Description
The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.
Goal of the Firm
Maximize Shareholder Wealth or Value of the Firm
Financing
Decision
Dividend
Decision
Investment
Decision
Long-term
investments
Short-term
investments
CAPITAL BUDGETING
Introduction
? The investment decisions of a firm are generally known as
the capital budgeting, or capital expenditure decisions.
? The firm’s investment decisions would generally include
expansion, acquisition, modernisation and replacement of
the long-term assets.
Meaning of Capital Budgeting
It is the process of evaluating and selecting long
term investment decision in capital expenditure that
are consistent with the goal of share holders.
Capital expenditure
It is an out lay of funds that is expected to produce
benefit over a period of time, that is more than one
year.
Objectives
Capital Budgeting Involves
? The search of new and profitable investment
proposals.
? The making of an economical analysis to
determine the investment proposals.
Classification of investment projects
Or Decisions in Capital Budgeting
? An independent project is one the acceptance or rejection of
which does not directly eliminate other projects from
consideration.
? For example, management may want to introduce a new
product line and at the same time may want to replace a
machine which is currently producing a different product.
? These projects can be evaluated independently and a
decision made to accept or reject them depending upon
whether they add value to the firm.
? Two or more projects that cannot be pursued simultaneously are called
mutually exclusive projects – the acceptance of one prevents the
acceptance of the alternative proposal.
? Therefore, mutually exclusive projects involve ‘either-or’ decisions –
alternative proposals cannot be pursued simultaneously.
? For example, a firm may own a block of land which is large enough to
establish a shoe manufacturing business or a steel fabrication plant. If
shoe manufacturing is chosen the alternative of steel fabrication is
eliminated.
? A car manufacturing company can locate its manufacturing complex in
Sydney, Brisbane or Adelaide. If it chooses Adelaide, the alternatives of
Sydney and Brisbane are precluded.
? A contingent project is one the acceptance or rejection of
which is dependent on the decision to accept or reject one
or more other projects. Contingent projects may be
complementary or substitutes.
?
? For example, the decision to start a pharmacy may be
contingent upon a decision to establish a doctors’
chamber in an adjacent building.
? In this case the projects are complementary to each other.
? capital rationing
? Capital rationing means that there are limits on the amount
of funds a company can raise to finance capital expansion.
? For example, the airline may not be able to issue enough
debt to buy new airplanes to service all ten new cities. Or it
may be that a business is reluctant to issue new stock
because of concerns of diluting ownership. When there is
capital rationing, firms need to treat their new projects like
mutually exclusive projects and use a ranking approach.
The airline should rank which cities provide the greatest
potential for profits and expand into those cities first.
? Substitute projects are ones where the degree of success (or even
the success or failure) of one project is increased by the decision to
reject the other project.
? For example, market research indicates demand sufficient to justify
two restaurants in a shopping complex and the firm is considering
one Chinese and one Thai restaurant.
? Customers visiting this shopping complex seem to treat Chinese and
Thai food as close substitutes and have a slight preference for Thai
food over Chinese. Consequently, if the firm establishes both
restaurants, the Chinese restaurant’s cash flows are likely to be
adversely affected.
? This may result in negative net present value for the Chinese
restaurant. In this situation, the success of the Chinese restaurant
project will depend on the decision to reject the Thai restaurant
proposal. Since they are close substitutes, the rejection of one will
definitely boost the cash flows of the other.
Features of Capital Budgeting
? It involves the exchange of current funds for the benefit to
be achieved in future.
? Future benefits are expected to be realized over a series
of years.
? The funds are invested in non flexible and long term
activities.
? It involves generally huge funds
? They are irreversible in nature.
Methods of Capital Budgeting
? Non-discounted Cash Flow Criteria
? Payback Period (PB)
? Accounting Rate of Return (ARR)
? Discounted Cash Flow (DCF) Criteria
? Net Present Value (NPV)
? Internal Rate of Return (IRR)
? Profitability Index (PI)
Payback Period Method
? Payback is the number of years required to
recover the original cash outlay invested in a
project.
? If the project generates constant annual cash
inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow.
That is:
0
Initial Investment
Payback = =
Annual Cash Inflow
C
C
? The project would be accepted if its payback
period is less than the maximum or standard
payback period set by management.
