CAPITAL BUDGETING TECHNIQUES

BY: SHASHIPRAKASH SAINI MBA-IB ROLL NO- 56

INTRODUCTION
Capital budgeting is a complex process which may be divided into the following phases: Identification of potential investment opportunities Assembling of proposed investments Decision making Preparation of capital budgeting and appropriations Implementation Performance review

Capital budgeting techniques are used to assess the feasibility of any investment project. Following are most common techniques Net Present Value method Benefit Cost Ratio (Profitability Index) Internal Rate of Return Payback Period rule Average Accounting Return rule

The NPV of a project is the sum of the present values of all the cash flows positive as well as negatives that are expected to occur over the life of the project. NPV= Total PV of future Cash flows Initial Investment A project is accepted when the NPV is zero or positive Reinvestment Assumption: the NPV rule assumes that all cash flows can be reinvested at discount rate

CONTD.
Advantage NPV are additive i.e NPV of projects is the sum of the NPVs of individual projects included in the package NPV uses cash flow NPV uses all cash flows of the project NPV discounts all cash flows properly Disadvantage NPV is expressed in absolute terms rather than relative terms and hence does not factor in the scale of investment. NPV rules does not consider the life of project. Hence when mutually exclusive projects with different lives are considered, the NPV rule is biased in favour of longer term project.

Two ways of defining the relationship between benefits and costs

Benefit cost ratio : BCR = PVB/I

Net Benefit cost ratio : NBCR= ( PVB I)/I = BCR 1 Where PVB is present value of benefits and I is initial investment Minimum Acceptance criteria: accept if BCR> 1 or NBCR> o Ranking criteria: Select alternative with highest BCR Advantage: Since this criterion measures NPV per rupee of outlay, it can discriminate better between large and small investments . Hence is preferable over NPV

Internal Rate of Return

IRR is the discount rate that sets NPV to zero In NPV we assume discount rate is known and determine the NPV IN IRR we set NPV equal to zero and determine the discount rate that satisfies this condition Minimum Acceptance Criteria: Accept if the IRR exceeds the required return Ranking Criteria: Select alternative with the highest IRR. Reinvestment assumption: All future cash flows assumed reinvested at the IRR.

CONTD.
Advantage: Easy to understand and communicate Disadvantage: Does not distinguish between investing and borrowing IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments

Payback Period rule

The payback period answers the question of; how long does it take the project to pay back its initial investment Payback Period = number of years to recover initial costs The shorter the payback period the more attractive the investment. The reasons are that: The earlier the investment is recovered, the sooner the cash funds can be used for other purpose. The risk of loss from changed economic conditions is less in a shorter payback-period

CONTD
ADVANATGE DISADVANTAGE

Easy to understand

Biased toward liquidity

Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria An accepted project based on the payback criteria may not have a positive NPV

Average Accounting Return rule

Average Accounting Return is defined as Profit after tax/ Book value of the investment The higher the AAR, the better the project Projects which have AAR equal to or greater than cutoff rate of return (which is between 20% and 30%) are accepted and others are rejected

CONTD.
ADVANTAGE DISADVANTAGE

Accounting information is usually available Easy to calculate

Ignores the time value of money Uses an arbitrary benchmark cutoff rate

Based on book values, not cash flows and market values