Capital budgeting is a crucial process for evaluating and selecting long-term investments that align with a company's goals. It involves analyzing potential projects, determining which will yield the best returns, and efficiently allocating limited resources to maximize shareholder value.

The capital budgeting process includes generating investment proposals, analyzing and evaluating them, selecting the best options, and implementing and monitoring chosen investments. Key techniques used include Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, and Profitability Index (PI).

Capital Budgeting Overview

Importance of capital budgeting

• Evaluates and selects long-term investments aligning with company's strategic goals
  • Analyzes potential projects or investments
  • Determines investments yielding the most return over applicable period
• Crucial for several reasons
  • Allocates limited resources efficiently
  • Ensures selected investments align with company objectives
  • Maximizes shareholder value
  • Supports long-term financial planning and decision-making

Steps in capital budgeting

1. Generating investment proposals

   • Identifies potential investment opportunities
   • Gathers relevant information and data

2. Analyzing and evaluating investment proposals

   • Estimates cash flows associated with each investment
   • Assesses risk and uncertainty
   • Applies appropriate capital budgeting techniques

3. Selecting investments based on evaluation results

   • Compares investment alternatives
   • Chooses projects meeting or exceeding company's required rate of return

4. Implementing and monitoring selected investments

   • Executes chosen projects
   • Tracks progress and performance
   • Makes necessary adjustments based on changes in circumstances

Capital Budgeting Techniques

Techniques for capital budgeting

• Net Present Value (NPV)
  • Calculates present value of project's future cash inflows and outflows
  • Considers time value of money
  • Positive NPV indicates profitable investment
• Internal Rate of Return (IRR)
  • Represents discount rate making NPV of project equal to zero
  • Measures project's expected rate of return
  • Projects with IRR higher than required rate of return considered acceptable
• Payback Period
  • Determines length of time required to recover initial investment
  • Does not consider time value of money or cash flows beyond payback period
  • Shorter payback periods generally preferred (1-3 years)
• Profitability Index (PI)
  • Measures ratio of present value of future cash inflows to initial investment
  • PI greater than 1 indicates profitable investment
  • Useful for ranking projects when capital is limited

Application of budgeting techniques

• Gather relevant data for investment project
  • Initial investment cost
  • Expected cash inflows and outflows
  • Project duration (5-10 years)
  • Required rate of return (10-15%)
• Calculate NPV
  • Discount future cash flows using required rate of return
  • Subtract initial investment from sum of discounted cash flows
  • $NPV = \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t} - Initial Investment$
• Calculate IRR
  • Set NPV equation equal to zero and solve for discount rate
  • Compare IRR to required rate of return
• Calculate Payback Period
  • Determine number of periods required to recover initial investment
• Calculate Profitability Index
  • Divide present value of future cash inflows by initial investment
  • $PI = \frac{Present Value of Future Cash Inflows}{Initial Investment}$
• Make investment decisions based on results of applied techniques
  • Consider company's strategic goals and risk tolerance
  • Select projects with positive NPVs, IRRs exceeding required rate of return, and/or high PIs (>1.2)