Capital Budgeting Process Overview

Capital Budgeting

• This process evaluates investments and significant expenses to get the best returns.
• It involves decisions made when the expected results occur after more than a year.
• Includes decisions on disinvesting, selling off a part of the business.

Objectives of Capital Budgeting

• Select profitable projects.
• Control capital expenditure.
• Find the right sources of funds.

Capital Budgeting Process

• Project Identification and Generation: Identifying investment opportunities, driven by business needs.
• Project Screening and Evaluation: Selecting criteria to assess project desirability, aligning with maximizing company value, uses time value of money concepts.
• Project Selection: No one-size-fits-all method, different businesses have different requirements.
• Implementation: Spending the allocated funds, implementing the project.
• Performance Review: Comparing actual results to the standard expectations, identifying and resolving issues for future project selection and execution.

Significance of Capital Budgeting

• Essential tool in financial management.
• Provides managers with a framework for evaluating project viability.
• Exposes the risk and uncertainty associated with different projects.
• Helps control over-investment or under-investment.
• Provides management control over capital expenditure projects.
• Optimizing resource allocation is crucial for company success.

Payback Period Method

• Determines the time it takes for a project's cash inflows to recover the initial investment.
• Focuses solely on cash inflows, project life span, and initial investment, ignoring time value of money.
• Formula: Payback period = Cash outlay (investment) / Annual cash inflow

Accounting Rate of Return (ARR) Method

• Aims to address the limitations of the payback period method.
• Calculates the average net income expected from an asset, divided by its average capital cost, expressed as a percentage.
• Provides a measure of profitability compared to the capital cost.
• However, also ignores time value of money and project lifespan.
• Not consistent with maximizing shareholder value.
• Formula: ARR= Average income/Average Investment

Discounted Cash Flow (DCF) Method

• Calculates cash inflows and outflows throughout a project's life.
• Discounts these cash flows using a discounting factor, accounting for the time value of money.
• Compares discounted cash flows to assess project profitability.

Net Present Value (NPV) Method

• Widely used capital budgeting method.
• Discounts future cash inflows to their present value.
• Compares the present value of cash inflows to the initial investment.
• Projects with a positive NPV are acceptable.
• Formula: NPV = PVB – PVC (PVB = Present value of benefits; PVC = Present value of Costs)

Internal Rate of Return (IRR) Method

• Calculates the discount rate that makes the NPV of a project equal to zero.
• Represents the project's expected rate of return.
• Considers the time value of money.
• Projects with an IRR greater than the cost of capital are profitable.
• Projects with an IRR greater than the firm's weighted average cost of capital (WACC) are accepted.

Profitability Index (PI) Method

• Measures the present value of future cash inflows relative to the initial investment.
• Evaluates the project's return per unit of investment.
• Projects with a PI greater than 1.0 are accepted.

Dividend Policy

• A firm's plan for distributing earnings between reinvestment and cash dividends to shareholders.
• Determines how much of the company's profits are paid out in dividends, and how much are retained for future growth.

Dividend Theories

• Different frameworks to explain the impact of dividend policy on firm value.
• Walter's model: Focuses on the relationship between a company's internal rate of return (r) and its cost of capital (k) to determine optimal dividend payout.
• Gordon's model: Views the value of a share as the present value of an infinite stream of future dividends, emphasizing the impact of dividend policy on share price.
• Modigliani and Miller hypothesis: Argues that under certain conditions, dividend policy is irrelevant to firm value, as investors can create their own desired payout by buying and selling shares.

Walter's Model

• Assumptions:
  • All investments are financed by retained earnings.
  • Constant internal rate of return (r) and cost of capital (k).
  • Earnings are either distributed as dividends or reinvested immediately.
  • Constant earnings and dividends over time.
• Propositions:
  • When r > k: Higher retention ratio increases value per share.
  • When r < k: Lower retention ratio increases value per share.
  • When r = k: Dividend policy is irrelevant.
• Criticisms:
  • Ignores the benefits of an optimal capital structure.
  • Assumes constant internal rate of return and cost of capital.

Gordon's Model

• Assumptions:
  • All-equity firm with no external financing.
  • Constant internal rate of return (r) and cost of capital (k).
  • Perpetual life with a constant retention ratio, resulting in a constant growth rate.
  • No corporate taxes.
  • Cost of capital (k) is greater than the growth rate (g).
• Propositions:
  • When r > k: Higher retention ratio increases value per share.
  • When r < k: Lower retention ratio increases value per share.
• Value per share is the present value of an infinite stream of future dividends.
• Criticisms:
  • Doesn't account for capital structure or taxes.
  • Real-world scenarios rarely have constant growth rates.

This quiz covers the essential aspects of the capital budgeting process, including project identification, screening, selection, implementation, and performance review. Understand how to evaluate investments and make informed financial decisions that align with business objectives. Test your knowledge on selecting profitable projects and controlling capital expenditures.