- Because of constraints like project dependencies, capital rationing, and project indivisibility, investment projects cannot be viewed in isolation. Two common approaches used to evaluate multiple projects are the method of ranking and mathematical programming.
- The method of ranking ranks projects by their NPV, IRR or BCR but has problems like conflict in rankings between criteria and inability to handle project indivisibility.
- Mathematical programming models like linear programming, integer linear programming and goal programming formulate the problem as an objective function subject to constraints, allowing complex project interdependencies and capital rationing to be incorporated.
The presentation covers project constraints: project dependence, capital rationing, project invisibility. It covers comparing project under constraints: methods of ranking, ranking conflicts,
Describes in detail the steps involved in the calculation of Internal Rate of Return. Useful to students of Under graduate, post graduate and professional course students pursuing course in finance
The document discusses different approaches for evaluating and ranking multiple projects with constraints. It describes methods like ranking projects based on importance, and mathematical programming approaches like linear programming and integer linear programming models. These models aim to maximize objectives like net present value while considering constraints like limited capital budgets and project dependencies. The integer programming model is highlighted as being able to handle project interdependencies and capital projects that cannot be partially accepted.
Development financial institutions (DFIs) play an important role in India by providing long-term financing for industrial and infrastructure projects. DFIs were established to resolve market failures in financing long-term investments. Some of the first DFIs were created in Europe in the 1800s, and helped drive industrialization. In Asia, Japan Development Bank fostered rapid industrialization. In India, several national and state-level DFIs were established after independence to promote industrialization and rural development through long-term financing. National-level DFIs include NABARD, IFCI, IDBI, SIDBI, and Exim Bank, while state-level DFIs include State Financial Corporations and
The document discusses various aspects of project review and administration for capital budgeting such as controlling in-progress projects, conducting post-completion audits, evaluating economic versus book rates of return, guidelines for project abandonment analysis, addressing agency problems, and disciplining the capital budgeting process for small expenditures. It also provides details on evaluating capital budgeting systems, classification of investment proposals, and overcoming resistance to abandoning failing projects.
Understand the nature and importance of investment decisions.
Distinguish between discounted cash flow (DCF) and non-discounted cash flow (non-DCF) techniques of investment evaluation.
Explain the methods of calculating net present value (NPV) and internal rate of return (IRR).
Show the implications of net present value (NPV) and internal rate of return (IRR).
Describe the non-DCF evaluation criteria: payback and accounting rate of return and discuss the reasons for their popularity in practice and their pitfalls.
Illustrate the computation of the discounted payback.
Describe the merits and demerits of the DCF and Non-DCF investment criteria.
Compare and contract NPV and IRR and emphasise the superiority of NPV rule.
This document discusses capital rationing, which refers to choosing investment projects under financial constraints when there are more options available than funds. It outlines factors that can lead to capital rationing like management restrictions or imperfect capital markets. There are two types: soft rationing imposed by management, and hard rationing limited by external sources. Capital rationing involves ranking projects by profitability measures, selecting the highest ranked until funds are used up. The document provides an example of allocating $13 million between 5 projects ranked by profitability index.
The presentation covers project constraints: project dependence, capital rationing, project invisibility. It covers comparing project under constraints: methods of ranking, ranking conflicts,
Describes in detail the steps involved in the calculation of Internal Rate of Return. Useful to students of Under graduate, post graduate and professional course students pursuing course in finance
The document discusses different approaches for evaluating and ranking multiple projects with constraints. It describes methods like ranking projects based on importance, and mathematical programming approaches like linear programming and integer linear programming models. These models aim to maximize objectives like net present value while considering constraints like limited capital budgets and project dependencies. The integer programming model is highlighted as being able to handle project interdependencies and capital projects that cannot be partially accepted.
Development financial institutions (DFIs) play an important role in India by providing long-term financing for industrial and infrastructure projects. DFIs were established to resolve market failures in financing long-term investments. Some of the first DFIs were created in Europe in the 1800s, and helped drive industrialization. In Asia, Japan Development Bank fostered rapid industrialization. In India, several national and state-level DFIs were established after independence to promote industrialization and rural development through long-term financing. National-level DFIs include NABARD, IFCI, IDBI, SIDBI, and Exim Bank, while state-level DFIs include State Financial Corporations and
The document discusses various aspects of project review and administration for capital budgeting such as controlling in-progress projects, conducting post-completion audits, evaluating economic versus book rates of return, guidelines for project abandonment analysis, addressing agency problems, and disciplining the capital budgeting process for small expenditures. It also provides details on evaluating capital budgeting systems, classification of investment proposals, and overcoming resistance to abandoning failing projects.
Understand the nature and importance of investment decisions.
Distinguish between discounted cash flow (DCF) and non-discounted cash flow (non-DCF) techniques of investment evaluation.
Explain the methods of calculating net present value (NPV) and internal rate of return (IRR).
