Capital Budgeting - Practical Question

Prof. M H

12 Jul 202018:09

Summary

TLDRThe video script discusses 'Capital Budgeting' and its significance in business decision-making. It explains the concept, involving companies in evaluating and ranking investment options like machinery and equipment. The script introduces several techniques for capital budgeting, including Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. It uses an example of a company, 'Akbar Limited,' to demonstrate how to calculate NPV and make investment decisions based on discounted cash flow. The tutorial is designed to help understand the basics of capital budgeting and its crucial role in determining profitable investments.

Takeaways

😀 Capital Budgeting is a process where companies are involved and ranked based on investment decisions.
📈 The process involves deciding where to invest in machinery and equipment for profitability.
💡 Example given is a company needing to choose between two options for equipment, highlighting the decision-making aspect of capital budgeting.
🔢 Techniques such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period are discussed as methods for evaluating investments.
🌐 The concept of discounted cash flow and the time value of money is explained, emphasizing the importance of considering the present value of future cash flows.
📚 A detailed calculation example is provided, using a hypothetical company named 'Akbar Limited' to demonstrate the application of capital budgeting techniques.
💼 The script explains the calculation of payback period and NPV, and how to use these to decide between different investment options.
📊 The importance of considering the total percentage value and the recovery of investment is highlighted.
📈 The script discusses the concept of the 'bacterial' rate of return, which seems to be a specific way of calculating returns over time.
🔑 The decision between investing in 'Equipment One' or 'Recruitment' is framed as a choice between quicker recovery (shorter payback period) versus higher net present value.
🏁 The script concludes by emphasizing the importance of understanding capital budgeting, suggesting that revisiting the material will enhance comprehension.

Q & A

What is capital budgeting?
-Capital budgeting is a process by which companies evaluate and rank potential investments, such as in plants, machinery, and equipment, to determine which will be most profitable.
What are some examples of where capital budgeting decisions are applied?
-Capital budgeting decisions can be applied when a company needs to invest in machinery, plants, or equipment, for example, deciding between two types of equipment for manufacturing.
What are the key techniques used in capital budgeting?
-Some key techniques used in capital budgeting include Payback Period, Discounted Payback Period, Net Present Value (NPV), Profitability Index (PI), and Accounting Rate of Return (ARR).
What is the Payback Period technique in capital budgeting?
-The Payback Period technique calculates the time it takes for a company to recover its investment from the cash inflows generated by the project.
How is the Discounted Payback Period different from the Payback Period?
-The Discounted Payback Period considers the time value of money, calculating the time it takes to recover an investment based on the present value of future cash inflows, accounting for inflation or interest rates.
What is Net Present Value (NPV) in capital budgeting?
-Net Present Value (NPV) is the total of the present values of cash inflows and outflows. If the NPV is positive, the investment is considered profitable as the returns exceed the costs.
How does the Profitability Index (PI) work?
-Profitability Index (PI) is calculated by dividing the present value of future cash inflows by the initial investment. A PI greater than 1 indicates that the investment will yield a return greater than its cost.
What is meant by the term 'mutually exclusive equipment' in the context of the script?
-'Mutually exclusive equipment' means that the company can only choose one of the two options (equipment) for investment, so they must select the one that provides the best return.
What factors influence the selection of equipment in capital budgeting?
-Factors influencing equipment selection include the initial cost, the useful life of the equipment, annual cash inflows generated, and the discount rate applied to account for the time value of money.
In the provided example, what is the difference between Equipment 1 and Equipment 2?
-Equipment 1 costs ₹10 lakhs and has a useful life of 5 years with an annual cash inflow of ₹3 lakhs. Equipment 2 costs ₹15 lakhs, has a life of 6 years, and generates ₹4 lakhs in cash inflow annually. These details help in determining which equipment is more profitable based on NPV and Payback Period techniques.

Outlines

00:00

📊 Introduction to Capital Budgeting

The script introduces the concept of capital budgeting, which is a process where companies are involved and ranked based on their potential for investment. It explains that capital budgeting involves deciding where to invest in machinery or equipment in various plants to maximize profitability. The script uses an example of a company needing to choose between two options for equipment and discusses various techniques that will be explored later, such as net present value and payback period. It sets the stage for a deeper dive into capital budgeting techniques and their applications in business decision-making.

05:00

🔍 Detailed Explanation of Discounted Payback Period and Present Value

This paragraph delves into the discounted payback period and present value as key components of capital budgeting. It explains the concept of the payback period and how it is calculated, emphasizing the importance of considering the time value of money. The script provides a formula for calculating the discounted payback and present value, suggesting that these techniques help in evaluating the profitability of investments over time. An example is given to illustrate how to calculate these values for a company named 'Akbar Limited,' which is considering an investment in equipment versus recruitment, highlighting the steps and considerations involved in such financial decisions.

10:02

🏦 Advanced Capital Budgeting Techniques and Their Application

The script continues with an in-depth look at advanced capital budgeting techniques, focusing on the practical application of these methods. It discusses how to calculate the present value of future cash flows and how to use these calculations to make informed investment decisions. The paragraph provides a detailed walkthrough of the calculations, including how to account for inflation and other economic factors that can affect the value of an investment. An example involving a property deal between two individuals is used to illustrate the concept of discounted cash flow and how it can be used to evaluate the real value of an investment over time.

