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Overview of
Capital-Budgeting
Techniques
2
Capital Budgeting Concepts
Capital Budgeting involves evaluation of (and decision about) projects. Which projects should be
accepted? Here, our goal is to accept a project which maximizes the shareholder wealth. Benefits are
worth more than the cost.
The Capital Budgeting is based on forecasting.
Estimate future expected cash flows.
Evaluate project based on the evaluation method.
Classification of Projects
Mutually Exclusive - accept ONE project only
Independent - accept ALL profitable projects.
3
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.
4
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 or semiautomatic
machinery
Where to locate manufacturing facility?
Should we outsource components and parts?
5
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
6
Techniques of Capital Budgeting
Analysis
1. Payback Period Approach
2. Discounted Payback Period Approach
3. Net Present Value Approach
4. Internal Rate of Return
5. Profitability Index
7
Which Technique should we follow?
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
15
Capital Budgeting Methods
Payback Period
Number of years needed to recover your initial outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
21
Capital Budgeting Methods
Payback Period
Number of years needed to recover your initial outlay.
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
0 1 2 3 4
P R O J E C T Evaluation:
Time A B Company sets maximum
0 (10,000.) (10,000.) acceptable payback. If
1 3,500 500 Max PB = 3 years,
2 3,500 500
accept project A and
3 3,500 4,600
4 3,500 10,000
reject project C
0 1 2 3 4
Methods that consider time value of money and all cash flows
NPV
NPV == PV
PV of
of Inflows
Inflows -- Initial
Initial Outlay
Outlay
35
Capital Budgeting Methods
Net Present Value
Present Value of all costs and benefits of a project.
Concept is similar to Intrinsic Value of a security but
subtracts of cost of project.
NPV
NPV == PV
PV of
of Inflows
Inflows -- Initial
Initial Outlay
Outlay
k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
k=10%
0 1 2 3 4
Definition:
The IRR is that discount rate at which
NPV = 0
Outflow = PV of Inflows
54
Capital Budgeting Methods
Internal Rate of Return
Determine the mathematical solution for IRR
Outflow = PV of Inflows
Solve for Discount Rates
55
Capital Budgeting Methods
Decision Rule for Internal Rate of Return
Independent Projects
Accept Projects with
IRR required rate
PI = PV of Inflows
Initial Outlay
57
Capital Budgeting Methods
Profitability Index
Very Similar to Net Present Value
PI = PV of Inflows
Initial Outlay
PI = PV of Inflows
Initial Outlay
PI =
10,000
11,095
PI = = 1.1095
10,000
63
Capital Budgeting Methods
Profitability Index Decision Rules
Independent Projects
Accept Project if PI ³ 1
Mutually Exclusive Projects
Accept Highest PI ³ 1 Project
64
Comparison of Methods
Project 1
0 1 2
Project 1
0 1 2
Both Projects have
(10,000) 5,000 5,000
Identical Payback
Project 2
0 1 2 3
Another problem with IRR is that if the sign of the cash flow changes more
than once, there is a possibility of multiple IRR. See p 340.
To find MIRR
1.Find the FV of all intermediate CFs using the cost of
capital (the hurdle rate) as the interest rate.
2.Add all FV.
3. Find that discount rate which makes the PV of the FV
equal to the PV of outflows.