CMS 15489

Mushtaq Ahmed
Strategic Finance
MS Management Sciences
Assignment # 2

Capital Budgeting and Optimal Timing of Investment: A Case of Developing, Emerging or

Developed Country
Capital Budgeting
Capital budgeting is the process of planning expenditures on assets with cash flows expected to
extend beyond one year.
Capital Budgeting Process
Capital budgeting involves the following process:
a. Generating investment proposals consistent with the firms strategic objectives.
b. Estimating after-tax incremental operating cash flows for the investment projects.
c. Evaluating project incremental cash flows.
d. Selecting projects based on a value-maximizing acceptance criterion.
e. Re-evaluating implemented investment projects continually and perform post audits for
completed projects.
Classification of Investment Project Proposals
Generally the investment project proposals are classified into the following:
Replacements
a. Need to continue current operations
b. Need to reduce costs
Expansions
a. Need to expand existing products or markets
b. Need to expend into new products or markets
c. Others: safety/environmental projects, mergers
Capital Budgeting Techniques
Following capital budgeting techniques are used to evaluate the projects:
Payback Period (PBP)
PBP is the period of time required for the cumulative expected cash flows from an investment
project to equal the initial cash outflow.
Internal Rate of Return (IRR)
IRR is the discount rate that equates the present value of the future net cash flows from an
investment project with the projects initial cash outflow.
Net Present Value (NPV)
NPV is the present value of an investment projects net cash flows minus the projects initial cash
outflow.
Profitability Index (PI)
PI is the ratio of the present value of a projects future net cash flows to the projects initial cash
outflow.

Optimal Timing of Investment: A Case of Developing, Emerging or Developed Country

A capital budgeting analysis is used to determine whether the benefits stemming from
investments in a real asset are worth more than the cost of the asset. Generally the following
capital budgeting techniques and decision rules are used for optimal timing of investment in
developing, emerging or developed country:
The Pay Back Decision Rule:
If payback < maximum payback, then accept the project
If payback > maximum payback, then reject the project
The NPV Decision Rule:
If NPV > 0, then accept the project
If NPV < 0, then reject the project
The IRR Decision Rule:
If IRR > r, then accept the project
If IRR < r, then reject the project
The PI Decision Rule:
If PI > 1, then accept the project
If PI < 1, then reject the project

Notwithstanding developing, emerging or developed country, the optimal timing for investment
in any project would be when the sum of the expected net positive cash flows during the critical
payback period is greater than the initial cost, NPV is greater than zero, the IRR is greater than
hurdle rate and the PI is greater than one.TTTTTHHH