capital budgeting in financial management

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Capital Budgeting
By: Shikha Gupta,
(MBA Finance; NET in Management)
Assistant Professor, IITM

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Table of Contents
Introduction
Types of Capital Budgeting Proposals
Capital Budgeting Techniques
Conclusions
Importance of Capital Budgeting Decisions

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Three pillars of Financial Management: FDI
Capital Budgeting is used to make the Investment Decision
Financial
Markets
Financing
Decision Investment
Decision
Returns from Investment
Reinvestment
Refinancing
Real Assets
Dividend
Decision
Returns to Security Holders
Finance
Manager

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Capital Budgeting: Introduction
Definition:
Firm’s decision to invest its current funds most efficiently in the
long term assets in anticipation of an expected flow of benefits
over a series of years
Investment
Decision
Long-Term
CAPITAL
BUDGETING
Short-Term
Working Capital
Management

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Importance of Capital Budgeting Decisions
 Irreversible decision
 Involves commitment of large
amount of funds
 Have long-term implication for
the firm and influence its risk
profile
 Requires assessment of future
events which are uncertain

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Types of Capital Budgeting Proposals
Independent
Proposals
Independent proposals do not depend upon each other
Example:
Dependent
Proposals
The acceptance of one proposal is contingent upon the
acceptance of other proposal
Example:
Mutually
Exclusive
Proposals
The acceptance of one proposal results in the automatic
rejection of the other proposal
Example:

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Techniques of Capital Budgeting
Discounted Cash
flow(DCF) Criteria
NPV
IRR
PI
Non-discounted
Cash flow Criteria
PBP
ARR
Considers
Ignores
Time Value of Money

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DCF: Net Present Value (NPV)
 Explicitly recognizes time value of money
 All cash inflows and outflows are converted into present value
(PV) using an appropriate discount rate (usually cost of capital)
 Finally, NPV is computed by subtracting the PV of cash
outflows (COs) from the PV of cash inflows(CIs)
Conclusion:
 If NPV > Zero Accept the proposal
 If NPV < Zero Reject the Proposal
NPV PV of CIs PV of COs

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DCF: Internal Rate of Return (IRR)
Methods:
 Trial and Error Method
 Interpolation Method
Formulae:
Lower Interest Rate + NPV of Lower Rate x (Higher Rate - Lower Rate)
NPV Lower Rate (-) NPV Higher Rate
IRR is the rate where NPV ZERO
Definition:
It is defined as the rate which equates the present value of cash
inflows with the present value of cash outflows of an Investment

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DCF: Profitability Index Method / Benefit Cost Ratio
Definition:
It gives the present value of future benefits computed at the
required rate of return on the initial investment
Gross Profitability Index (PI)
PV of Cash Inflows
PV of Cash Outflows
Rule of Acceptance:
 If PI > 1 Accept the proposal
 If PI < 1 Reject the Proposal
 If PI = 1 Neutral
Net Profitability Index (PI) Gross Profitability Index 1

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Non-Discounted Cash Flows: Pay-Back Period
Definition:
Number of years required to recover the initial investment in full
with the stream of annual cash flows generated by the project
 In Case of Constant Annual Cash Inflows:
 In Case of Uneven or Unequal Cash Inflows:
It can be calculated by adding up the cash inflows until the total is equal to
the initial investment with the help of cumulative cash inflow.
Pay-back Period
Cash Outlay (Initial Investment)
Annual Cash Inflows

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Non-Discounted Cash Flows: Average Rate of Return
Method (ARR) or Accounting Rate of Return Method
Definition:
 Focuses on the average net income generated in a project in
relation to the project's average investment outlay
 Involves accounting profits not cash flows and is similar to the
performance measure of return on capital employed (ROCE)
Average Rate of Return
Average Income
Average Investments*
100
* Average Investment = Original Investment / 2

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Conclusion
Capital Budgeting involves of planning the
deployment of available capital for the purpose
of maximizing the long-term profitability of the
firm
Investment Decision Making or Capital
Expenditure Decisions" relates to the
evaluation of several alternative capital
projects for the purpose of assessing those
which have the highest rate of return on
investment

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Thank You