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    Capital Budgeting

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    Aryan Raj Rajput
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    Capital Budgeting

    Uploaded by

    Aryan Raj Rajput
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    Na

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    Copyright:

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    Download as pptx, pdf, or txt
    12 views34 pages

    Capital Budgeting

    Uploaded by

    Aryan Raj Rajput
    Na

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 34

    CAPITAL

    BUDGETING

    Gurunath Waghale
    Assistant Professor
    MIT ADT University
    DEFINATION

    • 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.

    • Capital Budgeting is the process of making investments


    decisions in capital expenditure.

    • Capital Budgeting is long term planning for making and


    financing proposed capital outlays.
    Examples of Long Term Capital
    Expenditure
    CASES FOR CAPITAL BUDGETING-

     Replacement

     Expansion

     Diversification

     Research and development

     Miscellaneous
    IMPORTANCE OF CAPITAL
    BUDGETING-
    INVOLVEMENT OF HEAVY FUND-
    Capital budgeting decisions require large capital outlays. It is therefore
    absolutely necessary that the firm should carefully plan they are put to
    most profitable use.

    LONG TERM IMPLICATION-


    The effect of capital budgeting decision will be felt by the firm over a long
    period and therefore they have decisive influence on the rate and
    direction of the growth of the firm.
    CONT.
    .
     IRREVERSIBLE DECISION-
    In most cases, capital budgeting decisions are irreversible.
    This is because it is very difficult to find a market for the
    capital assets. The only alternative will be to scrap the capital
    assets so purchased or sell them at a substantial loss in the
    event of the decision being proved wrong.

    MOST DIFFICULT TO MAKE-


    The capital budgeting decision require an assessment of
    future events which are uncertain . It is really difficult task to
    estimate the probable future events, the probable benefits
    and cost accurately in quantitative terms because of
    economic ,political, social , and technological factors.
    PROCESS OF CAPITAL BUDGETING-

     Capital budgeting is a difficult process to the investment of available


    funds. The benefit will attained only in the near future but, the future
    is uncertain.

     Identification of various investments proposals


     Screening or matching the proposals
     Evaluation
     Fixing priority
     Final approval
     Implementing
     Performance review of feedback
    The Position of Capital Budgeting

    Financial Goal of the Firm:


    Wealth Maximisation

    Investment Decison Financing Decision Dividend Decision

    Long Term Assets Short Term Assets Debt/Equity M ix Dividend Payout Ratio

    Capital Budgeting
    KINDS OF CAPITAL BUDGETING DECISIONS
    (Proposals / Projects)

    1. ACCEPT OR REJECT DECISIONS:- INDEPENDENT PROJECT /

    PROPOSALS.

    2. MUTUALLY EXCLUSIVE DECISIONS: - MUTUALLY EXECUTIVE


    PROJECTS /
    PROPOSALS.

    3. CAPITAL RATIONING DECISIONS: - DEPENDENT PROJECTS


    /PROPOSALS. (WHEN
    FUND HAS TO BE
    DISTRIBUTED IN
    MULTIPLE PROJECTS)
    Capital Budgeting: Project Categorization

    • Establishment of New Products & Services

    • Replacement Projects: Maintenance or Cost Reduction

    • Expansion of Existing Projects

    • Research and Development Projects

    • Long Term Contracts

    • Safety and/or Environmental Projects


    TECHNIQUES (METHODS) OF CAPITAL
    BUDGETING-

    CAPITAL
    BUDGETING
    TECHNIQUES

    Non- Discounting
    Discountin criteria
    g Criteria
    Pay- NP Profitabilit IR
    AR
    Back y Index
    R V R
    Period
    Suggested Cash Flow
    PAY BACK PERIOD
     The payback period is the length of time required to recover the initial cost
    of the project. The payback period is the length of time required to recover
    the initial cost of the project. The payback period therefore can be looked
    upon as the length of time required for a proposal to break even on its
    net investment.

     CALCULATION OF PAYBACK PERIOD-

     When Annual Inflow are Equal.

     PBP = CF0 / CFn

     When the Annual Cash Inflow are Unequal


    Remaining Amount to be recovered
     PBP = Minimum Full / Whole Years require + -----------------------------
    Cash Inflow of next year
     Project Acceptance criteria.
    1. Lower the PBP – Accept the project
    2. Higher the PBP – Reject the project

     Merits of PBP
    1. Simple to calculate
    2. Liquidity Indications
    3. Break even of investment can be calculated.

     Demerits of PBP
    1. Ignores the profitability factor.
    2. Its is the method of recovery.
    3. Ignores salvage Value.
    4. Ignores the time value of money.
    EXAMPLE-
    CONT…
    DISCOUNTED PAY BACK PERIOD METHOD
    • Under this method the present value of all cash outflows and
    inflows are computed at an appropriate discount rate.

    • The present values of all inflows are cumulated in order of time.


    The time period at which the cumulated present value of cash
    inflows equals the present value of cash outflows is known as
    discounted pay back period.

    • The project which gives a shorter discounted pay back period is


    accepted.

