The document outlines the principles of capital budgeting in corporate finance, emphasizing the importance of investing in projects that produce returns exceeding the minimum acceptable hurdle rate while considering project risk. Key methods for investment analysis, such as net present value and internal rate of return, are presented, along with considerations for cash flow measurement and the impact of sunk costs. The analysis also highlights complex decision-making scenarios, including capital rationing and risk assessment techniques.

2. CAPITAL BUDGETING

3. INTRODUCTION TO CORPORATE FINANCE
First Principles of Corporate Finance
Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and should reflect the financing
mix used-either owners’ funds (equity) or borrowed money (debt).
• Returns on projects should be measured on the basis of cash flows generated
and the timing of these cash flows; they should also take into account both
positive and negative side effects of these projects.
Choose a financing mix that maximizes the value of the firm and matches the assets being
financed.
If there are not enough investments that earn the hurdle rate, return the cash to the owners of
the firm. The form of returns - dividends and stock buybacks - will depend on the stockholders
characteristics.
Objective : Maximize the Value of the firm.

4. WHAT ARE CAPITAL BUDGETING DECISIONS ?
The basic characteristic of capital budgeting (also referred
to as capital expenditure) is that it involves a current outlay
of funds in the hope of receiving a stream of benefits in
future.

5. WHY ARE CAPITAL BUDGETING DECISIONS IMPORTANT ?
• They have long term consequences.
• It is difficult to reverse capital budgeting decisions.
• It involves substantial outlays.

6. ASSEMBLING OF INVESTMENT PROPOSALS
• Modernisation and Replacement Decisions
• Expansion and Diversification
• New Product Investments
• Obligatory and Welfare Investments

7. Steps in Investment Analysis
• Estimate a hurdle rate for the project, based upon the riskiness of the
investment
• Estimate revenues and accounting earnings on the investment.
• Measure the accounting return to see if the investment measures up to the
hurdle rate.
• Operating income = EBIT = Reve – exp (SGA +COGS) – DEP= EBIT
• Convert accounting earnings (EBIT) into cash flows
• Use the cash flows to evaluate whether the investment is a good investment.
• Time weight the cash flows ( Investment Criterias)
• Use the time-weighted cash flows to evaluate whether the investment is a
good investment.

8. INVESTMENT CRITERIA
NetPresentValue BenefitCostRatio InternalRateofReturn
DiscountedCashFlowCriteria
PayBackPeriod AccountingRateofreturn
NonDiscountedCashFlowCriteria
InvestmentCriteria

9. NET PRESENT VALUE
• Net Benefit over and above the compensation for time and risk and
confirms to objective of Finance.
• Sum of the Present Values of all cash flows discounted at an appropriate
discount rate.
• It takes into account the time value of money
• It considers the cash flow stream in entirety.
• It follows the principle of value additivity.
• It is consistent with shareholders value maximisation.
• Problem in Mutually exclusive projects
• Its an absolute not a relative measure. You cannot rank projects.

10. BENEFIT COST RATIO
• This is the Net Present Value per Rupee of outlay.
• Therefore it can differentiate between large and
small projects.
• It is recommended in cases of Constrained capital
budgets.

11. INTERNAL RATE OF RETURN
• The Discount Rate that makes the Net Present
Value equal to zero.
• Makes sense to business men who think in terms
of rate of return.
• However if the cash flow stream changes sign
there may be multiple returns.
• Projects of different scales cannot be ranked.

12. PAY BACK PERIOD
• It is the length of time required to recover the initial cash outlay.
• It is a rough and ready method for dealing with risk. And short
paybacks mean quick profits and Easier to communicate
• It emphasizes early cash inflows , so good for firms hard pressed
for liquidity.
• Ignores all cash flows after the cut off date
• Equal weights to all cash flows before cut off dates.
• Discounted Payback simply means the number of years that the
project must last in order for it to make sense in terms of net
present value.

13. Book RATE OF RETURN
• It is the average rate of return given by Profit After Tax
divided by Book value of Investment.
• It is based on accounting information.
• Book rate of return is an average across all activities
and not an ideal benchmark for all new projects.

