CAPITAL
BUDGETING
PRESENTED BY:
What is CAPITAL BUDGETING?
Spending decision planning and analysis defining investors future profits including regeneration of invested capital.
WHAT IT INCLUDES?
It involves the projects taken up which adds to company value generating long term benefits in terms of capital
It is the initial assessment to get the rough idea of profits and loss a company or firm can face after investment.
Basically governed by cash management system(Assessments includes calculating cash/capital in flow and outflow).
ANALYSIS/ TECHNIQUES
DISCOUNTED
ANALYSIS
CAPITAL PAYBACK
BUDGETING
ANALYSIS
THROUGHPUT
ANALYSIS
CAPITAL BUDGETING PROCESS
Identification of Investment Opportunities & Inflation scope / valuation
Estimation of Cash Flows
Evaluation of Cash Flows
Selection of Projects
Implementation of Projects
Review and Monitoring
IMPORTANCE OF CAPITAL BUDGETING
Capital budgeting helps businesses prioritize investments and allocate financial resources more effectively,
reducing the risk of investing in unprofitable projects and maximizing returns. Overall, capital budgeting is an
essential tool for businesses to achieve long-term growth and success.
Informs long-term investment decisions
Reduces risk of unprofitable investments
Maximizes profits by aligning with business goals
Prioritizes investments and allocates resources efficiently
Provides a framework for evaluating opportunities
Promotes long-term growth and success
Enables planning and budgeting for future investments
RISKS/LIMITATIONS
Market trends
Legal ,social,environmental considerations
Accuracy issues when investment capital is huge
Invesement should generate build in inflation for stakeholders.
TECHNIQUES OF CAPITAL BUDGETING
INTERNAL RATE OF RETURN
NET PRESENT VALUE
PROFITABILITY INDEX
PAYBACK PERIOD
MODIFIED INTERNAL RATE OF RETURN
Internal Rate of Return (IRR)
Internal Rate of Return refers to the discount rate that makes the present value of expected after-tax `cash inflows
equal to the initial cost of the project.
IRR is the discount rate that makes the present values of a project’s estimated cash inflows equal to the present
value of the project’s estimated cash outflows.
If IRR is greater than the required rate of return for the project, then accept the project. And if the IRR is less than
the required rate of return, then reject the project.
PV (inflows) = PV (outflows)
Formula
IRR is calculated by finding the discount rate that makes the present value of cash inflows equal to the initial
investment.
For example:
if an investment costs $100,000 and is expected to generate $25,000 in annual cash inflows for the next five years,
the IRR calculation would involve finding the discount rate that makes the net present value of these cash inflows
equal to $100,000.
Advantages:
Considers the time value of money
Accounts for all expected cash inflows and outflows
Provides a measure of the investment’s profitability
Can be used to compare multiple investment opportunities
Limitations:
Requires accurate estimates of future cash flows and discount rates
May lead to incorrect decisions when evaluating mutually exclusive projects
May result in multiple IRR values for some projects
NET PRESENT VALUE (NPV):
The Net Present Value (NPV) method is a capital budgeting technique used to determine the value of an investment by
comparing the present value of its expected cash inflows to the initial investment cost.
This method compares the present value of a project’s cash inflows to the present value of its cash outflows, taking into
account the time value of money.
Calculation- Formula:
NPV = -Initial Investment + PV of Expected Cash Inflows
Where: PV = Present Value, Initial Investment = Total cost of the investment, Expected Cash Inflows = Future cash inflows
discounted to their present value
Example:
If an investment costs $100,000 and is expected to generate $25,000 in annual cash inflows for the next five years, with a discount rate of 10%, the NPV
calculation would be as follows:
1. Identify the Cash Flows:
Initial Investment (Year 0): $100,000
Annual Cash Inflows (Years 1-5): $25,000
2. Apply the Discount Rate:
-Discount Rate: 10%
3. Discount Cash Flows: Year 1: $25,000 / (1 + 0.10)^1 = $22,727.27
Year 2: $25,000 / (1 + 0.10)^2 = $20,661.16
Year 3: $25,000 / (1 + 0.10)^3 = $18,783.79
Year 4: $25,000 / (1 + 0.10)^4 = $17,076.17
Year 5: $25,000 / (1 + 0.10)^5 = $15,530.15
4. Calculate NPV: -
NPV = Sum of Present Values of Cash Flows - Initial Investment
NPV = $22,727.27 + $20,661.16 + $18,783.79 + $17,076.17 + $15,530.15 - $100,000
5. Compute the NPV:
NPV ≈ $94,778.54 - $100,000
6. Final Calculation: - NPV ≈ -$5,221.46
Therefore, the Net Present Value (NPV) of this investment is approximately -$5,221.46.
A negative NPV suggests that the investment may not meet the desired rate of return (10% in this case) and may not be
considered economically feasible.
Advantages:
Considers the time value of money
Accounts for all expected cash inflows and outflows
Provides a measure of the investment’s profitability
Can be used to compare multiple investment opportunities
Limitations:
Requires accurate estimates of future cash flows and discount rates
Can be complex and time-consuming to calculate
Does not consider non-financial factors such as environmental impact or social responsibility.
PROFITABILITY INDEX
The profitability index (PI), alternatively referred to as value
investment ratio (VIR) or profit investment ratio (PIR), describes
an index that represents the relationship between the costs and
benefits of a proposed project.
The profitability index is calculated as the ratio between the
present value of future expected cash flows and the initial
amount invested in the project. A higher PI means that a project
will be considered more attractive.
FORMULA FOR THE PROFITABILITY INDEX
ADVANTAGES DISADVANTAGES
o
It considers the time value o
It only considers the initial
of money. investment.
o
It allows for comparison of o
It doesn't consider the size
projects with different of the project.
lifespans. o
It relies on accurate
Payback Period
The term payback period refers to the
amount of time it takes to recover the
cost of an investment. Simply put, it is
the length of time an investment
reaches a break even point
