c
 


 m
 c
 

 The investment decisions of a firm are
generally known as Capital Budgeting.
 In the words of LYNCH Ơ capital budgeting
consists in planning development of
available capital for the purpose of
maximising the long term profitability of
the concern ơ

 
 c
 

 Large investments
 Long term commitment of funds
 Irreversible nature
 Long term effect on profitability
 Difficulties of investment decisions
 National importance
 Ú
 c
 

 Identification of investment proposals
 Screening the proposals
 Evaluation of various proposals
 Fixing priorities
 Final approval and preparation of capital
expenditure budget
 Implementing proposal
 Performance review
   

ô


  ô

  J
J
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)

Mô


 
  
M JJ
Payback Period (PB)
Discounted Payback Period (DPB)
Accounting Rate of Return (ARR)
 
Ú

 
m

 Cash flows of the investment project should be
forecasted based on realistic assumptions.

 Appropriate discount rate should be identified to

discount the forecasted cash flows. The appropriate
discount rate is the projectƞs opportunity cost of capital.

 Present value of cash flows should be calculated using

the opportunity cost of capital as the discount rate.

 The project should be accepted if NPV is positive (i.e.,

NPV>0)



 


 Accept the project when NPV is positive

NPV > 0
 Reject the project when NPV is negative
NPV < 0
 May accept the project when NPV is zero
NPV = 0
 The NPV method can be used to select between
mutually exclusive projects; the one with higher
NPV should be selected.
    Úm

m 
J

J
Time Value
Measure of True Profitability
Value Additivity
Shareholder Value

ô 

ô 
JJ
Involved cash flow estimation
Discount rate is difficult to determine
Mutually exclusive projects
Ranking of Projects
 
  
 

 The Internal Rate of Return (IRR) is the
rate that equates the investment outlay
with the present value of cash inflow
received after one period.

 This also implies that the rate of return is

the discount rate which makes NPV = 0
    m

m 
J

J
Time Value
Profitability measure
Acceptance rule
Shareholder value

ô 

ô 
JJ
Multiple rates
Mutually exclusive projects
Value additivity
 Ú  

 Profitability Index is the ratio of the
present value of the cash inflows, at the
required rate of return, to the initial cash
outflow of the investment.



 


 Accept the project when PI is greater than

one. PI > 1
 Reject the project when PI is less than
one. PI < 1
 May accept the project when PI is equal to
one. PI = 1
 The project with positive NPV will have PI
greater than one. PI less than one means
that the projectƞs NPV is negative.
    Úm

 It recognizes the Time Value of money.
 It is consistent with the shareholder value
maximization principle.
 In the PI Method, since the present value of
cash inflows is divided by the initial cash
outflow, it is relative measure of a projectƞs
profitability.
 Like the NPV Method, PI criteria also requires
calculation of cash flows and estimate of the
discount rate.
 Ú  
 Payback is the number of years required
to recover the original cash outlay
invested in a project.

 If a project generates constant annual

cash inflows, the Payback period can be
computed by dividing cash outlay by
annual cash inflow



 


 The project would be accepted if its Payback

period is less than the maximum or À
 period set by the mgmt.

 As a ranking method, it gives highest ranking to

the project, which has the shortest payback
period and lowest ranking to the project with
highest payback period.
    Ú  

   
J

J
Simplicity
Cost effective
Short term effects
Risk shield
Liquidity

À 
   
J


J
Cash flows after payback
Cash flows ignored
Cash flows patterns
Administrative difficulties
Inconsistent with shareholder value

  
 
m

 The Accounting rate of return is the ratio of the
average after-
after-tax profit divided by the average
investment. The average investment would be
equal to half of the original investment if it were
depreciated constantly.

 A variation of the ARR method is to divide

average earnings after taxes by the original cost
of the project instead of the average cost.



 


 The method will accept all those projects whose

ARR is higher than the minimum rate established
by the mgmt and reject those projects which
have ARR less than the minimum rate.

 This method would rank a project as number

one if it has highest ARR and lowest rank would
be assigned to the project with lowest ARR.
    
m

m 
J

J
Simplicity
Accounting Data
Accounting Profitability

ô 

ô 
JJ
Cash flows ignored
Time value ignored
Arbitrary cut-
cut-off
 Ú

M 
Here, the present value is Here, the discount rate is not
determined by discounting predetermined
the future cash flows of a
project at a predetermined
rate
It recognises the importance It does not consider the
of market rate of interest market rate of interest
The intermediate cash inflows The intermediate cash flows
are reinvested at a cut off are presumed to be reinvested
rate at the IRR
It is more reliable It is less reliable
 
 c 

c
Ú

  
 Expected economic life of the project
 Selling price of the product
 Production cost
 Depreciation rate
 Rate of taxation
 Future demand of the product

m
c
Ú


  
 Not practically true
 Requires estimation of future cash inflows
and outflows
 Cannot be correctly quantified
 Urgency
 Uncertainty and risk pose