A Summary of Capital Budgeting Techniques
A SUMMARY OF CAPITAL BUDGETING TECHNIQUES
E A G C EDIRISINGHE - FGS/02/25/01/2012/044
COURSE MBA 61043- CORPORATE FINANCE SECOND YEAR SEMESTER ONE – 2013
Master of Business Administration
Faculty of Commerce and Management Studies University of Kelaniya
Course Instructors
:
Dr.P.M.C. Thilkarathne Dr.D.K.Y. Abeyawardena
Corporate Finance - MBA 61043
CAPITAL BUDGETING TECHNIQUES
Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project,
management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. Several alternatives exist for organizations to make their capital budgeting (CB) decisions or the alternative projects can be ranked in line with the benefits arrived in terms of profitability and the revenue generated. (Gitman, 2008). Net present value (NPV), internal rate of return (IRR), accounting rate of return (ARR) and PBK are generally described as the most commonly used CBTs. The two former techniques are based on the cash-flow concept and are usually categorized as sophisticated techniques. Bierman & Smidt (1993 cited in Axelsson, et al., 2003) illustrates that the two latter techniques can be described as rule-of-thumb approaches and are commonly categorized as naive techniques. Additionally, Pandey (1999) figures out two types of CBTs and grouped them as follows. 1. Discounted cash flow (DCF) criteria NPV, IRR, profitability index (PI) and discounted payback period (DPBK) 2. Non-DCF criteria PBK and ARR
Discounted Cash Flow Criteria The DCF is a cash flow summary that has been adjusted to reflect the time value of money. It is an important criterion in evaluating or comparing investments or purchases; other things being equal, the purchase or investment associated with the larger DCF is the better decision. Almost every manager trained in finance will ask
E A G C EDIRISINGHE - FGS/02/25/01/2012/044
COURSE MBA 61043- CORPORATE FINANCE SECOND YEAR SEMESTER ONE – 2013
Master of Business Administration
Faculty of Commerce and Management Studies University of Kelaniya
Course Instructors
:
Dr.P.M.C. Thilkarathne Dr.D.K.Y. Abeyawardena
Corporate Finance - MBA 61043
CAPITAL BUDGETING TECHNIQUES
Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project,
management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. Several alternatives exist for organizations to make their capital budgeting (CB) decisions or the alternative projects can be ranked in line with the benefits arrived in terms of profitability and the revenue generated. (Gitman, 2008). Net present value (NPV), internal rate of return (IRR), accounting rate of return (ARR) and PBK are generally described as the most commonly used CBTs. The two former techniques are based on the cash-flow concept and are usually categorized as sophisticated techniques. Bierman & Smidt (1993 cited in Axelsson, et al., 2003) illustrates that the two latter techniques can be described as rule-of-thumb approaches and are commonly categorized as naive techniques. Additionally, Pandey (1999) figures out two types of CBTs and grouped them as follows. 1. Discounted cash flow (DCF) criteria NPV, IRR, profitability index (PI) and discounted payback period (DPBK) 2. Non-DCF criteria PBK and ARR
Discounted Cash Flow Criteria The DCF is a cash flow summary that has been adjusted to reflect the time value of money. It is an important criterion in evaluating or comparing investments or purchases; other things being equal, the purchase or investment associated with the larger DCF is the better decision. Almost every manager trained in finance will ask
References: 1. Axelsson, H. Jakovicka, J. and Kheddache, M., 2002. Capital budgeting sophistication and performance. M.Sc. Göteborg University. 2. Bhandari,S.B., 1986. Discounted payback: A criterion for capital investment decisions. Journal of small business management, 24. 3. Gitman, L.J., 2008. Principles of Managerial Finance. San Diego: Addison- Wesley. 4. Megginson, W.L. and Smart, S.B., 2008. Introduction to corporate finance. 2nd ed. United States of America: Cengage learning. 5. Needles, B.E. Anderson, H.R. and Caldwell, J.C., 1984. Principles of accounting. 2nd ed. United States of America: Houghton Mifflin Company. 6. Panday, I.M., 1999. Finance management. 8th ed. Chennai: Vijay Nicole imprints. 7. Peterson, P.P. and Fabozzi, F.J., 2002. Capital budgeting: theory and practice. Canada: John Wiley and sons. 8. Tajirian, A., (1997). Capital budgeting process. Available from: http://www.morevalue.com/i-reader/ftp/Ch9.PDF. [Accessed 12 November]. University of Kelaniya 10 Page |