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# CAPITAL BUDGETING

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### CAPITAL BUDGETING

1. 1. FINANCIAL MATHEMATICS
2. 2. CAPITAL BUDGETING • Capital budgeting –Investment decisions of a firm. • Investment decision rules –Capital budgeting techniques. • Grouped under 2 categories: 1.DISCOUNTED CASHFLOW • Net present value(NPV) • Internal rate of return(IRR) • Profitability index(PI) • Discounted payback period 2.NON-DISCOUNTED • Payback period (PB)
3. 3. NPV • Net present value – NPV is defined as the worth of an investment after taking into account all the cash flows associated with it. • Steps to calculate NPV – The first step is to estimate the expected future cash flows. – The second step is to estimate the required return for projects of this risk level. – The third step is to find the present value of the cash flows and subtract the initial investment.
4. 4. FORMULAE
5. 5. NPV – Decision Rule • If the NPV is positive, accept the project • A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. • Accept if NPV >0 • Reject if NPV <0 • May accept if NPV=0
6. 6. MERITS & DE-MERITS OF NPV MERITS DE-MERITS Considers all cash flows Requires estimates of cash flows-tedious True measure of profitability Requires computation of opportunity cost of capital Based on the concept of time value of money Satisfies the value additivity principle Consistent with wealth maximization principle.
7. 7. IRR • Internal rate of return is the interest rate at which the project cash flows give a zero NPV • If IRR > cost of capital ,proceed with the project • It takes into account the magnitude and timing of cash flows. • It is also known as yield on an investment. • To calculate the rate of return on a project: 1. Setting the NPV of the project to zero. 2. Solving for “r”. • Value of “r” by trial and error
8. 8. MERITS & DE-MERITS OF IRR MERITS DE-MERITS Considers all cash flows Requires estimates of cash flows-tedious True measure of profitability Does not hold the value additivity principle Based on the concept of time value of money Generally, consistent with wealth maximization principle Relatively difficult to compute.
9. 9. PROFITABILITY INDEX • It is defined as, the ratio of present values of cash inflows, at the required rate of return, to the initial cash outflow of the investment. PI= PV of cash inflows Initial cash outlay • Measures the benefit per unit cost, based on the time value of money. • Acceptance Rule: • Accept if PI > 1 • Reject if PI < 1 • May accept if PI = 1
10. 10. MERITS & DE-MERITS OF PI MERITS DE-MERITS Considers all cash flows Requires estimates of cash flows-tedious Recognizes the time value of money Relative measure of profitability Consistent with wealth maximization principle
11. 11. PAYBACK • It is defined as the number of years required to recover the original cash outlay that is invested in a project. Payback = Initial Investment Annual cash inflow • Computation – Estimate the cash flows – Subtract the future cash flows from the initial cost until the initial investment has been recovered • Decision Rule – Accept if the payback period is less than some preset limit(Standard payback)
12. 12. MERITS & DE-MERITS OF PAYBACK MERITS DE-MERITS Easy to understand and compute Ignores the time value of money It ranks projects Ignores cash flows occurring after the payback period Easy and crude way to cope with risk Not a measure of profitability Uses cash flows information No objective way to determine standard payback No relation with wealth maximization principle
13. 13. DISCOUNTED PAYBACK • One of the serious objections to the payback method-It does not discount cash flows. • It is defined as the time period it takes for the discounted cash flows generated by the project to cover the initial investment in the project. • It still fails to consider the cash flows after the payback period. • Decision Rule - Accept the project if it pays back on a discounted basis within the specified time
14. 14. MERITS & DE-MERITS OF DISCOUNTED PAYBACK MERITS DE-MERITS Includes time value of money Requires an arbitrary cutoff point Easy to understand Ignores cash flows beyond the cutoff point
15. 15. Weighted Average Cost of Capital(WACC) • It is defined as the average cost of raising finance for the business • Depends on the financing mix of the company’s capital (depends on the level of debt and equity) • It is used as the discount rate in project appraisal • Formulae: WACC = MV of debt/MV of debt +equity *net cost of debt+ MV of equity/MV of debt +equity *cost of equity
16. 16. WHY WACC? • Advantages of WACC: • Flexibility and simplicity • Disadvantages of WACC: • While the relative debt and equity values can be easily determined, calculating the costs of debt and equity can be problematic.
17. 17. THANK YOU