CONTENTS

1.          Review of capital budgeting techniques

2.          Investment appraisal techniques

3.          Projects selection under capital rationing

4.          Abandonment value

5.          Risk analysis in capital budgeting

6.          Actual measurement of risk

7.          Incorporating risk in capital budgeting

8.          Sensitivity analysis

9.          Break-even analysis

10.        A simulation approach to capital budgeting under risk

11.        Decision tree for sequential decisions

12.        Utility theory

1.          REVIEW OF CAPITAL BUDGETING TECHNIQUES

 Capital budgeting (investment) decisions may be defined as the firm's decisions to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefit over a series of years.  The firm therefore:

(a)        exchanges current funds for future benefits

(b)        invests the funds in long-term assets

(c)        expects future benefit over a series of years

2.          INVESTMENT APPRAISAL TECHNIQUES

         The investment appraisal techniques can be categorised into two groups:

(a)        Discounted Cashflow methods

i.           Net present value method                  ii.            Internal rate of return

                      iii.      Profitability index

(b)        Non-discounted cashflow method

i.           Accounting rate of return

ii.          Payback period

          DISCOUNTED CASHFLOW METHODS

           1.       Net Present Value (NPV)

                    This is defined mathematically as the present value of cashflow less the initial outflow.

n

            NPV = ∑ Ct t - I o            t=1 (1+K )

                    Where C_t is the cashflow

                                                        K is the opportunity cost of capital                                                   I_o is the initial cash outflow

                                           n is the useful life of the project

                     Decision Rule using NPV

                     The decision rule under NPV is to:

-            Accept the project if the NPV is positive

-            Reject the project if NPV is negative

                    Note: if the NPV = 0, use other methods to make the decision.

           2.      Internal Rate of Return (IRR)

                   The internal rate of return of a project is that rate of return at which the projects NPV = 0

                     Therefore IRR occurs where:

n

                                                               NPV = ^∑₍₁₊^C_r^t ₎t - I _o  =  0

                                                                           t=1

                                Where r = internal rate of return

  Note that IRR is that ratio of return that causes the present value of cashflows to be equal to the initial cash outflow.

                                Decision Rule under IRR

                               If IRR > opportunity cost of capital - accept the project

-            IRR < opportunity cost of capital - reject the project

-            IRR = opportunity cost of capital - be indifferent

3.          Profitability Index

                           This is a relative measure of projects profitability.  It is given by the following formula.

n

 ∑t=1 (1+CKt )t

                                                                                PI =                    

                                                                                     Enroll Now To Read More