15-01-2013, 02:48 PM
CAPITAL BUDGETING TECHNIQUES
CAPITAL BUDGETING.ppt (Size: 1.18 MB / Downloads: 32)
Meaning of Capital Budgeting
Capital budgeting addresses the issue of strategic long-term investment decisions.
Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not.
Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.
Significance of Capital Budgeting
Considered to be the most important decision that a corporate treasurer has to make.
So much is the significance of capital budgeting that many business schools offer a separate course on capital budgeting
Why Capital Budgeting is so Important?
Involve massive investment of resources
Are not easily reversible
Have long-term implications for the firm
Involve uncertainty and risk for the firm
Due to the listed factors, capital budgeting decisions become critical and must be evaluated very carefully.
Any firm that does not follow the capital budgeting process will not be maximizing shareholder wealth and
management will not be acting in the best interests of shareholders.
Similarly, Euro-Disney, Concorde Plane, Saturn of GM all faced problems due to bad capital budgeting, while Intel became global leader due to sound capital budgeting decisions in 1990s.
Capital Budgeting Process
It is a complex process, divided into following phases:
Identification of potential investment opportunities
Assembling of proposed investments
Decision making
Preparation of capital budget and appropriation
Implementation
Performance review
Decision making
A system of rupee gateways usually characterises capital investment decision making
Executives are vested with the power to okay investment proposal up to certain limits
Investments requiring higher outlays need the approval of the board of directors
Properties of the NPV Rule
NPV are Additive: For two projects A & B, net present value of combined investment is: NPV (A) + NPV (B)
This property has several implications:
Value of a firm = Σ Present value of projects + Σ NPV of expected future projects
First term on right hand side of equation captures the value of assets in place & second term the value of growth opportunities
When a firm terminates an existing project which has a negative NPV based on its expected future cash flows, the value of the firm increases by that amount. Likewise, when a firm undertakes a new project that has a negative NPV, the value of the firm decreases by that amount.
Limitations
NPV is expressed in absolute terms rather than relative terms & hence does not factor in the scale of investment. Thus project A may have NPV of 5000 while project B has NPV of 2500 but A may require an investment of 50,000 while for B it is only 10,000.
Advocates of NPV argue that what matters is the surplus value, over & above the hurdle rate, irrespective of what the scale of investment is.
NPV rule does not consider life of project. Hence, when mutually exclusive projects with different lives are being considered, the NPV rule is biased in favor of longer term projects.