ASSIGNMENT NO.
01
SUBMITTED BY:
AREEBA SEHRISH
ROLL NO.:
22011554-016
SEMESTER:
4th
COURSE TITLE:
MANAGERIAL FINANCE
COURSE CODE:
COMM-207
DEPARTMENT:
BS- ACCOUNTING AND FINANCE
SUBMITTED TO:
MAM MARINA AFZAL
CAPITAL BUDGETING
Capital Budgeting is planning and managing a company's long-term investments in projects and
assets, ensuring they align with its strategic goals and financial objectives. It involves evaluating
investment opportunities' potential profitability and risks, prioritizing them based on their
expected returns and impacts, and making informed decisions on which projects to undertake.
Key Elements of Capital Budgeting:
Investment Evaluation:
Assessing the potential returns and risks associated with each investment opportunity.
Cash Flow Estimation:
Projecting the future cash inflows and outflows associated with the investment.
Decision Criteria:
Using financial metrics and decision rules (such as NPV, IRR, and payback period) to evaluate
the attractiveness of the investment.
Risk Analysis:
Identifying and mitigating potential risks that could affect the investment’s outcomes.
Project Selection:
Choosing the investments that best fit the company’s strategic goals and financial constraints.
Monitoring and Review:
Continuously tracking the performance of the investment and making adjustments as necessary.
Importance of Capital Budgeting:
Strategic Alignment:
Ensures that investments are in line with the company’s long-term objectives.
Resource Allocation:
Helps in the efficient distribution of capital to projects with the highest potential returns.
Risk Management:
Aids in identifying, assessing, and mitigating risks associated with significant investments.
Financial Control:
Provides a structured approach to managing large capital expenditures.
Value Maximization:
Focuses on investments that are expected to enhance the firm’s value and contribute to
shareholder wealth.
TECHNIQUES OF CAPITAL BUDGETING:
The four primary techniques of capital budgeting used to evaluate potential investment projects
are:
1. Net Present Value (NPV):
Definition:
NPV is the sum of the present values of all cash inflows and outflows associated with a project,
discounted at the project's cost of capital.
Formula:
NPV=∑𝐶.F/(1+𝑟)^𝑡- 𝐶0
where C.F is the cash flow at time 𝑡, 𝑟 is the discount rate, and 𝐶0 is the initial investment.
Decision Rule:
Accept the project if NPV > 0; reject if NPV < 0.
2. Internal Rate of Return (IRR):
Definition:
IRR is the discount rate that makes the NPV of a project zero. It represents the expected annual
rate of return on the investment.
Formula:
0=∑𝐶𝑡/(1+𝐼𝑅𝑅)^𝑡−𝐶0
Decision Rule:
Accept the project if IRR > required rate of return; reject if IRR < required rate of return.
3. Payback Period:
Definition:
The payback period is the amount of time it takes for an investment to generate cash flows
sufficient to recover the initial investment.
Formula:
Payback Period=Initial Investment/Annual Cash Inflow (For constant annual cash inflows)
Decision Rule:
Accept the project if the payback period is less than a predetermined threshold; reject if it is
longer.
4. Profitability Index (PI):
Definition:
PI is the ratio of the present value of future cash flows to the initial investment. It measures the
relative profitability of a project.
Formula:
PI=(∑𝐶𝑡/(1+𝑟)^𝑡)/𝐶0
Decision Rule:
Accept the project if PI > 1; reject if PI < 1.
Each of these techniques has its strengths and limitations, and they are often used in conjunction
to provide a comprehensive evaluation of potential investments.
1. Net Present Value (NPV)
Definition: NPV is the sum of the present values of all cash inflows and outflows associated
with an investment, discounted at the project's cost of capital. It represents the net gain or loss in
value from undertaking the project.
Advantages:
o Time Value of Money: Accounts for the time value of money, providing a more accurate
reflection of an investment’s value.
o Absolute Measure: Provides a direct measure of the expected increase in value from the
investment.
o Risk Adjustment: Can incorporate varying discount rates to reflect project-specific
risks.
Disadvantages:
o Complexity: Requires detailed cash flow projections and an appropriate discount rate,
which can be complex and subjective.
o Estimation Error: Sensitive to estimates of future cash flows and discount rates, leading
to potential inaccuracies.
o Not Easily Interpreted: This may be less intuitive for stakeholders who prefer relative
measures like percentages.
2. Internal Rate of Return (IRR)
Definition: IRR is the discount rate that makes the NPV of an investment zero. It represents the
expected annual rate of return from the project.
Advantages:
o Time Value of Money: Considers the time value of money, similar to NPV.
o Relative Measure: Provides a rate of return, which is intuitive and easy to compare with
other projects and required return rates.
o Decision Making: Useful for comparing projects of different sizes and durations.
Disadvantages:
o Multiple IRRs: This can produce multiple IRRs if there are alternating cash flows,
leading to ambiguity.
o Reinvestment Assumption: Assumes that interim cash flows are reinvested at the IRR,
which may be unrealistic.
o Scale of Investment: May favor smaller projects with high returns over larger projects
with significant absolute returns.
3. Payback Period
Definition: The payback period is the time it takes for an investment to generate cash flows
sufficient to recover its initial cost.
Advantages:
o Simplicity: Easy to understand and calculate, making it a straightforward decision tool.
o Liquidity Focus: Emphasizes quick recovery of initial investment, which can be
important for liquidity considerations.
o Risk Aversion: Useful for projects where risk increases with time, as it favors quicker
returns.
Disadvantages:
o Time Value of Money: Ignores the time value of money, potentially leading to
suboptimal decisions.
o Cash Flows Beyond Payback: Ignores cash flows that occur after the payback period,
missing the full profitability picture.
o Short-Term Focus: This may lead to a preference for short-term projects over more
profitable long-term investments.
4. Profitability Index (PI)
Definition: PI is the ratio of the present value of future cash flows to the initial investment. It
indicates the value created per unit of investment.
Advantages:
o Time Value of Money: Considers the time value of money, providing a more accurate
assessment of value.
o Relative Measure: Useful for comparing projects of different scales, especially when
capital is limited.
o Prioritization: Helps in ranking and selecting projects when resources are constrained.
Disadvantages:
o Complexity: Requires accurate cash flow projections and discount rates, similar to NPV.
o Interpretation: This can be less intuitive than a direct NPV figure, as it represents a ratio
rather than a dollar amount.
o Mutually Exclusive Projects: This may not always lead to the same decision as NPV
when comparing mutually exclusive projects.
Each of these capital budgeting techniques has its place in investment decision-making, and
often, companies use a combination of these methods to get a comprehensive understanding of
an investment’s potential.