Show the implications of net present value (NPV) and internal rate of return (IRR).
Describe the non-DCF evaluation criteria: payback and accounting rate of return and discuss the reasons for their popularity in practice and their pitfalls.
Illustrate the computation of the discounted payback.
Describe the merits and demerits of the DCF and Non-DCF investment criteria.
Compare and contract NPV and IRR and emphasise the superiority of NPV rule.
This document discusses capital rationing, which refers to choosing investment projects under financial constraints when there are more options available than funds. It outlines factors that can lead to capital rationing like management restrictions or imperfect capital markets. There are two types: soft rationing imposed by management, and hard rationing limited by external sources. Capital rationing involves ranking projects by profitability measures, selecting the highest ranked until funds are used up. The document provides an example of allocating $13 million between 5 projects ranked by profitability index.
Prepared by the students of corporate finance at the MBA program of IE Business School, this presentation provides an introduction to project finance and analyzes two case studies involving project finance.
This document discusses sources of working capital finance in India, focusing on trade credit and bank borrowing. It provides details on trade credit terms, benefits, and factors to consider in deciding whether to take a discount or pay later. For bank borrowing, it outlines forms of financing like overdrafts and cash credits, as well as security requirements and regulations on financing based on recommendations from the Tandon and Chore Committees to the Reserve Bank of India.
EVA is a measure of economic profit calculated as net operating profit after tax minus the cost of financing the firm's capital. To derive NOPAT, sales minus variable costs equals contribution, minus fixed costs equals EBITDA, minus depreciation/amortization and tax equals NOPAT. EVA is used to measure a firm's economic value created over the required return of investors, and is determined to pay incentives and bonuses. Key benefits of EVA include measuring value creation, managing decisions to link to value creation, and motivating managers with incentive plans tied to shareholder value. Adjustments help translate financial statements to an economic framework for EVA calculation.
Accounting Rate of Return (ARR) is a simple capital budgeting tool that considers net income and book value of investments as reported in financial statements, without regard to time value of money. There are two types: ARR on asset value, which calculates return on assets (ROA), and ARR on capital invested, which calculates return on capital employed (ROCE). ARR can be calculated by taking the average net income over the project life and dividing it by the average book value of assets or total capital invested. While simple to calculate, ARR does not consider market values or time value of money, and can be manipulated through depreciation methods.
The document provides an overview of the Indian banking system. It discusses the structure of the system, which includes the Reserve Bank of India (central bank), scheduled commercial banks (public sector banks, private sector banks, foreign banks, regional rural banks, cooperative banks), and their roles. It also summarizes the primary functions of banks, which are accepting various types of deposits from the public and granting loans and advances. Secondary functions of banks include performing agency functions like funds transfer and collection services, as well as general utility functions.
1) Capital budgeting is the process of planning for capital expenditures that are expected to generate returns over multiple years. It involves evaluating potential long-term investment projects and determining which ones to undertake.
2) The document discusses various capital budgeting techniques for evaluating projects, including payback period, accounting rate of return, net present value, and internal rate of return. It also outlines the typical capital budgeting process of identifying, screening, evaluating, approving, implementing, and reviewing projects.
3) Key factors in capital budgeting include properly accounting for the time value of money, risk analysis, and ensuring projects will maximize long-term profitability for the company. Both traditional and modern discounted cash flow methods have advantages and
Financial engineering involves the design and implementation of innovative financial products and processes. It deals with creating new financial instruments or repackaging existing ones. Some examples of financial engineering in India include debt-oriented mutual funds, interest rate futures, and floating rate bonds. Financial engineering can be applied to equity, debt, hybrid instruments, and derivatives. It is used by investment banks and for purposes like risk management, valuation, and portfolio management. The field needs further development to provide more choices for investors and corporations to improve financial efficiency and solutions.
The Reserve Bank of India (RBI) recognizes the importance of risk management in the banking sector. In 1999, RBI issued guidelines for banks regarding asset liability management and managing credit, market, and operational risks. The major risks banks face are liquidity risk, interest rate risk, market risk, credit or default risk, and operational risk. RBI evaluates banks' financial soundness using the CAMELS framework, which assesses capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk. RBI's guidelines require banks to establish comprehensive risk rating systems, develop value at risk methodologies, and integrate asset liability management and credit policy activities to better manage risks.
Financial engineering involves the design, development, and implementation of innovative financial instruments and processes to creatively address problems in finance. It refers specifically to bundling and unbundling securities to maximize profits using various asset combinations, applying theoretical finance and computer modeling. Financial engineering relies on tools from fields like computational intelligence, mathematical finance, and computer simulation for trading, hedging, investment decisions, and risk management. In contrast, financial analysis assesses the viability, stability, and profitability of a business by professionals through evaluation of financial statements and market conditions.
