Prepared By Deepa Antony Batch 1 S2 MGT1oo5211

What is Capital Budgeting?

Capital budgeting is a planning process. Used to determine whether a firm's long term

investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.
It is budget for major capital, or investment,

expenditures.
Also called investment appraisal.

Many formal methods are used in capital budgeting, including the techniques such as
Discounted pay back period Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity

Profitability Index
The profitability index is a technique of

capital budgeting. This holds the relationship between the investment and a proposed project's payoff. Mathematically the profitability index is given by the following formula: Profitability Index = (Present Value of future cash flows) / (Present Value of Initial investment)

The profitability index is also

sometimes called as value investment ratio or profit investment ratio.

Profitability index is used to rank

various projects.

Net Present value

Net present value (NPV) is a widely used

tool for capital budgeting.

NPV mainly calculates whether the cash

flow is in excess or deficit and also gives the amount of excess or shortfall in terms of the present value.

The NPV can also be defined as the

present value of the net cash flow.

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 time r -- rate of discount Ct -- net cash flow at time t C0 --capital outlay when t = 0

Modified Internal Rate of Return

The Modified Internal Rate of Return

(MIRR) gives the measure of an investment's attractiveness in a business.

The prime use of the modified

internal rate of return in the capital budgeting process is to rank various

Internal Rate of Return

It 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 benefits of the investment. Or in other words IRR is the Required Rate that equates the NPV of an investment zero.

NPV and IRR methods will always

result identical accept/reject decisions for independent projects.

The reason is that whenever NPV is

positive , IRR must exceed Cost of Capital. However this is not true in case of mutually exclusive projects

Discounted Payback Period

Payback period does not take into account

the time value of money. Thus, future cash inflows are not discounted or adjusted for debt/equity used to undertake the project , inflation, etc.
But DPP considers the time value of

money, it shows the breakeven after covering such costs. This technique is somewhat similar to payback period except that the expected future cash flows

Discounted payback period is how long an

investments cash flows, discounted at projects cost of capital, will take to cover the initial cost of the project. In this approach, the PV of future cash inflows are cumulated up to time they cover the initial cost of the project. Discounted payback period is generally higher than payback period because it is money you will get in the future and will be less valuable than money today

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 assets than do current assets, capital assets are long-term. Therefore, a firm that makes a mistake in its capital budgeting process has to live with that mistake for a long period of time.

Firms spend considerable time in planning

capital budgeting decisions. Involve top executives from production, engineering, marketing and so on not only financial managers.

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