    • Calculation Table:- Eg. and Then use same PBP formula to


    calculate it
    Year Cash PV Factor Present Cumulativ
    Inflow Value @ Value of e P.V. of
    8% Cash Cash
    Inflow Inflow
    AVERAGE (ACCOUNTING) RATE OF RETURN (ARR)
     Average rate of return means the average rate of return or profit taken
    for considering the project evaluation.
     It measures the profitability of the investment (project) using information
    taken from financial statements.
     This method is one of the traditional methods for evaluating the project
    proposals:
     Under this method, profit after tax and depreciation is considered.

    Formula-
    MERITS-
     1.It is easy to calculate and simple to understand.
     2. It is based on the accounting information rather than cash inflow.
     3. It is not based on the time value of money.
     4. It considers the total benefits associated with the project.

    DEMERITS-
     It ignores the time value of money.
     It ignores the reinvestment potential of a project.

    Project Acceptance criteria.


     Higher the ARR Percentage – Accept the Project
     Lower the ARR percentage – Reject the Project
    EXAMPLE-
    NET PRESENT VALUE (NPV)

     It is the excess of present value of cash inflow over


    present value of cash outflow.
     It is difference between present value of future
    expected cash flows and cash outflow (initial
    investment).
     It is the best method for evaluation of investment proposal.
     This method consists Time value of money.

     P.V. Factor:-

     r – discounting rate
     n – number of year (for which PV is to be
    calculated)

     Formula

    NPV = Present Value of Cash Inflow – Cash Outflow


    Project Acceptance criteria

    A. For independent proposal

    1. If NPV is Positive – Accept


    2. If NPV is Negative – Reject
    3. If NPV is Zero - Accept

    A. For Mutually Exclusive proposal

    1. Project with higher positive value – Accept


    2. Project with lower positive value – Reject
    3. Project with higher negative value – Reject
    4. Project with lower negative value – Accept
    MERITS-

    1. Recognizes time value of money


    2. Recognizes quality of benefits
    3. No ambiguity
    4. Recognizes entire life
    5. Compatible with maximization of wealth principle

    DEMERITS-

    6. Difficult to calculate
    2. Cost of capital may not be right discount rate
    3. It may give good results while comparing projects with
    unequal lives
    EXAMPLE-
    Internal Rate of Return (IRR)
    • IRR is that discount rate which bring down the value of net cash
    inflow during the life of the project so that it is equal to the value of
    initial investment.

    • IRR is the rate of return that a project earns.

    • The rate of discount calculated by trial and error , where the present value of
    future cash flows is equal to the present value of outflows, is known as the
    Internal Rate of Return.

    Formula-
    Positive NPV
    IRR = Higher Rate - ------------------------------------- * Difference in Discounting Rate
    Difference in cash Flows
    Project Acceptance criteria
    1. IRR > k (Require Rate of Return) – Accept the project
    2. IRR = k (Require Rate of Return) – Accept the project
    3. IRR < k (Require Rate of Return) – Reject the project

    Relation between NPV & IRR

    • NPV > 0, then IRR > k


    • NPV = 0, then IRR = k
    • NPV<0, then IRR<k

    MERITS-
    • Finds the Time Value of Money
    • Simple to Use and Understand
    • Hurdle Rate (Cost of capital / discounting factor) Not Required

    DEMERITS-
    • Ignores Size of Project
    • Ignores Future Costs
    • Ignores Reinvestment Rates
    Example
    The expected cash flows of a project are:-

    Year Cash Flows ( Rs.)


    1 20,000
    2 30,000
    3 40,000
    4 50,000
    5 30,000

    • The cash outflow is Rs. 1,00,000


    • Calculate the IRR
    Computation of IRR
    Cash Flows PV Factors PV of Cash PV Factors PV of Cash
    (Rs.) @19% Flows (Rs.) @18% Flows (Rs.)

    20,000 .84 16,800 .847 16,940


    30,000 .706 21,180 .718 21,540
    40,000 .593 23,720 .609 24,360
    50,000 .499 24,950 .516 25,800
    30,000 .42 12,600 .437 13,110
    Total Cash Inflow 99,250 1,01,750
    Less Cash Outflows 1,00,000 1,00,000

    NPV (-)750 (+)1750


    Computation of IRR Contd..
    Profitability Index (PI)
     It is also a time adjusted method of evaluating investment proposal .
     Profitability index also called as Benefit- Cost ratio or desirability factor is
    relationship between present value of cash inflow and the present value of
    cash outflow.
     PI is the ratio of the present value of cash flows (PVCF) to the initial
    investment of the project.

     FORMULA-

    Present Value of Cash


    Inflow

    Profitability Index =
    Present Value of Cash Outflow
    / Investment
    Project Acceptance criteria

    • Higher the PI – Accept the Project


    • Lowe the PI – Reject the Project

    MERITS-

     It is consistent with goal of maximizing the shareholders


    wealth.
     It uses cash flow.
     It recognized the time value of money.
    DEMERITS-

    • The main demerit of this method is that is requires detailed long


    term forecast of incremental benefits and costs.
    • Its also have the difficulty in determining appropriate discount rate.
    EXAMPLE-
    REFERENCES-
    • FINANCIAL MANAGEMENT
    BY PROF. DR. SATISH INAMDAR

    • FINANCIAL MANAGEMENT
    BY C. PARAMASIVAN

    • FINANCIAL MANAGEMENT BY KHAN & JAIN


    THANK YOU….

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