Prudential norms on Income recognition, asset classification and provisioning...Pankaj Baid
The document outlines the Reserve Bank of India's prudential norms for classifying bank loans as non-performing assets and provisions related to loan advances. Key points include:
- Loans are classified as NPAs if interest or principal payments are overdue for more than 90 days.
- Income from NPAs should not be recognized and any interest recorded previously must be reversed.
- NPAs are further classified as substandard, doubtful or loss assets based on number of days past due.
- Higher provisioning is required for worse classified assets to account for higher credit risk.
The document discusses housing finance. It describes the different types of housing finance like direct finance, supplementary finance, and indirect finance. It discusses the purpose, quantum, eligibility, and terms of housing loans. Housing loans are typically provided for purchasing or building a house. The loan amount usually ranges from Rs. 100,000 to Rs. 2 crores. Individuals over 18 with sufficient income are eligible, and loans are typically repaid over 15-25 years. Housing loans have a margin of 80-85% of the property cost and are secured by a mortgage on the property. Interest rates can be fixed or floating.
CDR is a method used by companies with outstanding debt obligations to reorganize the terms of debt agreements in order to achieve advantages like waiving interest, concessions in payments, and converting debt to equity. It allows a business to gain control of its finances and improve its credit rating with help from creditors. However, it can also place holds on new credit and negatively impact a company's public image. The CDR process in India involves a standing forum, empowered group, and CDR cell that work to restructure eligible corporate debts.
| Capital Budgeting | CB | Payback Period | PBP | Accounting Rate of Return |...Ahmad Hassan
After studying this, you should be able to:
• Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability.
• Understand the three major discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and accounting rate of return (ARR).
• Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. l Define, construct, and interpret a graph called an “NPV profile.”
• Understand why ranking project proposals on the basis of the IRR, NPV, and ARR methods “may” lead to conflicts in rankings.
• Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or ARR rankings.
• Understand how “sensitivity analysis” allows us to challenge the single-point input estimates used in traditional capital budgeting analysis.
• Explain the role and process of project monitoring, including “progress reviews” and “postcompletion audits.”
This document discusses cash flow projections and principles for estimating cash flows. It contains the following key points:
- Cash flow projection involves estimating the amounts of cash that will be received and spent by a business over a period of time, often related to a specific project.
- There are four basic principles for estimating cash flows: incremental principle, separation principle, post-tax principle, and consistency principle.
- A cash flow stream for a project has three components: initial investment, operating cash inflows during the project lifetime, and terminal cash inflow from liquidating the project at the end.
This document provides an overview of capital budgeting decisions and investment evaluation methods. It discusses key concepts like net present value (NPV), internal rate of return (IRR), payback period, and accounting rate of return. The document explains how to calculate each method and their respective acceptance rules. It also compares NPV and IRR, noting they may provide conflicting recommendations for mutually exclusive projects. The document is intended to help readers understand important investment evaluation techniques.
- Capital budgeting is the process of evaluating investments in long-term assets. It involves estimating cash flows, determining the required rate of return, and using decision criteria to evaluate whether to accept or reject investment projects.
- Traditional methods of capital budgeting include payback period and accounting rate of return. Modern discounted cash flow methods include net present value, internal rate of return, and profitability index.
- Net present value discounts future cash flows to determine if a project's present value of cash inflows exceeds the present value of cash outflows. The profitability index measures the present value of cash inflows relative to the investment outlay.
This document discusses the roles of banks, including intermediation, payment systems, and financial services. It describes how banks transfer funds from savers to borrowers through intermediation, and how they facilitate payments through various systems like NEFT, EFT, NDS, and RTGS. It also outlines the types of financial services banks provide, dividing them into asset/fund-based services like term lending and bill discounting, and fee-based services like corporate and retail banking products.
The document discusses the recommendations of the Narsimham Committee I, which was formed in 1991 to recommend reforms for improving the efficiency and effectiveness of India's financial system and banking sector. The committee recommended several reforms, including reducing statutory pre-emptions like SLR and CRR, introducing interest payments on CRR balances, phasing out directed lending programs, increasing transparency, improving loan recovery processes, deregulating interest rates, restructuring banks, introducing standardized asset classification and provisioning norms, allowing entry of private banks, abolishing branch licensing controls, implementing capital adequacy requirements, standardizing income recognition practices, and having RBI solely regulate the banking system instead of joint control with the Ministry of Finance. Many of the recommendations were
This document discusses multiple projects and constraints in project management. It covers constraints like project dependence, capital rationing, and project indivisibility that must be considered when evaluating multiple projects. Mathematical programming techniques like linear programming can be used to determine the optimal combination of projects under these constraints. Linear programming formulates the project selection problem with an objective function to maximize value and constraint equations for limited resources and project interdependencies. The optimal solution selects the feasible combination of projects with the highest value.
