Advance Financial Risk
Management
Topic: Capital Budgeting
Submitted To: Mr. Kashif Abbas
Presented by:
1. Mr. Adnan Khan
2. Ms. Aneha Zahid
3. Ms. Quratulain
Program: MS Management Sciences
Session: 2022-24
Riphah International University, QIE Lahore

Outline
 Introduction
 Duties of Financial Managers
 Definition of Budget
 Budget sector and types of budget
 Capital Budgeting
 Importance of Capital Budgeting
 Capital Budgeting: Project Categorization
 Capital Budgeting: Eight Steps
 Evaluation Criteria: Capital investment Appraisals
 Non-Discounted and Discounted Cash Flow (DCF) Techniques
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)
 Summary and Conclusions

Introduction
 Capital Budgeting is the process of determining which real
investment projects should be accepted and given an
allocation of funds from the firm.
 To evaluate capital budgeting processes, their consistency
with the goal of shareholder wealth maximization is of
utmost importance.
 Capital budgeting is the planning process used to determine a
firms long term investments such as new machinery,
replacement machinery, new plants, new products and research
and development projects.

Recall the Flows of funds and decisions
important to the financial manager
Financial
Manager
Financial
Markets
Real Assets
Financing
Decision
Investment
Decision
Returns from Investment Returns to Security Holders
Reinvestment Refinancing
Capital Budgeting is used to make the Investment Decision

The Three Primary Duties of the
Financial Manager
Whether managing monies for the home, or for the firm, our
duties are met with decisions framed by the same general
principles. These principles instruct us in making three main
types of decisions as we perform those three primary duties:
• The capital budgeting decision
• The capital structure decision
• The working capital decision

The Capital Budgeting Decision
With the capital budgeting decision, the financial manager
decides where best to deploy monies long-term. The
purchase of a new delivery truck or a new warehouse
is a capital budgeting decision; the payment of a utility
bill is not.
With the making of this decision, we consider three features
of the cash flows deriving from the decision:
• The size of the cash flows
• The timing of the cash flows
• The risk of the cash flows
We review a couple examples of capital budgeting decisions.

The Capital Structure Decision
With the capital structure decision, the financial manager decides
from where best to acquire monies long-term. The purchase of that
new delivery truck with cash or with a loan from GMAC or Ford
Motor Credit is a capital structure decision; the use of long-term
borrowing to fund a franchise purchase is another.
Perhaps most importantly, the decision to fund a firm’s growth with
equity - such as with funds invested by the firm’s founders, angel
investors, venture capitalists or public stock offerings – or debt, is
a critical capital structure choice. Two features of this choice bear
mentioning:
• The risk of the debt
• The loss of control and reduced potential cash flows to the
founders with an equity or stock sale
We expand our review with a few capital structure decisions.

The Working Capital Decision
With the working capital decision, current assets and current liabilities
become the focus of the financial manager.
Such items as cash balances, accounts receivable, inventory levels and
short-term accruals (such as prepaid rent or utilities) are included
among the short-term assets that comprise one component of working
capital.
Also with the working capital decision, we concern ourselves with short-
term obligations such as accounts payable to vendors, and other debt
that is expected to be paid off within one year.
Net working capital is a meaningful outcome of the working capital
decision-making matrix. Net working capital is merely the difference
between current assets and current liabilities.

The Capital Budgeting Choice: Capital
Budgeting Decision-making Criteria
Recall the definition of a capital budgeting choice; we are
deploying firm resources long-term towards the maximization
of shareholder wealth.
How do we know when we are doing that?
We use your text and four new tools to assist us:
• The Net Present Value or NPV rule in Section 8.1
• The Payback rule in Section 8.2
• The Internal Rate of Return or IRR rule in Section 8.4
• The Profitability Index in Section 8.5

Definition of Budget
 Budgeting is a management tool for planning and controlling future
activity.
 Financial Buzz Words: A plan for saving, borrowing and spending.
 Budget is a financial plan and a line of all planned expenses and
revenues.

Budget Sector:
Business start up Budget, Corporate/business budget, Government Budget,
Event management budget, Personal/Family budget.
Budget Types:
 Basis of Flexibility: fixed and variable budget.
 Basis of time period: short term and long term budget.
 Basis of functionality: Sales, production, market, project, revenue, Cash
Flow Budgets etc.

Capital Budgeting
 Capital: Operating assets used for production
 Budget: A plan that details projected cash flows during some period.
 Capital Budgeting: Process of analyzing projects and deciding which
ones to include in capital budget.

Importance of Capital budgeting:
• Growth, Large Amount, Irreversibility, Complexity, Risk, Long term
implications.
Benefits of Capital budgeting Decision:
Capital Budgeting Decisions evaluate a proposed project to forecast return
from the project and determine whether return from the project is
adequate.
It Evaluate expenditure decisions which involve current outflow of funds
but are likely to produce benefits over a period to time more then one
year.

Capital Budgeting: Project Categorization:
Establishment of new products and Services.
Replacement projects: Maintenance or cost
reduction
Expansion of existing projects
Research and development projects
Long term contracts
Safety and environmental projects

Eight Steps of Capital Budgeting
• Eight Steps:

Evaluation Criteria: Capital Investment Proposal

NPV: Strengths and Weaknesses
• Strengths
• Resulting number is easy to interpret: shows how wealth will
change if the project is accepted.
• Acceptance criteria is consistent with shareholder wealth
maximization.
• Relatively straightforward to calculate
• Weaknesses
• Requires knowledge of finance to use.
• An improper NPV analysis may lead to the wrong choices of
projects when the firm has capital rationing – this will be
discussed later.

PI: Strengths and Weaknesses
• Strengths
• PI number is easy to interpret: shows how many $ (in PV terms) you get back
per $ invested.
• Acceptance criteria is generally consistent with shareholder wealth
maximization.
• Relatively straightforward to calculate.
• Useful when there is capital rationing (to be discussed later).
• Weaknesses
• Requires knowledge of finance to use.
• It is possible that PI cannot be used if the initial cash flow is an inflow.
• Method needs to be adjusted when there are mutually exclusive projects (to be
discussed later).

IRR: Strengths and Weaknesses
 Strengths
IRR number is easy to interpret: shows the return the
project generates.
Acceptance criteria is generally consistent with
shareholder wealth maximization.
Weaknesses
Requires knowledge of finance to use.
Difficult to calculate – need financial calculator.
It is possible that there exists no IRR or multiple IRRs for
a project and there are several special cases when the IRR
analysis needs to be adjusted in order to make a correct
decision (these problems will be addressed later).

Summary and Conclusion
 We have studied evaluation criteria for Capital Budgeting like, NPV, IRR,
and PI, are all good techniques for capital budgeting and allow us to
accept or reject investment projects consistent with the goal of
shareholder wealth maximization.
 Generally an impression created that the firm should use NPV method
for Decision Making.
 Beware, however, there are times when one technique’s output is better
for some decisions or when a technique has to be modified given
certain circumstances.