1. Capital Budgeting Analysis
Financial Policy and Planning
MB 29

2. 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

3. 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.

4. 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

5. 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

6. 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.

7. Techniques of Capital Budgeting Analysis
Payback Period Approach
Discounted Payback Period Approach
Net Present Value Approach
Internal Rate of Return
Profitability Index

8. 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

9. 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?

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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.

16. 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