Capital Budgeting

Name :-Shringar Thakkar

Div:- A
Roll Number:172
Capital Budgeting
• Capital budgeting is the process a business
undertakes to evaluate potential major
projects or investments. Construction of a
new plant or a big investment in an outside
venture are examples of projects that
would require capital budgeting before they
are approved or rejected.
• As part of capital budgeting, a company
might assess a prospective project's lifetime
cash inflows and outflows to determine
whether the potential returns that would
be generated meet a sufficient target
benchmark. The capital budgeting process
is also known as investment appraisal.
Capital Budgeting Process for various
classification of projects
• Investment Screening and Selection -Projects consistent with the
corporate strategy are identified by production, marketing and
Research and Development management of the firm.
• Capital Budget Proposal -A capital budget is proposed for the projects
surviving the screening and selection process.
• Budgeting Approval and Authorisation -Projects included in the
capital budget are authorised, allowing further fact gathering and
analysis, and approved, allowing expenditures for the projects.
• Project Tracking - After a project is approved, work on it begins.
Capital Budgeting Process for various classification of projects

• Post-Completion
Audit -Following a
period time, perhaps
two or three years
after approval,
projects are
reviewed to see
whether they should
be continued.
Principles of Capital Budgeting Process
• Capital budgeting has five principles that play a crucial role in the
allocation of money and the process of capital budgeting.
• The five principles are
(1) decisions are based on cash flows, not accounting income
(2) cash flows are based on opportunity cost
(3) The timing of cash flows are important
(4) cash flows are analyzed on an after tax basis
(5) financing costs are reflected on project’s required rate of return.
Criteria for selection of Investment
Evaluation And Capital Projects
• Accounting or Average Rate of Return
Method
• Pay Back Period
• Discounted Cash Flow Techniques
• Net Present Value Method
• Internal Rate of Return or Yield Method
• Profitability Index (PI) or Benefit Cost
Ratio
• Terminal Value (TV) Method
Techniques of Capital Budgeting
Evaluation
• Internal Rate of Return-The internal rate of return calculation is used to
determine whether a particular investment is worthwhile by assessing the
interest that should be yielded over the course of a capital investment.
• Net Present Value-Net present value (NPV) is used for the same purpose
as the internal rate of return, analyzing the projected returns for a
potential investment or project.
• Profitability Index-The profitability index is a capital budgeting tool
designed to identify the relationship between the cost of a proposed
investment and the benefits that could be produced if the venture was
successful.
Techniques of Capital Budgeting Evaluation

