This PPT consists the details about capital budgeting techniques.

1. Capital Budgeting

2.  Capital Budgeting (CB) refers to the complete process
of generating/initiating investment proposals,
evaluating, ranking and selecting the best
alternative(s), monitoring and making follow up on
investment(s) made.
 “Capital budgeting is long term planning for making
and financing proposed capital outlays”- Charles T
Horngreen.

3.  Influence the firm’s growth in the long-run
 Affect the risk of the firm
 Involve commitment of large amount of funds
 Irreversible or reversible at substantial loss
 Among the most difficult decisions to make

4. Investment refers to an outlay of funds on which management expects
a return. An investment creates value for shareowners when expected
returns from investment exceed its cost.
Capital Expenditure refers to long term commitment of resources that
provide future benefits to business.
Independent Projects are projects where selection or rejection of one
project does not have any impact on the selection or rejection of the
other project. Management can select any number of projects from the
given options.

5. Mutually Exclusive Projects are projects that compete each other,
acceptance of one project becomes automatic rejection of the other or
vice versa. The projects compete with each other based on the
superior financial performance.
Decision Rules: The decision rules for independent and mutually
exclusive projects slightly differ. The way of looking at investment
opportunities under both types varies.

6.  Expansion of existing business or expansion of new
business
 Replacement or modernization

7. Three steps are involved-
 Estimation of cash flows
 Estimation of required rate of return
(opportunity cost of capital)
 Application of a decision rule for making the
choice

8. Traditional Techniques
Discounted Cash Flow or
Time Adjusted Techniques
PB
Discounted PB
NPV
MIRR
IRR
TV
PI or B/C Ratio
ARR

9. # Tech.
Accept or Reject Criteria for …
Single or Independent Project(s) Mutually Exclusive Projects
1. PB Less than the Target Period Shortest Payback Period
2. DPB Less than the Target Period Shortest Payback Period
3. ARR Above the Target Rate With the highest ARR
4. NPV A positive NPV With the highest positive NPV
5. IRR
Higher than the Target Rate (Cost of
Capital)
With the highest IRR
6. MIRR
Higher than Target Cost of Capital
(i.e. WACC)
With higher MIRR
7. TV
If PVTS>PVO Accept,
And if PVTS<PVO Reject
With the highest PVTS>PVO
8. PI (B/C Ratio) PI exceeding 1 Higher PI

10. 

11.  In case of unequal cash inflows, the payback period
can be found out by adding up the cash inflows
until the total is equal to initial cash outlay.
 Acceptance Rule-
1. Method of ranking project
2. Accepted if payback period is less than the maximum or
standard pay-back period
3. Highest ranking is giving to the project, which has shortest
payback period

12.  In this method, we discount cash flows and then
calculate the payback.
 It is the number of period taken in recovering the
investment outlay on the present value basis.

13.  Under ARR, accounting concept of profit (net profit
after tax & depreciation) is used rather than cash
inflows.
Accounting rate of return=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
× 100
Average Annual Profit =
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡
𝑁𝑜.𝑜𝑓 𝑌𝑒𝑎𝑟𝑠

14. Case-1 when only original investment is given
Average Annual Investment =
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
2
Case-2 When original investment & scrap value is given, then
Average Investment = [
(𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒)
2
]
Case 3- When original investment and working capital are
given-
Average Investment = [
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
2
] + working capital

15.  Acceptance Rule
1. Accept those projects whose ARR is higher than
the minimum rate established by the management
2. Rank can be given to the projects based on their
ARR

16.  Includes time of money factor
 Following steps are involved-
1. Cash flows of the investment project should be forecasted
2. Appropriate discount rate should be identified to discount
forecasted cash flows
3. Present value of the cash flow should be calculated
4. NPV = present value of cash inflow – present value of
cash outflow
 Acceptance Rule
Project should be accepted if NPV is positive

17.  Profitability Index=
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤
𝑃𝑟𝑒𝑠𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤
If PI> 1, Project should be accepted

18.  IRR is a discount rate that makes the net present value (NPV)
of all cash flows equal to zero in a discounted cash flow
analysis.
 Or IRR is the discount rate which makes NPV= 0
 the higher an internal rate of return, the more desirable an
investment is to undertake.

22.  The modified internal rate of return (MIRR) assumes
that positive cash flows are reinvested at the firm's
cost of capital and that the initial outlays are
financed at the firm's financing cost.
 By contrast, the traditional internal rate of return
(IRR) assumes the cash flows from a project are
reinvested at the IRR itself.

23. FVCF(c) = the future value of positive cash flows at the cost of
capital for the company
PVCF = the present value of negative cash flows at the
financing cost of the company
n = no of periods

25.  Assume that a two-year project with an initial outlay of $195
and a cost of capital of 12% will return $121 in the first year
and $131 in the second year. To find the IRR of the project so
that the net present value (NPV) = 0 when IRR = 18.66%:
To calculate the MIRR of the project, assume that the
positive cash flows will be reinvested at the 12% cost of capital.
Therefore, the future value of the positive cash flows when t = 2
is computed as: