Capital budgeting is the process of evaluating long-term investments to maximize shareholder wealth. It involves significant funds with long-term impacts on business success. Various techniques are used to evaluate projects, including payback period, net present value (NPV), and internal rate of return (IRR). NPV discounts future cash flows to measure value today, while IRR is the discount rate that yields an NPV of zero. Both have advantages and disadvantages, such as NPV considers time value of money while IRR may favor longer projects. Firms select projects with the highest positive NPV or IRR depending on whether projects are independent or mutually exclusive.
2. Capital Budgeting
• Capital budgeting is the process of evaluating and selecting long-term investments
that are consistent with the firm’s goal of maximizing owner wealth.
3. Nature
CB Decisions have long-term impact on the business stability,
growth & success
CB Decisions involve huge investment of funds
CB Decisions are more complicated from concerns of future cash
flow estimates and their evaluation at the time of making
investment.
CB Decisions are not easily reversible mainly because of loss of
investment.
4. Importance
Huge amount of resources are involved that has impact on
business strategy, growth, and survival.
Difficult to “bail out”, once an investment is made.
The capital investments are challenging and critical to the
success of the company. An incorrect decision may end with the
company’s closing-out from the market.
5. Process
CB is a five steps process that is followed by the investment
Managers:
Initiating
Analyzing
Ranking
Implementin
g
Monitoring &
making follow-up
7. Objectives
Understand the key elements of the capital budgeting process.
Calculate, interpret, and evaluate the payback period.
Calculate, interpret, and evaluate the net present value (NPV) and economic value added (EVA)
Calculate, interpret, and evaluate the internal rate of return (IRR).
Use net present value profiles to compare NPV and IRR techniques.
Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each
approach.
8. PAYBACK PERIOD
Defined as the numbers of years required to cover the original cost outlay.
PAYBACK PERIOD = 𝐼𝑁𝐼𝑇𝐼𝐴𝐿 𝐼𝑁𝑉𝐸𝑆𝑇𝑀𝐸𝑁𝑇
𝐴𝑁𝑁𝑈𝐴𝐿 𝐶𝐴𝑆𝐻 𝐹𝐿𝑂𝑊
9. ADVANTAGES AND DISADVANTAGES
OF PAYBACK PERIOD
MERITS DEMERITS
Simple. Ignores cash after the payback period.
Emphasizes on earlier cash flows. Fails to consider „time value of the
money’
Rough and ready method or dealing with
risk.
10. AVERAGE RATE OF RETURN (ARR)
Investment project is judged by looking at its rate of return on book value.
Evaluates return on accounting profits. i.e. on accrual basis.
Annual returns are expressed in percentage of net investment.
AVERAGE RATE OF RETURN =
𝐴𝑉𝐸𝑅𝐴𝐺𝐸 𝑃𝑅𝑂𝐹𝐼𝑇 𝐴𝐹𝑇𝐸𝑅 𝑇𝐴𝑋
𝐴𝑉𝐸𝑅𝐴𝐺𝐸 𝐼𝑁𝑉𝐸𝑆𝑇𝑀𝐸𝑁𝑇
× 100
11. ADVANTAGES AND DISADVANTAGES OF
ACCOUNTING RATE OF RETURN (ARR)
MERITS DEMERITS
Simple. Ignores the life of the project.
Considers value of project to its economic
life.
Fails to consider „time value of the money’.
Based on accounting profits; no separate
calculation
Required.
Fails to consider „time value of the money’.
& Affected by accounting practices; changes
in method of depreciation and inventory
costing affects earnings and hence ARR.
12. DISCOUNTED PAYBACK METHOD
Improvement over „payback period method", considers „time
value of money‟.
It surmounts the objection that equal weight is given to all flows
starting year one to the cut off date.
In other words, it discounts the cash inflow by applying the
present value factors for different periods.
Calculated by counting the years the discounted cash flows add
up to the initial investment.
Still takes no account of cash flow after the cut-off date.
13. NET PRESENT VALUE (NPV) METHOD
Its the difference between the total discounted inflows and outflows.
Depends solely on the forecasted cash flows and the opportunity cost of
capital.
Opportunity cost of capital is the expected rate of return on investment
of equivalent risks.
Present value of cash flows is calculated using opportunity cost of
capital at discount rate.
Ideal for mutually exclusive projects.
Projects are ranked in the order of highest „Net Present Values‘.
14. ADVANTAGES AND DISADVANTAGES OF
NET PRESENT VALUE (NPV) METHOD
ADVANTAGES DISADVANTAGES
Considers "time value of money‟. Difficult to ascertain future cash
flows.
Relies on discount rate and
estimated cash flows.
Biased towards longer term projects
Financial.
15. INTERNAL RATE OF RETURN (IRR)
METHOD
Also known as the „Marginal Rate of Return ‟or „Time Adjusted Rate of Return‟.
It is the discount rate at which the present value of cash flows equals the present value
of cash outflows. i.e. NPV = 0
In other words, IRR is the rate of return the project earns.
The rate of discount is determined by the „trial and error method‟ .
The point of intersection represents the IRR; where NPV is equal to zero.
17. ADVANTAGES AND DISADVANTAGES OF
INTERNAL RATE OF RETURN (IRR) METHOD
MERITS DEMERITS
Considers Working Capital and Scrape
Value
Lengthy, based on „trial and error
method‟.
Considers cash flows during the whole
economic life.
Assumes that future cash flows are
reinvested at a rate equal to IRR.
18. DIFFERENCE BETWEEN NPV METHOD AND
IRR METHOD
NET PRESENT VALUE INTERNAL RATE OF RETURN
Assumes that cost of capital is known. Assumes that NPV is zero.
Calculates NPV, given the discount rate. Figures out discount rate that makes NPV zero.
19. PROFITABILITY INDEX
The profitability index (or the benefit cost ratio) is the present value of forecasted future
cash flows divided by the initial investment:
PROFITABILITY INDEX =
P/V OF CASH INFLOW
INITIAL CASH OUTFLOW
20. DECISION RULES
FOR ALL CAPITAL BUDGETING TECHNIQUES
# Tech. Single or Independent
Project(s)
Mutually Exclusive Projects
1 PB Less than the Target Period Shortest Payback Period
2 DPB Less than the Target Period Shortest Payback Period
3 ARR Above the Target Rate With the highest ARR
4 NPV A positive NPV With the highest positive NPV
5 IRR Higher than the Target Rate
(Cost of
Capital)
With the highest IRR
6 MIRR Higher than Target Cost of
Capital
(i.e. WACC)
With higher MIRR
7 TV If PVTS>PVO Accept,
And if PVTS<PVO Reject
With the highest PVTS>PVO
8 PI(B/C Ratio) PI exceeding 1 Higher PI
