BASICS OF CAPITAL BUDGETING
DEFINITION OF CAPITAL BUDGETING
apital budgeting refers to theprocessbusinessesusetoevaluate
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potential major projects or investments, such as constructing new
plantsorinvestinginlong-termassets.Thisdecision-makingprocess
iscriticalasitdeterminesthefuturegrowthandfinancialhealthofthe
company.
KEY CONCEPTS AND METHODS
1. Net Present Value (NPV)
● D
efinition:NPV is the sum of the present value of a project's
cash inflows and outflows, discounted at the cost of capital. It
measures the profitability of an investment in dollar terms.
Decision Rule:
● Accept if NPV > 0 (project adds value).
● For mutually exclusive projects, select the one with the highest
NPV.
Advantages:
● Accounts for the time value of money.
● Considers all cash flows.
● Provides a direct measure of added value to the firm.
Disadvantages:
● Assumes a constant discount rate.
● Not useful when comparing projects of unequal lifespans or
sizes.
2. Internal Rate of Return (IRR)
● D
efinition:The IRR is the discount rate that makes the NPV
of a project equal to zero. It represents the expected annual
return on a project.
Decision Rule:
● AccepttheprojectifIRR>WACC(WeightedAverageCostof
Capital).
● Formutuallyexclusiveprojects,selecttheonewiththehighest
IRR, provided IRR > WACC.
Advantages:
● Easy to understand and communicate as it provides a
percentage return.
● Considers the time value of money.
Disadvantages:
● AssumesreinvestmentatthesamerateasIRR,whichcanbe
unrealistic.
● Can result in multiple IRRswithnon-normalcashflows(cash
flows with more than one sign change).
3. Modified Internal Rate of Return (MIRR)
● D
efinition: MIRR adjusts the IRR toassumereinvestmentat
thefirm’scostofcapital(WACC),solvingtheissueofmultiple
IRRs.
Advantages:
● Avoids the multiple IRR problem.
● More realistic assumption about reinvestment rates.
Disadvantages:
● More complex to calculate than IRR.
● Does not solve the size problem of comparing projects with
vastly different scales.
4. Payback Period
● D
efinition: The payback period is the time it takes for a
project to recover its initial investment from the cash inflows.
Decision Rule:
● Accept projects with a payback period less than a
predetermined threshold.
Advantages:
● Simple and easy to use.
● Provides insight into liquidity and risk by showing how quickly
the investment is recovered.
Disadvantages:
● Ignores the time value of money.
● Ignores cash flows beyond the payback period.
Discounted Payback Period:
● Similar to the regular payback period but accounts for the time
value of money by discounting future cash flows.
Application of Methods in Decision-Making Crossover Rate
● D efinition: The crossover rate is the discount rate at which
Independent vs. Mutually Exclusive Projects
two projects havethesameNPV.Itoccursduetodifferences
● Independent Projects: These projects do not affect each
in the timing of cash flows.
other. You can accept all projects that meet thecriteria(e.g.,
● Implication: When choosing between mutually exclusive
NPV > 0, IRR > WACC).
projects,ifthecostofcapitalisbelowthecrossoverrate,one
● Mutually Exclusive Projects: Only one project can be
project is better, while the other project becomes preferable
selected. In this case, use NPV tomaximizethefirm’svalue,
when the cost of capital is above the crossover rate.
asIRRmayleadtoincorrectdecisionsduetoitsreinvestment
assumption.
Steps in Capital Budgeting
Ranking Conflicts: NPV vs. IRR . E
1 stimate Cash Flows– Identify all inflows and outflows.
● Conflicts between NPV and IRR can arise when: 2. Assess Risk– Evaluate the riskiness of these cash flows.
○ Projects differ in scale. 3. Determine Cost of Capital (WACC) – Calculate the firm’s
○ Projects have different cash flow timings. cost of financing.
○ Resolution:NPVisgenerallypreferredasitmeasures 4. Compute NPV, IRR, and Payback Period – Use these
absolute value added to the firm, while IRR can metrics to evaluate the project.
sometimesfavorsmallerprojectswithhighpercentage 5. Decision Making – Accept or reject based on the criteria
returns but lower actual dollar value. mentioned above.
6. Monitor and Review – Continuously track the project’s
Types of Cash Flow Streams progress.
● N ormal Cash Flow: A series of cash inflows following an
initial outflow (one sign change).
Other Important Considerations
● Non-normalCashFlow:Morethanonesignchange,leading ● R isk Assessment: Capital budgeting involves assessing the
to multiple IRRs. Example: A nuclear power plant that has riskiness of future cash flows. Firms may adjust thediscount
large initial outflows, followed by inflows, and then another rate (WACC) upward for riskier projects to account for this
large outflow for decommissioning. uncertainty.
● Qualitative Factors: Apart from quantitative analysis,
qualitative factors like strategic alignment, environmental
impact, and regulatory requirements should also be
considered.
Final Decision Criteria for Students
● U seNPVasthePrimaryMetric:NPVisthemostreliableand
theoretically sound method. Use IRR for a secondary check,
but be cautious of its assumptions.
● UnderstandPaybackforRiskInsight:Whilenotasprecise,
the payback period gives insight into the liquidity and risk of
projects.
● Be Mindful of Reinvestment Assumptions: IRR assumes
reinvestment at the IRR itself, which may not always be
realistic.NPVassumesreinvestmentatWACC,whichismore
conservative.
● Focus on the TimeValueofMoney:Alwaysdiscountfuture
cash flows to account for the time value of money.
Conclusion
apital budgeting isessentialinmakingsoundinvestmentdecisions.
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Understanding and correctly applying methods like NPV, IRR, and
payback can guide a company toward profitable and strategically
aligned investments. For students, mastering these methods willnot
only help in exams but also in real-world financial analysis.