• Accounting Rate of Return-The accounting rate of return is the

projected return that an organization can expect from a proposed
capital investment. To discover the accounting rate of return, finance
professionals must divide the average profit by the initial investment.
• Payback Period-The payback period is a unique capital budgeting
method. Specifically, the payback period is a financial analytical tool
that defines the length of time necessary to earn back money that has
been invested.
Risk adjusted discount rate
• A risk-adjusted discount rate is the rate obtained by combining an
expected risk premium with the risk-free rate during the calculation of
the present value of a risky investment.
• A risky investment is an investment such as real estate or a business
venture that entails higher levels of risk.
• Although it is the usual convention to use the market rate as the
discount rate in most applications, under certain circumstances, the
application of a risk-adjusted discount rate becomes crucial.
Risk evaluation in capital budgeting
• To compares and contrasts the deterministic and probabilistic
methods as a tools for capital budgeting. The method usually used in
capital budgeting is to calculate a “best estimate” based on the
available data and use it as an input in the evaluation model. Capital
Budgeting Method used for this paper is Net Present Value.
Decision making under risk and
uncertainty
• Making decisions under
certainty is easy. The cause and
effect are known, and the risk
involved is minimal.
• What’s tough is making decisions
under risk and uncertainty.
• The outcome is unpredictable
because you don’t have all the
information about the
alternatives.
• Risk refers to decision-making
situations under which all
potential outcomes and their
likelihood of occurrences are
known to the decision-maker,
and uncertainty refers to
situations under which either
the outcomes and/or their
probabilities of occurrences are
unknown to the decision-maker.
Risk analysis in project selection
• Project selection is usually based on several decision-making points,
such as the project’s potential for profitability and its life-cycle cost.
• As the inflow of funds is usually limited, project selection is critical.
Another key decision making point that is usually left out is the level
of risk.
• During the project selection process, risk management needs to be
conducted.
• It is imperative to conduct Risk Management and Project Selection
simultaneously.
Risk Management
• Risk management is the process of identifying, assessing and controlling threats to an
organization's capital and earnings. These risks stem from a variety of sources including
financial uncertainties, legal liabilities, technology issues, strategic management errors,
accidents and natural disasters.
• A successful risk management program helps an organization consider the full range of
risks it faces. Risk management also examines the relationship between risks and the
cascading impact they could have on an organization's strategic goals.
• This holistic approach to managing risk is sometimes described as enterprise risk
management because of its emphasis on anticipating and understanding risk across an
organization. In addition to a focus on internal and external threats, enterprise risk
management (ERM) emphasizes the importance of managing positive risk. Positive risks
are opportunities that could increase business value or, conversely, damage an
organization if not taken. Indeed, the aim of any risk management program is not to
eliminate all risk but to preserve and add to enterprise value by making smart risk
decisions.
Objectives of Risk Management
• Identifies And Evaluates Risk:-Risk management identifies and analysis
various risk associated with business. It identifies risk at early stages and
takes all necessary steps to avoid their harmful effects. Information from
past is analysed to recognise all possible future unfortunate events.
• Reduce And Eliminate Harmful Threats:-Harmful risks and threat are part
of every business organisation. They have negative effect on productivity
and profitability of business. Risk management techniques helps in
avoiding and reducing the effect of these threats to business.
• Support Continuity Of Organisation:-Risk management has an efficient role
in long term growth and survival of the business. Every business faces
several risk and unfortunate events during its life cycle.
Objectives of Risk Management
• Supports Efficient Use Of Resources:-Risk management aims at efficient
utilisation of all resources. Fuller utilisation leads to better productivity and
increased profits. Risk management techniques support strategic planning for
better results. It sets plans for functioning of business and ensures that all
activities are going on their planned track.
• Better Communication Of Risk Within Organisation:-Risk management develops
better communication network between directors, managers and employees. It
helps in spreading all information regarding risk easily around the organisation
timely.
• Reassures Stakeholders:-Stakeholders are an important part of every business
organisation. Business must aim at serving the interest of its stakeholders for
their support.
Steps in risk management process
• Step 1: Risk Identification:-The first step in the risk management
process is to identify all the events that can negatively (risk) or
positively (opportunity) affect the objectives of the project:Project
milestones,Financial trajectory of the project,Project scope
• Step 2: Risk Assessment:-There are two types of risk and opportunity
assessments: qualitative and quantitative.
• Step 3: Risk Treatment:-In order to treat risks, an organization must first
identify their strategies for doing so by developing a treatment plan.
• Step 4: Risk Monitoring and Reporting:-Risks and opportunities and
their treatment plans need to be monitored and reported on.
Probability Analysis
• Probability Analysis — a technique used by risk managers for
forecasting future events, such as accidental and business losses. This
process involves a review of historical loss data to calculate a
probability distribution that can be used to predict future losses. The
probability analyst views past losses as a range of outcomes of what
might be expected for the future and assumes that the environment
will remain fairly stable. This technique is particularly effective for
companies that have a large amount of data on past losses and that
have experienced stable operations. This type of analysis is contrasted
to trend analysis.
Advantages of Probability Analysis
• Cluster sampling: convenience and ease of use.
• Simple random sampling: creates samples that are highly
representative of the population.
• Stratified random sampling: creates strata or layers that are highly
representative of strata or layers in the population.
• Systematic sampling: creates samples that are highly representative of
the population, without the need for a random number generator.
Disadvantages of Probability Analysis
• Cluster sampling: might not work well if unit members are not
homogeneous (i.e. if they are different from each other).
• Simple random sampling: tedious and time consuming, especially
when creating larger samples.
• Stratified random sampling: tedious and time consuming, especially
when creating larger samples.
• Systematic sampling: not as random as simple random sampling,
Sensitivity analysis
• Sensitivity analysis is a financial model that determines how target
variables are affected based on changes in other variables known as
input variables. This model is also referred to as what-if or simulation
analysis. It is a way to predict the outcome of a decision given a certain
range of variables. By creating a given set of variables, an analyst can
determine how changes in one variable affect the outcome.
• Both the target and input—or independent and dependent—variables
are fully analyzed when sensitivity analysis is conducted. The person
doing the analysis looks at how the variables move as well as how the
target is affected by the input variable.
Standard deviation
• The standard deviation is a measure of the
amount of variation or dispersion of a set of
values. A low standard deviation indicates that
the values tend to be close to the mean (also
called the expected value) of the set, while a
high standard deviation indicates that the values
are spread out over a wider range.
• Standard deviation may be abbreviated SD, and
is most commonly represented in mathematical
texts and equations by the lower case Greek
letter sigma σ, for the population standard
deviation, or the Latin letter s, for the sample
standard deviation.
Coefficient of Variation
• The coefficient of variation (CV) is a
statistical measure of the relative
dispersion of data points in a data
series around the mean.
• In finance, the coefficient of variation
allows investors to determine how
much volatility, or risk, is assumed in
comparison to the amount of return
expected from investments.
• The lower the ratio of the standard • Please note that if the expected return in the
deviation to mean return, the better denominator of the coefficient of variation
formula is negative or zero, the result could be
risk-return trade-off. misleading
 Decision Tree Analysis
• Decision tree analysis is the process
of drawing a decision tree, which is
a graphic representation of various
alternative solutions that are
available to solve a given problem,
in order to determine the most
effective courses of action. Decision
trees are comprised of nodes and
branches - nodes represent a test
on an attribute and branches
represent potential alternative
outcomes.
Thankyou