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Capital Budgeting Analysis

Meaning of Capital Budgeting


Capital budgeting addresses the issue of strategic long-term investment decisions.
Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.

Significance of Capital Budgeting


Considered to be the most important decision that a corporate treasurer has to make.
So much is the significance of capital budgeting that many business schools offer a separate course on capital budgeting

Why Capital Budgeting is so Important?


Involve massive investment of resources Are not easily reversible Have long-term implications for the firm Involve uncertainty and risk for the firm

Features of Capital Budgeting Decisions


Exchange of current funds for future benefits Investment of funds in long-term assets Occurence of future benefit over a series of years

Importance of Investment Decisions


Influence growth of the firm Affect the risk of the firm Involve commitment of large amount of funds Irreversible, or reversible at substantial loss Most difficult decision to make

CAPITAL BUDGETING PROCESS

Identification of potential investment opportunities Assembling of investment proposals Decision making Preparation of capital budget and appropriation Implementation Performance review

Purpose of Investment Decisions


Mandatory investments/statutory requirements Replacement projects Expansion projects Diversification projects-new geographical locations Research and developement projects Miscellaneous projects- Interior decoration/recreational projects

Investment Evaluation Criteria


Estimation of cash flows

Estimation of the required rate of return(the opportunity cost of capital) Application of a decision rule for making the choice.

Investment Decision Rule


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.

It should help to choose among mutually exclusive projects that project which maximises the shareholders wealth.
It should be a criterion which is applicable to any conceivable investment project independent of others.

Techniques of Capital Budgeting Analysis


Discounted cash Flow

Non Discounted cash Flow

Discounted Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability Index

ARR Payback method

Which Technique should we follow?


A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization.
A technique is considered consistent with wealth maximization if It is based on cash flows Considers all the cash flows Considers time value of money Is unbiased in selecting projects

Accounting Rate of Return Method

The accounting rate of return (ARR) also known as the return on Investment(ROI),

Uses accounting information as revealed by financial

statements, investment.

to

measure

the

profitability

of

an

The accounting rate of return is the ratio of the average

after tax profit divided by the average investment.

Formula
ARR = Average Income Average Investment
100

Evaluation of ARR Method


Simplicity Accounting data Accounting profitability

Disadvantages of the method


Cash flow ignored Time value ignored

Payback Period Approach


The amount of time needed to recover the initial investment. The number of years it takes including a fraction of the year to recover initial investment is called payback period. To compute payback period, keep adding the cash flows till the sum equals initial investment. Simplicity is the main benefit, but suffers from drawbacks. Technique is not consistent with wealth maximizationWhy?

Formula for even payback


Payback = Initial Investment Annual Cash inflow

Problems on Payback
A project requires a cash outlay of Rs.20,000/- and generates cash inflows in the following order. What is the projects payback? Year 0 1 2 cash flow (20,000) 8,000 7,000

3
4

4,000
3,000