Capital Budgeting Techniques

CAPITAL BUDGETING TECHNIQUESPresnted By:-Niladri Bhattacharjee(48)Section- B

Outline• Meaning of Capital Budgeting• Significance of Capital Budgeting Analysis• Traditional Capital Budgeting Techniques

• Payback Period Approach• Discounted Payback Period Approach• Discounted Cash Flow Techniques

• Net Present Value• Internal Rate of Return• Profitability Index• Net Present Value versus Internal Rate of Return

Meaning of Capital Budgeting• Capital budgeting addresses the issue of strategic long-term investment decisions.

• Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not.

• Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.

Significance of Capital Budgeting• Considered to be the most important decision that a

corporate treasurer has to make.• So much is the significance of capital budgeting that many

business schools offer a separate course on capital budgeting

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

CONTD…• Due to the above factors, capital budgeting decisions

become critical and must be evaluated very carefully.

• Any firm that does not follow the capital budgeting process will not be maximizing shareholder wealth and management will not be acting in the best interests of shareholders.

Techniques of Capital Budgeting Analysis• Payback Period Approach• Discounted Payback Period Approach• Net Present Value Approach• Internal Rate of Return• Profitability Index

Which Technique should we follow?• A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization.

• A technique is considered consistent with wealth maximization if • It is based on cash flows• Considers all the cash flows• Considers time value of money• Is unbiased in selecting projects

Payback Period Approach

• The amount of time needed to recover the initial investment

• The number of years it takes including a fraction of the year to recover initial investment is called payback period

• To compute payback period, keep adding the cash flows till the sum equals initial investment

• Simplicity is the main benefit, but suffers from drawbacks

• Technique is not consistent with wealth maximization—Why?

PBP Strengths and Weaknesses

StrengthsStrengths::• Easy to use and

understand• Can be used as a measure of liquidity

• Easier to forecast ST than LT flows

WeaknessesWeaknesses::• Does not account

for TVM• Does not consider

cash flows beyond the PBP• Cutoff period is

subjective

Discounted Payback Period• Similar to payback period approach with one difference that it considers time value of money

• The amount of time needed to recover initial investment given the present value of cash inflows

• Keep adding the discounted cash flows till the sum equals initial investment

• All other drawbacks of the payback period remains in this approach

• Not consistent with wealth maximization

Net Present Value Approach• Based on the dollar amount of cash flows• The dollar amount of value added by a project• NPV equals the present value of cash inflows minus initial investment

• Technique is consistent with the principle of wealth maximization—Why?

• Accept a project if NPV ≥ 0

NPV Strengths and Weaknesses

StrengthsStrengths::• Cash flows

assumed to be reinvested at

the hurdle rate.• Accounts for TVM.• Considers all

cash flows.

WeaknessesWeaknesses::• May not include

managerial options

embedded in the project.

Internal Rate of Return• The rate at which the net present value of cash flows of a

project is zero, I.e., the rate at which the present value of cash inflows equals initial investment

• Project’s promised rate of return given initial investment and cash flows

• Consistent with wealth maximization• Accept a project if IRR ≥ Cost of Capital

IRR Strengths and Weaknesses

StrengthsStrengths: : • Accounts for TVM• Considers all

cash flows• Less subjectivity

WeaknessesWeaknesses: : • Assumes all cash

flows reinvested at the IRR

• Difficulties with project rankings

and Multiple IRRs

NPV versus IRR• Usually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project

• IRR can be in conflict with NPV if • Investing or Financing Decisions• Projects are mutually exclusive

• Projects differ in scale of investment• Cash flow patterns of projects is different

• If cash flows alternate in sign—problem of multiple IRR• If IRR and NPV conflict, use NPV approach

Profitability Index (PI)• A part of discounted cash flow family• PI = PV of Cash Inflows/initial investment• Accept a project if PI ≥ 1.0, which means positive NPV

• Usually, PI consistent with NPV• PI may be in conflict with NPV if

• Projects are mutually exclusive• Scale of projects differ• Pattern of cash flows of projects is different

• When in conflict with NPV, use NPV

PI Strengths and Weaknesses

StrengthsStrengths::• Same as NPV• Allows comparison of different scale projects

WeaknessesWeaknesses::• Same as NPV• Provides only

relative profitability• Potential Ranking

Problems

Evaluating Projects with Unequal Lives• Replacement Chain Analysis• Equivalent Annual Cost Method• If two machines are unequal in life, we need to make

adjustment before computing NPV.

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 project’s estimated cash flows

• PI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment

THANK YOU