capita- budgeting

8/7/2019 Capita- Budgeting

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Capital BudgetingCapital Budgeting

Decision CriteriaDecision CriteriaThe Investment DecisionThe Investment Decision


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Investment DecisionsInvestment Decisions

Basic TerminologyBasic Terminology

Capital InvestmentCapital Investment

Capital ProjectCapital Project



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Capital InvestmentCapital Investment

InvestmentInvestment inin RealReal AssetsAssets

suchsuch asas Land,Land, PlantPlant &&

Machinery,Machinery, BuildingBuilding andandFinancialFinancial AssetsAssets suchsuch asas

Shares,Shares, BondsBonds etcetc..


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Capital ProjectsCapital Projects

AA setset ofof assetasset investmentsinvestments

thatthat areare contingentcontingent onon oneone

anotheranother andand areare consideredconsideredtogethertogether..


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TheThe processprocess ofof identifyingidentifying

andand selectingselecting investmentinvestment inin

assetsassets whosewhose expectedexpectedbenefitsbenefits exceedexceed theirtheir costscosts..


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Classifying ProjectsClassifying Projects

ShortShort--termterm VsVs.. LongLong termterm

projects(Time)projects(Time)

ReplacementReplacement VsVs.. ExpansionExpansion

projects(projects( NatureNature ofof project)project)

IndependentIndependent VsVs.. MutuallyMutually ExclusiveExclusive

projectsprojects (( DegreeDegree ofof dependence)dependence)ContingentContingent ProjectsProjects (Degree(Degree ofof

dependence)dependence)


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ShortShort--termterm:: IfIf benefitsbenefits areare receivedreceived

withinwithin currentcurrent periodperiod..

LongLong--termterm:: IfIf benefitsbenefits areare receivedreceived

beyondbeyond thethe assetasset period(period( capitalcapital

expenditure)expenditure)..

Short/Long-term Projects


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ReplacementReplacement::

MaintainMaintain currentcurrent levellevel ofof operatingoperating

activityactivity..

ExpansionExpansion::

BroadenBroaden existingexisting productproduct lineslines..

Replacement/Expansion


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IndependentIndependent::

AcceptanceAcceptance /Rejection/Rejection isis independentindependent

MutuallyMutually ExclusiveExclusive::AcceptanceAcceptance ofof oneone projectproject leadsleads toto

rejectionrejection ofof anotheranother

Independent/Mutually Exclusive


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ProjectsProjects thatthat areare dependentdependent onon anotheranother

projectsprojects acceptance/rejectionacceptance/rejection..

Contingent Projects


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YouYou areare thethe CFOCFO ofof 2020thth CenturyCentury OldOld

FoxFox.. YourYour companycompany isis planningplanning toto

makemake aa bigbig budgetbudget moviemovie calledcalled DesiDesi

JurassicJurassic ParkPark.. ListList thethe informationinformation youyou

needneed toto makemake aa decisiondecision..

Capital Budgeting

&

Shareholder Wealth Maximization


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Suppose you estimated that the movie makingSuppose you estimated that the movie making

would cost 500mn and you expect yearly cashwould cost 500mn and you expect yearly cash

flows(flows(mnmn) as below in how many years would) as below in how many years would

you recover your investment?you recover your investment?

00 11 22 33 44 55 8866 77

(500) 150 150 100 100 150 150 150 150(500) 150 150 100 100 150 150 150 150

CFO SpeakCFO Speak


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0 1 2 3 4 5

(2,50,000)70,000 70,000 70,000 70,000 70,000

CFO SpeakCFO Speak

Suppose a project costs Rs.2,50,000 and youSuppose a project costs Rs.2,50,000 and you

expect cash flows as below and the opportunityexpect cash flows as below and the opportunity

cost to your shareholders is 10% do you thinkcost to your shareholders is 10% do you think

accepting this project would increase theiraccepting this project would increase their

wealth? Use the template in the next slide towealth? Use the template in the next slide to

help you in your decision making:help you in your decision making:


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CFO Help DeskCFO Help Desk

Year Cash flows

( in Rs.000s)

PVIF@ ?% PV

( in Rs.000s)

0 (2,50,000) 1.00 (2,50,000)

1 70,0002 70,000

3 70,000

4 70,000

5 70,000

Total PV of Cash

inflows

Answer?????? ?


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0 1 2 3 4 5

(2,50,000)70,000 70,000 70,000 70,000 70,000

CFO SpeakCFO Speak

Suppose a project costs Rs.2,50,000 and youSuppose a project costs Rs.2,50,000 and you

expect cash flows as below and you have beenexpect cash flows as below and you have been

asked to find the discount rate at which theasked to find the discount rate at which the

sum total of the expected cash flows will equalsum total of the expected cash flows will equal

the initial outflow of Rs.2,50,000 what is yourthe initial outflow of Rs.2,50,000 what is your

answer?answer?

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