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    UNIT - 1 - Capital Budgeting Techniques - Prasanna Chandra

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    Rakshith S
    The document discusses various capital budgeting techniques used to evaluate investment projects. It begins by explaining the importance of capital budgeting and outlining the typical capital budgeting process. It then covers different investment criteria including net present value, benefit-cost ratio, internal rate of return, payback period, and accounting rate of return. Formulas and examples are provided for calculating each technique. The techniques consider both discounted and non-discounted cash flows over the life of an investment project.

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    UNIT - 1 - Capital Budgeting Techniques - Prasanna Chandra

    Uploaded by

    Rakshith S
    175 views17 pages
    The document discusses various capital budgeting techniques used to evaluate investment projects. It begins by explaining the importance of capital budgeting and outlining the typical capital budgeting process. It then covers different investment criteria including net present value, benefit-cost ratio, internal rate of return, payback period, and accounting rate of return. Formulas and examples are provided for calculating each technique. The techniques consider both discounted and non-discounted cash flows over the life of an investment project.

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    UNIT_1_Capital Budgeting Techniques- Prasanna Chandra

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    The document discusses various capital budgeting techniques used to evaluate investment projects. It begins by explaining the importance of capital budgeting and outlining the typical capital budgeting process. It then covers different investment criteria including net present value, benefit-cost ratio, internal rate of return, payback period, and accounting rate of return. Formulas and examples are provided for calculating each technique. The techniques consider both discounted and non-discounted cash flows over the life of an investment project.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    175 views17 pages

    UNIT - 1 - Capital Budgeting Techniques - Prasanna Chandra

    Uploaded by

    Rakshith S
    The document discusses various capital budgeting techniques used to evaluate investment projects. It begins by explaining the importance of capital budgeting and outlining the typical capital budgeting process. It then covers different investment criteria including net present value, benefit-cost ratio, internal rate of return, payback period, and accounting rate of return. Formulas and examples are provided for calculating each technique. The techniques consider both discounted and non-discounted cash flows over the life of an investment project.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 17

    Prasanna Chandra

    6e

    © Centre for Financial Management , Bangalore


    FUNDAMENTALS OF
    FINANCIAL MANAGEMENT
    © Centre for Financial Management , Bangalore
    TECHNIQUES OF CAPITAL
    BUDGETING
    Chapter 11
    OUTLINE
     Importance
     Capital Budgeting Process

    © Centre for Financial Management , Bangalore


     Project Classification
     Investment Criteria
     Net Present Value
     Benefit Cost Ratio
     Internal Rate of Return
     Modified Internal Rate of Return
     Payback Period
     Accounting Rate of Return
    CAPITAL EXPENDITURES AND
    THEIR IMPORTANCE
    The basic characteristics of a capital expenditure (also

    © Centre for Financial Management , Bangalore


    referred to as a capital investment or just project) is that
    it involves a current outlay (or current and future
    outlays) of funds in the receiving a stream of benefits in
    future.
    Importance stems from:
     Long-term consequences
     Substantial outlays
     Difficulty in reversing
    CAPITAL BUDGETING PROCESS

     Identification of Potential Investment Opportunities

    © Centre for Financial Management , Bangalore


     Assembling of Investment Proposals
     Decision Making
     Preparation of Capital Budget and Appropriations
     Implementation
     Performance Review
    PROJECT CLASSIFICATION

     Mandatory Investments

    © Centre for Financial Management , Bangalore


     Replacement Projects
     Expansion Projects
     Diversification Projects
     Research and Development Projects
     Miscellaneous Projects
    INVESTMENT CRITERIA

    INVESTMENT

    © Centre for Financial Management , Bangalore


    CRITERIA

    DISCOUNTING NON-DISCOUNTING
    CRITERIA CRITERIA

    NET BENEFIT INTERNAL ACCOUNTING


    PAYBACK
    PRESENT COST RATE OF RATE OF
    PERIOD
    VALUE RATIO RETURN RETURN
    © Centre for Financial Management , Bangalore
    NET PRESENT VALUE
    NET PRESENT VALUE
    The net present value of a project is the sum of the present value of all
    the cash flows associated with it. The cash flows are discounted at an
    appropriate discount rate (cost of capital).

