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INTRODUCTION

CAPITAL BUDGETING

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INTRODUCTION -CAPITAL

BUDGETING Investment and financing of funds are two crucial functions of

finance manager. The investment of funds requires a number ofdecisions to be taken in a situation in which funds are investedand benefits are expected over a long period. The financemanager of concern has to decide about the asset compositionof 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 fixedassets is known as capital budgeting.

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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 likelyto produce benefits over a period of time longer than

one year.

The benefit increased revenue or reduction in cost.

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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 offuture events, which are difficult to predict.

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TYPES OF CAPITAL BUDGETING DECISIONS

CAPITAL

BUDGET

ING

DECISIONS

ON THE

BASIS OF

FIRMS

EXIST

ENCE

ON THE

BASIS

OF

DECISION

SITUATION

REPLACE

MENT

DECISIONS

MODERNI

SATION

DECIONS

EXPAN

SION

DECISIONS

DIVERSI

FICATION

DECISIONS

MUTUALLY

EXCLUSIVE

DECISIONS

ACCEPT-

REJECT

DECISIONS

CONTIN

GENT

DECISIONS

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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

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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

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Net Present Value (NPV)Method

NPV is defined as the sum of present values of all the cash inflowsless the sum of the present values of all the cash outflows associatedwith the proposal.

The general formula of NPV is:

n CtNPV = - Initial Investment

t=1 (1+r) n

Where,

NPV = Net Present ValueCt = Cash flow at the end of year t

n = life of the project

r = discount rate

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Acceptance rule -NPV

Acceptance rule

If NPV>0 Accept

If NPV

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MERITS -NPV

Based on the concept of Time value of money

The whole stream of cash flows is considered

Consistent with shareholders wealth maximizationprinciple.

NPV uses the discounted cash flows. The NPVs of

different projects can be compared.

Satisfies the value- additivity principle. True measure of profitability

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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.

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INTERNAL RATE OF RETURN

The discount rate which equates the present value of cash

inflows and outflows is its Internal rate of return.

Formula n Ct

NPV = - Co =0

t=1 (1+r) n

Acceptance rule

Accept if IRR>k

Reject if IRR< k

Project may be accepted if IRR =k

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MERITS & DEMERITS- IRR

MERITS

1. Considers all cash flows

2. True measure of profitability

3. Based on the concept of Time

value of money4. Generally, consistent with

wealth maximization principle

DEMERITS

1. Requires estimates of cash

flows which is a tedious task.

2. Does not hold the value

additivity principle i.e. IRRs oftwo or more projects cannot

be added.

3. At times fails to indicate

correct choice between

mutually exclusive projects.

4. At times yields multiple rates5. Relatively difficult to compute.

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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

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NON-DISCOUNTED

CASHFLOW CRITERIA

PAYBACKPERIODPAYBACKPERIOD

ACCOUNTINGRATEOFRETURNACCOUNTINGRATEOFRETURN

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MERITS & DEMERITS- PB

MERITS

1. Easy to understand and

compute and inexpensive

to use

2. Emphasizes liquidity3. Easy and crude way to

cope with the risk.

4. Uses cash flows

information.

DEMERITS

1. Ignores the time value of

money

2. Ignores cash flows

occurring after the paybackperiod.

3. Not a measure of

profitability.

4. No objective way to

determine standardpayback.

5. No relation with wealth

maximization principle.

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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 numberof 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.

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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 ifARR>minimum rate

Reject ifARR

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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 cashflows

3. No objective way to

determine minimum

acceptable rate of

return.