Capital Budgeting Decision

What is capital budgeting?

(Estimating relevant
cash flows)

Project Cash Flows

The capital budgeting decision is
essentially based upon a cost/benefit analysis.

The cost of a project is called the net investment. The benefits from a project are the future cash flows generated. We call these the net cash flows.

How Capital Budgeting Fits Into The Financial Planning Of A Corporation

Overall Financial Goal: Maximize Shareholder Wealth

Investment Decision Long Term Assets Short Term Assets Financing Decision Debt/Equity Mix Dividend Decision Dividend Payout Ratio

Capital Budgeting

Types of Capital Budgeting Decisions

Projects may be classified as revenue generating

projects or cost reducing projects. The capital budgeting decisions may be taken by a newly incorporated firm or by an existing firm. New firm: Selection of a plant to be installed Capacity utilization at initial stages To set up or not simultaneously the ancillary unit Existing firm: Replacement and modernization decision(cost reduction decision) Expansion Diversification (revenue increasing decision)

Role of Finance Manager

The role of Finance Manager lies in the process of critical and in-depth analysis and evaluation of various alternative proposals and then select those proposals which minimize the cost of capital and maximize the profitability and shareholders wealth.

 Capital budgeting is the decision-

making process used in the acquisition of long-term physical assets.

For example:
A new hotel A casino expansion Addition of a bar to a restaurant Replacement of a sprinkler system at a hotel

Decision-making Criteria in Capital Budgeting

The Ideal Evaluation Method should:

a) include all cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project.

Steps in the Process

Step 1: Proposal Generation
How are projects initiated? How much is available to spend? Step 2: Review and Analysis Preliminary project review Technically feasible? Compatible with corporate strategy? Step 3: Decision Making What are the costs and benefits? Our Focus What is the projects return? What are the risks involved?

Steps in the Process

Step 4: Implementation

When to implement? How to implement? Step 5: Follow-Up Is the project within budget? What lessons can be drawn?

Identifying the relevant cash flows in capital budgeting decisions

Accounting profit v/s cash flows

Accounting approach benefits Revenues Rs.1,000 (Less: expenses ) Cash expenses Rs.500 Depreciation Rs. 300 Earning before Tax Rs. 200 Taxes(0.35) 70 Net earnings after 130 taxes/cash flow Cash Flow approach benefits Revenues Rs.1,000 Less expenses: Cash expenses 500 Taxes 70 Net earnings after 430 taxes/cash flows

So capital budgeting is
Capital Budgeting is the process of identifying,
evaluating, and implementing a firms longer term (greater than a year) investment opportunities. firms shareholder wealth.

It seeks to identify investments that will increase a

The typical capital budgeting decision involves

evaluating a project that requires a large up-front investment followed by a series of smaller cash inflows.

Motives for capital expenditures

Expansion or growth of the firm will
typically entail increased investment in fixed or capital assets. assets.

Replacement of obsolete or worn-out Renewal of an existing asset.

Basic terminology in Capital Budgeting

Mutually Exclusive Projects are investments that
compete in some way for a companys resources. A firm can select one or another but not both.

Independent Projects, on the other hand, do not

compete with the firms resources. A company can select one, or the other, or both -- so long as they meet minimum profitability thresholds.

Basic terminology
If the firm has unlimited funds for making investments,
then all independent projects that are acceptable projects (i.e., determined to add value to the firm) can be accepted and implemented. restrictions since they only have a given amount of funds to invest in potential investment projects at any given time.
firms as they will typically have numerous good projects and will have to choose amongst them.

However, in most cases firms face capital rationing

Capital rationing is particularly applicable to high-growth

Basic terminology
The accept-reject decision involves the evaluation of
capital expenditure proposals to determine whether they meet the firms minimum acceptance criteria.

The ranking decision involves the ranking of capital

expenditures on the basis of some predetermined measure, such as the rate of return.

Basic terminology
The relevant cash flows to evaluate a project
are the incremental cash flows that are, all changes in the firms future cash flows that are a direct consequence of accepting the project.
project, if needed) is the risk-adjusted required rate of return for the project which reflects the riskiness of the cash flows of the project. projects cost of capital or hurdle rate.

