CAPITAL BUDGETING

CAPITAL BUDGETING =INVESTING in Long-term Assets CAPITAL: Fixed assets used in production BUDGET: Plan of in- and outflows during some period CAPITAL BUDGET: A list of planned investment (i.e., expenditures onfixed assets) outlays for different projects. CAPITAL BUDGETING: Process of selecting viable investment projects.

SIGNIFICANCE OF CAPITAL BUDGETING:

1. Substantial Capital Outlays: capital budgeting decisions involve substantial capital outlays. 2. Long-term implications: capital budgeting proposals are of longer duration and hence have longterm implications. 3. Strategic in nature: capital budgeting decision can affect the future of the company significantly as it constitutes the strategic determinant for success of the company. a right investment decision is the secret of the success of many business enterprises. 4. Irreversible: once the funds are committed to a particular project, we cannot take back the decision. if the decision is to be reversed, we may have to lose a significant portion of the funds already committed. it may involve loss of time and efforts. In other words, the capital budgeting decisions are irreversible or may not be easily reversible.
BASIC STEPS OF CAPITAL BUDGETING:

1. 2. 3. 4. 5.

Estimate the cash flows Assess the riskiness of the cash flows. Determine the appropriate discount rate. Find the PV of the expected cash flows. Accept the project if PV of inflows > costs.

Capital budgeting decisions: 1. Construction of a new building, or renovation of existing old buildings. 2. Interior decoration of a given building. 3. Purchase of technology from a foreign country. 4. Building a production facility 5. Buying a new delivery truck. 6. Making a new product. 7. Starting a new business 8. Replacement decisions for replacing worn out or damaged equipment as well as replacing obsolete equipment. And so on. METHOD OF CAPITAL BUDGETING: A) Traditional methods 1. Payback period. 2. Accounting rate of return B) Discounted cash flow methods 1. Internal rate of return 2. Net present value 3. Profitability index Payback period. The length of time until the accumulated cash flows from the investment equal or exceed the original cost. We will assume that cash flows are generated continuously during a period. Advantages and Disadvantages of the Payback Rule Advantages Easy to Understand Biased toward liquidity Allows for quick evaluation of managers Adjusts for uncertainty of later cash flows (by ignoring them altogether)

Disadvantages Ignores the time value of money Ignores cash flow beyond the payback period Biased against long-term projects Internal rate of return: The discount rate that makes the present value of future cash flows equal to the initial cost of the investment.

Advantages and Disadvantages of the IRR Rule

Advantages

Closely related to NPV rule, often leading to the same decisions Easy to understand and communicate

Disadvantages

May result in multiple answers with non-conventional cash flows.

May lead to incorrect decisions with mutually exclusive investment projects.

Not always easy to calculate.

Net Present Value Rule (NPV): The net present value is the difference between the market value
of an investment and its cost.