This document provides an overview of various methods for project selection and portfolio management. It discusses selection models that organizations use to save time and money and maximize success likelihood. Both numeric and non-numeric models are described. The document then examines specific approaches like checklist models, scoring models, analytical hierarchy process (AHP) models, and profile models. It also covers financial models for project evaluation, including discounted cash flow analysis, net present value (NPV), internal rate of return, and payback period. Examples are provided to illustrate how to calculate payback period and NPV. Overall, the document outlines different techniques that decision-makers can employ to evaluate and select projects in a portfolio.
Prepared by the students of corporate finance at the MBA program of IE Business School, this presentation provides an introduction to project finance and analyzes two case studies involving project finance.
This document discusses sources of working capital finance in India, focusing on trade credit and bank borrowing. It provides details on trade credit terms, benefits, and factors to consider in deciding whether to take a discount or pay later. For bank borrowing, it outlines forms of financing like overdrafts and cash credits, as well as security requirements and regulations on financing based on recommendations from the Tandon and Chore Committees to the Reserve Bank of India.
EVA is a measure of economic profit calculated as net operating profit after tax minus the cost of financing the firm's capital. To derive NOPAT, sales minus variable costs equals contribution, minus fixed costs equals EBITDA, minus depreciation/amortization and tax equals NOPAT. EVA is used to measure a firm's economic value created over the required return of investors, and is determined to pay incentives and bonuses. Key benefits of EVA include measuring value creation, managing decisions to link to value creation, and motivating managers with incentive plans tied to shareholder value. Adjustments help translate financial statements to an economic framework for EVA calculation.
Accounting Rate of Return (ARR) is a simple capital budgeting tool that considers net income and book value of investments as reported in financial statements, without regard to time value of money. There are two types: ARR on asset value, which calculates return on assets (ROA), and ARR on capital invested, which calculates return on capital employed (ROCE). ARR can be calculated by taking the average net income over the project life and dividing it by the average book value of assets or total capital invested. While simple to calculate, ARR does not consider market values or time value of money, and can be manipulated through depreciation methods.
The document provides an overview of the Indian banking system. It discusses the structure of the system, which includes the Reserve Bank of India (central bank), scheduled commercial banks (public sector banks, private sector banks, foreign banks, regional rural banks, cooperative banks), and their roles. It also summarizes the primary functions of banks, which are accepting various types of deposits from the public and granting loans and advances. Secondary functions of banks include performing agency functions like funds transfer and collection services, as well as general utility functions.
1) Capital budgeting is the process of planning for capital expenditures that are expected to generate returns over multiple years. It involves evaluating potential long-term investment projects and determining which ones to undertake.
2) The document discusses various capital budgeting techniques for evaluating projects, including payback period, accounting rate of return, net present value, and internal rate of return. It also outlines the typical capital budgeting process of identifying, screening, evaluating, approving, implementing, and reviewing projects.
3) Key factors in capital budgeting include properly accounting for the time value of money, risk analysis, and ensuring projects will maximize long-term profitability for the company. Both traditional and modern discounted cash flow methods have advantages and
Financial engineering involves the design and implementation of innovative financial products and processes. It deals with creating new financial instruments or repackaging existing ones. Some examples of financial engineering in India include debt-oriented mutual funds, interest rate futures, and floating rate bonds. Financial engineering can be applied to equity, debt, hybrid instruments, and derivatives. It is used by investment banks and for purposes like risk management, valuation, and portfolio management. The field needs further development to provide more choices for investors and corporations to improve financial efficiency and solutions.
The Reserve Bank of India (RBI) recognizes the importance of risk management in the banking sector. In 1999, RBI issued guidelines for banks regarding asset liability management and managing credit, market, and operational risks. The major risks banks face are liquidity risk, interest rate risk, market risk, credit or default risk, and operational risk. RBI evaluates banks' financial soundness using the CAMELS framework, which assesses capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk. RBI's guidelines require banks to establish comprehensive risk rating systems, develop value at risk methodologies, and integrate asset liability management and credit policy activities to better manage risks.
Financial engineering involves the design, development, and implementation of innovative financial instruments and processes to creatively address problems in finance. It refers specifically to bundling and unbundling securities to maximize profits using various asset combinations, applying theoretical finance and computer modeling. Financial engineering relies on tools from fields like computational intelligence, mathematical finance, and computer simulation for trading, hedging, investment decisions, and risk management. In contrast, financial analysis assesses the viability, stability, and profitability of a business by professionals through evaluation of financial statements and market conditions.
Prudential norms on Income recognition, asset classification and provisioning...Pankaj Baid
The document outlines the Reserve Bank of India's prudential norms for classifying bank loans as non-performing assets and provisions related to loan advances. Key points include:
- Loans are classified as NPAs if interest or principal payments are overdue for more than 90 days.
- Income from NPAs should not be recognized and any interest recorded previously must be reversed.
- NPAs are further classified as substandard, doubtful or loss assets based on number of days past due.
