Ramesh Kumar N presents information on capital budgeting analysis. He has over 32 years of experience in banking and finance. Capital budgeting is the process of analyzing long-term investment projects to determine if they will increase shareholder value. It is a critical decision for companies, as projects involve large investments and risks. Techniques for evaluating projects include payback period, net present value (NPV), internal rate of return (IRR), and profitability index. NPV is the preferred method as it considers all cash flows and time value of money, consistent with maximizing shareholder wealth.

1. Ramesh Kumar N Capital Budget1
Capital Budgeting – an analysis
Ramesh Kumar N

2. Ramesh Kumar N C2
Presenter’s background
RAMESH KUMAR NANJUNDAIYA – MS (Belgium), MBA (US)
 Associate Partner & Head - Finance/Business set-up and Family Office of M/s. Insta Solu Venture
Consultants, LLP, Bangalore, India
 Certified as “Independent Corporate Director”, by World Council For Corporate Governance,
London, UK [License # WCFCG/IID/DCD/2011/1711] – 2011
 Visiting Guest Faculty in “International Marketing”and “Corporate Finance” course for final year
MBA students at a known institutions in Bangalore, India.
Professional overview
 An accomplished professional with over 32 years’ of experience in banking and the financial
sector with established credentials in Corporate Banking and Marketing, Financial Management,
Venture & PE Capital sourcing, setting up JVs and with forte in Start ups to promote new
commercial banks, ventures, undertaking IPO groundwork & Listing for SMEs.
 Senior banker with working experience gained in known international banks as BNP, SCB,
Citibank, EBIL, Barclays Bank, Banque Saudi Fransi in such diverse countries as the Middle East
(GCC) region, West Europe and India.
 Trainer in Corporate Banking and Credit, International Trade and Marketing and Business
Consultation.

3. Ramesh Kumar N C3
Definition
 Budget – It is a description of a financial plan. It is a
list of estimates of revenues to and expenditures by
an agent for a stated period of time. Normally a
budget describes a period in the future not the past.
 Capital Budgeting - Capital budgeting (also known
as investment appraisal) is the process by which
a company determines whether projects (such as
investing in R&D, opening a new branch, replacing a
machine) are worth pursuing. A project is worth
pursuing if it increases the value of the company. A
project typically adds value to the company if it earns
a rate of return that exceeds the cost of capital.

4. Ramesh Kumar N C4
Meaning and Risk issues
 Capital budgeting addresses the issue of strategic
long-term investment decisions.
 Capital budgeting can be defined as the process of
analyzing, evaluating and deciding whether
resources should be allocated to a project or not.
 Process of capital budgeting ensure optimal
allocation of resources and helps management work
towards the goal of shareholder wealth
maximization.

5. Ramesh Kumar N C5
Why is it so significant for a company
 Considered to be the most important
decision that a corporate treasurer has to
make for the company and for the benefit of
its shareholders/stakeholders.
 So much is the significance of capital
budgeting that many business schools offer a
separate course on capital budgeting

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What does it entail
Involve massive investment of
resources
Are not easily reversible
Have long-term implications for the firm
Involve uncertainty and risk for the firm

7. Ramesh Kumar N C7
Is this a critical decision
 Due to the above factors, capital budgeting decisions become
critical and must be evaluated very carefully.
 Any firm that does not follow the capital budgeting process will
not be maximizing shareholder wealth and
 Management will not be acting in the best interests of
shareholders.
 Kingfisher Airlines – present situation
 Concorde Plane – had to face major problem due to bad capital
budgeting.
 Good international company today is CISCO.

8. Ramesh Kumar N C8
Techniques
 Payback Period Approach
 Discounted Payback Period Approach
 Net Present Value Approach
 Internal Rate of Return
 Profitability Index

9. Ramesh Kumar N C9
Which method to use and follow
 A technique that helps us in selecting
projects that are consistent with the principle
of shareholder wealth maximization.
 A technique is considered consistent with
wealth maximization if
– It is based on cash flows
– Considers all the cash flows
– Considers time value of money
– Is unbiased in selecting projects

10. Ramesh Kumar N C10
Pay back period
 The amount of time needed to recover the initial
investment
 The number of years it takes including a fraction of
the year to recover initial investment is called
payback period
 To compute payback period, keep adding the cash
flows till the sum equals initial investment
 Simplicity is the main benefit, but suffers from
drawbacks
 Technique is not consistent with wealth maximization
—Why?

11. Ramesh Kumar N C11
Discounted pay back
 Similar to payback period approach with one
difference that it considers time value of money
 The amount of time needed to recover initial
investment given the present value of cash inflows
 Keep adding the discounted cash flows till the sum
equals initial investment
 All other drawbacks of the payback period remains in
this approach
 Not consistent with wealth maximization

12. Ramesh Kumar N C12
Net present value
 Based on the dollar amount of cash flows
 The dollar amount of value added by a
project
 NPV equals the present value of cash inflows
minus initial investment
 Technique is consistent with the principle of
wealth maximization—Why?
 Accept a project if NPV ≥ 0

13. Ramesh Kumar N C13
IRR
 The rate at which the net present value of
cash flows of a project is zero, I.e., the rate at
which the present value of cash inflows
equals initial investment
 Project’s promised rate of return given initial
investment and cash flows
 Consistent with wealth maximization
 Accept a project if IRR ≥ Cost of Capital

14. Ramesh Kumar N C14
NPV versus IRR
 Usually, NPV and IRR are consistent with each
other. If IRR says accept the project, NPV will also
say accept the project
 IRR can be in conflict with NPV if
– Investing or Financing Decisions
– Projects are mutually exclusive
 Projects differ in scale of investment
 Cash flow patterns of projects is different
– If cash flows alternate in sign—problem of multiple IRR
 If IRR and NPV conflict, use NPV approach

15. Ramesh Kumar N C15
Profitability index [PI]
 A part of discounted cash flow family
 PI = PV of Cash Inflows/initial investment
 Accept a project if PI ≥ 1.0, which means positive
NPV
 Usually, PI consistent with NPV
 PI may be in conflict with NPV if
– Projects are mutually exclusive
 Scale of projects differ
 Pattern of cash flows of projects is different
 When in conflict with NPV, use NPV

16. Ramesh Kumar N C16
Project evaluation methods
 Replacement Chain Analysis
 Equivalent Annual Cost Method
 If two machines are unequal in life, we need
to make adjustment before computing NPV.

17. Ramesh Kumar N C17
Which technique is good
 Although our decision should be based on NPV, but
each technique contributes in its own way.
 Payback period is a rough measure of riskiness.
The longer the payback period, more risky the
project is.
 IRR is a measure of safety margin in a project.
Higher IRR means more safety margin in the
project’s estimated cash flows.
 PI is a measure of cost-benefit analysis. How much
NPV for every dollar of initial investment.
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