Capital Budgeting

Financial Policy and Planning

Outline
Meaning of Capital Budgeting
Significance of Capital Budgeting
Analysis
Capital Budgeting Techniques
• Net Present Value
• Profitability Index
• Internal rate of return
• Modified internal rate of return
• Equivalent annuity
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.
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
Techniques of Capital Budgeting
Net present value
Profitability index
Internal rate of return
Modified internal rate of return
Equivalent annuity
Net Present Value
Based on the rupee amount of cash flows
The rupee amount of value added by a
project
NPV equals the present value of cash inflows
minus initial investment
Technique is consistent with the principle of
wealth maximization—Why?
Accept a project if NPV ≥ 0
Profitability Index (PI)
Profitability index identifies the relationship of
investment to payoff of a proposed project
PI = PV of Cash Inflows/initial investment
Accept a project if PI ≥ 1.0, which means positive
NPV
Profitability Index is also known as Profit Investment
Ratio
PI may be in conflict with NPV if
Projects are mutually exclusive
• Scale of projects differ
• Pattern of cash flows of projects is different
MIRR (modified internal rate of
return)
Determines the attractiveness of an
investment.
Makes explicit assumptions about the rate of
investment of cash flows .
Calculates negative cash flow which cannot
be done by IRR.
IRR ignores the reinvestment potential of
positive cash flow where as MIRR considers
it.
Internal Rate of Return
The rate at which the net present value
of cash flows of a project is zero, I.e.,
the rate at which the present value of
cash inflows equals initial investment
Project’s promised rate of return given
initial investment and cash flows
Consistent with wealth maximization
Accept a project if IRR ≥ Cost of Capital
Equivalent annuity
The equivalent annuity method expresses the
NPV as an annualized cash flow by dividing it
by the present value of the annuity factor
Often used when comparing investment
projects of unequal life spans
The use of the EAC method implies that the
project will be replaced by an identical
project..
Alternatively the chain method can be used
with the NPV method
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