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Capital Budgeting


Capital Budgeting
Capital budgeting involves planning and justifying large expenditures on long-term projects
Projects can be classified as:
Replacement Expansion New venture

Importance of c.b d
Growth Risk Funding Irreversibility Complexity

Capital Budgeting Techniques

How many years to recover initial cost

Net Present Value

Present value of inflows less outflows

Projects return on investment Ratio of present value of inflows to outflows

Internal Rate of Return

Profitability Index

Capital Budgeting Techniques Payback

Payback period is the time it takes to recover early cash outflows
Shorter paybacks are better

Payback Decision Rules

Stand-alone projects
payback period < policy maximum accept Payback period > policy maximum reject If PaybackA < PaybackB choose Project A

Mutually Exclusive Projects

Weaknesses of the Payback Method

Ignores time value of money Ignores cash flows after payback period

Capital Budgeting Techniques Payback

Why Use the Payback Method?
Its quick and easy to apply Serves as a rough screening device

The Present Value Payback Method

Calculate payback period using the present value of project cash flows
Not widely used

Capital Budgeting Techniques Net Present Value (NPV)

NPV is the sum of the present values of a projects cash flows at the cost of capital

If PV inflows > PV outflows

=> NPV > 0


Capital Budgeting Techniques Net Present Value (NPV)

NPV and Shareholder Wealth
A projects NPV is the net effect that it is expected to have on the firms value To maximize shareholder wealth, select the capital spending program with the highest NPV


Capital Budgeting Techniques Net Present Value (NPV)

Decision Rules
Stand-alone Projects
NPV > 0 accept NPV < 0 reject

Mutually Exclusive Projects

NPVA > NPVB choose Project A over B


Internal Rate of Return (IRR)

Decision Rules
Stand-alone Projects
If IRR > cost of capital (k) accept If IRR < cost of capital (k) reject

Mutually Exclusive Projects

IRRA > IRRB choose Project A over Project B

Internal Rate of Return (IRR)

Calculating IRRs
Finding IRRs usually requires an iterative, trial-and-error technique
Guess at the projects IRR Calculate the projects NPV using this interest rate
If NPV = zero, the guessed interest rate is the projects IRR If NPV > 0, try a higher interest rate If NPV < 0, try a lower interest rate


Techniques Internal Rate of Return (IRR)

Technical Problems with IRR
Multiple Solutions
Unusual projects can have more than one IRR The number of positive IRRs to a project depends on the number of sign reversals to the projects cash flows
Normal pattern involves only one sign change

The Reinvestment Assumption

IRR method implicitly assumes cash inflows will be reinvested at the projects IRR
For projects with extremely high IRRs, this is unlikely

These are rarely of practical concern


Comparing IRR and NPV

NPV and IRR do not always select the same project in mutually exclusive decisions
A conflict can arise if NPV profiles cross in the first quadrant In the event of a conflict The selection of the NPV method is preferred