Define capital budgeting. Discuss the techniques of capital budgeting.

 Capital budgeting: Capital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

 Many formal methods are used in capital budgeting, including the techniques such as:

 ·        Accounting rate of return

·       Payback period

·        Net present value

·        Profitability index

·        Internal rate of return

·        Modified internal rate of return

·        Equivalent annuity

·        Real Options Valuation

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

 Net present value

 Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). This valuation requires estimating the size and timing of all the incremental cash flows from the project. The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the Minimum acceptable rate of return on an investment. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate whern a project's risk is higher than the risk of the firm as a whole.

Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted.

In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

 

Equivalent annuity method

 

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan.

 The use of the EAC method implies that the project will be replaced by an identical project.

 The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.

 Profitability index

 Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.

 The ratio is calculated as follows:

Profit abilit v index - PV of future cash flows Initial investment

 Assuming that the cash flow calculated does not include the investment made in the project, a profitability index of 1 indicates breakeven. Any value lower than one would indicate that the project's PV is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.

 Rules for selection or rejection of a project:

 ·         If PI > 1 then accept the project

·         If PI < 1 then reject the project