Capital Budgeting Fundamentals

Capital Budgeting

Definition

• Capital budgeting is the process of evaluating and selecting long-term investment projects that align with an organization's goals and objectives.
• It involves allocating resources to projects that are expected to generate future cash flows.

Importance of Capital Budgeting

• Helps to:
  • Identify profitable projects
  • Optimize resource allocation
  • Maximize shareholder value
  • Minimize risk

Capital Budgeting Techniques

1. Payback Period

• Measures the time it takes for an investment to generate cash flows equal to the initial investment.
• Formula: Payback Period = Initial Investment / Annual Cash Flow

2. Net Present Value (NPV)

• Calculates the present value of future cash flows using a discount rate.
• Formula: NPV = Σ (CFt / (1 + r)^t)
  • CFt = Cash Flow at time t
  • r = Discount Rate
  • t = Time period

3. Internal Rate of Return (IRR)

• The discount rate that makes the NPV equal to zero.
• Formula: IRR = r when NPV = 0

4. Profitability Index (PI)

• Evaluates the profitability of a project by comparing the present value of cash inflows to the present value of cash outflows.
• Formula: PI = Present Value of Cash Inflows / Present Value of Cash Outflows

Capital Budgeting Processes

1. Identification

• Identify potential projects that align with the organization's goals and objectives.

2. Evaluation

• Evaluate projects using the above techniques (payback period, NPV, IRR, PI).

3. Selection

• Select the projects that meet the organization's investment criteria.

4. Implementation

• Implement the selected projects and monitor their performance.

5. Review and Revision

• Review and revise the capital budgeting process as needed.

Capital Budgeting

• Evaluates and selects long-term investment projects aligning with an organization's goals and objectives
• Allocates resources to projects expected to generate future cash flows

Importance of Capital Budgeting

• Identifies profitable projects
• Optimizes resource allocation
• Maximizes shareholder value
• Minimizes risk

Capital Budgeting Techniques

Payback Period

• Measures the time taken for an investment to generate cash flows equal to the initial investment
• Formula: Payback Period = Initial Investment / Annual Cash Flow

Net Present Value (NPV)

• Calculates present value of future cash flows using a discount rate
• Formula: NPV = Σ (CFt / (1 + r)^t)
• CFt = Cash Flow at time t
• r = Discount Rate
• t = Time period

Internal Rate of Return (IRR)

• The discount rate that makes the NPV equal to zero
• Formula: IRR = r when NPV = 0

Profitability Index (PI)

• Evaluates project profitability by comparing present value of cash inflows to present value of cash outflows
• Formula: PI = Present Value of Cash Inflows / Present Value of Cash Outflows

Capital Budgeting Processes

Identification

• Identifies potential projects aligning with the organization's goals and objectives

Evaluation

• Evaluates projects using payback period, NPV, IRR, and PI techniques

Selection

• Selects projects that meet the organization's investment criteria

Implementation

• Implements selected projects and monitors their performance

Review and Revision

• Reviews and revises the capital budgeting process as needed