Capital Budgeting

Capital Budgeting Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s future.

Capital budgeting Capital budgeting (is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research and development projects are worth pursuing

Investment Decisions Replacement Projects Expansion Projects Diversification Projects Research and Development Projects

Capital Budgeting Process Identification Of Investment Proposals Screening The Proposals Evaluation Of Various Proposals Establishing Priorities Final Approval Implementing Proposal Performance Review

Pay back The number of years required to recover a project’s cost, or “How long does it take to get our money back?” Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.

Years 1 2 3 4 5 Project A 1,000,000 250,000                                

Disadvantages · The payback period entirely ignores many of the cash inflows, which occur after the payback period. The payback period also ignores the salvage value and the total economic life of the project. . It ignores the timing of the occurrence of the cash flows. It considers the cash flows occurring at different point of time as equal in money worth and ignores the time value of money · Advantages of the payback method: · Payback can be important: long payback means capital tied up and high investment risk. The method also has the advantage that it involves a quick, simple calculation and an easily understood concept.

ARR annualized net income earned on the average funds invested in a project. the annual returns of a project are expressed as a percentage of the net investment in the project. ARR= Average Annual Profits/Average Investment

Net present value (NPV This technique involves calculating the present value of all future cash inflows and cash outflows that will result from undertaking a project These positive and negative present values are then netted off against one another to determine the net present value of the project

The net present value of a project is calculated where: Ft = cash flow generated by the project in year t r = the opportunity cost of capital C0 = the cost of the project (initial cash flow,) n = the life of the project in years

strengths It recognizes the time value of money. It helps in evaluation of proposals involving cash flows over a period of several years. The cash flows occurring at different point of time are not directly comparable, but they can be made comparable by the application of the discounting procedure. The NPV technique considers the entire cash flow stream and all the cash inflows and outflows, irrespective of the timing of their occurrence, are incorporated in the calculation of the NPV. The NPV technique is based on the cash flows rather than the accounting profit and thus helps in analysing the effect of the proposal on the wealth of the shareholders in a better way.

Internal rate of return (IRR) The IRR technique is also based on a DCF model, but focuses on the rate of return in the DCF equation rather than the NPV The IRR is defined as the discount rate that equates the present value of a project’s cash inflows with the present value of the its cash outflows This is the equivalent of saying that the IRR is the discount rate at which the NPV of the project is equal to 0

Inflation and Capital Budgeting nominal values are the actual amount of money making up cash flows real values reflect the purchasing power of the cash flows real values are found by adjusting the nominal values For the rate of inflation

Inflation and Capital Budgeting INFLATION EFFECTS TWO ASPECTS OF CAPITAL BUDGETING PROJECTED CASH FLOWS DISCOUNT RATE

Inflation and Capital Budgeting Nominal Discount rate= (1+Inflation rate)*(1+real rate of discount)-1 Effect of capital Budgeting Can Be can be incorporated by Discounting the money cash flows at nominal discount rate Discounting real cash flows at the real discount rate

Inflation and Capital Budgeting inflation has the following effects: a) Inflation will mean higher costs and higher selling prices. It is difficult to predict the effect of higher selling prices on demand. A company that raises its prices by 30%, because the general rate of inflation is 30%, might suffer a serious fall in demand. b) Inflation, as it affects financing needs, is also going to affect the cost of capital. c) Since fixed assets and stocks will increase in money value, the same quantities of assets must be financed by increasing amounts of capital. If the future rate of inflation can be predicted with some degree of accuracy, management can work out how much extra finance the company will need and take steps to obtain it, e.g. by increasing retention of earnings, or borrowing.