- Higher provisioning is required for worse classified assets to account for higher credit risk.
The document discusses housing finance. It describes the different types of housing finance like direct finance, supplementary finance, and indirect finance. It discusses the purpose, quantum, eligibility, and terms of housing loans. Housing loans are typically provided for purchasing or building a house. The loan amount usually ranges from Rs. 100,000 to Rs. 2 crores. Individuals over 18 with sufficient income are eligible, and loans are typically repaid over 15-25 years. Housing loans have a margin of 80-85% of the property cost and are secured by a mortgage on the property. Interest rates can be fixed or floating.
CDR is a method used by companies with outstanding debt obligations to reorganize the terms of debt agreements in order to achieve advantages like waiving interest, concessions in payments, and converting debt to equity. It allows a business to gain control of its finances and improve its credit rating with help from creditors. However, it can also place holds on new credit and negatively impact a company's public image. The CDR process in India involves a standing forum, empowered group, and CDR cell that work to restructure eligible corporate debts.
| Capital Budgeting | CB | Payback Period | PBP | Accounting Rate of Return |...Ahmad Hassan
After studying this, you should be able to:
• Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability.
• Understand the three major discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and accounting rate of return (ARR).
• Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. l Define, construct, and interpret a graph called an “NPV profile.”
• Understand why ranking project proposals on the basis of the IRR, NPV, and ARR methods “may” lead to conflicts in rankings.
• Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or ARR rankings.
• Understand how “sensitivity analysis” allows us to challenge the single-point input estimates used in traditional capital budgeting analysis.
• Explain the role and process of project monitoring, including “progress reviews” and “postcompletion audits.”
This document discusses cash flow projections and principles for estimating cash flows. It contains the following key points:
- Cash flow projection involves estimating the amounts of cash that will be received and spent by a business over a period of time, often related to a specific project.
- There are four basic principles for estimating cash flows: incremental principle, separation principle, post-tax principle, and consistency principle.
- A cash flow stream for a project has three components: initial investment, operating cash inflows during the project lifetime, and terminal cash inflow from liquidating the project at the end.
This document provides an overview of capital budgeting decisions and investment evaluation methods. It discusses key concepts like net present value (NPV), internal rate of return (IRR), payback period, and accounting rate of return. The document explains how to calculate each method and their respective acceptance rules. It also compares NPV and IRR, noting they may provide conflicting recommendations for mutually exclusive projects. The document is intended to help readers understand important investment evaluation techniques.
- Capital budgeting is the process of evaluating investments in long-term assets. It involves estimating cash flows, determining the required rate of return, and using decision criteria to evaluate whether to accept or reject investment projects.
- Traditional methods of capital budgeting include payback period and accounting rate of return. Modern discounted cash flow methods include net present value, internal rate of return, and profitability index.
- Net present value discounts future cash flows to determine if a project's present value of cash inflows exceeds the present value of cash outflows. The profitability index measures the present value of cash inflows relative to the investment outlay.
This document discusses the roles of banks, including intermediation, payment systems, and financial services. It describes how banks transfer funds from savers to borrowers through intermediation, and how they facilitate payments through various systems like NEFT, EFT, NDS, and RTGS. It also outlines the types of financial services banks provide, dividing them into asset/fund-based services like term lending and bill discounting, and fee-based services like corporate and retail banking products.
The document discusses the recommendations of the Narsimham Committee I, which was formed in 1991 to recommend reforms for improving the efficiency and effectiveness of India's financial system and banking sector. The committee recommended several reforms, including reducing statutory pre-emptions like SLR and CRR, introducing interest payments on CRR balances, phasing out directed lending programs, increasing transparency, improving loan recovery processes, deregulating interest rates, restructuring banks, introducing standardized asset classification and provisioning norms, allowing entry of private banks, abolishing branch licensing controls, implementing capital adequacy requirements, standardizing income recognition practices, and having RBI solely regulate the banking system instead of joint control with the Ministry of Finance. Many of the recommendations were
This document discusses multiple projects and constraints in project management. It covers constraints like project dependence, capital rationing, and project indivisibility that must be considered when evaluating multiple projects. Mathematical programming techniques like linear programming can be used to determine the optimal combination of projects under these constraints. Linear programming formulates the project selection problem with an objective function to maximize value and constraint equations for limited resources and project interdependencies. The optimal solution selects the feasible combination of projects with the highest value.
This document provides an overview of various methods for project selection and portfolio management. It discusses selection models that organizations use to save time and money and maximize success likelihood. Both numeric and non-numeric models are described. The document then examines specific approaches like checklist models, scoring models, analytical hierarchy process (AHP) models, and profile models. It also covers financial models for project evaluation, including discounted cash flow analysis, net present value (NPV), internal rate of return, and payback period. Examples are provided to illustrate how to calculate payback period and NPV. Overall, the document outlines different techniques that decision-makers can employ to evaluate and select projects in a portfolio.
