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Agenda
Importance

Investment Criteria
Payback Period Accounting Rate of Return Net Present Value Benefit Cost Ratio/Profitability Index Internal Rate of Return

Capital Expenditure
Capital Budgeting is planning and control process of capital expenditures for the purpose of maximizing the long-term profitability of the firm. It involves evaluation of (and decision about) projects. Which projects should be accepted? The goal of evaluation is to accept a project which maximizes the shareholder wealth. Benefits are worth more than the cost.

Basic Features of Capital Budgeting Decisions

1. Potentially large anticipated benefits 2. A relatively high degree of risk 3. A relatively long term period between the initial outlay and anticipated return 4. Irreversible

3 Kinds of Capital Budgeting Decisions

Accept Reject Decisions

Kinds of Decisions

Mutually Exclusive Decisions

Capital Rationing Decisions

Information Required for Capital Budgeting Decisions

Cash Flows: Cash revenue, cash expenses Cash Inflows are befits generated & Cash Outflows are costs incurred. Cost of New Asset Additional Working Capital to carry additional inventory Net annual Cash Inflows/Operating Cash Flows Terminal Cash Inflows

Techniques of Capital Budgeting

Pay Back Method

Payback period shows the length of time required to repay the total initial investment through investment cash flows. It is calculated Using the formula: Pay Back Period =Cost of Assets/Net Annual Cash Flows

Acceptance Rule : A project is acceptable if its payback period is shorter than or equal to the cutoff period.

ARR (Also known as ROI)

ARR= Average after tax profits/Average Investments Average after tax profits =[ EBITt(1-T) ]/n Average Investments =( I0 +In )/ 2 Advantages : Simplicity, Accounting data, Incorporates entire stream of income Disadvantages : Ignores time value of money, limitations of accounting (e.g.non cash items)

ARR - Acceptance Rule

Accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate.

Net Present Value

The net present value of a project is the sum of the present value of all the cash flows associated with it. The cash flows are discounted at an appropriate discount rate (cost of capital)

n Ct NPV = Initial investment t=1 (1 + rt )t

Profitability Index (B-C ratio)

PI is ratio of the PV of cash inflows to the initial cash outflow Acceptance rule :
Accept if PI>1 Reject if PI <1 May accept if PI=1

PI is relative measure of projects profitability, we can come to know if project will increase shareholder value of not.

IRR
IRR is akin to NPV. Mechanics are similar. Initial and future cash flows should be known, then we attempt to answer the question that what maximum rate of return these cash flows support we find out the value of r. So IRR is the discount rate which makes its NPV equal to zero. Or Discount rate that equates the PV of future cash flows with investment

Calculate r ?

n Ct = Initial investment t=1 (1 + rt )t

Trail and Error Method is used to calculate IRR

Quick calculation can made using excel

Ends