Payback Analysis (cont.)
 The major weakness of the payback period is that the appropriate
payback period is merely a subjectively determined number.
 It cannot be specified in light of the wealth maximization goal

because it is not based on discounting cash flows to determine

whether they add to the firm’s value.
 A second weakness is that this approach fails to take fully into
account the time factor in the value of money.
 A third weakness of payback is its failure to recognize cash flows
that occur after the payback period.
Net Present Value (NPV)
Net present value (NPV) is a sophisticated capital
budgeting technique; found by subtracting a project’s
initial investment from the present value of its cash
inflows discounted at a rate equal to the firm’s cost of
capital.
NPV = Present value of cash inflows – Initial
investment
Decision Rule
Decision criteria:
 If the NPV is greater than Rs. 0, accept the project.
 If the NPV is less than Rs. 0, reject the project.

If the NPV is greater than Rs. 0, the firm will earn a

return greater than its cost of capital. Such action
should increase the market value of the firm, and
therefore the wealth of its owners by an amount equal
to the NPV.
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is a sophisticated
capital budgeting technique; the discount rate that
equates the NPV of an investment opportunity with Rs.
0 (because the present value of cash inflows equals the
initial investment); it is the rate of return that the firm
will earn if it invests in the project and receives the
given cash inflows.
Internal Rate of Return (IRR)
Decision criteria:
 If the IRR is greater than the cost of capital, accept the
project.
 If the IRR is less than the cost of capital, reject the project.

These criteria guarantee that the firm will earn at least

its required return. Such an outcome should increase
the market value of the firm and, therefore, the wealth
of its owners.
Discounted Payback Period
 One of the major disadvantages of simple payback
period is that it ignores the time value of money. To
counter this limitation, an alternative procedure
called discounted payback period may be followed,
which accounts for time value of money by
discounting the cash inflows of the project.
 In discounted payback period we have to calculate the
present value of each cash inflow taking the start of the
first period as zero point. For this purpose the
management has to set a suitable discount rate. The
discounted cash inflow for each period is to be
calculated using the formula:
Discounted Cash Inflow = Actual Cash Inflow/(1 + i)n
 Where,

   i is the discount rate;

   n is the period to which the cash inflow relates.
Decision Rule
 If the discounted payback period is less that the
target period, accept the project. Otherwise reject.
Profitability index
 Profitability index is actually a modification of the
net present value method. While present value is an
absolute measure (i.e. it gives as the total dollar
figure for a project), the profibality index is a
relative measure (i.e. it gives as the figure as a
ratio).
PI = Present Value of Future Cash Flows
Initial Investment Required 

PI = 1 +  Net Present Value

Initial Investment Required
Decision Rule
 Accept a project if the profitability index is greater
than 1, stay indifferent if the profitability index is
zero and don't accept a project if the profitability
index is below 1.

 Profitability index is sometimes called benefit-cost

ratio too and is useful in capital rationing since it
helps in ranking projects based on their per dollar
return.