Capital budgeting 01.pptx

What is Capital Budgeting?
•The process of identifying,
analyzing, and selecting investment
projects
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What is
Capital
Budgeting?
• Capital budgeting is the process a business undertakes to
evaluate potential major projects or investments.
Construction of a new plant or a big investment in an
outside venture are examples of projects that would
require capital budgeting before they are approved or
rejected.
• As part of capital budgeting, a company might assess a
prospective project's lifetime cash inflows and outflows to
determine whether the potential returns that would be
generated meet a sufficient target benchmark. The capital
budgeting process is also known as investment appraisal.
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Importance of Investment Decisions
• Investment decisions concerned with the allocation of funds into
different investment opportunities for the purpose of earning the
highest possible return. It simply assists firms in selecting the right
type of assets for deploying their funds. These decisions are taken by
the investor or top-level managers who properly analyses each
opportunity before investing any fund into them
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Affects Firm Growth
• Investment decisions have long term effects on the earning potential
and growth rate of a firm. These decisions decide the position of an
organization in the coming future. Proper planning of investment may
lead to a large flow of funds. Whereas, any wrong decision may prove
disastrous for a firm existence leading to heavy losses
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Determines Risk
• These decisions carry a high degree of risk as funds are committed for
a longer period. Individuals invest a large amount on the basis of
expected income in the future which is totally uncertain. Different
tools and techniques are used by investors for analyzing available
assets for a risk factor while taking such decisions
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Larger Investments
• Investment decisions are taken for the deployment of huge funds for
a longer period. Such decisions require proper attention as the firm
has limited funds whereas demand exceeds the existing resources.
Proper planning of investment and monitoring of expenditures should
be necessarily done by each firm for attaining goals.
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No-Going Back
• Decisions related to investment are mostly of irreversible nature. It is
impossible to revert back from such decisions once capital items are
already acquired. Finding a market for disposing of permanent assets
without incurring heavy losses is quite difficult
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Investment Decision
• This decision in financial management is concerned with allocation of
funds raised from various sources into acquisition assets or
investment in a project.
• i. Expansion of business
• ii. Diversification of business
• iii. Productivity improvement
• iv. Product improvement
• v. Research and Development
• vi. Acquisition of assets (tangible and intangible), and
• vii. Mergers and acquisitions
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Investment Decision
• Further, Investment decision not only involves allocating capital to long
term assets but also involves decisions of utilizing surplus funds in the
business, any idle cash earns no further interest and therefore not
productive. So, it has to be invested in various as marketable securities
such as bonds, deposits that can earn income.
• Most of the investment decisions are uncertain and a complex process as it
involves decisions relating to the investment of current funds for the
benefit to be achieved in future. Therefore while considering investment
proposal it is important to take into consideration both expected return
and the risk involved. Thus, finance department of an organization has to
decide to allocate funds into profitable ventures so that there is safety on
investment and regular returns is possible.
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Factors which affect to the investment
decisions
• Investment decisions are the financial decisions taken by
management to invest funds in different assets with an aim to earn
the highest possible returns for the investors. It involves evaluating
various possible investment opportunities and selecting the best
options. The investment decisions can be long term or short term
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Long Term Investment Decisions:
• Long term investment decisions are all such decisions which are related to
investing of funds for a long period of time. They are also called as Capital
Budgeting decisions.
• The long term investment decisions are related to management of fixed
capital. These decisions involve huge amounts of investments and it is very
difficult to reverse such decisions. Therefore, it is must that such decisions
are taken only by those people who have comprehensive knowledge about
the company and its requirements. Any bad decision may severely damage
the financial fortune of the business enterprise
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Investment Decisions
• (i) Cash Flow of the Project- Before considering an investment option,
business must carefully analyse the net cash flows expected from the
investment during the life of the investment. Investment should be
done only if the net cash flows are more than the funds invested.
• (ii) The Rate of Return- The rate of return is the most important
factor while taking an investment decision. The investment
must be done in the projects which earn the higher rate of
return provided the level of risk is same
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What Is Net Present Value (NPV)
• Net present value (NPV) is the difference between the present value
of cash inflows and the present value of cash outflows over a period
of time.
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Example 01 -
• Nimala Fernando is evaluating a new project for her firm, B Ltd.. She
has determined that the after-tax cash flows for the project will be
Rs.10,000; Rs 12,000; Rs 15,000; Rs. 10,000; and Rs. 7,000,
respectively, for each of the Years 1 through 5. The initial cash outlay
will be Rs. 40,000. Nimala Fernando has determined that the
appropriate discount rate (k) for this project is 13%.
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What Is Internal Rate of Return (IRR)?
• The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability
of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash
flows equal to zero in a discounted cash flow analysis.
• IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is not the actual
dollar value of the project. It is the annual return that makes the NPV equal to zero.
• Generally speaking, the higher an internal rate of return, the more desirable an investment is to
undertake. IRR is uniform for investments of varying types and, as such, can be used to rank
multiple prospective investments or projects on a relatively even basis. In general, when
comparing investment options with other similar characteristics, the investment with the highest
IRR probably would be considered the best.
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What Is the Profitability Index (PI)?
• The profitability index (PI), alternatively referred to as value
investment ratio (VIR) or profit investment ratio (PIR), describes
an index that represents the relationship between the costs and
benefits of a proposed project. It is calculated as the ratio
between the present value of future expected cash flows and
the initial amount invested in the project. A higher PI means that
a project will be considered more attractive
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Example - 01
• Company c Ltd is considering two projects:
• Project A requires an initial investment of $1,500,000 to yield estimated
annual cash flows of:
• The appropriate discount rate for this
project is 10%
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• Project B requires an initial investment of $3,000,000 to yield estimated
annual cash flows of
• Company A is only able to undertake one project. Using the profitability
index method, which project should the company undertake
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Advantages of the Profitability Index
• The profitability index indicates whether an investment should create
or destroy company value.
• It takes into consideration the time value of money and the risk of
future cash flows through the cost of capital.
• It is useful for ranking and choosing between projects when capital is
rationed.
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Investment
Evaluation
Criteria
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Investment Evaluation Criteria
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NPV
Acceptance
Rule
Accept the project when NPV is positive
NPV > 0
• Reject the project when NPV is negative
NPV < 0
• May accept the project when NPV is
zero NPV = 0
• The NPV method can be used to select between
mutually exclusive projects; the one with the
higher NPV should be selected.
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Evaluation of
the NPV
Method
NPV is most acceptable investment rule for the
following reasons:
• Time value is considered.
• Measure of true profitability because it
considers all
• cash flows occurring over the life of the project
• Value-additivity
• Consistent with the objective shareholder value
maximization.
Limitations:
• Involved cash flow estimation
• Discount rate difficult to determine
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IRR
Acceptance
Rule
Accept the project when r > k.
Reject the project when r < k.
May accept the project when r = k.
In case of independent projects, IRR and NPV
rules will give the same results if the firm has no
shortage of funds.
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PI Acceptance Rule
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The following are the PI acceptance rules:
Accept the project when PI is greater than one.
PI > 1
Reject the project when PI is less than one.
PI < 1
May accept the project when PI is equal to one.
PI = 1
The project with positive NPV will have PI greater than one. PI less than means
that the project’s NPV is negative.

Capital budgeting 01.pptx

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Capital budgeting 01.pptx