8 Steps

Capital Budgeting
1. Determine the Total
Add a heading
Cash Outlay
By Asif Masani

2. Project the Future

Cash Flows
If you want to buy a new equipment we Identify appropriate reference class
should’nt just run the analysis on Gather cash flow data generated by
purchase price of the equpiment but the cases in referenced class
on the total cost including installation, Use judgement and develop the
training etc future cash flows on a realistic basis

3. Required Rate of 4. Calculate the Payback

Return Period
The payback period is the time
Most companies add the risk free rate
required to recoup the cash outlay
of return and the Weighted average
through the projected cash flows.
cost of capotal (WACC) together to
Payback period = Investment
obtain this minimum hurdle rate.
Total Cash Flow

5. Calculate the NPV of

6. Calculate IRR
future Cashflows
We calculated the NPV in the previous step
where we may learn that our capital
NPV = Cash Flow (1) + Cashflow(2)+ etc - expenditure has a ROR greater than or less
Total Cash Outlay than the company’s hurdle rate.
1+hurdle rate) (1+hurdle rate)^2 We don’t know the actual annualized rate of
return for the capital investment.
For (IRR) we have to solve the same equation
for “r” so that NPV is Zero
7. Calculate the 8: Make your
Profitability Index (PI) Recommendation
PI clearly shows what $1 invested Use all 4 methods (NPV, Payback
today returns in today’s dollars. The Period IRR and PI) and compare the
formula is proposed investments.
PI = Present Value of all Future Cash Each of the above method provides a
flows slightly different angle on the potential
attractiveness of the proposed
Investment investment.

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