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Agenda
 What is Capital Budgeting.
 Why Capital Budgeting is so Important.
 The Capital Budgeting Decisions.
 Methods of Capital Budgeting
 Payback
 Discounted Payback
 Net Present Value (NPV)
 Internal rate of Return (IRR)
 Profitability Index (PI)

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What is Capital Budgeting ?
 Capital budgeting is the process of analyzing
Potential Projects.
 Capital budgeting can be defined as the process of analyzing,
evaluating, and deciding whether resources should be
allocated to a project or not.
 Process of Capital budgeting ensure optimal allocation of
resources and helps management work towards the goal of
shareholder wealth maximization.
Why Capital Budgeting is so Important?
Involve Massive investment of Resources.
Have Long-term Implications for the Firm.
Involve uncertainty and risk for the Firm.
Due to the above factors, capital budgeting decisions
become critical and must be evaluated very
carefully. Any firm that does not follow the capital
budgeting process will not be able to Maximize
Shareholder Wealth and management will not be
acting in the best interests of shareholders.
The Capital Budgeting Decision
Types of Decisions
◦ Expansion of Facilities
◦ Replacement
◦ Lease or Make or buy
Methods of Capital Budgeting
 Payback
 Discounted Payback
 Net Present Value (NPV)
 Internal rate of Return (IRR)
 Profitability Index (PI)

Let us see how these methods Work

Payback Period Method
 The payback Period defined as the expected
number of years required to recover the
original investment, it is the formal method
used to evaluate capital budgeting project.
0 1 2 3 4
* -----------* -----------* ----------* -------------*
-1000 500 400 300 100
-1000 + 500+400 = 100
100/300 = 0.33
Payback = 2.33 Years
Payback Period Pros &Cons
Advantage
1. Easy to calculate
2. Provide an indication
of a project’s risk and liquidity

Disadvantage
 Ignore cash flow after payback period
 Doesn’t consider time value of Money
Discounted Payback
 It is a similar to the regular payback period except
that the expected cash flow is discounted by the
project’s cost of capital. Thus the discounted
payback period is defined as the number of years
required to cover the investment from discounted net
cash flows.
0 1 2 3 4
* -----------* -----------* ----------* -------------*
-1000 500 400 300 100
455 330 225 68
- 1000 + 455 + 330 = 215/225 = 0.95
Discounted Payback Period = 2.95 Years
Discounted Payback Period Pros &Cons
Advantage
 Consider Time value of Money
Disadvantage
 Ignore cash flow after payback period

Ignores cash flows

after the payback
Period.
Net Present Value (NPV)
The net present value ( NPV) Method is based
upon the discounted cash flow (DCF) Technique ,
it is based on all discounted cash flows of the
project by using cost of capital rate and then sums
those cash flows, the project should be accepted if
NPV is positive or = Zero.
Calculation of NPV
Cost of
Capital @
10% 0 1 2 3 4
* --------------------* -----------* -----------* -------------*
-1000 500 400 300 100
+455
+330
+225
+ 68
====
+ 78
If Positive NPV we will accept the Project (√)
Internal Rate of Return (IRR)
 Internal rate of Return (IRR) is defined as the
discounted rate that forces a project’s NPV to equal
zero. The project should be accepted if the IRR is
greater than cost of capital
0 1 2 3 4
* --------------------* -----------* -----------* -------------*
-1000 500 400 300 100
-1000+ 500 + 400 + 300 + 100 = Zero
(1+IRR) 1 (1+IRR) 2 (1+IRR) 3 (1+IRR) 4

 If IRR > WACC we will accept the project because the

project’s rate of return is greater than its cost.
 If IRR < WACC we will Reject the project because the
project’s rate of return is less than its
Profitability Index (PI )
The profitability index (PI) is equal to the present value of net cash flows
divided by the initial cash outflow

It is calculated as follows:

The above formula can simply be represented as follows

Profitability
index
= Total present value of net cash flows (i.e. without the initial cost)
Initial cost

Decision rule is to invest in the project when the project profitability index is
greater than 1
Profitability Index (PI )
0 1 2 3 4
Cost of * --------------------* -----------* -----------* -------------*
Capital @ -1000 500 400 300 100
10%
+455
+330
+225
+ 68
====
Profitability index shows the
+ 1078
dollars of present value divided
PI = 1078 = $ 1.08 by the initial cost, so it measure
1000
relative profitability.
So the project is expected to produce $1.08 for each $ 1 of
investment, if we compare 2 projects we will select the project
with higher (PI) and must be greater than (1).
Which Approach is Better?
On a purely theoretical basis, NPV is considered the better
approach because:-
◦ NPV measures how much wealth a project creates (or
destroys if the NPV is negative for shareholders.
◦ Also NPV consider reinvestment of cash flow at cost of
capital which is more conservative.
◦ Despite the fact most of the financial managers prefer to
use the IRR approach in addition to NPV method because
of the preference for rates of return.
Thank You