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Capital Budgeting Analysis

Financial Management

B 642

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Outline

Meaning of Capital Budgeting

Types of Capital Budgeting Decisions

Significance of Capital Budgeting Analysis

Traditional Capital Budgeting TechniquesPayback Period Approach

Discounted Payback Period ApproachDiscounted Cash Flow Techniques Net Present Value

Internal Rate of Return

Profitability Index

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Meaning of Capital Budgeting

Capital budgeting addresses the issue ofstrategic long-term investment decisions.

Capital budgeting can be defined as theprocess of analyzing, evaluating, and decidingwhether resources should be allocated to aproject or not.

Process of capital budgeting ensure optimalallocation of resources and helpsmanagement work towards the goal ofshareholder wealth maximization.

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Types of Capital BudgetingDecisions

Should we add a new product to our existingproduct line?

Should we expand into a new market?

Should we replace our existing machinery?

Should we buy fully automatic or

semiautomatic machineryWhere to locate manufacturing facility?

Should we outsource components and parts?

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Why Capital Budgeting is soImportant?Involve massive investment of

resourcesAre not easily reversible

Have long-term implications for the

firmInvolve uncertainty and risk for thefirm

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Due to the above factors, capital budgeting decisionsbecome critical and must be evaluated very carefully.

Any firm that does not follow the capital budgetingprocess will not be maximizing shareholder wealthand management will not be acting in the bestinterests of shareholders.

RJR Nabiscos smokeless cigarette project example

Similarly, Euro-Disney, Concorde Plane, Saturn of GMall faced problems due to bad capital budgeting,while Intel became global leader due to sound capitalbudgeting decisions in 1990s.

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Techniques of Capital BudgetingAnalysis

Payback Period Approach

Discounted Payback Period ApproachNet Present Value Approach

Internal Rate of Return

Profitability Index

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Which

T

ech

nique sh

ould wefollow?A technique that helps us in selecting projectsthat are consistent with the principle ofshareholder wealth maximization.

A technique is considered consistent withwealth maximization if

It is based on cash flowsConsiders all the cash flows

Considers time value of money

Is unbiased in selecting projects

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PaybackPeriod ApproachThe amount of time needed to recover theinitial investment

The number of years it takes including afraction of the year to recover initialinvestment is called payback period

To compute payback period, keep adding thecash flows till the sum equals initial

investmentSimplicity is the main benefit, but suffersfrom drawbacks

Technique is not consistent with wealth

maximizationWhy?

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DiscountedPaybackPeriodSimilar to payback period approach with onedifference that it considers time value ofmoney

The amount of time needed to recover initialinvestment given the present value of cashinflows

Keep adding the discounted cash flows till the

sum equals initial investmentAll other drawbacks of the payback periodremains in this approach

Not consistent with wealth maximization

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NetPresent Value Approach

Based on the dollar amount of cash flows

The dollar amount of value added by aproject

NPV equals the present value of cash inflowsminus initial investment

Technique is consistent with the principle ofwealth maximizationWhy?

Accept a project if NPV > 0

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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 ofcash inflows equals initial investment

Consistent with wealth maximization

Accept a project if IRR > Cost of Capital

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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 meanspositive NPV

Usually, PI consistent with NPV

PI may be in conflict with NPV ifProjects are mutually exclusiveScale of projects differ

Pattern of cash flows of projects is different

When in conflict with NPV, use NPV