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What is Capital Budgeting?

“Capital Budgeting is the process of identifying, Analyzing and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.”

What is Capital Budgeting?

“Capital Budgeting is the process of planning expenditures on assets with cash flows that are expected to extend beyond one year”

Functions

- Generating Investment projects proposals consistent with firm’s strategy.
- Estimating after tax operating cash flows for investment projects.
- Evaluating project cash flows.
- Selecting a project based on Value-Maximizing criteria.

Our Focused Area

Selecting a project based on Value-Maximizing criteria.

Pay Back Period (PBP)

“The Length of time required for an investment’s net Revenues to cover its cost.”

Net Present Value (NPV)

“The Present value of an investment project’s is net cash flows minus the Project’s initial cash outflow.”

NPV=Present value of cash flows – Initial Investment

NPV= cf1 + cf2 + …….. + cfn - ICO

(1+r)1 (1+r)2 (1+r)n

Where:

cf = Cash flow

r = Interest rate

ICO= Initial Cash out flow

Project with +ve NPV will be selected

Internal Rate of Return (IRR)

“The discount Rate that equates the present value of the future net cash flows from an investment project’s initial cash out flow.”

If IRR > Given Rate, project will b accepted.

Profitability Index (PI)

“The Ratio of the present value of a project’s future net cash flow to the project’s initial cash out flow”

Example

ABC company has two projects Project A and Project B, the maximum pay back period and interest rate for both projects is 4years and 12% respectively, cash flows of different years for both projects is given. Evaluate both projects on the basis of four capital budgeting techniques and decide which project is beneficial for the company.

Pay Back Period (PBP)

Project A

Project B

PBP = 4 + 90,000 – 81,000

20,000

= 4 + 9,000

20,000

= 4 + 0.45

= 4.45 Years

4 Years, 5 Months & 12 days

PBP =3 + 70,000 – 65,000

30,000

= 3+ 5,000

30,000

= 3+ 0.14

= 3.14

3 Year,1 Month & 20 days

Calculation Of Net Present Value

Project A

Calculation Of Net Present Value

Project B

Net Present Value (NPV)

Project A

Project B

NPV = Total Present Value – Initial Investment

= 70,474 – 90,000

= -19,526

NPV = Total Present Value – Initial Investment

= 95,635 – 70,000

= 25,635

Steps for Calculation of IRR

- Calculate average cash flow
- Divide Initial Investment by answer of above step
- Find the Answer of above step in table and see % of rate
- Calculate total present value with the help of above found rate
- Get another total present value with another supposed rate.
- Apply the formula

Step 1 : Average Cash Inflow

Project A

Project B

Average = Total Cash Inflow

No. of Years

= 1,01,000

5

= 20,200

Average = Total Cash Inflow

No. of Years

= 1,40,000

5

= 28,000

Step 2: Division

Project A

Project B

Divide Initial Investment by answer of previous step.

= 90,000

20,200

= 4.45

Divide Initial Investment by answer of previous step.

= 70,000

28,000

= 2.5

Project B

Step 4 & 5: Calculate NPV

Project A

Project B

Present value with 4%

= 88,979 – 90,000

= -1021

Present value with 2%

=94,694 – 90,000

= 4694

Present value with 28%

= 62,920 – 70,000

= -7080

Present value with 23%

= 71020 – 70000

= 1020

Step 6: Apply The Formula

Project A

Project B

IRR= 2%+2% 4694

4694 + 1021

=2%+2% 4694

5715

= 2% + 2% ( 0.8213)

= 2% + 1.64%

= 3.64%

IRR = 23%+5% 1020

1020 + 7080

=23%+5% 1020

8100

= 23%+5% (0.125925)

= 23% + 0.63%

= 23.62%

Profitability Index

Project A

Project B

PI = Net Present Value

Initial Investment

= 70,474

90,000

= 0.78

PI = Net Present Value

Initial Investment

= 95,635

70,000

= 1.36

Conclusion

On the basis of above Techniques The Project B is Not Beneficial for Company ABC.

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