? As a ranking method, it gives highest ranking to
the project, which has the shortest payback
period and lowest ranking to the project with
highest payback period
Accounting Rate of Return
Method
? The accounting rate of return is the ratio of the
average after-tax profit divided by the net
investment.
? Average rate of return =(Average annual
profit/Net investment in the project) x 100
? This method will accept all those projects whose
ARR is higher than the minimum rate
established by the management and reject those
projects which have ARR less than the minimum
rate.
? This method would rank a project as number
one if it has highest ARR and lowest rank would
be assigned to the project with lowest ARR.
? Cash flows of the investment project should be
forecasted based on realistic assumptions.
? Appropriate discount rate should be identified to
discount the forecasted cash flows. The appropriate
discount rate is the project’s opportunity cost of
capital.
? The project should be accepted if NPV is positive
(i.e., NPV > 0).
? Net present value should be found out by
subtracting present value of cash outflows
from present value of cash inflows. The
formula for the net present value can be
written as follows:
3 1 2
0
2 3
0
1
NPV
(1 ) (1 ) (1 ) (1 )
NPV
(1 )
n
n
n
t
t
t
C C C C
C
k k k k
C
C
k
=
(
= + + + + ÷
(
+ + + +
¸ ¸
= ÷
+
¿
Where C1, C2 ….Cn ? Cash inflows in
future course of action.
K ? Discount rate
Co ? Cash outflow
? Accept the project when NPV is positive
NPV > 0
? Reject the project when NPV is negative
NPV < 0
? May accept or reject the project when NPV
is zero NPV = 0
? The NPV method can be used to select
between mutually exclusive projects; the
one with the higher NPV should be
selected.
Evaluation of the NPV Method
? NPV is most acceptable investment rule for
the following reasons:
? Time value into consideration
? Measures true profitability
? Increase shareholder’s value
? Limitations:
? Difficulties in cash flow estimation
? Difficulties in determining Discount rate
Internal Rate of Return Method
? The internal rate of return (IRR) is the rate
that equates the investment outlay with the
present value of cash inflow received in
future period. This also implies that the rate
of return is the discount rate which makes
NPV = 0.
Where C1, C2 ….Cn ? Cash inflows in
future course of action.
r ? Discount rate or IRR
Co ? Cash outflow
? Uneven Cash Flows: Calculating IRR by Trial
and Error
? The approach is to select any discount rate to
compute the present value of cash inflows. If the
calculated present value of the expected cash inflow
is lower than the present value of cash outflows, a
lower rate should be tried. On the other hand, a
higher value should be tried if the present value of
inflows is higher than the present value of outflows.
This process will be repeated unless the net present
value becomes zero.
? Accept the project when r > k.
? Reject the project when r < k.
? May accept the project when r = k.
? r-IRR
? k-Cost of capital
? IRR method has following merits:
? Time value
? Profitability measure
? shareholder value
? IRR method may suffer from:
? Multiple IRR
? Profitability index is the ratio of the
present value of cash inflows, at the
required rate of return, to the initial
cash outflow of the investment.
? The following are the P
I
acceptance rules:
? Accept the project when PI > 1
? Reject the project when PI < 1
? May accept the project when PI = 1
? The project with positive NPV will have PI
greater than one. PI less than means that the
project’s NPV is negative.
? It recognises the time value of money.
? It is consistent with the shareholder value
maximisation principle. A project with PI greater than
one will have positive NPV and if accepted, it will
increase shareholders’ wealth.
? In the PI method, since the present value of cash
inflows is divided by the initial cash outflow, it is a
relative measure of a project’s profitability.
? Like NPV method, PI criterion also requires calculation
of cash flows and estimate of the discount rate. In
practice, estimation of cash flows and discount rate
pose problems.
? It should maximise the shareholders’ wealth.
? It should consider all cash flows and Time Value of
Money to determine the true profitability of the
project.
? It should provide for an objective and
unambiguous way of separating good projects
from bad projects.
? It should help ranking of projects according to their
true profitability.
? Identification of investment proposals
? Screening the proposals
? Evaluation of various proposals
? Fixing priorities
? Final approval and preparation of capital
expenditure budget
? Implementation of proposal
? Performance review
doc_395320394.ppt
The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.
