Capital Budgeting

It is :
Large investment in plant or equipment

with returns over a period of time.

Investment may take place over a period of time

A Strategic Investment Decision

Why Capital Budgeting is so Important?

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

Decision-making Criteria in Capital Budgeting

How do we decide if a capital investment project should be accepted or rejected?

Decision-making Criteria in Capital Budgeting

The ideal evaluation method should:

a) include all cash flows that occur during the life of the project, b) consider the time value of money, and c) incorporate the required rate of return on the project.

OVERALL AIM
To maximise shareholders wealth..
Projects should give a return over and above the marginal weighted average cost of capital. Projects can be; Mutually exclusive Independent

What is the difference between independent and mutually exclusive projects?

Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.

Capital Budgeting Process

1. Estimate the cash flows. 2. Assess the riskiness of the cash flows. 3. Determine the appropriate discount rate. 4. Find the PV of the expected cash flows. 5. Accept the project if PV of inflows > costs.

Techniques of Capital Budgeting Analysis

Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability Index

Payback period
Payback measures the time it will take to recoup, in the form of expected future cash flows, the net initial investment in a project Shorter payback period are preferable

FORMULA:For a project with equal annual receipts: I= initial investment C =net annual cash inflow

Example :
Years 0 1 2 250,000 3 250,000 4 250,000 5 250,000

Project A 1,000,000 250,000

= 4 years

Net Present Value

NPV method calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time, using the Required Rate of Return

Net Present Value Example

Year in the Life of the Project
0 $(250,000)

1 $125,000

2 $130,000

3 $115,000

Net initial investment

Annual cash inflows

Net Cash Year 10% Col. Inflows 1 0.909 $125,000 2 0.826 130,000 3 0.751 115,000 Total PV of net cash inflows Net initial investment Net present value of project

NPV of Net Cash Inflows $113,625 107,380 86,365 $307,370 $250,000 $ 57,370

Internal rate of return

The IRR is the discount rate at which the NPV for a

project equals zero. This rate means that the present value of the cash inflows for the project would equal the present value of its outflows. The IRR is the break-even discount rate. The IRR is found by trial and error.

PROFITABILITY INDEX (PI)

The profitability index, or PI, method compares the present value of future cash inflows with the initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows (PVCF) to the initial investment of the project.

Profitability Index (PI)

Method:

PVCash flows after theinitial investment PI Initial Investment

Note: PI should always be expressed as a positive number.

If PI 1, then accept the real investment project;

otherwise, reject it.

Which technique is superior?

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 a project is IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the projects estimated cash flows PI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment

Comparison of Capital Budgeting Models

Method Strengths Weaknesses Payback Easy to understand Ignores profitability Based on cash flows and the time value of money Highlights risks NPV & IRR Based on cash Difficult to flows, profitability & determine time value of money discount rate