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Unit 2 Finance

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24 views

Unit 2 Finance

Uploaded by

anukhananu0
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CAPITAL BUDGETING

Capital Budgeting is used to evaluate those expenditure decision the


benefit of which occurs for more than a year.
It focuses on efficient and effective allocation of capital to maximize
the shareholder’s wealth.
Importance of capital budgeting
Helps in Financing Decisions
Understanding the expected cash flows and returns from an investment helps in making financing decisions.
Capital budgeting provides insights into how much funding is required, the duration of the investment, and
whether the project can generate sufficient returns to cover the cost of capital.
Reduction of Uncertainty
The future is inherently uncertain, but capital budgeting techniques like scenario analysis, sensitivity analysis, and
simulation help reduce uncertainty. By analyzing different scenarios, companies can estimate how different factors
may impact the project's success.
Performance Evaluation
Capital budgeting also aids in evaluating the performance of a project after it has been implemented. By
comparing actual results with projections, companies can assess whether the project met its financial and
operational targets and identify areas for improvement.
Risk Management
Capital budgeting involves analyzing the potential risks associated with an investment. By using techniques like Net
Present Value (NPV), Internal Rate of Return (IRR), and scenario analysis, companies can evaluate the risks and make
informed decisions that minimize the likelihood of financial losses.
Wealth Maximization
The ultimate goal of financial management is to maximize shareholder wealth. Capital budgeting helps identify
projects that contribute the most to the value of the firm. By selecting investments with positive NPV, companies can
increase their profitability and, in turn, enhance shareholder wealth.
Cash Flow Management
Capital budgeting helps in forecasting the future cash inflows and outflows of a project. Understanding the timing and
magnitude of cash flows ensures that companies have adequate liquidity and can plan for financing needs effectively.
Independent decision , accepting on
one decision may or may not reject
the other.
Inter-related decision , accepting of
one surely reject the other

Allocation of capital, is done in a


manner that the long term returns
of the firm are maximized.
TRADITIONAL MODERN
TT
TECHNIQUE TECHNIQUE

NPV – WHAT IS THE VALUE OF


PAY BACK PERIOD – TIME TO INVESTMENT.
RECOVER YOUR INVESTMENT IRR – RATE OF RETURN ON
INVESTMENT
ARR – WHAT IS THE AVERAGE
RATE OF RETURN ON P.I – PROFIT RATIO FOR EVERY
INVESTMENT DOLLAR SPENT
PAY BACK PERIODS
Independent decisions, Acceptance of one does
not reject the other one.

Interrelated decision acceptance of one may


reject the other one.

Allocation of capital done in a manner so that


the long term returns of the firm are
maximized
Computation of pay back period

Regular cash flow with uniform amount - initial investment


Average cash inflow

Irregular cash flow is computed with the help of the statistical


approach
Net Present Value (NPV) is a capital budgeting method used to evaluate the profitability of an investment by
calculating the difference between the present value of cash inflows and the present value of cash outflows over a
project's lifetime.
•Decision Rule: Accept the project if NPV > 0, as it indicates that the project is expected to add value to the
firm.

•Advantages:
•Considers the time value of money.
•Takes into account all cash flows over the life of the project.
•Helps in maximizing shareholders' wealth.

•Disadvantages:
•Requires an accurate discount rate, which can be difficult to estimate.
•May be less useful when comparing projects of different sizes or durations.
Internal Rate of Return (IRR) is a capital budgeting technique used to evaluate the profitability of potential
investments. It represents the discount rate at which the Net Present Value (NPV) of all cash flows (both inflows and
outflows) from a project equals zero.

Definition: IRR is the rate of return at which the NPV of an investment is zero. It is the rate at which the project breaks
even in terms of the present value of inflows and outflows.
Applications:
Independent Projects: For independent projects, IRR works well as a decision criterion if it is greater than the
cost of capital.
Mutually Exclusive Projects: For comparing mutually exclusive projects, using IRR alone may lead to incorrect
decisions due to issues with project size, timing of cash flows, or different life spans.
Advantages of IRR:
Easy to Understand: The IRR is expressed as a percentage, which is easily interpretable as the expected rate of
return.
Considers Time Value of Money: IRR takes into account the time value of money by discounting future cash
flows.
Provides a Benchmark: It helps in comparing the profitability of different investment opportunities.
Disadvantages of IRR:
Multiple IRRs: Projects with non-conventional cash flows (where cash flows change signs multiple times) may have
multiple IRRs, leading to ambiguity.
Assumes Reinvestment at IRR: IRR assumes that all cash inflows can be reinvested at the IRR itself, which may not be
realistic. This is why Modified Internal Rate of Return (MIRR) is sometimes preferred, as it assumes reinvestment at
the cost of capital.
Scale of Investment: IRR does not consider the scale of the project. It may lead to wrong decisions when comparing
projects of different sizes, as a project with a higher IRR might have a smaller NPV compared to one with a lower IRR
but a higher absolute value of cash flows.
Ranking Problems: IRR can sometimes give a different ranking than NPV when comparing mutually exclusive projects,
potentially leading to suboptimal decisions if used in isolation.
Profitability Index (PI), also known as the Benefit-Cost Ratio, is a capital budgeting technique that measures the
relative profitability of an investment. It is the ratio of the present value of future cash inflows to the initial
investment, providing an indication of the value created per unit of investment.

Definition: The Profitability Index is the ratio of the present value of expected cash inflows to the initial
investment. It helps in determining how much value is generated for each dollar invested in the project.
Decision Rule:
Accept the Project: If PI > 1, as this indicates that the project's returns exceed its costs
and value is being added.
Reject the Project: If PI < 1, as this indicates that the project's costs outweigh its benefits.
Interpretation:
PI > 1: The project is expected to create value; the higher the PI, the more attractive the
project.
PI = 1: The project is expected to break even.
PI < 1: The project is expected to destroy value.
Advantages of Profitability Index:
Disadvantages of Profitability Index:
Mutually Exclusive Projects: PI may not always provide the correct decision when
comparing mutually exclusive projects, as it does not consider the absolute size of the
project’s NPV.
Ignores Scale of Investment: A project with a higher PI may not necessarily be the
most profitable in terms of total NPV if it involves a much smaller scale of investment
compared to another project with a lower PI.
Dependency on Discount Rate: The calculated PI is highly sensitive to the chosen
discount rate, which can sometimes be difficult to determine accurately.
Applications:
Capital Rationing: When a company has limited funds available for investment, PI can
help in selecting projects that maximize the value created per dollar invested.
Independent Projects: For independent projects, PI provides a measure of efficiency in
resource allocation.

Profitability Index (PI) is a useful tool for evaluating the attractiveness of an investment
relative to its cost.

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