Goal of the Firm
Maximize Shareholder Wealth or Value of the Firm
Financing
Decision
Dividend
Decision
Investment
Decision
Long-term
investments
Short-term
investments
CAPITAL BUDGETING
Introduction
? The investment decisions of a firm are generally known as
the capital budgeting, or capital expenditure decisions.
? The firm’s investment decisions would generally include
expansion, acquisition, modernisation and replacement of
the long-term assets.
Meaning of Capital Budgeting
It is the process of evaluating and selecting long
term investment decision in capital expenditure that
are consistent with the goal of share holders.
Capital expenditure
It is an out lay of funds that is expected to produce
benefit over a period of time, that is more than one
year.
Objectives
Capital Budgeting Involves
? The search of new and profitable investment
proposals.
? The making of an economical analysis to
determine the investment proposals.
Classification of investment projects
Or Decisions in Capital Budgeting
? An independent project is one the acceptance or rejection of
which does not directly eliminate other projects from
consideration.
? For example, management may want to introduce a new
product line and at the same time may want to replace a
machine which is currently producing a different product.
? These projects can be evaluated independently and a
decision made to accept or reject them depending upon
whether they add value to the firm.
? Two or more projects that cannot be pursued simultaneously are called
mutually exclusive projects – the acceptance of one prevents the
acceptance of the alternative proposal.
? Therefore, mutually exclusive projects involve ‘either-or’ decisions –
alternative proposals cannot be pursued simultaneously.
? For example, a firm may own a block of land which is large enough to
establish a shoe manufacturing business or a steel fabrication plant. If
shoe manufacturing is chosen the alternative of steel fabrication is
eliminated.
? A car manufacturing company can locate its manufacturing complex in
Sydney, Brisbane or Adelaide. If it chooses Adelaide, the alternatives of
Sydney and Brisbane are precluded.
? A contingent project is one the acceptance or rejection of
which is dependent on the decision to accept or reject one
or more other projects. Contingent projects may be
complementary or substitutes.
?
? For example, the decision to start a pharmacy may be
contingent upon a decision to establish a doctors’
chamber in an adjacent building.
? In this case the projects are complementary to each other.
? capital rationing
? Capital rationing means that there are limits on the amount
of funds a company can raise to finance capital expansion.
? For example, the airline may not be able to issue enough
debt to buy new airplanes to service all ten new cities. Or it
may be that a business is reluctant to issue new stock
because of concerns of diluting ownership. When there is
capital rationing, firms need to treat their new projects like
mutually exclusive projects and use a ranking approach.
The airline should rank which cities provide the greatest
potential for profits and expand into those cities first.
? Substitute projects are ones where the degree of success (or even
the success or failure) of one project is increased by the decision to
reject the other project.
? For example, market research indicates demand sufficient to justify
two restaurants in a shopping complex and the firm is considering
one Chinese and one Thai restaurant.
? Customers visiting this shopping complex seem to treat Chinese and
Thai food as close substitutes and have a slight preference for Thai
food over Chinese. Consequently, if the firm establishes both
restaurants, the Chinese restaurant’s cash flows are likely to be
adversely affected.
? This may result in negative net present value for the Chinese
restaurant. In this situation, the success of the Chinese restaurant
project will depend on the decision to reject the Thai restaurant
proposal. Since they are close substitutes, the rejection of one will
definitely boost the cash flows of the other.
Features of Capital Budgeting
? It involves the exchange of current funds for the benefit to
be achieved in future.
? Future benefits are expected to be realized over a series
of years.
? The funds are invested in non flexible and long term
activities.
? It involves generally huge funds
? They are irreversible in nature.
Methods of Capital Budgeting
? Non-discounted Cash Flow Criteria
? Payback Period (PB)
? Accounting Rate of Return (ARR)
? Discounted Cash Flow (DCF) Criteria
? Net Present Value (NPV)
? Internal Rate of Return (IRR)
? Profitability Index (PI)
Payback Period Method
? Payback is the number of years required to
recover the original cash outlay invested in a
project.
? If the project generates constant annual cash
inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow.
That is:
0
Initial Investment
Payback = =
Annual Cash Inflow
C
C
? The project would be accepted if its payback
period is less than the maximum or standard
payback period set by management.
