Capital budgeting

• The process of identifying, analyzing, and selecting investment

projects whose returns (cash flows) are expected to extend
beyond one year. The term capital budgeting is otherwise
called as investment appraisal .

• Capital budgeting is a step by step process that businesses use

to determine the merits of an investment project. The decision
of whether to accept or deny an investment project.

• Examples include investment in assets, such as equipment,

buildings, and land, as well as the introduction of a new
product, or a new program for research and development.
 Capital budgeting importance in Finance

• Capital budgeting decisions have placed greater

emphasis due to the following:

• (a) Long-term Applications

• (b) Competitive Position of an Organization
• (c) Cash Forecasting
• (d) Maximization of Wealth
 (a) Long-term Applications:
• Implies that capital budgeting decisions are helpful for an
organization in the long run as these decisions have a
direct impact on the cost and future prospects of the
organization.
• In addition, these decisions affect the organization’s
growth rate.
• Therefore, an organization needs to be careful while
making capital decisions as any wrong decision can prove
to be fatal for the organization.
• For example, over-investment in various assets can cause
shortage of capital to the organization, whereas insufficient
investments may hamper the growth of the organization.
(b) Competitive Position of an Organization:

• Refers to the fact that an organization can plan its

investment in various fixed assets through capital
budgeting.

• In addition, capital investment decisions help the

organization to determine its profits in future.

• All these decisions of the organization have a major

impact on the competitive position of an organization.
 (c) Cash Forecasting:

• Implies that an organization needs a large amount of

funds for its investment decisions.

• With the help of capital budgeting, an organization is

aware of the required amount of cash, thus, ensures
the availability of cash at the right time.

• This further helps the organization to achieve its long-

term goals without any difficulty.
 (d) Maximization of Wealth:

• Refers to the fact that the long-term investment

decisions of an organization helps in safeguarding the
interest of shareholders in the organization.

• If an organization has invested in a planned manner,

shareholders would also be keen to invest in the
organization.

• This helps in maximizing the wealth of the

organization. 
Project evaluation and selection of alternative
methods

We will evaluate four alternative methods of project

evaluation and selection used in capital budgeting:

1. Payback period(PBP)
2. Internal rate of return(IRR)
3. Net present value(NPV)
4. Profitability index(PI)
 Discounted v/s non discounted capital
budgeting techniques.

Capital Budgeting Evaluation Techniques

Discounting Techniques
Non- Discounting
Techniques 1) NPV method
2) Profitability index
1) Payback period method
3) IRR
 Non-Discount Method
• A non-discount method of capital budgeting does not
consider the time value of money.
• In other words, each dollar earned in the future is
assumed to have the same value as each dollar that
was invested many years earlier.
• The payback method is one of the techniques used
in capital budgeting that does not consider the time
value of money.
• The payback method simply computes the number of
years it will take for an investment to return cash
equal to the amount invested
 Discounting Method
• Any method of investment project evaluation and
selection that adjusts cash flows over time for the time
value of money.

• What is the difference between discounted and

undiscounted cash flows?
• The difference is the time value of money.
 Pay back period

• Is the time required for a firm to recover its original

investment.

• The formula to calculate payback period of a project depends on

whether the cash flow per period from the project is even or
uneven. 
 Payback Period if Cash Flow is even
• In case they are even, the formula to calculate payback
period is:
• Payback Period = Initial Investment/Cash Inflow per
Period
• Example : Even Cash Flows
Company Z is planning to undertake a project
requiring initial investment of $105 million. The
project is expected to generate $25 million per year for
7 years. Calculate the payback period of the project.
• Solution
Payback Period = Initial Investment ÷ Annual Cash
Flow = $105M ÷ $25M = 4.2 years
Payback Period if Cash Flow is uneven
• When cash inflows are uneven, we need to calculate
the net cash flow for each period and then use the
following formula for payback period:
• Payback Period = A +B/C
• In the above formula,
A is the last period with a negative cumulative cash
flow;
B is the absolute value of cash flow at the end of the
period A;
C is the total cash flow during the period after A.
Payback Period if Cash Flow is uneven
 DECISION CRITERIA

When the payback period is used to make accept–reject

decisions, the following decision criteria apply:

1) If PBP > Target period – Accept the proposal

2) If PBP < Target period – Reject the proposal

 Net present value NPV
• The present value of an investment project’s net cash
flows minus the project’s initial cash outflow.

• Formula:
 Net present value NPV
Consider the Hoofdstad Project, which requires an
investment of $1 billion initially, with subsequent cash
flows of $200 million, $300 million, $400 million, and
$500 million. We can characterize the project with the
following end-of-year cash flows:

What is the net present value of the Hoofdstad Project if

the required rate of return of this project is 5%?
 Net present value NPV
• 
 DECISION CRITERIA

• When NPV is used to make accept–reject decisions,

the decision criteria are as follows:

• If the NPV is greater than $0, accept the project.

• If the NPV is less than $0, reject the project.

 Internal rate of return

• Internal rate of return (IRR) is the interest rate at

which the net present value  of all the cash flows (both
positive and negative) from a project or investment equal
zero. OR
• The Internal Rate of Return is the interest rate that
makes the Net Present Value zero.
• Internal rate of return is used to evaluate the attractiveness
of a project or investment.
• If the IRR of a new project exceeds a company’s required
rate of return, that project is desirable.
• If IRR falls below the required rate of return, the project
should be rejected.
 Internal rate of return
• Formula

• Let’s look at Tom’s Machine Shop. Tom is considering

purchasing a new machine, but he is unsure if it’s the best use
of company funds at this point in time. With the new $100,000
machine, Tom will be able to take on a new order that will pay
$20,000, $30,000, $40,000, and $40,000 in revenue.
Calculate IRR.

• Let’s start with 8 percent.

• As you can see, ending NPV is not equal to zero. Since it’s a positive number,
we need to increase the estimated Internal Rate. Let’s increase it to 10
percent and recalculate.
 Profitability Index
• The profitability index (PI), or benefit-cost ratio, of a
project is the ratio of the present value of future net
cash flows to the initial cash outflow.

• It can be expressed as
 Profitability Index
• We determined, at that time, that for an initial cash
outflow of $100,000, the Faversham Fish Farm
expected to generate net cash flows of $34,432,
$39,530, $39,359, and $32,219 over the next 4 years.
If a required rate of return is 12 percent, calculate the
profitability index.
Profitability Index

Decision Rule

• PI > 1, Accept the project

• PI < 1, Reject the project

 Potential difficulties

Independent Project

• So far our analysis has shown that for a single,

conventional, independent project, the IRR, NPV, and
PI methods would lead us to make the same accept-
reject decision.
• We must be aware, however, that several different
types of project pose potential difficulties for the
capital budgeting analyst.
 Dependent Project

• A dependent (or contingent) project – one whose

acceptance depends on the acceptance of one or more
other projects – deserves special attention.
• The addition of a large machine, for example, may
necessitate construction of a new factory wing to
house it.
• Any contingent proposals must be part of our thinking
when we consider the original, dependent proposal.
 Mutually Exclusive
• In evaluating a group of investment proposals, some of
them may be mutually exclusive.
• A mutually exclusive project is one whose acceptance
prevent the acceptance of one or more alternative
proposals. For example, if the firm is considering
investment in one of two computer systems, acceptance
of one system will rule out the acceptance of the other.
• Two mutually exclusive proposals cannot both be
accepted. When faced with mutually exclusive projects,
merely knowing whether each project is good or bad is
not enough. We must be able to determine which one is
best.