15:03

📈 Conclusion and Encouragement for Further Learning

The final paragraph summarizes the key points of capital budgeting and encourages viewers to continue learning about the topic. It mentions that understanding capital budgeting is crucial for making smart investment decisions and that the concepts covered in the script are fundamental to financial analysis. The speaker reassures viewers that with further study, they will be able to grasp the complexities of capital budgeting and apply these techniques effectively in their business endeavors.

Mindmap

Keywords

💡Capital Budgeting

Capital Budgeting refers to the process of making investment decisions regarding long-term investments, such as acquiring fixed assets, by businesses. It is a critical process that involves evaluating different investment options and selecting the ones that are most likely to generate profit. In the script, the concept is discussed as a way to decide where to invest in machinery or equipment within a company, highlighting its importance in strategic decision-making.

💡Equipment

Equipment in this context refers to the machinery and tools that a company might consider investing in as part of its capital budgeting process. The script mentions that a company has two options for equipment and needs to decide which one to invest in based on profitability. Equipment is a tangible asset that can significantly impact a company's operations and bottom line.

💡Discounted Payback Period

The Discounted Payback Period is a variation of the traditional payback period method that takes into account the time value of money. It calculates the time it takes for an investment to recover its cost based on discounted cash inflows. The script mentions this concept as one of the techniques used to evaluate investment options, emphasizing the importance of considering the time value of money in capital budgeting decisions.

💡Net Present Value (NPV)

Net Present Value is a financial metric used to determine the potential profit or loss from an investment by discounting future cash flows to their present value. A positive NPV indicates a profitable investment. The script discusses NPV as a key technique in capital budgeting, where it is used to rank investment options and decide which ones are most profitable after considering the time value of money.

💡Profitability Index

The Profitability Index is a method used to evaluate the profitability of an investment. It is calculated by dividing the present value of an investment's cash inflows by the initial investment cost. The script refers to the Profitability Index as a tool in the capital budgeting process to help determine which investment options are the most worthwhile.

💡Accounting Rate of Return (ARR)

The Accounting Rate of Return is a financial metric that calculates the percentage return on an investment based on the annual net income generated by the investment divided by the initial investment cost. Although not explicitly mentioned in the script, it is related to the profitability of investments, which is a central theme in capital budgeting discussions.

💡Recruitment

Recruitment, as discussed in the script, refers to the process of hiring new employees. It is presented as an alternative investment option to purchasing equipment, where the company must decide whether to invest in human resources or machinery. The decision between recruitment and equipment purchase is an example of the types of choices companies face in capital budgeting.

💡Time Value of Money

The Time Value of Money is a financial concept that states that money available now is worth more than the same amount in the future due to its potential earning capacity. This concept is fundamental to capital budgeting, as it influences the evaluation of investment options. The script mentions the Time Value of Money in the context of discounting future cash flows to determine their present value.

💡Inflation

Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. In the script, inflation is mentioned in relation to the Discounted Payback Period, where it can affect the real value of future cash flows, thus influencing investment decisions.

💡Cash Flow

Cash Flow represents the inflow and outflow of cash within a business over a specific period. In capital budgeting, as discussed in the script, cash flow is a crucial element for evaluating investments. Positive cash flows from an investment indicate that it is generating profits, which is a key consideration in capital budgeting decisions.

💡Return on Investment (ROI)

Return on Investment is a financial metric used to evaluate the efficiency of an investment by comparing the return (profit) against the cost. While not explicitly mentioned in the script, ROI is an underlying concept in capital budgeting as companies seek to maximize their ROI when deciding where to invest their capital.

Highlights

Introduction to Capital Budgeting and its significance in decision-making for investments.

Definition of Capital Budgeting as a process involving companies to rank and select profitable investments.

Explanation of the decision-making process in investing in machinery and equipment in various plants.

Discussion on the example of a company with two options for equipment and the concept of capital budgeting in decision-making.

Introduction to the concept of 'Net Present Value' and its importance in investment decisions.

Explanation of the 'Accounting Rate of Return' and its role in evaluating profitability.

Emphasis on the importance of the 'Profitability Index' in capital budgeting techniques.

Introduction to the case study of 'Akbar Limited' and the decision to select between two equipment options.

Presentation of financial data for 'Akbar Limited' to calculate the Net Present Value and Payback Period.

Calculation of the Payback Period and its significance in deciding the return on investment.

Explanation of the formula for calculating the Net Present Value and its components.

Detailed calculation steps for the Net Present Value of the investment in recruitment versus equipment.

Discussion on the concept of 'Discounted Payback Period' and its relevance in capital budgeting.

Importance of considering inflation and its impact on the value of money over time in capital budgeting decisions.

Explanation of the 'Internal Rate of Return' method and its comparison with other capital budgeting techniques.

Final decision-making based on the Net Present Value, Payback Period, and Profitability Index of the equipment options.

Summary of the capital budgeting process and the decision to select Equipment Two over Recruitment due to a higher Net Present Value.