? As a ranking method, it gives highest ranking to
the project, which has the shortest payback
period and lowest ranking to the project with
highest payback period
Accounting Rate of Return
Method
? The accounting rate of return is the ratio of the
average after-tax profit divided by the net
investment.
? Average rate of return =(Average annual
profit/Net investment in the project) x 100
? This method will accept all those projects whose
ARR is higher than the minimum rate
established by the management and reject those
projects which have ARR less than the minimum
rate.
? This method would rank a project as number
one if it has highest ARR and lowest rank would
be assigned to the project with lowest ARR.
? Cash flows of the investment project should be
forecasted based on realistic assumptions.
? Appropriate discount rate should be identified to
discount the forecasted cash flows. The appropriate
discount rate is the project’s opportunity cost of
capital.
? The project should be accepted if NPV is positive
(i.e., NPV > 0).
? Net present value should be found out by
subtracting present value of cash outflows
from present value of cash inflows. The
formula for the net present value can be
written as follows:
3 1 2
0
2 3
0
1
NPV
(1 ) (1 ) (1 ) (1 )
NPV
(1 )
n
n
n
t
t
t
C C C C
C
k k k k
C
C
k
=
(
= + + + + ÷
(
+ + + +
¸ ¸
= ÷
+
¿
Where C1, C2 ….Cn ? Cash inflows in
future course of action.
K ? Discount rate
Co ? Cash outflow
? Accept the project when NPV is positive
NPV > 0
? Reject the project when NPV is negative
NPV < 0
? May accept or reject the project when NPV
is zero NPV = 0
? The NPV method can be used to select
between mutually exclusive projects; the
one with the higher NPV should be
selected.
Evaluation of the NPV Method
? NPV is most acceptable investment rule for
the following reasons:
? Time value into consideration
? Measures true profitability
? Increase shareholder’s value
? Limitations:
? Difficulties in cash flow estimation
? Difficulties in determining Discount rate
Internal Rate of Return Method
? The internal rate of return (IRR) is the rate
that equates the investment outlay with the
present value of cash inflow received in
future period. This also implies that the rate
of return is the discount rate which makes
NPV = 0.
Where C1, C2 ….Cn ? Cash inflows in
future course of action.
r ? Discount rate or IRR
Co ? Cash outflow
? Uneven Cash Flows: Calculating IRR by Trial
and Error
? The approach is to select any discount rate to
compute the present value of cash inflows. If the
calculated present value of the expected cash inflow
is lower than the present value of cash outflows, a
lower rate should be tried. On the other hand, a
higher value should be tried if the present value of
inflows is higher than the present value of outflows.
This process will be repeated unless the net present
value becomes zero.
? Accept the project when r > k.
? Reject the project when r < k.
? May accept the project when r = k.
? r-IRR
? k-Cost of capital
? IRR method has following merits:
? Time value
? Profitability measure
? shareholder value
? IRR method may suffer from:
? Multiple IRR
? Profitability index is the ratio of the
present value of cash inflows, at the
required rate of return, to the initial
cash outflow of the investment.
? The following are the P
I
acceptance rules:
? Accept the project when PI > 1
? Reject the project when PI < 1
? May accept the project when PI = 1
? The project with positive NPV will have PI
greater than one. PI less than means that the
project’s NPV is negative.
? It recognises the time value of money.
? It is consistent with the shareholder value
maximisation principle. A project with PI greater than
one will have positive NPV and if accepted, it will
increase shareholders’ wealth.
? In the PI method, since the present value of cash
inflows is divided by the initial cash outflow, it is a
relative measure of a project’s profitability.
? Like NPV method, PI criterion also requires calculation
of cash flows and estimate of the discount rate. In
practice, estimation of cash flows and discount rate
pose problems.
? It should maximise the shareholders’ wealth.
? It should consider all cash flows and Time Value of
Money to determine the true profitability of the
project.
? It should provide for an objective and
unambiguous way of separating good projects
from bad projects.
? It should help ranking of projects according to their
true profitability.
? Identification of investment proposals
? Screening the proposals
? Evaluation of various proposals
? Fixing priorities
? Final approval and preparation of capital
expenditure budget
? Implementation of proposal
? Performance review
doc_395320394.ppt