FNCE10002 Lecture Notes - Lecture 4: Capital Budgeting, Net Present Value, Payback Period
19 Jun 2018
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Department
Course
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Principles of Finance
Lecture 4: Capital budgeting 1
The capital budgeting process
The process of capital budgeting follows these main steps:
1. Generation of investment proposals
2. Evaluation and selection of investment proposals
3. Approval and control of capital expenditures
4. Post-completion audit of investment projects
The main methods that are used by manager to evaluate projects are:
- Net present value (NPV)
- Internal rate of return (IRR)
- Accounting rate of return (ARR)
- Payback period
- Profitability index (Present value of net cash flows/Initial outlay)
The net present value method
The NPV method involves calculating the difference between the present value of the net cash flows from
an investment and the initial investment outlay. All cash inflows - all cash out flows. Then discounted at
required rate of return to reflect riskiness.
All cash flows are discounted at the required rate of return which reflects the project’s risk
Project’s net cash flows
- Identify the size and timing of incremental cash flows as a result of the project
- Net cash flows after corporate taxes need to be evaluated
- Incremental cash flows are the cash flows earned by the firm if the project is undertaken minus
cash flows earned by the firm if the project is not undertaken
Net present value is computed as…
Decision rule: Accept project if NPV > 0, reject if NPV < 0
Multiple internal rates of return
It is possible that projects have more than one discount rate for which the NPV of a project equals zero.
Internal rate of return
IRR Investment Rule: Take any investment opportunity where the IRR exceeds the opportunity cost of
capital. Turn down any opportunity whose IRR is less than the opportunity cost of capital.
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