340
Capital
Budgeting
Techniques:
Certainty and Risk
Chapter Across the Disciplines
Why This Chapter Matters To You
Accounting: You need to understand cap-
ital budgeting techniques in order to
develop good estimates of the relevant
cash flows associated with a proposed
capital expenditure and to appreciate how
risk may affect the variability of cash
flows.
Information systems: You need to under-
stand capital budgeting techniques,
including how risk is measured in those
techniques, in order to design decision
modules that help reduce the amount of
work required in analyzing proposed capi-
tal projects.
Management: You need to understand
capital budgeting techniques in order to
understand the decision criteria used to
accept or reject proposed projects; how to
apply capital budgeting techniques when
capital must be rationed; and behavioral
and risk-adjustment approaches for deal-
ing with risk, including international risk.
Marketing: You need to understand capi-
tal budgeting techniques in order to
understand how proposals for new prod-
ucts and expansion of existing product
lines will be evaluated by the firm’s deci-
sion makers and how risk of proposed pro-
jects is treated in capital budgeting.
Operations: You need to understand capi-
tal budgeting techniques in order to
understand how proposals for the acquisi-
tion of new equipment and plants will be
evaluated by the firm’s decision makers,
especially when capital must be rationed.
9
LEARNING GOALS
Calculate, interpret, and evaluate the
payback period.
Apply net present value (NPV) and
internal rate of return (IRR) to relevant
cash flows to choose acceptable
capital expenditures.
Use net present value profiles to
compare the NPV and IRR techniques
in light of conflicting rankings.
Discuss two additional considerations
in capital budgeting—recognizing
real options and choosing projects
under capital rationing.
Recognize sensitivity analysis and
scenario analysis, decision trees, and
simulation as behavioral approaches
for dealing with project risk, and the
unique risks that multinational
companies face.
Understand the calculation and
practical aspects of risk-adjusted
discount rates (RADRs).
LG6
LG5
LG4
LG3
LG2
LG1
CHAPTER 9 Capital Budgeting Techniques: Certainty and Risk 341
Capital Budgeting Techniques
When firms have developed relevant cash flows, as demonstrated in Chapter 8,
they analyze them to assess whether a project is acceptable or to rank projects. A
number of techniques are available for performing such analyses. The preferred
approaches integrate time value procedures, risk and return considerations, and
valuation concepts to select capital expenditures that are consistent with the
firm’s goal of maximizing owners’ wealth. This section and the following one
focus on the use of these techniques in an environment of certainty. Later in the
chapter, we will look at capital budgeting under uncertain circumstances.
We will use one basic problem to .
This document discusses project costs, budgeting, and appraisal. It defines key terms like project costs, classifications of costs, and budgeting. It explains methods for forecasting, budgeting, and appraising projects. Project appraisal techniques like payback period, accounting rate of return, and net present value are explained in detail. Factors that affect project costs and the importance of project cost management are also discussed.
This document discusses project selection and initiation. It begins by outlining the learning outcomes and assessment criteria for Study Unit 2, which includes explaining how projects are identified and selected, developing a project charter, explaining outsourcing projects using requests for proposals, and describing the proposal solicitation process. It then provides information on identifying the source of projects, selecting projects using criteria, developing a project charter, explaining the use of requests for proposals, and fully explaining the solicitation process. The document discusses identifying needs, problems or opportunities; preparing requests for proposals; and selecting projects with the greatest benefit. It also outlines the project selection process and different methods for project evaluation and prioritization, including net present value, internal rate of return, benefit-
The Role of the Business Case in Public Investment Management and Project Por...Dr Rupert Booth
The document outlines Saudi Arabia's Public Investment Management (PIM) framework and Project Portfolio Planning (PPP) process. It introduces the Five Case Model business case approach used in PPP. The model assesses the strategic, economic, commercial, financial, and management cases for projects. It then discusses each step of Saudi Arabia's PPP process in detail, including screening projects using a strategic assessment, risk assessment, and strategic outline case with cost-benefit analysis. The best projects are prioritized to create a five-year project portfolio plan. Project execution is supported by a stage gate process and standardized 'White Book' procedures.
INFORMATION SYTEMS 3
Part-3: Mr. and Mrs. Rodgers House (House construction)
BUDGET AND RISK MANAGEMENT
1.0.
Overall Project Budget
A technique called Earned Value Management (EVM) compares project performance to the project baseline (Xu et al., 2018). All project managers pursuing Project Management Professional (PMP) certification learn and memorize the earned value calculations. Their application in real life is patchy, though. According to Insight, EVM is among the "critical few" best areas of practice for keeping track of a project's progress from both a schedule and cost standpoint (Vasyunina, 2017). The binary way of thinking about projects is widespread:
· On time versus late
· Over budget versus under budget.
