Capital Budgeting- 30 Jan 2011 [Compatibility Mode]

8/7/2019 Capital Budgeting- 30 Jan 2011 [Compatibility Mode]

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CHAPTER

CapitalCapitalCapitalCapital

TechniquesTechniques TechniquesTechniques



2

WHAT IS C APITAL BUDGETING?

The process of planning and evaluating

expenditures on assets whose cash flowsare expected to extend beyond one year

Analysis of potential additions to fixed assets

Long-term decisions; involve largeexpenditures

Very important to firm’s future



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GENERATING IDEAS FOR C APITAL

PROJECTS

A firm’s growth and its ability to remain

competitive depend on a constant flow of ideas for new products, ways to make

existing products better, and ways to

produce output at a lower cost.Procedures must be established for

evaluating the worth of such projects.



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PROJECT CLASSIFICATIONS Replacement Decisions: whether to purchase

capital assets to take the place of existing assets to

maintain or improve existing operations Expansion Decisions: whether to purchase capital

projects and add them to existing assets to increase

ex s ng opera ons Independent Projects: Projects whose cash flows

are not affected by decisions made about other

projects

Mutually Exclusive Projects: A set of projects

where the acceptance of one project means the others

cannot be accepted



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Determine the cost, or purchase price, of the asset.

Estimate the cash flows expected from the project.

Assess the riskiness of cash flows.

Compute the present value of the expected cash flows

SIMILARITIES BETWEEN C APITAL

BUDGETING AND A SSET V ALUATION

to obtain as estimate of the asset’s value to the firm. Compare the present value of the future expected cash

flows with the initial investment.



CAPITAL BUDGETING

Purpose

Expansion

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Improvement

Replacement

R & D



THE B ASICS OF C APITAL

BUDGETING

Should we

u t splant?



IDEAL SELECTION METHOD

Will:-

Select the project that maximises shareholderswealth

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Discount the cash flows at the appropriatemarket determined opportunity cost of capital

Will allow managers to consider each projectindependently from all others



C APITAL BUDGETING PROCESS

1. Estimate the cash flows.

2. Assess the riskiness of the cash

flows.

. e erm ne e appropr a ediscount rate.

4. Find the PV of the expected cash

flows.5. Accept the project if PV of inflows

> costs.



SELECTION METHODS

Payback

Internal Rate of Return (IRR)

1 0

Net Present Value (NPV)

Profitability Index



P AYBACK PERIOD

FORMULA:-

For a project with equal annual receipts:

Years 0 1 2 3 4 5

Project A 1,000,000 250,000 250,000 250,000 250,000 250,000

Where: I= initial investmentC =net annual cash inflow

Example 1:

= 4 years



INTERNAL RATE OF RETURN

The IRR is the discount rate at which the NPVfor a project equals zero. This rate means that

the present value of the cash inflows for the

outflows.

The IRR is the break-even discount rate.

The IRR is found by trial and error.



NET PRESENT V ALUE METHOD

Discount cash inflows to their present

value and then compare with capitaloutlay required by the investment

Discount rate (hurdle rate or requiredrate of return) - required minimum rate of

1 3

return given riskiness of investmentProposal is acceptable when NPV is ≥ zero

The higher the NPV, the more attractivethe investment



NET PRESENT V ALUE

DECISION RULE: Invest

in capital assets?

Is NPV positive?

Invest

Is NPV negative?

Do not invest



.

PROFITABILITY INDEX (PI)

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

.

In this method, a project with a PI greater than 1 isaccepted, but a project is rejected when its PI is lessthan 1

PI= PVCF/Initial Investment



COMPARISON OF C APITAL

BUDGETING MODELS

Method Strengths Weaknesses

Pa back Eas to understand I nores rofitabilit

Based on cash flows

Highlights risks

and the time valueof money

NPV &IRR

Based on cashflows, profitability &

time value of money

Difficult todetermine

discount rate

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Capital Budgeting- 30 Jan 2011 [Compatibility Mode]