Capital Budgeting-Deepa

7/31/2019 Capital Budgeting-Deepa

1/15

Prepared ByDeepa AntonyBatch 1 S2

MGT1oo5211


2/15


3/15

Many formal methods are used in capital

budgeting, including the techniques such as

Discounted pay back period

Net present valueProfitability index

Internal rate of return

Modified internal rate of return

Equivalent annuity


4/15

Profitability Index

The profitability index is a technique ofcapital budgeting.

This holds the relationship between theinvestment and a proposed project'spayoff.

Mathematically the profitability index isgiven by the following formula:

Profitability Index = (Present Value offuture cash flows) / (Present Value of Initialinvestment)


5/15

The profitability index is alsosometimes called as value

investment ratio or profit investmentratio.

Profitability index is used to rankvarious projects.


6/15

Net Present value

Net present value (NPV) is a widely usedtool for capital budgeting.

NPV mainly calculates whether the cashflow is in excess or deficit and also givesthe amount of excess or shortfall in termsof the present value.

The NPV can also be defined as thepresent value of the net cash flow.


7/15

Mathematically,

NPV = ?(Ct / (1+r)t) - C0 , where the

summation takes the value of t ranging from 1

to n

n -- total project time

t -- cash flow timer -- rate of discount

Ct -- net cash flow at time t

C0 --capital outlay when t = 0


8/15

Modified Internal Rate

of Return

The Modified Internal Rate of Return

(MIRR) gives the measure of aninvestment's attractiveness in abusiness.

The prime use of the modifiedinternal rate of return in the capital

budgeting process is to rank various


9/15

Internal Rate of

ReturnIt is an another important technique used

in Capital Budgeting Analysis to access the

viability of an investment proposal.Most important alternative to Net Present

Value (NPV).

IRR is The Discount rate at which the

costs of investment equal to the benefitsof the investment. Or in other words IRR isthe Required Rate that equates the NPV ofan investment zero.


10/15

NPV and IRR methods will alwaysresult identical accept/reject

decisions for independent projects.

The reason is that whenever NPV is

positive , IRR must exceed Cost ofCapital. However this is not true incase of mutually exclusive projects


11/15

Discounted PaybackPeriodPayback period does not take into account

the time value of money. Thus, future cashinflows are not discounted or adjusted for

debt/equity used to undertake the project ,inflation, etc.

But DPP considers the time value ofmoney, it shows the breakeven aftercovering such costs. This technique issomewhat similar to payback period

except that the expected future cash flows


12/15

Discounted payback period is how long aninvestments cash flows, discounted atprojects cost of capital, will take to coverthe initial cost of the project.

In this approach, the PV of future cashinflows are cumulated up to time theycover the initial cost of the project.

Discounted payback period is generallyhigher than payback period because it ismoney you will get in the future and will beless valuable than money today


13/15

IMPORTANCE

Capital Budgeting is an extremely important

aspect of a firm's financial management. Although capital assets usually comprise a

smaller percentage of a firm's total assetsthan do current assets, capital assets arelong-term.

Therefore, a firm that makes a mistake in itscapital budgeting process has to live withthat mistake for a long period of time.


14/15

Firms spend considerable time in planningcapital budgeting decisions.

Involve top executives from production,engineering, marketing and so on not onlyfinancial managers.


15/15

THANKYOU

THANK YOU..

Documents

Capital Budgeting-Deepa