On the project cost, both performance evaluation elements have a significant impact (Chang et al., 2022). If our costs are lower yet we are running late, EVM provides excellent facts of the matter.
Determining Earned Value
Computing EV involves:
· The sum of the up-to-date project budget, known as the planned value (PV)
· Current costs are identical to Actual Cost (AC).
· The project budget is multiplied by the proportion of execution to determine earned value (EV).
Now that we have these numbers, we can start making some computations of:
Schedule Performance Index (SPI) = EV/PV
SPI contrasts actual and anticipated progress. Whenever the SPI value had been than 1.0, fewer tasks were completed than expected. SPI > 1.0 denotes the completion of more work than anticipated.
Determining the CPI:
CPI= AC÷EV
The CPI evaluates the worth of finished work in relation to its true cost. Its score of 1.0 denotes high costs than anticipated. A CPI of greater than one shows that costs remained lower than expected.
For the SPI and CPI, >1 is favorable while 1 is unfavorable.
Remember that;
Subtracting instead of dividing allows you to rapidly determine the difference between the project budget and the timeline. Schedule variance (SV) equals EV-PV, whereas cost variance = EV-AC. You can easily execute the subtraction operation in your head, and in this case, >0 is favorable to 0 in this situation.
Except in the case of SPI or CPI, deviation is reliant on the project's scope. Therefore, we cannot compare it across construction project or across time effectively, as the budget might have changed.
Calculating the Project EAC:
CPI = EAC ÷ Overall Budget
EAC represents the prediction aggregate cost.
In summary:
· Project is halfway to its completion,
· PV = $55,000
· AC= $45,000
The calculations are as follows:
EV=100,000 ×1/2
=$50,000
SV =EV-PV
Where EV=50,000 and PV=55,000
Therefore, SP= 50,000-55,000
=-$5000
In this case, the value of SP is -$5,000, which is unfavorable for our project because it is less than 0.
SPI = EV/PV
Thus;
SP1=50,000 ÷55,000
= $0.91
However, the SPI value is less than.
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2. OUTLINE
• Constraints
• Method of Ranking
• Mathematical programming approach
• Linear programming model
• Integer linear programming model
• Goal programming model
4. Methods of Ranking
Because of economic dependency, capital rationing, or project
indivisibility, a need arises for comparing projects in order to accept
some and reject others. What approaches are available for determining
which projects to accept and which projects to reject? Basically,two
approaches are available: (i) the method of ranking, and (ii) the method
of mathematical programming.
Fairly simple, the method of ranking consists of two steps (i) Rank all
projects in a decreasing order according to their individual NPVs IRRs or
BCRs (iii) Accept projects in that order until the capital budget is
exhausted.
The method of ranking, originally proposed by Joel Dean is seriously
impaired by two problems: (i) conflict in ranking as per discounted cash
flow criteria, and (ii) project indivisibility
5. Feasible Combination Approach
The following procedure may be used for selecting the set of investments
under capital rationing.
1. Define all contributions of projects which are feasible, given the
capital budget restriction and project interdependencies
2. Choose the feasible combination that has the highest NPV
6. Mathematical Programming Approach
A mathematical programming model is formulated in terms of two broad
categories of equations: (i) the objective function, and (ii) the constraint equations.
The objective function represents the goal or objective the decision maker seeks to
achieve. Constraint equations represent restrictions –arising out of limitations of
resources, environmental restrictions, and managerial policies – which have to be
observed. The mathematical model seeks to optimise the objective function subject
to various constraints
The objective function and constraint equations are defined in terms of
parameters and decision variables. Parameters represent the characteristics of the
decision environment which are given. Decision variables represent what is
amenable to control by the decisions makers.
Out of the wide variety of mathematical programming models, we shall discuss
three types:
Linear programming model
Integer programming model
Goal programming model
7. Linear Programming Model
The most popular mathematical programming model, the linear
programming model is based on the following assumptions
• The objective function and the constraint equations are linear
• All the coefficients in the objective function and constraint equations
are defined with certainty.
• The objective function is unidimensional
• The decision variables are considered to be continuous
• Resources are homogenous. This means that if 100 hours of direct
labour are available, each of these hours is equally productive.
8. Linear Programming Model of a Capital
Rationing Problem
The general formulation of a linear programming model for a capital
rationing problem is :
Maximise
NPVj Xj
Subject to
CFjt Xj ≤ Kt (t = 0,1,….m)
0 ≤ Xj ≤ 1
Where NPVj = net present value of project j
Xj = amount of project j accepted
CFjt = cash outflow required for project j in period t
n
n
j =1
j =1
9. Kt = capital budget available in period t
The following features may be noted.
1. All the input parameters – NPVj, CFjt , Kt – are
assumed to be known with certainty.
2. The Xj decision variables are assumed to be continuous
but limited by a lower restriction (0) and an upper
restriction (1)
3. The NPV calculation is based on a cost of capital
figure which is known with certainty.
