CAPITAL BUDGETING

MANUALS AND PROFITABILITY

Made by Waqar asim 50

Usman tariq 49 Atif khan 41

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

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

TECHNIQUES OF CAPITAL BUDGETING ANALYSIS Payback Period Approach Discounted Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability Index

PAYBACK PERIOD APPROACH

The amount of time needed to recover the initial investment

The number of years it takes including a fraction of the year to recover initial investment is called payback period

NET PRESENT VALUE APPROACH Based on the dollar amount of cash

flows The dollar amount of value added by

a project NPV equals the present value of cash

inflows minus initial investment Technique is consistent with the

principle of wealth maximization—Why?

Accept a project if NPV ≥ 0

INTERNAL RATE OF RETURN The rate at which the net present value

of cash flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment

Project’s promised rate of return given initial investment and cash flows

Consistent with wealth maximization Accept a project if IRR ≥ Cost of Capital

NPV VERSUS IRR Usually, NPV and IRR are consistent

with each other. If IRR says accept the project, NPV will also say accept the project

IRR can be in conflict with NPV if Investing or Financing DecisionsProjects are mutually exclusive

Projects differ in scale of investmentCash flow patterns of projects is different

If cash flows alternate in sign—problem of multiple IRR

If IRR and NPV conflict, use NPV approach

PROFITABILITY INDEX (PI) A part of discounted cash flow family

PI = PV of Cash Inflows/initial investment

Accept a project if PI ≥ 1.0, which means positive NPV

Usually, PI consistent with NPV When in conflict with NPV, use NPV

OUR SURVEY AND DATA:

WHICH INDUSTRY USING MANUALS

  1995 2005 2015 Non Response

Engineering Industry  20 25 23 5(3)

Chemical Industry  3 3 3 1(1)

Forest industry  5 5 5 3(2)

Other companies  2 5 6 1(1)

All  30 38 37 10(7)

TYPES OF INVESTMENTS COVERED BY THE MANUALS

Types of investments covered by manuals

Machine, land and plant 29

Some intangibles of which 14

R&D 8

Marketing Investment  7

Expense investment 3

In house Training  1

Leasing 17

Acqusations 2

Separate manuals for R&D 3

Acquisitions 2

FMS investment 1

PURPOSE BEHIND IT

The purpose of the capital budgeting manuals

Unity principles for evaluating and ranking  13

Financial Planning  6

strategic planning and control  11

create a common group language  3

Based on the 22 manuals ( one manual can be used for more than one purpose  

TABLE OF FREQUENCY OF DIFFERENT PROFITABILITY CRITERIA

Table of frequency of different profitability criteria

Details 1995 2005 2015

Payback 79 87 100

simple payback  46 60 79

discounted payback  32 27 28

simple payback only NA 7 7

IRR method 62 93 93

IRR method 54 53 45

IRR  50 50 45

True IRR 4 3 0

Capital value method 68 N.A 72

NPV 11 33 55

Terminal Value  0 0 3

Profitability Index 14 20 21

Annuity  25 10 14

Annuity index 7 10 7

MAPI 7 10 3

ARR method 11 3 0

Break Even method 4 0 3

No specific method 0 0 3

Note this date was collected randomly from market

CONCLUSIONS: