Project classification: Capital budgeting decisions generally are termed either replacement decisions or expansion decisions.

Decisions: Replacement decisions: Involve determining whether capital projects should be purchased to take the place of existing assets that might be worn out, damaged, or obsolete. Usually the replacement projects are necessary to maintain or improve profitable operations using the existing production levels expansion decisions if a firm is considering whether to increase operations by adding capital projects to existing assets that will help produce either more of its existing products or entirely new products

Projects: independent project: projects whose cash flows are not affected by one another, so the acceptance of one project does not affect the acceptance of the other projects All independent projects can be purchased if they all are acceptable mutually exclusive projects: when one project is taken on, the others must be rejected

Advantages and Disadvantages of Net Present Value (NPV) Advantages of Net Present Value (NPV) 1. NPV gives important to the time value of money. 2. In the calculation of NPV, both after cash flow and before cash flow over the life span of the project are considered. 3. Profitability and risk of the projects are given high priority. 4. NPV helps in maximizing the firm's value.

Disadvantages of Net Present Value (NPV) 1. NPV is difficult to use. 2. NPV cant give accurate decision if the amount of investment of mutually exclusive projects is not equal. 3. It is difficult to calculate the appropriate discount rate. 4. NPV may not give correct decision when the projects are of unequal life. Advantage and disadvantage of IRR: Advantage: 1. It calculates Break-even, 2. IRR calculates an alternative cost of capital including an appropriate risk premium. 3. It use cash flow and consider time value of money in calculation Disadvantages

1. IRR cannot not be use to rate mutually exclusive projects 2. The IRR also cannot be use in the usual manner for projects that start with an initial positive cash inflow, like Deposit in Fixed account by Customer, intermediate cash flows are never reinvested or considered at the project's IRR, thus making IRR little edgy as compared to NPV. NPV versus IRR When NPV>0, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project. When IRR>k, a project is acceptable because the firm will earn a return greater than its required rate of return (k) if it invests in the project. When NPV>0, IRR>k for a projectthat is, if a project is acceptable using NPV, it is also acceptable using IRR

Conflicts between NPV and IRR NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, you should always use NPV

IRR is unreliable in the following situations Non-conventional cash flows Mutually exclusive projects When analyzing a single conventional project, both NPV and IRR will provide the same indicator about whether to accept the project or not. However, when comparing two projects, the NPV and IRR may provide conflicting results. It may be so that one project has higher NPV while the other has a higher IRR. This difference could occur because of the different cash flow patterns in the two projects. Project B -5000 0 0 0 0 15000

Project A Year 0 -5000 Year 1 2000 Year 2 2000 Year 3 2000 Year 4 2000 Year 5 2000

NPV $2,581.57 $4,313.82 IRR 29% 25% The above example assumes a discount rate of 10%. As you can see, Project A has higher IRR, while Project B has higher NPV. If these two projects were independent, it wouldnt matter much because the firm can accept both the projects. However, in case of mutually exclusive projects, the firm needs to decide one of the two projects to invest in. When facing such a situation, the project with a higher NPV should be chosen because there is an inherent reinvestment assumption.

Payback Definition The payback method is defined as the time, usually expressed in years, it takes for the cash income from a capital investment project to equal the initial cost of the investment. It is also considered as Initial screening tool for selecting appropriate projects.

Advantages 1. Payback period, as a tool of analysis, is often used because it is easy to apply and understand for most individuals, regardless of academic training or field of endeavor. 2. The payback period is an effective measure of investment risk. It is widely used when liquidity is an important criterion to choose a project. 3. Payback period method is suitable for projects of small investments; it not worth spending much time and effort in sophisticated economic analysis in such projects 4. Discontinued payback period method considers the time value of money. Disadvantages: 1. Payback ignores the time value of money. 2. Payback ignores cash flows beyond the payback period, thereby ignoring the "profitability" of a project. 3. Additional complexity arises when the cash flow changes sign several times. Profitability index: Profitability index is an investment appraisal technique calculated by dividing the present value of future cash follows of a project by the initial investment required for the project. Sometimes called benefit-cost ratio too. It is useful in capital rationing since it helps in ranking projects based on their per dollar return Formula: PI = ( present value of future cash flows / invested initial capital) =1+ ( NPV / Initial investment required) Explanation: Actually a modification of the net present value method. Profitability index is a relative measure (i.e. it gives as the figure as a ratio).

Decision Rule Accept a project if the profitability index is greater than 1, Stay indifferent if the profitability index is zero and Dont accept a project if the profitability index is below 1.