Hussain A. Al Awami, B.Sc. Pharm., M.Sc., MBA
The Basics of Capital Budgeting: Evaluating Cash Flow
Non-discounted methods Discounted methods
Relevant cash flows estimation
• Overview of capital budgeting • Capital budgeting decision rules:
– Payback period – Discounted payback period – NPV – IRR – MIRR – Profitability index
Overview of capital budgeting
What is capital budgeting?
• Analysis of potential projects. • Deciding which one is more important • Adds to the firm value
Importance of capital budgeting
• Strategic direction • Long term decision and effects last long time • It might have serious financial consequences
Capital budgeting success
• Flow of ideas • Proper incentive • Screening • Selection by priority
Does all projects require capital budgeting?
• Cost of capital budgeting should be considered • Simple or complicated decisions • Value of investment to the firm
Independent & mutually exclusive projects?
Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.
Capital Budgeting Decision Rules
Capital budgeting decision rules
• • • • • • Payback period Discounted payback period NPV IRR MIRR Profitability index
What is the payback period?
The number of years required to recover a project’s cost, or how long does it take to get the business’s money back?
Strengths of Payback: 1. Provides an indication of a project’s risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores the TVM. 2. Ignores CFs occurring after the payback period.
Discounted Payback period
• Net present value depends on DCF • Steps:
– Find PV for each cash flow – Sum all – Take positive NPV
• NPVS = $78.82 •...