    NAVEEN ENTERPRISE’S CAPITAL PROJECT

    © Centre for Financial Management , Bangalore


    Year Cash Flow Discount Factor Present Value
    0 -100.00 1.000 -100.00
    1 34.00 0.870 29.58
    2 32.50 0.756 24.57
    3 31.37 0.658 20.64
    4 30.53 0.572 17.46
    5 79.90 0.497 39.71
    Sum = 31.96

    PROS CONS
     Reflects the time value of money  Is an absolute measure and not a
     Considers the cash flow in its entirely relative measure
     Squares with the objective of wealth
    maximisation
    BENEFIT COST RATIO
    PVB
    Benefit-cost Ratio : BCR =
    I
    PVB = present value of benefits
    I = initial investment
    To illustrate the calculation of these measures, let us consider a project which is being

    © Centre for Financial Management , Bangalore


    evaluated by a firm that has a cost of capital of 12 percent.
    Initial investment : Rs 100,000
    Benefits: Year 1 25,000
    Year 2 40,000
    Year 3 40,000
    Year 4 50,000
    The benefit cost ratio measures for this project are:
    25,000 40,000 40,000 50,000
    (1.12) (1.12)2 (1.12)3 (1.12)4
    BCR = = 1.145
    100,000
    + + +
    PROS CONS
    Measures bang per buck Provides no means for aggregation
    INTERNAL RATE OF RETURN

    © Centre for Financial Management , Bangalore


    The internal rate of return (IRR) of a project is the discount rate that makes its
    NPV equal to zero. It is represented by the point of intersection in the above
    diagram

    NET PRESENT VALUE INTERNAL RATE OF RETURN


     Assumes that the discount rate  Assumes that the net present value
    (cost of capital) is known. is zero.
     Calculates the net present value,  Figures out the discount rate that
    given the discount rate. makes net present value zero.
    CALCULATION OF IRR
    You have to try a few discount rates till you find the one that makes the NPV zero

    © Centre for Financial Management , Bangalore


    Year Cash Discounting Discounting Discounting
    flow rate : 20% rate : 24% rate : 28%
    Discount Present Discount Present Discount Present
    factor Value factor Value factor Value

    0 -100 1.000 -100.00 1.000 -100.00 1.000 -100.00


    1 34.00 0.833 28.32 0.806 27.40 0.781 26.55
    2 32.50 0.694 22.56 0.650 21.13 0.610 19.83
    3 31.37 0.579 18.16 0.524 16.44 0.477 14.96
    4 30.53 0.482 14.72 0.423 12.91 0.373 11.39
    5 79.90 0.402 32.12 0.341 27.25 0.291 23.25

    NPV = 15.88 NPV = 5.13 NPV = - 4.02


    CALCULATION OF IRR

    © Centre for Financial Management , Bangalore


    NPV at the smaller rate
    Smaller Sum of the absolute values of the Bigger Smaller
    discount + NPV at the smaller and the bigger X discount – discount
    rate discount rates rate rate

    5.13
    24% + 28% - 24% = 26.24%
    5.13 + 4.02
    PAYBACK PERIOD
    Payback period is the length of time required to recover the initial
    outlay on the project
    NAVEEN ENTERPRISE’S CAPITAL PROJECT
    Year Cash flow Cumulative cash flow

    © Centre for Financial Management , Bangalore


    0 -100 -100
    1 34 - 66
    2 32.5 -33.5
    3 31.37 - 2.13
    4 30.53 28.40

    PROS CONS
    • Simple • Fails to consider the time value
    of money
    • Rough and ready method • Ignores cash flows beyond the
    for dealing with risk payback period
    • Emphasises earlier cash inflows
    AVERAGE RATE OF RETURN Average PAT
    Average Book Value of Investment (Beginning)

    NAVEEN ENTERPRISE’S CAPITAL PROJECT


    Year Book Value of PAT
    Investment(Beg)
    1 100 14

    © Centre for Financial Management , Bangalore


    2 80 17.5
    3 65 20.12
    4 53.75 22.09
    5 45.31 23.57

    1/5 (14+17.5 +20.12+22.09+23.57)


    1/5(100+80+65+53.75+45.31)

    PROS CONS
    • Simple • Based on accounting profit,
    ARR•= Based on accounting information = 28.31%
    not cash flow
    businessmen are familiar with • Does not take into account the
    • Considers benefits over the entire project life time value of money
    INVESTMENT APPRAISAL
    IN PRACTICE
     Over time, discounted cash flow methods

    © Centre for Financial Management , Bangalore


    have gained in importance and internal rate of
    return is the most popular evaluation method.
     Firms typically use multiple evaluation
    methods.
     Accounting rate of return and payback period
    are widely employed as supplementary
    evaluation methods.
    SUMMING UP
    n Ct
    • NPV =  –I
    t=1 (1 + r) t

    PVB
    • BCR =
    I
    • IRR is the value of r in the following equation
    n Ct

    © Centre for Financial Management , Bangalore


    I= 
    t = 1 (1 + r)t
    • MIRR is calculated as follows:
    TV
    PVC =
    (1 + MIRR)n
    • The payback period is the length of time required to recover the initial cash
    outlay on the project
    • The accounting rate is defined as:
    Average profit after tax
    Average book value of investment

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