Module 3:

The Basics of Capital Budgeting

Should we build this plant?

Capital Budgeting

A firms decision to invest its current funds most efficiently in the longterm assets in anticipation of an expected cash flow benefits over a series of years Importance: Influence the firms growth Affect the risk of the firm Involve commitment of large funds Irreversibility Complexity of decision making Investment decisions influence firms value Firms value will increase if investment is profitable & adds to shareholders wealth

AN INVESTMENT WILL ADD TO SHAREHOLDERS WEALTH IF IT YIELDS BENEFITS AS PER THE HURDLE RATE/DISCOUNT RATE (PRINCIPLE RELATED TO INVESTMENT DECISION)
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Capital budgeting process

Identification of potential investment opportunities

Assembling of investment proposals

Decision Making Preparation of Capital Budget and appropriations Implementation Performance review
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Types of Investment Decisions

May be classified as:

Expansion

& Diversification

May add to its existing capacity: Related or Unrelated Diversification

Replacement

& Modernization

To improve operating efficiency & cost

Also,
Mutually

Exclusive investments Independent investments Contingent investments

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Basic Principles
Focus on Cash Flows Measure Cash flows on Incremental Basis Exclude Financing Costs Treat inflation Consistently

Types of Cash Flows

Initial flows Operational Cash Flows Terminal Flows

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Evaluation Criteria

Discounted Cash Flow Criteria

Net

Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Terminal Value Method (TV)

Non-Discounted Cash Flow Criteria

Payback

Period (PB) Discounted Payback period Accounting rate of return (ARR)

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Net Present Value Method

Described as the summation of the present value of cash proceeds in each year minus the summation of present values of the net cash outflows in each year Following steps are involved:
Cash

flows to be forecasted Appropriate discount rate to be identified PV of cash flows to be calculated NPV should be found out; Project should be accepted if NPV>0
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Net Present Value Method

Net Present Value can be calculated by using the following formula:

Ct NPV C0 n 1 t 1 k

Where C1, C2..represent net cash inflows in the year 1,2,n; k is the cost of capital, C0 is the initial cost of investment
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Example : NPV

Assume that Project X costs Rs. 2500 now and is expected to generate year end cash inflows of Rs. 900, 800, 700, 600 and Rs. 500 in years 1 through 5. the opportunity cost of capital is 10%. Calculate the NPV of the project. Should the project be accepted?

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Merits of NPV method

Time Value Measure of true profitability Value Additive Shareholder Wealth Maximization

Demerits of NPV method

Cash Flow estimation Discount rate Mutually exclusive projects ( details to be studied later ) Ranking of Projects

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