capital budgeting techniques
TRANSCRIPT
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CAPITAL BUDGETING TECHNIQUESPresnted By:-Niladri Bhattacharjee(48)Section- B
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Outline• Meaning of Capital Budgeting• Significance of Capital Budgeting Analysis• Traditional Capital Budgeting Techniques
• Payback Period Approach• Discounted Payback Period Approach• Discounted Cash Flow Techniques
• Net Present Value• Internal Rate of Return• Profitability Index• Net Present Value versus Internal Rate of Return
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Meaning of Capital Budgeting• Capital budgeting addresses the issue of strategic long-term investment decisions.
• 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.
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Significance of Capital Budgeting• Considered to be the most important decision that a
corporate treasurer has to make.• So much is the significance of capital budgeting that many
business schools offer a separate course on capital budgeting
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Why Capital Budgeting is so Important?
• Involve massive investment of resources
•Are not easily reversible•Have long-term implications for the firm
• Involve uncertainty and risk for the firm
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CONTD…• 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 maximizing shareholder wealth and management will not be acting in the best interests of shareholders.
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Techniques of Capital Budgeting Analysis• Payback Period Approach• Discounted Payback Period Approach• Net Present Value Approach• Internal Rate of Return• Profitability Index
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Which Technique should we follow?• A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization.
• A technique is considered consistent with wealth maximization if • It is based on cash flows• Considers all the cash flows• Considers time value of money• Is unbiased in selecting projects
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Payback Period Approach
• The amount of time needed to recover the initial investment
• The number of years it takes including a fraction of the year to recover initial investment is called payback period
• To compute payback period, keep adding the cash flows till the sum equals initial investment
• Simplicity is the main benefit, but suffers from drawbacks
• Technique is not consistent with wealth maximization—Why?
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PBP Strengths and Weaknesses
StrengthsStrengths::• Easy to use and
understand• Can be used as a measure of liquidity
• Easier to forecast ST than LT flows
WeaknessesWeaknesses::• Does not account
for TVM• Does not consider
cash flows beyond the PBP• Cutoff period is
subjective
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Discounted Payback Period• Similar to payback period approach with one difference that it considers time value of money
• The amount of time needed to recover initial investment given the present value of cash inflows
• Keep adding the discounted cash flows till the sum equals initial investment
• All other drawbacks of the payback period remains in this approach
• Not consistent with wealth maximization
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Net Present Value Approach• Based on the dollar amount of cash flows• The dollar amount of value added by a project• NPV equals the present value of cash inflows minus initial investment
• Technique is consistent with the principle of wealth maximization—Why?
• Accept a project if NPV ≥ 0
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NPV Strengths and Weaknesses
StrengthsStrengths::• Cash flows
assumed to be reinvested at
the hurdle rate.• Accounts for TVM.• Considers all
cash flows.
WeaknessesWeaknesses::• May not include
managerial options
embedded in the project.
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Internal Rate of Return• The rate at which the net present value of cash flows of a
project is zero, I.e., the rate at which the present value of cash inflows equals initial investment
• Project’s promised rate of return given initial investment and cash flows
• Consistent with wealth maximization• Accept a project if IRR ≥ Cost of Capital
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IRR Strengths and Weaknesses
StrengthsStrengths: : • Accounts for TVM• Considers all
cash flows• Less subjectivity
WeaknessesWeaknesses: : • Assumes all cash
flows reinvested at the IRR
• Difficulties with project rankings
and Multiple IRRs
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NPV versus IRR• Usually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project
• IRR can be in conflict with NPV if • Investing or Financing Decisions• Projects are mutually exclusive
• Projects differ in scale of investment• Cash flow patterns of projects is different
• If cash flows alternate in sign—problem of multiple IRR• If IRR and NPV conflict, use NPV approach
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Profitability Index (PI)• A part of discounted cash flow family• PI = PV of Cash Inflows/initial investment• Accept a project if PI ≥ 1.0, which means positive NPV
• Usually, PI consistent with NPV• PI may be in conflict with NPV if
• Projects are mutually exclusive• Scale of projects differ• Pattern of cash flows of projects is different
• When in conflict with NPV, use NPV
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PI Strengths and Weaknesses
StrengthsStrengths::• Same as NPV• Allows comparison of different scale projects
WeaknessesWeaknesses::• Same as NPV• Provides only
relative profitability• Potential Ranking
Problems
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Evaluating Projects with Unequal Lives• Replacement Chain Analysis• Equivalent Annual Cost Method• If two machines are unequal in life, we need to make
adjustment before computing NPV.
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Which technique is superior?
• Although our decision should be based on NPV, but each technique contributes in its own way.
• Payback period is a rough measure of riskiness. The longer the payback period, more risky a project is
• IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the project’s estimated cash flows
• PI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment
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