14. Analysing Cash Flows

15. Measures of return: Accounting Earnings
• Principles Governing Accounting Earnings Measurement
• Accrual Accounting: Show revenues when products and
services are sold or provided, not when they are paid for.
Show expenses associated with these revenues rather than
cash expenses.
• Operating versus Capital Expenditures: Only expenses
associated with creating revenues in the current period
should be treated as operating expenses. Expenses that
create benefits over several periods are written off over
multiple periods (as depreciation or amortization)

16. From Forecasts to Accounting Earnings
 Measure only Incremental cash flow
 Separate projected expenses into operating and capital expenses: Operating expenses, in
accounting, are expenses designed to generate benefits only in the current period, while
capital expenses generate benefits over multiple periods.
 Depreciate or amortize the capital expenses over time: Once expenses have been
categorized as capital expenses, they have to be depreciated or amortized over time.
 Allocate fixed expenses that cannot be traced to specific projects: Expenses that are not
directly traceable to a project get allocated to projects, based upon a measure such as
revenues generated by the project; projects that are expected to make more revenues
will have proportionately more of the expense allocated to them.
 Consider the tax effect: Consider the tax liability that would be created by the operating
income we have estimated
 Consider the duration for which projected

17. From Earnings to Cash Flows
• To get from accounting earnings to cash flows:
• you have to add back non-cash expenses (like depreciation and amortization)
• you have to subtract out cash outflows which are not expensed (such as
capital expenditures)
• you have to make accrual revenues and expenses into cash revenues and
expenses (by considering changes in working capital).
• Free cash Flow to FIRM = EBIT(1-T) +Depreciation/amortization – capex –
change in NWC
• FCFF WILL BE DISCOUNTED AT WACC (POST TAX)

18. Sunk Costs
• Any expenditure that has already been incurred, and cannot be recovered (even
if a project is rejected) is called a sunk cost
• When analyzing a project, sunk costs should not be considered since they are not
incremental
• By this definition, market testing expenses and R&D expenses are both likely to
be sunk costs before the projects that are based upon them are analyzed. If sunk
costs are not considered in project analysis, how can a firm ensure that these
costs are covered?
• Remember Cannibalization costs, if any.

19. Allocated Costs
• Firms allocate costs to individual projects from a centralized pool
(such as general and administrative expenses) based upon some
characteristic of the project (sales is a common choice)
• For large firms, these allocated costs can result in the rejection of
projects
• To the degree that these costs are not incremental (and would exist
anyway), this makes the firm worse off.
• Thus, it is only the incremental component of allocated costs that should
show up in project analysis.
• How, looking at these pooled expenses, do we know how much of the
costs are fixed and how much are variable?

20. Closure on Cash Flows
• In a project with a finite and short life, you would need to compute a salvage
value, which is the expected proceeds from selling all of the investment in the
project at the end of the project life. It is usually set equal to book value of fixed
assets and working capital (Don’t forget to recover working capital)
• In a project with an infinite or very long life, we compute cash flows for a
reasonable period, and then compute a terminal value for this project, which is
the present value of all cash flows that occur after the estimation period ends..

21. COMPONENTS OF CASH FLOW STREAM
• Initial Flow
Outlay on Plant & Machinery and F.A. + Outlay on Net Working
Capital
• Operational Flow
EBIT (1-T) + Depreciation
• Terminal Flow
P.T. Salvage value of F.A. & NWC.

22. Complex Investment Decisions
• How shall choice be made between investments with different lives?
• How shall choice be made between investments under capital rationing?

23. COMPLEX DECISIONS
• Annual Equivalent Value Method
Assume that each machinery is replaced in the last year of life with an
identical asset.
Calculate the AEV by using the formula,
AEV = NPV / Annuity Factor
• Investment Timing and Duration
Undertake the project at that point of time which maximises NPV.
• AEV can be used to find
• BCR/PI may be used for Capital Rationing – Multi Prd. Constraints and
Indivisibility

24. Risk Analysis in Capital Budgeting
• Conventional Techniques for Risk Analysis
--Payback -- Risk Adjusted Discount Rate
• Techniques
Sensitivity and Scenario Analysis

25. The proportion of proposed projects having positive NPVs at
the corporate hurdle rate is independent of the hurdle rate.
!!!
Its all about forecasts

26. Where does positive NPV come from?
• Projects may look attractive for two reasons:1) There are some
errors in forecast 2)The company genuinely expects to earn
excess profits.
• So increase odds in your favor by moving in areas of
competitive advantages.
• Look at economic rents and where even advantage is absent or
entry of competitors will push prices down or costs up, don’t
enter .
• When you have the market value of an asset use it..rather then
over analysis…gold, real estate..airplanes etc…
• PV calculations may vary and subject to error …that’s life!!!!!