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Meaning of Capital Budgeting Significance of Capital Budgeting Analysis Traditional Capital Budgeting Techniques Payback Period Approach Discounted Payback Period Approach Discounted Cash Flow Techniques Net Present Value Internal Rate of Return Profitability Index Net Present Value versus Internal Rate of Return
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Capitalbudgeting addresses the issue of strategic long-term investment decisions. Capitalbudgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Processof capital budgeting ensure optimal allocation of resources
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Considered to be the most important decision that a corporate treasurer has to make.
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Involve massive investment of resourcesAre not easily reversibleHave long-term implications for the firmInvolve uncertainty and risk for the firm
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Payback Period Approach Discounted Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability Index
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The amount of time needed to recover the initial investment Thenumber of years it takes including a fraction of the year to recover initial investment is called payback period
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Based on the dollar amount of cash flows The dollar 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
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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
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Usually,NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project IRR can be in conflict with NPV if Investing or Financing Decisions Projects are mutually exclusive Projects differ in scale of investment Cash flow patterns of projects is different If cash flows alternate in sign—problem of multiple IRR If IRR and NPV conflict, use NPV approach
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A part of discounted cash flow family PI = PV of Cash Inflows/initial investment Accept a project if PI ≥ 1.0, which means positive NPV Usually, PI consistent with NPV When in conflict with NPV, use NPV
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Although our decision should be based on NPV, but each technique contributes in its own way. Payback period is a rough measure of riskiness. The longer the payback period, more risky a project is IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the project’s estimated cash flows PI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment
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