EVALUATION OF CAPITAL

BUDGETING
PROJECT MANAGEMENT
TEAM 4
 MEANING

Capital budgeting is the process of

evaluating and selecting long-term
investments that are consistent with the goals
of shareholders (owners) wealth
maximization.
 What is Capital Budgeting?

 Analysis of potential additions to fixed assets.

 Long term decisions; Investing large expenditures.
 Very important for Firms’ future.
 Planning on long-term assets.
 Investment Concept.
 What is Capital Budgeting?

 Isit worth it to put money or “capital” into this

project?
 Is it worth it to use money to buy this machine?
 Is it worth it to put money in this business?
 Investment decisions may include

 New equipment
 Plant expansion
 Lease or Buy
 Timing of Replacement
 R&D
 Acquisition
 Features of Capital Budgeting

Potentially Large anticipated benefits

A relatively high degree of risk
A relatively long period between the initial
outlay and the anticipated returns.
 Advantages

 Helps in understanding Risk and its effects

 Decision-making in investment opportunities
 Various Techniques of capital budgeting
 Increases Shareholder’s wealth
 Adequate control over expenditure
 Choosing investment wisely
 Abstains from over and under investing
 Disadvantages

 Long-term and ir-reversibile in nature

 Uncertainty leads to wrong applicability
 Techniques are assumed and not real
 Expensive
 Wrong Decisions affect long-term durability
 Availability of skilled professionals is not easy
 CLASSIFICATION OF INVESTMENTS

Mutually Exclusive Investments

Independent Investments
Contingent Investments
CAPITAL BUDGETING PROCESS

Identifying
and generating
Projects

Performance Evaluating
Review the project

Implementat Selecting a
ion project
 Capital Budgeting Technique/
Investment Criteria

Investment
Criteria

Non
Discounted
Discounted
Criteria
Criteria

Accounting
Net Present Internal Rate of Profitability Pay Back
Rate of Return
Value (NPV) Return (IRR) Index (PI) Period
(ARR)
 Net Present Value (NPV)

 Discounted Cash flow technique that recognizes the time

value of money.
 Net present value (NPV) is the difference between the
present value of cash inflows and the present value of
cash outflows over a period of time.
 Acceptance Rule:
 If NPV is positive; project is accepted (NPV>0)
 If NPV is negative; project is Rejected (NPV<0)
 NPV FORMULA

 Ifthere’s one cash flow from a project that will be paid

❑
one year from now, then the calculation
❑ for the NPV of
the project is as follows:
 NPV = Cash flow / (1 + i)^t – initial investment.
 NPV = Today's value of the expected cash flows −
Today's value of invested cash.
 Internal Rate of Return (IRR)

 The Internal Rate of Return (IRR) is the rate of return that

a company can expect to earn by investing in a project.
 The Higher the IRR, The more desirable the Investment
 InIRR, the cashflow rate equals the cash outflow rate,
where NPV is zero.
 IRR FORMULA

 IRR is the interest rate received for an investment

consisting of money invested (negative value) and cash
flows (positive value) that occur at regular periods.
 Investment = Expected Annual net cashflow x PV annuity
Factor.
 PROFITABILITY INDEX (PI)

 The profitability index rule is a decision-making exercise

that helps evaluate whether to proceed with a project. 
 Rule:
 If the PI > 1, Project should be accepted.
 If the PI < 1, Project should be Rejected.
 PI FORMULA

 Profitability Index = Present Value of Cash inflows /

Initial Investment.
 Profitability
Index = 1 + (Net Present Value / Initial
Investment Required).
 Pay Back Period

 Pay Back is the no.of.years required to recover the

original cash outlay invested in a project.
 If the project generates constant annual cash inflows, the
payback period can be computed by dividing cash
outflow by annual cash inflow.
 Pay Back Formula

Payback Period = Initial investment /

Cash flow per year 
 ACCOUNTING RATE OF RETURN (ARR)

 It is used to measure the profitability of an investment.

 The accounting rate of return (ARR) formula is helpful
in determining the annual percentage rate of return of a
project.
 ARR is commonly used when considering multiple
projects, as it provides the expected rate of return from
each project.
 ARR FORMULA

 ARR = Average Annual Profit/ Initial Investment​.

 Acceptance Rule:
 ARR > Minimum rate, Project is accepted
 ARR < Minimum rate, Project is rejected.
 Factors Affecting Capital Budgeting

 Technological Changes
 Demand Forecast
 Competitive Strategy
 Type of Management
 Cash Flow
 Other Factors
 Conclusion

 Capital budgeting could be a particularly

beneficial method for choosing which investment
projects to continue pursuing and which to delay.
To that end, keep in mind that your capital
budgeting estimates are just that-theoretical.
THANK YOU