04 Capital Budgeting Decisions
Corporations face multiple decisions, but have to pick wisely due to limited capital.
Capital Budgeting¶
Process of evaluating firm’s long-term investment opportunities
Large investments usually consist of smaller investment decisions.
Framework¶
- Generation of investment idea
- Estimation of cash flows
- Select the appropriate opportunity cost of capital
- Selection of ideas based on acceptance criteria
- Re-evaluation
Types of Investments¶
- Revenue-enhancement
- Cost-reduction
- Mandatory [government] investments to meet regulations
Net Present Value (Primary)¶
It is in currency
One of
\[ \text{NPV} = \text{PV(Inflows)} - \text{PV(Outflows)} \]
| NPV | Meaning | Decision |
|---|---|---|
| \(>0\) | Actual returns > Minimum required return | Accept |
| \(<0\) | Actual returns < Minimum required return | Reject |
| \(0\) | Actual returns = Minimum required return | Doesn’t matter |
IRR (Primary)¶
Internal Rate of Return
\[ \text{IRR} = \text{Rate @ which NPV is 0} \]
Actual return of your project
We only know cashflows; no interest rates
Calculating
- Derive an equation in terms of
\[ \text{NPV} = 0 \\ \implies \sum \text{Discounted Cashflows} = 0 \\ \]
- Solve for \(r\)
Profitability Index (Secondary)¶
\[ \text{PI} = \frac{ \text{PV(Inflows)} }{ \text{PV(Outflows)} } \]
For every 1 unit of investment
\[ \begin{aligned} &\text{Additional value generated after taking minimum returns} \\ &= (\text{PI} - 1) \times \text{Original Investment} \end{aligned} \]
| NPV | Meaning | Decision |
|---|---|---|
| \(>1\) | Actual returns > Minimum required return | Accept |
| \(<1\) | Actual returns < Minimum required return | Reject |
| \(1\) | Actual returns = Minimum required return | Doesn’t matter |
Payback Period (Secondary)¶
- Simplest explanation
- If you have low DPP, that means the investement is less risky
Discounted Payback Period (Secondary)¶
\[ \text{DPP} = \]
Disadvantages¶
- Subjective payback period
- Only focusing on short-term gains
Required Rate of Return¶
\[ \text{RRR} = R_f + \beta \cdot \text{RP} \]
where
- \(R_f=\) Risk Free Return
- \(\text{RP} =\)Â Risk Premium