Capital Budgeting Chapter # 3

Outline Meaning of Capital Budgeting Types of Capital Budgeting Decisions Significance of Capital Budgeting Analysis Traditional Capital Budgeting Techniques Payback Period Approach Net Present Value Internal Rate of Return Profitability Index

Meaning of Capital Budgeting Capital budgeting addresses the issue of strategic long-term investment decisions(HR capital,FR capital,Physical Resource capital). Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated(jointventure,syengry,global partner) 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.

Types of Capital Budgeting Decisions Should we add a new product to our existing product line? Should we expand into a new market? Should we replace our existing machinery? Should we buy fully automatic machinery? Where to locate manufacturing facility?

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

Conti… 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.

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

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

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

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 NPV= PV - initial investment Accept a project if NPV > 0

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 Accept a project if IRR > Cost of Capital

Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. PI = PV of Cash Inflows/initial investment Accept a project if PI > 1.0, which means positive NPV