Capital Budgeting
(Anand)
Nature of Investment Decisions The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm?s investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision. Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firm?s expenditures and benefits, and therefore, they should also be evaluated as investment decisions. Feature of Investment Decisions The exchange of current funds for future benefits. The funds are invested in long-term assets. The future benefits will occur to the firm over a series of years. Importance of Investment Decisions § Growth
§ Risk
§ Funding
§ Irreversibility
§ Complexity
Three steps are involved in the evaluation of an investment: ?Estimation of cash flows ?Estimation of the required rate of return (the opportunity cost of capital) ?Application of a decision rule for making the choice
Evaluation Criteria
1. Discounted Cash Flow (DCF) Criteria ? Net Present Value (NPV) ? Internal Rate of Return (IRR) ? Profitability Index (PI)
2. Non-discounted Cash Flow Criteria ? Payback Period (PB) ? Discounted Payback Period (DPB) ? Accounting Rate of Return (ARR)
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