Capital Budgeting Decisions: Should We Build This Plant?
Capital Budgeting Decisions: Should We Build This Plant?
Capital Budgeting Decisions: Should We Build This Plant?
Should we
build this
plant?
SEEMA CHAKRABARTI
CAPITAL BUDGETING DECISIONS
The investment decisions of a firm are generally known
as the capital budgeting, or capital expenditure
decisions.
Independent investments
Contingent investments
AN EXAMPLE OF MUTUALLY
EXCLUSIVE PROJECTS
MIRR DPBP
NET PRESENT VALUE
NPV of a project is the sum of the present values
of all the cash flows positive as well as negative
that are expected to occur over the life of the
project.
The formula for NPV is:
C1 C2 C3 Cn
NPV n
C0
(1 k ) (1 k ) (1 k ) (1 k )
2 3
n
Ct
NPV C0
t 1 (1 k )
t
NET PRESENT VALUE
Where,
C = cash flow at the end of year t
t
Where,
PVB = present value of benefits
I = Initial investments
ACCEPTANCE RULE FOR BCR
BCR = 1 = Indifferent
0 1 2 3
-400
Discount Rate
0 1 2 2.4 3
CF -100 10 60 100 80
Cumulative -100 -90 -30 0 50
Weaknesses of Payback:
CFt -100 10 60 80
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs
ACCOUNTING RATE OF RETURN
The accounting rate of return is the ratio of the
average after-tax profit divided by the average
investment.