Capital Budgeting_Parakramesh Jaroli_MBA_FM

1. Presented By:
Parakramesh Jaroli
MBA (Dual) II - Semester

2. Capital Budgeting
• Capital budgeting(or investment appraisal) is the process of
evaluating and selecting long-term investments that are in line with
the goal of investors’ wealth maximization.
• We want to invest in projects where the value of the future returns is
greater than the cost.
In Capital Budgeting involves:-
• Evaluating investment project proposals that are strategic to
business overall objectives
• Estimating and evaluating how much cash flows incurred for each of
the investment proposals
• Selection an investment proposal that maximizes the return to the
investors

3. FEATURES OFCAPITAL BUDGETING
(i)Long-term effects
(ii)High degree of risk
(iii)Irreversibility
(iv)Complex decision
(v) Impact on Firm’s Competitive Strength
(vi) Impact on Cost Structure

4. PROCESS OF CAPITAL BUDGETING
CAPITAL
BUDGETING
PROCESS
PROJECT GENERATION
PROJECT EVALUATION
PROJECT SELECTION
PROJECT EXECUTION
PERFORMANCE REVIEW

5. Project Evaluation methods/ Techniques
of Capital Budgeting
Payback Period (PBP)
– Average Rate of Return
(ARR)
Net Present Value (NPV)
– Profitability Index (PI)
– Internal Rate of Return (IRR)
Techniques
of Capital
Budgeting
TRADITIONAL
Discounted
Cash Flow

6. Payback Period
• The payback method simply measures how long (in
years and/or months) it takes to recover the initial
investment.
• The maximum acceptable payback period is
determined by management.
• If the payback period is less than the maximum
acceptable payback period, accept the project.
• If the payback period is greater than the maximum
acceptable payback period, reject the project.

7. Pros and Cons of Payback Periods
• The payback method is widely used by large firms to
evaluate small projects.
• It is simple, intuitive, low cost and considers cash
flows rather than accounting profits (liquidity
oriented)
• Ignores the profitability of the projects
• Ignores the cost of capital
• Ignores PV of cash inflows
• Difficult to decide maximum acceptable period

8. Pay back method
• This method is based on the principal that every
capital expenditures pays itself back within a
certain period out of the additional earnings
generated from the capital assets.
• Formula:=
Original cost of the asset/Initial Investment
Net Annual cash inflow
Evaluation of a project:- if project doesn’t pay back
itself within period specified – it is rejected …

9. Accounting or Average rate of return
• The term “ Average annual net earnings” is the average of the earnings (after
depreciation and tax) over the whole of the economic life. One may calculate "
Average annual net earnings " before tax. Such rate is known as pre - tax
accounting rate of return.
• If ARR = OR > required rate of return then acceptable
• If ARR is < the desired rate then rejected
• When comparing investments, the higher the ARR, the more attractive the
investment
• +
• Formula:-
where

10. Net present value
• The net present value is the difference between present value of
benefits and present value of costs. If the net present value is
positive the conclusion is favorable to the decision to go ahead with
the project but if it is negative, the project is rejected.
Accept/Reject Criterion :
Where NPV > Zero accept the proposal
NPV = Zero accept the proposal
NPV < Zero reject the proposal
NPV = Net Present Value
• The net present value technique is a discounted cash flow method
that considers the time value of money in evaluating capital
investments.
• Net present value = Present value of net cash flow - Total net
initial investment

11. Advantages
• NPV method takes into account the time value of money.
• The whole stream of cash flows is considered.
• The net present value can be seen as the addition to the wealth
of share holders.
• The NPV uses the discounted cash flows i.e., expresses cash
flows in terms of current rupees. The NPVs of different
projects therefore can be compared. It implies that each project
can be evaluated independent of others on its own merit

12. Limitations
• It involves difficult calculations.
• The application of this method necessitates forecasting cash flows and the
discount rate. Thus accuracy of NPV depends on accurate estimation of
these two factors which may be quite difficult in practice.
• The ranking of projects depends on the discount rate.

13. NPV: Strengths and Weaknesses
• Strengths
– Resulting number is easy to interpret: shows how wealth will change if
the project is accepted.
– Acceptance criteria is consistent with shareholder wealth
maximization.
– Relatively straightforward to calculate
• Weaknesses
– Requires knowledge of finance to use.
– An improper NPV analysis may lead to the wrong choices of projects
when the firm has capital rationing – this will be discussed later.

14. Internal rate of return
• The internal rate of return method considers the time
value of money.
• This method measures the rate of return which earnings
are expected to yield on investment.
• Acceptance rule:-
• IRR = or > the cut of rate then project is
accepted.
• When it is < the cut of rate then project is
rejected.

15. IRR: Strengths and Weaknesses
• Strengths
– IRR number is easy to interpret: shows the return the project
generates.
– Acceptance criteria is generally consistent with shareholder
wealth maximization.
• Weaknesses
– Requires knowledge of finance to use.
– Difficult to calculate – need financial calculator.
– It is possible that there exists no IRR or multiple IRRs for a
project and there are several special cases when the IRR
analysis needs to be adjusted in order to make a correct
decision (these problems will be addressed later).
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16. Summary of Key Formulas/Definitions and Decision Criteria
for Capital Budgeting Techniques
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