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Capital Budgeting PPT

The document discusses capital budgeting techniques for evaluating investment projects. It covers non-discounted methods like payback period and accounting rate of return as well as discounted methods like net present value, internal rate of return, and profitability index. Decision criteria for accepting or rejecting projects based on these methods is also discussed.

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155 views12 pages

Capital Budgeting PPT

The document discusses capital budgeting techniques for evaluating investment projects. It covers non-discounted methods like payback period and accounting rate of return as well as discounted methods like net present value, internal rate of return, and profitability index. Decision criteria for accepting or rejecting projects based on these methods is also discussed.

Uploaded by

shyam
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Capital Budgeting

Source - https://twproject.com/

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Capital Budgeting
A capital budgeting decision is typically a go or no-go
decision on a product, service, facility, or activity of the
firm. That is, we either accept the business proposal or we
reject it.

 A capital budgeting decision will require sound estimates


of the timing and amount of cash flow for the proposal.

Projects can be classified as:


 Replacement
 Expansion
 New venture

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Characteristics of Business Projects
Project Types and Risk
Capital projects have increasing risk according to
whether they are replacements, expansions or new
ventures
Stand-Alone and Mutually Exclusive Projects
Stand-alone project has no competing alternatives

Mutually exclusive projects involve selecting one


project from among two or more alternatives

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4 Source :Self Created
Non Discounted Criteria
Payback Period Method: Pay back period is the period required to recover initial
cash outlay . As the name suggests, this method gives the period in which the
proposed project will generate cash to recover the initial investment. It purely
stresses on the cash inflows, economic life of the project and the investment made
in the project.

Pay Back Period= Cash Outlay (Investment)/Annual Cash Inflow Accounting

Average Rate of Return Method (ARR): This method helps to rectify the
disadvantages of the payback period method. It works on the base that any project
having ARR higher than the minimum rate set by the management will be
considered and those below the set rate are rejected.

ARR= (Average Profit/Average Investment)*100

5
Discounted Criteria

The discounted cash flow method calculates the cash inflow and outflow through the
life of an asset. These cash flows are then discounted through a discounting factor.
The discounted cash inflows and outflows are then compared.

Discounted Pay Back Period: In this method, cash flows are discounted through
discount factor. Remaining will be same as traditional method.

Net present Value (NPV) Method: The net present value is arrived by taking the
difference between the present value of cash inflows and the present value of cash
outflows over a period of time.

NPV=PVB-PVC

6
Internal Rate of Return (IRR):

• This is expressed as the rate at which the net present value of the investment is
zero.
The discounted cash inflows is equal to the discounted cash outflow. This method
considers time value of money. This method gives a rate of interest at which funds
invested in the project could be repaid out of the cash inflows.

IRR is the rate at which the NPV becomes zero.

Finding IRRs usually requires an iterative, trial-and-error technique

Calculate the project’s NPV using this interest rate

If NPV = zero, the guessed interest rate is the project’s IRR


If NPV > 0, try a higher interest rate
If NPV < 0, try a lower interest rate

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Continued…
Decision Rules
Stand-alone Projects
 If IRR > cost of capital (k)  accept
 If IRR < cost of capital (k)  reject

Mutually Exclusive Projects


 IRRA > IRRB  choose Project A over Project B

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Profitability Index (PI): It is the ratio of the present value of future
cash inflows, at the certain rate of return to the initial cash outflow of the
investment.

PI= PV of cash inflows/Initial cash outlay

All projects with PI > 1.0 is accepted.

Alternatively PI=1+NPV(benefits)/Initial Investment

9
Importance of Capital Budgeting

1)Involvement of Risk

2)Heavy and irreversible investments

3)Benefits in Long Run

10
References

•Financial Management and Policy, James C. Van Horne, 11th


Edition,
•International Financial Management, Alan C. Shapiro, Peter
Moles.
•Financial Management, Theory & Practice, Brigham &
Ehrhardt,
•Shashi K. Gupta, ‘Financial Management’,

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