The appropriate discount rate (to evaluate a

This rate of return is also referred to as the

Capital budgeting techniques

Once a projects relevant cash flows have
been determined, a firm must determine a method to analyze whether the project is acceptable and/or to rank projects. the time value of money, risk and return, and the effect on shareholder wealth.

The preferred approach would consider

Capital Budgeting Techniques

Pay Back Period (PBP):

Accounting rate of Return (ARR):

Net Present Value (NPV):
focus is on projects impact on accounting Profits

most commonly used

Internal Rate of Return (IRR):

considered as one of the best technique

widely used with strong intuitive appeal related to NPV

Profitability Index (PI):

Payback period
The payback method simply measures how long
(in years and/or months) it takes to recover the initial investment. determined by management.

The maximum acceptable payback period is Payback period decision rule:

If the payback period is less than the maximum acceptable payback period, the project is acceptable. Ranking: Projects with shorter payback periods are ranked higher.

Pros and cons of payback period

It is simple and intuitive. It is biased towards
liquidity, i.e., short-term projects. of later cash flows.

The appropriate

payback period is a subjectively determined number.

value of money.

It adjusts for uncertainty

It ignores the time

It ignores cash flows
beyond the cut-off date.

It is biased against

long-term projects.

Discounted payback period

The discounted payback method simply
measures how long (in years and/or months) it takes, using discounted cash flows, to recover the initial investment. period is determined by management.

The maximum acceptable discounted payback

Discounted payback period

Discounted payback period decision rule:
acceptable.
If the discounted payback period is less than the maximum acceptable payback period, the project is Ranking: Projects with shorter payback periods are ranked higher.

Pros and cons of discounted payback period

It is biased towards
liquidity, i.e., short-term projects. of later cash flows.

The appropriate

It adjusts for uncertainty

payback period is a subjectively determined number. beyond the cut-off date.

It ignores cash flows

It is biased against

long-term projects.

Net present value (NPV)

The Net Present Value (NPV) is a measure of how much
value is created or added for the firm today by undertaking an investment or project. generated by the project.

NPV is the present value of the incremental cash flows NPV can be calculated as:
CFt NPV (1 r ) t t 0
where CFt is the cash flow in year t and r is the hurdle rate for the project.
n

Net present value (NPV)

NPV decision rule:
If the NPV of a project is greater than zero, the project is acceptable. Ranking: Projects with higher NPVs are ranked higher.

NPV always provides the correct accept/reject

decision and considers the time value of money, risk and return as well as effect on owners wealth. capital rationing constraints.

The model is most appropriate when there are no

Pros and cons of NPV

It accurately assesses the
value of a project to a firm.

Absolute (dollar) returns

are more difficult to understand for some managers.

It incorporates all cash

flows, cash flow riskiness and time value of money in its calculation.

It is biased towards larger

projects. If projects can be replicated (or are scalable) this may result in incorrect rankings of projects.

Internal rate of return (IRR)

The Internal Rate of Return (IRR) is the discount rate
that will equate the present value of the outflows with the present value of the inflows, i.e., the rate of return for which the NPV is equal to zero. be calculated by solving the following equation (setting the NPV to zero):

The IRR is the projects intrinsic rate of return and can

CFt 0 (1 IRR )t t 0

Internal rate of return (IRR)

IRR decision rule:
If the projects IRR exceeds the projects hurdle rate (required rate of return), the project is acceptable. Ranking: Projects with higher IRRs are ranked higher.

When capital rationing is an issue, the IRR may

be the best method for ranking projects.

Pros and cons of IRR

It is closely related to
NPV, and generally leads to identical decisions.

It may result in multiple

answers or no answers with non-conventional cash flows. decisions in comparisons of mutually exclusive projects as it assumes cash flow are reinvested at the IRR.
hand.

It may lead to incorrect

It is easy to understand
and communicate (percentage returns). selecting smaller or larger projects.

It is not biased towards

Difficult to calculate by

Profitability index (PI)

The Profitability Index (PI) is a modification of NPV that
evaluates projects using a return measure.

The PI is calculated as:

PI decision rule:
If PI > 1 the project is acceptable. Ranking: Projects with higher PI are ranked higher.

Pros and cons of PI

It is closely related to
NPV, and generally leads to identical decisions.

The actual value is less

meaningful than a percentage return (such as IRR).

It is easier to

understand and communicate than NPV. selecting smaller or larger projects.

It is not biased towards

Thank You