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Capital budgeting is the process by which a company evaluates and decides on long-term investment projects. These projects often require significant funds and have impacts that last several years, such as purchasing machinery, launching a new product line, or building infrastructure.
Why is capital budgeting important? Because companies have limited resources, they must carefully choose projects that will maximize their value over time. A wrong investment can lead to losses or missed opportunities, while a good investment can drive growth and profitability.
In India and worldwide, businesses rely on capital budgeting to make informed decisions that balance risk and return. The key techniques used to evaluate these projects include:
Each technique helps managers understand different aspects of the investment, such as how quickly money is recovered, the value added in today's terms, or the rate of return expected.
The Payback Period is the simplest capital budgeting technique. It measures the time required to recover the initial investment from the project's cash inflows.
Think of it like lending money to a friend and wanting to know how long it will take before you get your money back.
Advantages:
Limitations:
graph TD A[Initial Investment: Rs.1,00,000] --> B[Year 1 Cash Inflow: Rs.30,000] B --> C[Year 2 Cash Inflow: Rs.40,000] C --> D[Year 3 Cash Inflow: Rs.50,000] D --> E[Cumulative Cash Flow] E --> F{Payback Period?} F -->|Between Year 2 and 3| G[Payback Period ≈ 2.4 years]Unlike the payback period, the Net Present Value (NPV) method accounts for the time value of money. It calculates the present value of all future cash inflows and outflows using a discount rate, usually the company's cost of capital.
NPV is the sum of discounted cash inflows minus the initial investment. A positive NPV means the project is expected to add value to the company.
Decision rule: Accept the project if NPV > 0; reject if NPV < 0.
The Internal Rate of Return (IRR) is the discount rate that makes the NPV of a project zero. In other words, it is the expected rate of return from the project.
To decide whether to accept a project, compare the IRR with the company's cost of capital:
Finding IRR often requires trial and error or interpolation between discount rates.
| Discount Rate (%) | NPV (Rs.) |
|---|---|
| 10 | Rs.15,000 |
| 15 | Rs.2,000 |
| 18 | Rs.-1,500 |
Since NPV changes from positive at 15% to negative at 18%, IRR lies between these two rates.
The Profitability Index (PI) is the ratio of the present value of future cash inflows to the initial investment. It helps in ranking projects, especially when capital is limited.
A PI greater than 1 indicates a good investment.
Formula:
Step 1: List cumulative cash inflows year-wise.
| Year | Cash Inflow (Rs.) | Cumulative Cash Inflow (Rs.) |
|---|---|---|
| 1 | 30,000 | 30,000 |
| 2 | 40,000 | 70,000 |
| 3 | 50,000 | 1,20,000 |
| 4 | 30,000 | 1,50,000 |
Step 2: Identify when cumulative cash inflow equals or exceeds initial investment.
At the end of Year 3, cumulative inflow is Rs.1,20,000, which equals the initial investment.
Answer: Payback Period = 3 years.
Step 1: Identify cash flows and discount rate.
Step 2: Calculate present value (PV) of each cash inflow using formula:
\[ PV_t = \frac{CF_t}{(1 + r)^t} \]Using the present value of annuity factor for 5 years at 10% (from standard tables) = 3.791
Step 3: Calculate total present value of inflows:
\[ PV = Rs.60,000 \times 3.791 = Rs.2,27,460 \]Step 4: Calculate NPV:
\[ NPV = PV - C_0 = Rs.2,27,460 - Rs.2,00,000 = Rs.27,460 \]Step 5: Decision:
Since NPV > 0, accept the project.
Step 1: Calculate NPV at 10% discount rate.
Present value annuity factor for 4 years at 10% = 3.170
\[ PV = Rs.50,000 \times 3.170 = Rs.1,58,500 \] \[ NPV = Rs.1,58,500 - Rs.1,50,000 = Rs.8,500 \]NPV is positive at 10%.
Step 2: Calculate NPV at 15% discount rate.
Present value annuity factor for 4 years at 15% = 2.855
\[ PV = Rs.50,000 \times 2.855 = Rs.1,42,750 \] \[ NPV = Rs.1,42,750 - Rs.1,50,000 = -Rs.7,250 \]NPV is negative at 15%.
Step 3: Use interpolation to estimate IRR:
\[ IRR = 10\% + \frac{8,500}{8,500 + 7,250} \times (15\% - 10\%) = 10\% + \frac{8,500}{15,750} \times 5\% \] \[ IRR = 10\% + 2.7\% = 12.7\% \]Step 4: Decision:
Since IRR (12.7%) > cost of capital (12%), accept the project.
Step 1: Calculate PI for Project A:
\[ PI_A = \frac{1,20,000}{1,00,000} = 1.2 \]Step 2: Calculate PI for Project B:
\[ PI_B = \frac{1,80,000}{1,50,000} = 1.2 \]Step 3: Since both have the same PI, consider other factors such as scale or risk. If only PI is considered, both are equally attractive.
Step 1: Calculate NPV at 10% discount rate.
Present value annuity factor for 5 years at 10% = 3.791
\[ PV = Rs.80,000 \times 3.791 = Rs.3,03,280 \] \[ NPV = Rs.3,03,280 - Rs.3,00,000 = Rs.3,280 \]Step 2: Calculate NPV at 11% discount rate.
Present value annuity factor for 5 years at 11% = 3.695
\[ PV = Rs.80,000 \times 3.695 = Rs.2,95,600 \] \[ NPV = Rs.2,95,600 - Rs.3,00,000 = -Rs.4,400 \]Step 3: Calculate NPV with 10% decrease in cash inflows (Rs.72,000) at 10% discount rate.
\[ PV = Rs.72,000 \times 3.791 = Rs.2,73,000 \] \[ NPV = Rs.2,73,000 - Rs.3,00,000 = -Rs.27,000 \]Step 4: Interpretation:
When to use: When cash inflows are uneven across years.
When to use: To quickly decide project acceptance in exams.
When to use: When exact IRR is not given and trial values are close.
When to use: When choosing between mutually exclusive projects with limited funds.
When to use: In all discounting and NPV calculations.
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