Capital Budgeting

CAPITAL BUDGETING •CAPITAL BUDGETING IS THE PROCESS OF EVALUATING AND SELECTING LONG-TERM INVESTMENTS THAT ARE CONSISTENT WITH THE FIRM’S GOAL OF MAXIMISING OWNERS’ WEALTH. •A CAPITAL EXPENDITURE IS AN OUTLAY OF FUNDS BY THE FIRM THAT IS EXPECTED TO PRODUCE BENEFITS OVER A PERIOD OF TIME GREATER THAN 1 YEAR. •THE BASIC MOTIVES FOR CAPITAL EXPENDITURE ARE TO EXPAND,REPLACE OR TO RENEW FIXED ASSETS . •STEPS IN CAPITAL BUDGETING PROCESS i PROPOSAL GENERATION ii REVIEW AND ANALYSIS iii DECISION MAKING iv IMPLEMENTATION v FOLLOW -UP RELEVANT CASH FLOWS i INCREMENTAL AFTER- TAX CASH FLOWS ii INCIDENTAL OR SYNERGISTIC EFFECTS iii INVESTMENT IN WORKING CAPITAL iv IGNORE SUNK COSTS v ACCOUNT FOR OPPORTUNITY COST vi IGNORE INTEREST PAYMENTS CASH FLOW COMPONENTS i INITIAL INVESTMENT ii OPERATING CASH FLOWS iii TERMINAL CASH FLOW TYPES OF PROJECTS i INDEPENDENT PROJECTS ii MUTUALLY EXCLUSIVE PROJECTS

CAPITAL BUDGETING TECHNIQUES •THERE ARE FOUR COMMONLY USED CAPITAL BUDGETING TECHNIQUES OR CRITERIA FOR DETERMINING THE ACCEPTABILITY OF INVESTMENT PROJECTS : 1. PAYBACK PERIOD 2. NET PRESENT VALUE ( NPV) 3. PROFITABILITY INDEX 4. INTERNAL RATE OF RETURN ( IRR)

PAYBACK PERIOD •PAYBACK PERIOD IS THE AMOUNT OF TIME REQUIRED FOR THE FIRM TO RECOVER ITS INITIAL INVESTMENT IN A PROJECT , AS CALCULATED FROM CASH INFLOWS. •THE DECISION CRITERIA : * IF THE PAYBACK PERIOD IS LESS THAN OR EQUAL TO THE MAXIMUM ACCEPTABLE PAYBACK PERIOD ACCEPT THE PROJECT, OTHERWISE REJECT IT.

NET PRESENT VALUE •THE NPV OF A PROJECT IS EQUAL TO THE PRESENT VALUE OF ITS CASH INFLOWS (DISCUNTED AT A RATE EQUAL TO THE FIRM’S COST OF CAPITAL) LESS THE PROJECT’S INITIAL INVESTMENT. • THE DECISION CRITERIA : • * IF NPV IS GREATER THAN OR EQUAL TO • $ 0 , ACCEPT THE PROJECT. OTHERWISE • REJECT IT.

PROFITABILITY INDEX ( PI) •THE PROFITABILITY INDEX OR BENEFIT /COST RATIO , IS THE RATIO OF PRESENT VALUE OF CASH INFLOWS TO THE INITIAL INVESTMENT. •THE DECISION CRITERIA : • * IF THE PI IS GREATER THAN OR EQUAL TO • 1.0 , ACCEPT THE PROJECT . OTERWISE • REJECT IT.

INTERNAL RATE OF RETURN (IRR) •IRR IS DEFINED AS THE DISCOUNT RATE THAT EQUATES PRESENT VALUE OF THE PROJECT’S CASH INFLOWS WITH ITS INITIAL INVESTMENT. IT IS THAT VALUE OF k THAT CAUSES NPV TO EQUAL 0. •THE DECISION CRITERIA: • * IF IRR IS GREATER THAN OR EQAUL TO THE COST OF CAPITAL ACCEPT THE PROJECT . OTHER WISE REJECT IT.

CONFLICTING RANKINGS •CONFLICTING RANKINGS OFTEN EMERGE AS A RESULT OF DIFFERENCES IN THE MAGNITUDE AND TIMING OF CASH FLOWS . •THE UNDERLYING CAUSE IS THE DIFFERING ASSUMPTION WITH REGARD TO THE REINVESTMENT OF INTERMEDIATE CASH INFLOWS. •NPV ASSUMES REINVESTMENT OF INTERMEDIATE CASH INFLOWS AT THE MORE CONSERVATIVE COST OF CAPITAL ; IRR ASSUMES REINVESTMENT AT THE PROJECT’S OWN IRR. •ON A PURELY THEORETICAL BASIS , NPV IS PREFERRED BECAUSE IT ASSUMES THE MORE CONSERVATIVE REINVESTMENT RATE. •IN PRACTICE, THE IRR IS MORE COMMONLY USED BECAUSE OF THE GENERAL DISPOSITION OF BUSINESS PEOPLE TOWARDS RATE OF RETURN RATHER THAN DOLLAR RETURNS.