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    Financial Management

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    Prathmesh Ambulkar
    Capital budgeting is used to evaluate large investments and expenses to obtain the best returns. Techniques like net present value (NPV), internal rate of return (IRR), and profitability index (PI) are used to analyze projects by discounting future cash flows. NPV considers the time value of money to determine if a project's future net earnings exceed the initial capital costs. IRR is the discount rate that results in an NPV of zero. PI is the ratio of discounted cash flows to initial investment. Payback period is the time required to recover the initial costs of a project from its cash inflows. Leverage refers to the use of debt in a company's capital structure.

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    Financial Management

    Uploaded by

    Prathmesh Ambulkar
    25 views5 pages
    Capital budgeting is used to evaluate large investments and expenses to obtain the best returns. Techniques like net present value (NPV), internal rate of return (IRR), and profitability index (PI) are used to analyze projects by discounting future cash flows. NPV considers the time value of money to determine if a project's future net earnings exceed the initial capital costs. IRR is the discount rate that results in an NPV of zero. PI is the ratio of discounted cash flows to initial investment. Payback period is the time required to recover the initial costs of a project from its cash inflows. Leverage refers to the use of debt in a company's capital structure.

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    Capital budgeting is used to evaluate large investments and expenses to obtain the best returns. Techniques like net present value (NPV), internal rate of return (IRR), and profitability index (PI) are used to analyze projects by discounting future cash flows. NPV considers the time value of money to determine if a project's future net earnings exceed the initial capital costs. IRR is the discount rate that results in an NPV of zero. PI is the ratio of discounted cash flows to initial investment. Payback period is the time required to recover the initial costs of a project from its cash inflows. Leverage refers to the use of debt in a company's capital structure.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    25 views5 pages

    Financial Management

    Uploaded by

    Prathmesh Ambulkar
    Capital budgeting is used to evaluate large investments and expenses to obtain the best returns. Techniques like net present value (NPV), internal rate of return (IRR), and profitability index (PI) are used to analyze projects by discounting future cash flows. NPV considers the time value of money to determine if a project's future net earnings exceed the initial capital costs. IRR is the discount rate that results in an NPV of zero. PI is the ratio of discounted cash flows to initial investment. Payback period is the time required to recover the initial costs of a project from its cash inflows. Leverage refers to the use of debt in a company's capital structure.

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     Capital budgeting is 

    a process of evaluating investments and


    huge expenses in order to obtain the best returns on
    investment.
     An organization is often faced with the challenges of selecting
    between two projects/investments or the buy vs replace
    decision.

    Time Value of Money


     It indicates that money earned today will be more than in its
    intrinsic value in the near future.
     Present Value – When future payment or series of payments are
    discounted at the given rate of interest up to the present date to
    reflect time value of money, the resulting value is called as
    present value
     Future Value – An amount obtained by enhancing the value of
    a present or a series of payments at the given rate of interest.
     Interest – It is charge against use of money paid by borrower to
    the lender.
     Discount Rate - It is the interest rate used to determine the
    present value of future cash flows in a discounted cash flow
    (DCF) analysis. This helps determine if the future cash flows
    from a project or investment will be worth more than the capital
    outlay needed to fund the project or investment in the present.
    Capital Budgeting Techniques
    1. NPA
     Net present value (NPV) is the difference between the present value of
    cash inflows and the present value of cash outflows over a period of
    time.
     NPV is used in capital budgeting and investment planning to analyze the
    profitability of a projected investment or project.
     For Example,
    Calculation of Net Present Value of Cash Flows
    Year Cash Flow PVIF@10% DCF
    1 20,000 0.9091 18,182
    2 16,000 0.8264 13,222
    3 20,000 0.7513 15,026
    4 30,000 0.6830 20,490
    5 10,000 0.6209 6,209
    Present Value of Cash Flows 73,129
    Less:- Initial Outlay 60,000
    Net Present Value 13,129
    Conclusion:- Since NPV is positive, it is worthwhile to invest into
    the project.

    2. Internal Rate of Return (IRR)


     It is a metric used in capital budgeting measuring the
    profitability of potential investments.
     It is the discount rate that makes the NPV equal to zero.
     It is determined using trial & error method.
     Formula:-
    NPV 1
    IRR = R1 + NPV 1−NPV 2 × (R2 – R1)

    Where, R1 = Lower Discount Rate


    R2 = Higher Discount Rate
    NPV1 = Higher NPV (derived from R1)
    NPV2 = Lower NPV (derived from R2)
     For Example,
    Calculation of Present Value of Cash Flows
    Year Cash PVIF PVIF
    Flow
    @ 10% DCF @ 15% DCF
    1 7,00,000 0.909 6,36,300 0.870 6,09,000
    2 7,00,000 0.826 5,78,200 0.756 5,29,200
    3 8,00,000 0.751 6,01,800 0.658 5,26,400
    4 8,00,000 0.683 5,46,400 0.572 4,57,600
    5 9,00,000 0.621 5,58,900 0.497 4,47,300
    6 9,00,000 0.564 5,07,600 0.432 3,88,800
    7 10,00,000 0.513 5,13,000 0.376 3,76,000
    8 10,00,000 0.467 4,67,000 0.327 3,27,000
    9 8,00,000 0.424 3,39,200 0.284 2,27,200
    10 6,00,000 0.386 2,31,600 0.247 1,48,200
    PV of Cash Flows 49,79,000 40,36,700
    Less:- Initial Outlay 40,00,000 40,00,000
    Net Present Value 9,79,000 36,700

    NPV 1
    IRR = R1 + NPV 1−NPV 2 × (R2 – R1)
    Where, R1 = Lower Discount Rate
    R2 = Higher Discount Rate
    NPV1 = Higher NPV (derived from R1)
    NPV2 = Lower NPV (derived from R2)

    9,79,000
    IRR = 10 + 9,79,000−36,700 × (15 – 10)
    = 10 + 1.0389 × 5 = 15.1945%
    3. Profitability Index (PI)
     The profitability index (PI) is a measure of a project's or
    investment's attractiveness when funds available are in short
    supply.
     The PI is calculated by dividing the present value of future
    expected cash flows by the initial investment amount in the
    project.
     It is a useful tool for ranking projects because it allows you to
    quantify the amount of value created per unit of investment.
     Formula :-

    4. Payback Period / Discounted Payback Period


     The payback period represents the number of years it takes to
    pay back the initial investment of a capital in project, from the
    cash flows that the project produces.
     Calculation of Payback Period
    Initial Outlay – Rs.60,000
    Year Cash Flow Cumulative
    CFs
    1 20,000 20,000
    2 16,000 36,000
    3 20,000 56,000
    4 30,000 86,000
    5 10,000 96,000
     Calculation of Discounted Payback Period
    Year Cash Flow PVIF@10% DCF Cumulative
    DCFs
    1 20,000 0.9091 18,182 18,182
    2 16,000 0.8264 13,222 ?
    3 20,000 0.7513 15,026 ?
    4 30,000 0.6830 20,490 ?
    5 10,000 0.6209 6,209 ?

    Leverage
     Leverage is the amount of debt a company has in its mix of
    debt and equity (its capital structure).
     A company with more debt than average for its industry is said
    to be highly leveraged.
     In simple words, when you borrow money to make an
    investment that will hopefully lead to greater returns. 

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