Page 164 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 6: Capital Budgeting

 Internal rate of return is the interest rate that discounts an investment's future cash flows Notes
to the present so that the present value of cash inflows exactly equals the present value of
the cash outflows.
 The process of selecting the more desirable projects among many profitable investments
is called capital rationing.

 Risk in capital budgeting is the degree of variability of cash flows.
 The conventional techniques to handle risk in capital budgeting are Payback, Risk adjusted
discount rate and Certainty equivalent method.

6.9 Keywords

Break-Even Time: It is the time taken from the start of the project till the period the Cumulative
Present Value of cash inflows of a project equal to present values of the total cash outflows.
Capital Budgeting: It refers to planning and deployment of available capital for the purpose of
maximizing long-term profitability of the firm.
Capital Rationing: The allocation of the limited funds available for financing the capital projects
to only some of the profitable projects in such a manner that the long term returns are maximized.
Risk-free Rate: The rate at which the future cash flows of a project which is not subjected to risk
are discounted.
Risky Investment: Risk in an investment refers to the variability that is likely to occur between
the estimated returns and the actual returns.

6.10 Review Questions

1. Why is capital budgeting significant to the firm?
2. How should working capital and sunk costs be treated in analyzing investment
opportunities? Explain with suitable examples.

3. Depreciation is a non-cash item and consequently does not affect the analysis of investment
proposal using discounted cash flow method. Comment.
4. Contrast the IRR and the NPV methods. Under what circumstances may they lead to

(a) Comparable recommendation
(b) Conflicting recommendation in circumstances in which they given contradictory
results which criteria should be used to select the project and why?

5. A project costing 5,60,000 is expected to produce annual net cash benefits of 80,000 over
a period of 15 years. Estimate the internal rate of return. Also find out the payback period
and obtain the IRR from it. How do you compare this IRR with one directly estimate?

6. How is risk assessed for a particular investment by using a probability distribution?
Discuss the method with an example.
7. Why are cash flows estimated for distant years usually less reliable than for recent years?
How can this factor be considered when evaluating the riskiness of a project?
8. What similarities and differences are there between risk adjusted discount rate method
and the certainty equivalent method?

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