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.