Capital Budgeting Analysis
Financial Management
B 642
Outline
Meaning of Capital Budgeting
Types of Capital Budgeting Decisions
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
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.
Types of Capital Budgeting
Decisions
Should we add a new product to our existing
product line?
Should we expand into a new market?
Should we replace our existing machinery?
Should we buy fully automatic or
semiautomatic machinery
Where to locate manufacturing facility?
Should we outsource components and parts?
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
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.
RJR Nabisco’s smokeless cigarette project example
Similarly, Euro-Disney, Concorde Plane, Saturn of GM
all faced problems due to bad capital budgeting,
while Intel became global leader due to sound capital
budgeting decisions in 1990s.
Techniques of Capital Budgeting
Analysis
Payback Period Approach
Discounted Payback Period Approach
Net Present Value Approach
Internal Rate of Return
Profitability Index
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
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?
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
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
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
Consistent with wealth maximization
Accept a project if IRR > Cost of Capital
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