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CAPITAL
BUDGETING
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CAPITAL BUDGETING
is a method of analyzing and comparing
substantial future investments and expenditures to
determine which ones are most worthwhile.
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Characteristics of Capital Budgeting


» a series of large anticipated benefits

» a relatively high degree of risk

» a relatively long period over which the returns

are likely to be realized


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Categories of Capital Investments


» New Products or New Markets
» Expansion of Existing Products or Markets
» Replacement Project Necessary to Continue
Operations as Usual
» Replacement Project Necessary to Reduce
Business Costs
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Elements of Capital Budgeting


» Cash Inflows
» Cash Outflows
» Budgeting Model
⋄ Payback period
⋄ Rate of return
⋄ Net present value
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Net Initial Investment


is the amount required to start a business or a
project. It is also called initial investment outlay or
simply initial outlay.

_
= +
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Accounting Rate of Return


calculates the return generated from the average
net income expected for each of the years the
proposed capital investment is expected to be
used in operations

=
10

MINIMUM ACCEPTABLE RATE OF


RETURN (MARR)
or hurdle rate is the minimum rate of return on a
project a manager or company is willing to accept
before starting a project
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PROCESS OF CAPITAL BUDGETING

Project
Project Performance
Screening Project Implementation
Identification & Review
& Selection
Generation
Evaluation
CATEGORIES OF PROJECT
CASH FLOW
Initial cash flow is the
amount of money paid out or
received at the start of a
project or investment.

INITIAL CASH FLOW


Cash flows generating from
the normal operations of the
project

OPERATING CASH FLOW


Net cash flow that occurs at
the end of a project and
represents the after-tax
proceeds from disposal of
assets and recoupment of
working capital

TERMINAL CASH
FLOW
CAPITAL BUDGETING -
DECISION MAKING
PAY B A C K P E R I O D N ET PR ESEN T VAL U E

• Difference between the present


• Years to recoup the initial investment value of cash inflows and the
• Accept project if payback is present value of cash outflows over
less than the company’s a period of time.
predetermined maximum; • Accept if the NPV of the project is
otherwise reject greater than or equal to zero;
otherwise reject
MODIFIED INTERNAL I N TER N AL R ATE O F
R AT E O F R E T U R N R ETU R N

• Assumes that positive cash flows • Projected percent rate of return


are reinvested at the firm's cost of project will earn
capital.
• Accept if the MIRR of the project is • Accept if the IRR of the project is
greater than or equal to the required greater than or equal to the required
rate of return; otherwise reject rate of return; otherwise reject
Project
Time A B
0 (10,000.00) (10,000.00)
1 3,500.00 500.00
2 3,500.00 500.00
3 3,500.00 4,600.00
4 3,500.00 10,000.00

WHICH ONE SHOULD YOU CHOOSE?


PAY B A C K P E R I O D

YR 0 YR 1 YR 2 YR 3 YR 4

Project A Project B
0 (10,000.00) (10,000.00) 0 (10,000.00) (10,000.00)
1 3,500.00 (6,500.00) 1 500.00 (9,500.00)
2 3,500.00 (3,000.00) 2 500.00 (9,000.00)
3 3,500.00 500.00 3 4,600.00 (4,400.00)
4 3,500.00 4 10,000.00 5,600.00
2.9 YEARS 3.4 YEARS
N E T P R E S E N T VA L U E

YR 0 YR 1 YR 2 YR 3 YR 4

𝐹𝑉
PV =
1+𝑅 𝑛

NPV = PV of Inflows – Initial Investment


N E T P R E S E N T VA L U E

YR 0 YR 1 YR 2 YR 3 YR 4

Project B
0 (10,000.00) (10,000.00) NPV = PV of Inflows – Initial Investment
1 500/(1+10)1 455.00
= 11,154 – 10,000
2 500/(1+10)2 413.00
3 4600/(1+10)3 3,456.00 = 1,154
4 10000/(1+10)4 6,830.00
N E T P R E S E N T VA L U E

CALCULATE FOR NPV OF PROJECT A


N E T P R E S E N T VA L U E

CALCULATE FOR NPV OF PROJECT A


Project A

0 (10,000.00) (10,000.00)
1 3500/(1.10)1 3181.82 NPV a = 1,095
2 3500/(1.10)2 2892.56 NPV b = 1,154
3 3500/(1.10)3 2629.60
4 3500/(1.10)4 2390.55
I N T E R N A L R AT E O F
RETURN