10. Integer Linear Programming Model
The principal motivation for the use of integer linear programming
approach are: (i) It overcomes the problem of partial projects which
besets the linear programming model because it permits only 0 or 1
value for the decision variables (ii) It is capable of handling virtually
any kind of project interdependency.
The basic integer linear programming model for capital budgeting
under capital rationing is as follows:
Maximise
Xj NPVj
Subject to
CFjt Xj ≤ Kt (t = 0,1,….m)
n
j =1
n
j =1
11. Xj = (0,1)
It may be noted that the only difference between this integer linear
programming model and the basic linear programming model discussed
earlier is that the integer linear programming model ensures that a project
is either completely accepted
(Xj =1) or completely rejected (Xj= 0).
12. Incorporating Project Interdependencies
in the Model
By constraining the decision variables to 0 or 1, the integer linear
programming model can handle almost any kind of project
interdependency. To illustrate, let us see how the following kinds of
project interdependence are incorporated in the integer linear
programming model:
• Mutual exclusiveness
• Contingency
• Complementariness
13. Goal Programming Model
Throughout this text we have assumed that the principal goal of financial
management is to maximise the wealth of shareholders, which, under
conditions of perfect capital market, can be realised by selecting the set of
capital projects that maximise net present value.
However, in the real world, capital market imperfections (like capital rationing,
differences in lending and borrowing rates, etc.) exist. Further, empirical
observation show that managers pursue a multiple goal structure which
includes, inter alia, the following:
Therefore, a realistic representation of real life situations should reflect the
multiple goals pursued by the management. The goal programming approach, a
kind of mathematical programming approach, provides a methodology for
solving an optimisation problem that involves multiple goals
• Growth in sales and market share
• Growth and stability of reported earnings
• Growth and stability of dividends
14. This approach, originally proposed by Charnes and Cooper in 1961, has
been extended by Ijiri, Ignizio, and others.
To use the goal programming model, the decision maker must:
1. State an absolute priority order among his goals
2. Provide a target value for each of his goals.
The goal programming methodology seeks to solve the programming
problem by minimising the absolute deviations from the specific goals in
order of the priority structure established. Goals at priority level one are
sought to be optimised first. Only when this is done will the goals at priority
level two be considered; so on and so forth. At a given priority level, the
relative importance of two or more goals is reflected in the weights assigned
to them.
15. Goal Programming Format
In general, the goal programming format is as follows:
Minimise = {P1 [f1 (d1 , d1 )] + P2 [ f2 (d2 , d2 )] +……
+Pm {fm (dm ,dm)]}
Subject to aj1 Xj C1
aj2 Xj C2
ajk Xj Ck
bj1 Xj + d1 – d1 = G1
bj2 Xj + d2 – d2 = G2
bjm Xj + dm – dm = Gm
Xj , di , di 0
The goal programming model is formulated in terms of three principal components: (i)
the objective function,(ii) the economic constraints, and (iii) the goal constraints.
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16. SUMMARY
Because of constraints like project dependencies, capital rationing, and
project indivisibility, investment projects cannot be viewed in and project
indivisibility, investment projects cannot be viewed in location.
Two projects are said to be economically dependent if the acceptance or
rejection of one changes the cash flow stream of the other or affects the
acceptance or rejection of the other. The types of economic dependency found
among projects are: mutual exclusiveness, negative dependency, and positive
dependency (complementariness).
Capital rationing exists when funds available for investment are inadequate
to undertake all projects which are otherwise acceptable. Capital rationing
may arise because of an internal limitation or an external constraint.
Capital projects are generally indivisible. This means that a capital project has
to be accepted or rejected in total – a project cannot be accepted partially.
Because of economic dependency, capital rationing, or project indivisibility, a
need arises for comparing projects in order to accept some and reject others.
Two approaches are available for this purpose: the method of ranking, and the
method of mathematical programming.
17. Fairly simple, the method of ranking consists of two steps: (i) Rank all
projects in decreasing order according to their individual NPVs, IRRs, or
BCRs. (ii) Accept projects in that order until the capital budget is exhausted.
The method of ranking is seriously impaired by two problems: (i) conflict in
ranking as per discounted cash flow criteria, and (ii) project indivisibility.
In a given set of projects, preference ranking tends to differ from one criterion
to another. Ranking conflicts are traceable to differing assumptions about the
rate of return at which intermediate cash flows are reinvested.
To select a set of projects, one may define all combinations of projects which
are feasible given the capital rationing constraint and project dependencies,
and then choose that combination which has the highest NPV associated with
it. This procedure may be called as the feasible combinations procedure.
A mathematical programming model is formulated in terms of two broad
categories of equations: (i) the objective function, and (ii) constraint
equations.
Out of the wide variety of mathematical programming models, three types
have greater applicability to the capital budgeting.
problem: linear programming model, integer linear programming model, and
goal programming model.
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