CAPITAL BUDGETING

INTRODUCTION
Financial manager always faces a wide variety of

investment alternatives specially in the case of capital investment decision It involves making capital expenditure in the initial stage of our project which are expected to provide cash inflows over a number of years Such capital expenditure may include expansion of facilities for existing product or a new product or replacement of existing facility with an improved one.

INTRODUCTION
Capital investment decision involves a large

irreversible commitment of resources that is generally subject to a significant degrees of risk Such decisions have far reaching effects on a companies profitability and flexibility over the long term

NATURE OF INVESTMENT DECISIONS

Known as capital budgeting decisions Defined as The firms decision to invest its current funds most

efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years Investment decisions would generally include expansion, acquisition mordernisation and replacement of the long term assets Sale of a division or a business

NATURE OF INVESTMENT DECISIONS

Change in the method of sales distribution or an

advertisement campaign or a research and development programme

NATURE OF INVESTMENT DECISIONS

Following are the features of investment decisions: The exchange of current funds for future benefits The funds are invested in long term assets Future benefits will occur to the firm over a series of years It is significant to emphasize that expenditures and

benefits of an investment should be measured in cash In the investment a analysis it is the cashflows which is important, not the accounting profit Investment decisions affect the firms value

IMPORTANCE OF INVESTMENT DECISIONS

Investment decisions require special attention

because of the following reasons

They influence the firms growth in the long run They effect the risk of the firm They involve commitment of large amount of funds They are irreversible or reversible at substantial loss They are among the most difficult decisions to make

IMPORTANCE OF INVESTMENT DECISIONS

Growth

A firms decision to invest in long term assets has a decisive influence on the rate and direction of its growth Long term commitment of funds may also change the risk complexity of the firm Investment decisions involve large amount of funds which make it imperative for the firm to plan its investment programmes very carefully

Risk

Funding

IMPORTANCE OF INVESTMENT DECISIONS

Irreversibility

Investment decisions are irreversible

Complexity

Investment decisions are amongst the most difficult decisions Assessment of future events which are difficult to predict

Types of investment decisions

There are many ways to classify investments One classification is as follows: Expansion of existing business Expansion of new business Replacement and modernization

Yet another usefull way to classify investments is

as follows:

Mutually exclusive investments Independent investments Contingent investments

INVESTMENT EVALUATION CRITERIA

Three steps are involved in the evaluation of an

investment:
Estimation of cashflows Estimation of the required rate of return(opportunity cost of capital) Application of a decision rule for making the choice

INVESTMENT DECISION RULE

Referred to as capital budgeting techniques A sound appraisal technique should be used to

measure the economic worth of an investment project The essential property of a sound technique is that it should maximise the shareholders wealth The following other characteristics should also be possessed by a sound investment evaluation criterion

It should consider all cashflows to determine the true profitability of the project

Investment decision rule

It should provide for an objective and unambiguous way of separating good projects from bad projects It should help ranking of projects according to their true profitability It should recognise the fact that bigger cashflows are preferable to smaller ones and early cashflows are preferable to later ones Should help to choose among mutually exclusive projects Should be a criterion which is applicable to any conceivable investment project independent of others

Evaluation criteria
A number of investment criteria (or capital

budgeting techniques) are in use in practice They may be grouped in the following two categories

Discounted cashflow criteria (DCF)

Net Present Vlaue (NPV) Internal rate of return (IRR) Profitability index (PI)

Non discounted cashflow criteria

Payback period (PB) Discounted payback period Accounting rate of return (ARR)

NET PRESENT VALUE

This method assumes that the project being

appraised has both inflows and outflows and thus, the result is a net (inflow minus outflow) present value A positive Net Present Value means that the investment increases the value of the firm This happens when the total value of the discounted inflows is greater than the outflows

NET PRESENT VALUE

Advantages

Tells wether the investment will increase the firms value Considers all cashflows Considers the time value of money Considers the riskiness of future cashflows Useful for the selection of mutually exclusive projects

Disadvantages

Involves calculation of the required rate of return to discount the cashflows