IMPORTANCE OF CAPITAL BUDGETING
Large amounts are involved
Funds mitted for long periods
Errors can be costly
TYPES OF CAPITAL INVESTMENT
Maintenance
Cost reduction
Expansion (existing products)
Expansion (new products/markets)
Mandatory
Miscellaneous
INVESTMENT APPRAISAL PROCESS
Estimate the investment required
Estimate cash flows from the pare the investment with the cash flows from the investment, using one or more decision rules:
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index
Payback Period
Suppose an investment has the following cash flows:
If the opportunity cost of this investment is 9%, the future cash flows must be discounted to make parable with the initial investment of 100:
NET PRESENT VALUE (NPV)
The present value of the future cash flows, discounted at 9% is 124, which is greater than the present value invested (. 100), so the investment will increase present wealth by 124 – 100 = 24. This figure of 24 is called the NPV – as long as the NPV of an investment is positive, it is worthwhile.
Year 0
Year 1
Year 2
Year 3
(100)
30
55
65
DISCOUNT RATE: THE COST OF CAPITAL
The appropriate discount rate is the rate of return that investors could get from an investment of similar risk and growth opportunities.
This is the minimum rate of return required by investors pensate them for their opportunity cost, and is called the ‘cost of capital’.
Advantages of NPV
It takes into account the time value of money.
It considers all financial information relevant to the decision, for the entire period of the investment.
It directly measures the prospective increase in the value of the firm, and consequently the shareholders’ wealth (maximisation of which is the firm’s main objective).
It is clear, unambiguous and simple to use.
Problems with NPV
It is difficult to accurately forecast future cash flows far into the future
It is difficult to accurately estimate the cost of capital, . the discount rate for the project.
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