INTRODUCTION

CAPITAL BUDGETING

INTRODUCTION -CAPITAL BUDGETING

 Investment and financing of funds are two crucial functions of

   

finance manager. The investment of funds requires a number of decisions to be taken in a situation in which funds are invested and benefits are expected over a long period. The finance manager of concern has to decide about the asset composition of the firm. The assets of a firm are broadly classified into Fixed assets Current assets The aspect of taking the financial decision with regard to fixed assets is known as capital budgeting.

MEANING OF CAPITAL BUDGETING

 Capital budgeting Planning for capital assets.  Capital budgeting decision A decision as to whether

or not money should be invested in long term projects.  For example Setting up of a factory, installing a machinery , creating additional capacities etc.,  The capital budgeting decisions evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of time longer than one year.  The benefit increased revenue or reduction in cost.

IMPORTANCE - REASONS
 Substantial expenditure  Long time period Not only affects the future

benefits and costs but also influences the direction of growth.  Irreversibility  Complex decision It involves assessment of future events, which are difficult to predict.

TYPES OF CAPITAL BUDGETING DECISIONS

CAPITAL BUDGET ING DECISIONS

ON THE BASIS OF FIRMS EXIST ENCE

ON THE BASIS OF DECISION SITUATION

REPLACE MODERNI EXPAN DIVERSI MUTUALLY MENT SATION SION FICATION EXCLUSIVE DECISIONS DECIONS DECISIONS DECISIONS DECISIONS

ACCEPTREJECT DECISIONS

CONTIN GENT DECISIONS

CAPITAL BUDGETING PROCESS

Capital budgeting is a complex process which may be divided into the following phases: Identification of potential investment opportunities

Decision making

Preparation of capital budget and appropriations Implementation

Performance review

INVESTMENT CRITERIA
Investment criteria

Non-discounting criteria

Discounting Criteria

Payback Period

Accounting Rate of Return

Net Present Value

Internal Rate of Return

Benefit-Cost Ratio /PI

Net Present Value (NPV) Method

 NPV is defined as the sum of present values of all the cash inflows

less the sum of the present values of all the cash outflows associated with the proposal.  The general formula of NPV is: n NPV =

Ct - Initial Investment (1+r) n

t=1

 Where,

NPV = Net Present Value Ct = Cash flow at the end of year t n = life of the project r = discount rate

Acceptance rule -NPV

Acceptance rule
 If NPV>0 Accept  If NPV<0 Reject  If NPV=0 A project may be accepted.

(Matter of indifference)

MERITS -NPV
     

Based on the concept of Time value of money The whole stream of cash flows is considered Consistent with shareholders wealth maximization principle. NPV uses the discounted cash flows. The NPVs of different projects can be compared. Satisfies the value- additivity principle. True measure of profitability

Limitations NPV
  

Requires estimates of cash flows of which is a tedious task. Absolute measure Requires computation of the opportunity cost of capital which poses practical difficulties.

INTERNAL RATE OF RETURN



The discount rate which equates the present value of cash inflows and outflows is its Internal rate of return.
n t=1 Ct - Co =0 (1+r) n

 Formula
NPV =

 Acceptance rule

Accept if IRR>k  Reject if IRR< k  Project may be accepted if IRR =k



MERITS & DEMERITS- IRR


1. 2. 3. 4.

MERITS
Considers all cash flows True measure of profitability Based on the concept of Time value of money Generally, consistent with wealth maximization principle


1. 2.

DEMERITS
Requires estimates of cash flows which is a tedious task. Does not hold the value additivity principle i.e. IRRs of two or more projects cannot be added. At times fails to indicate correct choice between mutually exclusive projects. At times yields multiple rates Relatively difficult to compute.

3.

4. 5.

PROFITABILITY INDEX
 The ratio of the present value of the

    

cash flows to the initial outlay is Profitability Index (PI) or Benefit-Cost ratio. Formula PI = PV of Annual Cash flows/ Initial Investment Acceptance Rule Accept if PI > 1 Reject if PI < 1 Project may be accepted if PI =1

MERITS & DEMERITS- PI/BCR


1. 2. 3. 4.

MERITS
Considers all cash flows Recognises the time value of money Relative measure of profitability Generally, consistent with wealth maximization principle


1.

DEMERITS
Requires estimates of cash flows which is a tedious task. At times fails to indicate correct choice between mutually exclusive projects.

2.

NON-DISCOUNTED CASHFLOW CRITERIA

PAYBACK PERIOD
ACCOUNTING RATE OF RETURN

PAYBACK PERIOD
 The number of years required to recover the initial

outlay of the investment is called Payback.  FormulaPB = Initial Investment/ Annual cash flow  Acceptance Rule
 Accept if PB < Standard payback  Reject if PB > Standard payback

MERITS & DEMERITS- PB

 1.

2. 3. 4.

MERITS Easy to understand and compute and inexpensive to use Emphasizes liquidity Easy and crude way to cope with the risk. Uses cash flows information.

 1. 2.

3. 4.

5.

DEMERITS Ignores the time value of money Ignores cash flows occurring after the payback period. Not a measure of profitability. No objective way to determine standard payback. No relation with wealth maximization principle.

Discounted Payback
 One of the serious limitation of PB is that it

does not discount the cash flows for calculating payback period.  The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis.  The discounted payback period still fails to consider the cash flows occurring after the Payback period.

ACCOUNTING RATE OF RETURN

 The ACCOUNTING RATE OF RETURN(ARR), also known as

Return on Investment, uses accounting information to measure the profitability of an investment.  The ARR is the ratio of the average after tax profit divided by the average investment.
 ARR = Average Income/ Average Investment  Acceptance Rule Accept if ARR>minimum rate  Reject if ARR<minimum rate

MERITS & DEMERITS- ARR

MERITS 1. Uses accounting data with which executives are familiar. 2. Easy to understand and compute. 3. Gives more weightage to future receipts. DEMERITS 1. Ignores the time value of money. 2. Does not use cash flows 3. No objective way to determine minimum acceptable rate of return.