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INTRODUCTION
Capital budgeting is a complex process which may be divided into the following phases: Identification of potential investment opportunities Assembling of proposed investments Decision making Preparation of capital budgeting and appropriations Implementation Performance review
Capital budgeting techniques are used to assess the feasibility of any investment project. Following are most common techniques Net Present Value method Benefit Cost Ratio (Profitability Index) Internal Rate of Return Payback Period rule Average Accounting Return rule
The NPV of a project is the sum of the present values of all the cash flows positive as well as negatives that are expected to occur over the life of the project. NPV= Total PV of future Cash flows Initial Investment A project is accepted when the NPV is zero or positive Reinvestment Assumption: the NPV rule assumes that all cash flows can be reinvested at discount rate
CONTD.
Advantage NPV are additive i.e NPV of projects is the sum of the NPVs of individual projects included in the package NPV uses cash flow NPV uses all cash flows of the project NPV discounts all cash flows properly Disadvantage NPV is expressed in absolute terms rather than relative terms and hence does not factor in the scale of investment. NPV rules does not consider the life of project. Hence when mutually exclusive projects with different lives are considered, the NPV rule is biased in favour of longer term project.
CONTD.
Advantage: Easy to understand and communicate Disadvantage: Does not distinguish between investing and borrowing IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments
CONTD
ADVANATGE DISADVANTAGE
Easy to understand
Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria An accepted project based on the payback criteria may not have a positive NPV
CONTD.
ADVANTAGE DISADVANTAGE
Ignores the time value of money Uses an arbitrary benchmark cutoff rate