YR 0 YR 1 YR 2 YR 3 YR 4

𝐹𝑉
PV =
1+𝑅 𝑛
𝐹𝑉
PV =
1+𝑅 𝑛
0 = PV of Inflows – Initial Investment
I N T E R N A L R AT E O F
RETURN

YR 0 YR 1 YR 2 YR 3 YR 4

Project A
0 -10,000.00 -10,000.00
IRR = 14.96%
1 3500/(1+R)1 3044.54
NPV = PV of Inflows – Initial Investment
2 3500/(1+R)2 2648.34
= 10,000 – 10,000
3 3500/(1+R)3 2303.71
=0
4 3500/(1+R)4 2003.92
N E T P R E S E N T VA L U E

CALCULATE FOR IRR OF PROJECT B


N E T P R E S E N T VA L U E

CALCULATE FOR IRR OF PROJECT B


Project B
0 (10,000.00) (10,000.00)
1 3500/(1+R)1 440.53 IRR a = 14.96%
2 3500/(1+R)2 388.13
3 3500/(1+R)3 3146.08
IRR b = 13.5%
4 3500/(1+R)4 6025.83
MODIFIED IRR

YR 0 YR 1 YR 2 YR 3 YR 4

𝑇𝑉 𝑖𝑛𝑓𝑙𝑜𝑤
PV outflow =
1+𝑀𝐼𝑅𝑅 𝑛

TV inflow = Cash inflows 1+𝑅 𝑛


MODIFIED IRR

YR 0 YR 1 YR 2 YR 3 YR 4

Project B 𝑇𝑉 𝑖𝑛𝑓𝑙𝑜𝑤
PV outflow =
0 -10,000.00 -10,000.00 1+𝑀𝐼𝑅𝑅 𝑛
1 500(1+R)3 440.53
2 500(1+R)2 388.13 16,330.50
10,000 =
3 4600(1+R)1 3146.08 1+𝑀𝐼𝑅𝑅 4
4 10000(1+R) 6025.83
16330.50 MIRR = 13.05%
ADVANCE ANALYSIS AND
APPRAISAL OF PERFORMANCE
FINANCIAL AND NON-FINANCIAL
PERFORMANCE MEASURE
FIVE MOST IMPORTANT
FINANCIAL METRICS
Net Income
Earnings Before Interest and Taxes
Gross Profit
Current Ratio
Return on Investment
Non-Financial Performance
Evaluation Parameters
BALANCE SCORE CARD
BALANCE SCORECARD
BALANCE SCORECARD
Then…

1st generation Balance Scorecard


(Kaplan and Norton, 1992)
BALANCE SCORECARD
Now…
COMPONENTS OF BSC
Four Perspective of Balance
Scorecard
Return on investment and
economic value added

Customer satisfaction, retention,


Perspective market share and account share
Four Perspective of Balance
Scorecard
Quality, response time, cost and
new product information
Perspective

Employer satisfaction and


information system availability
Perspective
Steps in designing accounting based
performance measures

Step 1 Step 3
Step 2
Choose performance measures that Choose a target level of performance
Choose the details of each
align with top management’s financial and feedback mechanism for each
performance measure in Step 1
goals performance measure in Step 1
Performance measurement in
Multinational Companies
FINANCIAL NON FINANCIAL
• Customer perspective: Market
• Return on Investment share, customer satisfaction
• Residual Income • Internal-business-processes
perspective: Manufacturing lead
• Economic Value Added time, yield, on-time performance,
no. of new product launches and
• Return of Sales no. of new patents field
• Learning-and-growth perspective:
employee satisfaction, information
system availability
Distinguishing performance of managers from
performance of organization units
A. By Purpose -
To measure the performance of the manager or performance of the
organizational unit

B. By Scope –
To evaluate the whole organization’s economic performance for decision-
making purposes versus the items that the manager cannot influence
Intensity of Incentives

Types of Incentives

A. Financial incentives
B. Non-financial incentives
Financial Incentives
PAY AND
ALLOWANCES

Perquisites BONUS

Productivity
Monetary
Commission linked Wage
Incentives Incentives

Stock Options
or Co- Profit Sharing
partnership

RETIREMENT
BENEFITS
Non-Financial Incentives
STATUS

Employee Organizational
Empowerment Climate

Non- Career
Employee
Participation
Financial Advancement
Incentives Opportunity

Employee
Recognition Job Enrichment
Programmes

Job Security