Capital Budgeting


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Capital Budgeting

  1. 1. Capital Budgeting
  2. 2. Capital Budgeting <ul><li>Capital budgeting is the process of evaluating proposed log term investment projects. </li></ul><ul><li>The projects may be the purchase of fixed assets, investment in research and development, advertising etc. </li></ul><ul><li>Careful capital budgeting is vital to ensure that the proposed investment will add value to the firm. </li></ul>
  3. 3. Decision practices <ul><li>Financial managers apply two decision practices when selecting capital budgeting projects. </li></ul><ul><li>Accept /rejects decision </li></ul><ul><li>Ranking </li></ul><ul><li>Accept/reject decision: this decision focuses on the question whether the proposed project would add value to the firm or will earn a rate of return that will be acceptable to the company. </li></ul>
  4. 4. <ul><li>Ranking: ranking compares projects to a standard measure like for instance the standard is how quickly the project pays off the initial investment, then the project that pays off the investment most rapidly would be ranked first. </li></ul>
  5. 5. Types of Projects <ul><li>Firm invest in two categories of projects, independent projects and mutually exclusive projects. </li></ul><ul><li>Independent projects: independent projects do not compete with each other, a firm may accept none, some or all from among a group of independent projects. Like a new telephone system and a warehouse. </li></ul><ul><li>Mutually exclusive projects: competes against each other , that is the best project among the proposed group of projects will be selected like purchasing of Xerox copier or Toshiba copier. </li></ul>
  6. 6. Stages in Capital Budgeting Process <ul><li>Finding projects </li></ul><ul><li>Estimating the incremental cash flows associated with projects. </li></ul><ul><li>Evaluating and selecting the projects </li></ul><ul><li>Implementing and monitoring the projects </li></ul>
  7. 7. Capital budgeting decision methods <ul><li>Payback method </li></ul><ul><li>Discounted payback method </li></ul><ul><li>Net present value </li></ul><ul><li>Internal rate of return </li></ul><ul><li>Profitability index </li></ul>
  8. 8. <ul><li>How do we decide if a capital investment project should be accepted or rejected? </li></ul>Decision-making Criteria in Capital Budgeting
  9. 9. <ul><li>The Ideal Evaluation Method should: </li></ul><ul><li>a) include all cash flows that occur during the life of the project, </li></ul><ul><li>b) consider the time value of money , </li></ul><ul><li>c) incorporate the required rate of return on the project. </li></ul>Decision-making Criteria in Capital Budgeting
  10. 10. <ul><li>The number of years needed to recover the initial cash outlay. </li></ul><ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>Payback Method
  11. 11. <ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>(500) 150 150 150 150 150 150 150 150 Payback Period 0 1 2 3 4 5 8 6 7
  12. 12. <ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>Payback period = 3.33 years. Payback Method 0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
  13. 13. <ul><li>Does not consider time value of money . </li></ul><ul><li>Does not consider any required rate of return . </li></ul><ul><li>Does not consider all of the project’s cash flows . </li></ul>Drawbacks of Payback Method
  14. 14. <ul><li>Discounts the cash flows at the firm’s required rate of return. </li></ul><ul><li>Payback period is calculated using these discounted net cash flows. </li></ul><ul><li>Problem : </li></ul><ul><li>does not examine all cash flows. </li></ul>Discounted Payback
  15. 15. <ul><li>1) Net Present Value (NPV) </li></ul><ul><li>2) Profitability Index (PI) </li></ul><ul><li>3) Internal Rate of Return (IRR) </li></ul><ul><li>Each of these decision-making criteria: </li></ul><ul><li>Examines all net cash flows, </li></ul><ul><li>Considers the time value of money, and </li></ul><ul><li>Considers the required rate of return. </li></ul>Other Methods
  16. 16. <ul><li>NPV = the total PV of the annual net cash flows - the initial outlay. </li></ul>Net Present Value NPV = - IO ACF t (1 + k) t n t=1 
  17. 17. Net Present Value <ul><li>Decision Rule : </li></ul><ul><li>If NPV is positive, ACCEPT . </li></ul><ul><li>If NPV is negative, REJECT . </li></ul>
  18. 18. Profitability Index NPV = - IO ACF t (1 + k) t n t=1 
  19. 19. t Profitability Index NPV = - IO ACF t (1 + k) t n t=1  PI = IO ACF t (1 + k) n t=1 
  20. 20. Profitability Index <ul><li>Decision Rule : </li></ul><ul><li>If PI is greater than or equal to 1, ACCEPT . </li></ul><ul><li>If PI is less than 1, REJECT . </li></ul>
  21. 21. <ul><li>IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay. </li></ul>Internal Rate of Return (IRR) n t=1  IRR: = IO ACF t (1 + IRR) t
  22. 22. IRR <ul><li>Decision Rule : </li></ul><ul><li>If IRR is greater than or equal to the required rate of return, ACCEPT . </li></ul><ul><li>If IRR is less than the required rate of return, REJECT . </li></ul>