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Capital and Capital BudgetingCapital and Capital Budgeting
Capital:
is the stock of assets that will generate a flow of income in the future.
Capital budgeting:
is the planning process for allocating all expenditures that will have an expected benefit to the firm for more than one year.
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Investment AppraisalInvestment Appraisal
Firms normally place projects in the following categories:
1. Replacement and maintenance of old or damaged equipment.
2. Investments to upgrade or replace existing equipment
3. Marketing investments to expand product lines or distribution facilities.
4. Investments for complying with government or insurance-company safety or environmental requirements.
Need of capital budgeting
A. Whether or not funds should be invested in long term projects
B. Analyze the proposal for expansion
C. To decide for the replacement of permanent assets
D. To make financial analysis of various proposals.
IMPORTANCE OF CAPITAL BUDGETING
1. LARGE INVESTMENT
2. LONG TERM COMMITMENT OF FUNDS
3. IRREVERSIBLE NATURE
4. LONG TERM EFFECT ON PROFITABILITY
5. DIFFICULTIES OF INVESTMENT DECISION
6. NATIONAL IMPORTANCE
CAPITAL BUDGETING PROCESS
CAPITAL BUDGETING PROCESS
1. INVESTMENT PROPOSAL
2. SCREEN PROPOSAL
3. EVALUATE VARIOUS
PROPOSALS
4. FIX PRIORITIES
5. FINAL APPROVAL
6. IMPLEMENT
THE PROPOSAL
7. REVIEW PERFORMANCE
METHODS OF CAPITAL BUDGETING
TRADITIONAL METHODS TIME ADJUSTED OR DISCOUNTED METHODS
PAY-BACK PERIOD METHOD
IMPROVEMENT OF TRADITIONAL APPROACHTO PAY BACK PERIOD METHOD
RATE OF RETURN METHOD
NET PRESENT VALUE METHOD
INTERNAL RATE OF RETURN METHOD
PROFITABILITY INDEX METHOD
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TRADITIONAL METHOD
Simple Technique for Appraisal of Investment
TRADITIONAL METHOD
Simple Technique for Appraisal of Investment
1. Payback-period criterion:
Payback period is the amount of time sufficient to cover the initial cost of an investment
But it ignores any returns accrue after the pay-back period; ignores the pattern of returns; ignores the time value (time cost) of money.
1. Payback-period criterion:
Payback period is the amount of time sufficient to cover the initial cost of an investment
But it ignores any returns accrue after the pay-back period; ignores the pattern of returns; ignores the time value (time cost) of money.
PAY BACK PERIODIn case of evaluation of a single project, it is adopted if it pays back for itself within a period specified by the management & if the project does not pay back itself within the period specified by the management then it is rejected. Formula to calculate pay back period is-
ADVANTAGES OF PAY BACK PERIOD
DISADVANTAGES OF PAY BACK PERIOD
SIMPLE TO UNDERSTAND SVING IN COST LESSER TIME LESSER LABOUR ACCEPTANCE
&REJECTION DECISION EASY
SHORT TREM APPROACH
NO CONSIDERRATION OF CASH INFLOWS EARNED AFTER PAY BACK PERIOD
NO CONSIDERATION OF COST OF CAPITAL
DIFFICULT TO DETERMINE MINIMUM ACCEPTABLE PAY BACK PERIOD
TREATS EACH ASSET INDIVIDUALLY IN ISOLATION
DOES NOT MEASURE THE TRUE PROFITABILITY
IMPROVEMENT IN TRADITIONAL APPROACH TO PAY BACK PERIOD METHOD
PROFITABILITY METHOD PAY BACK RECIPROCAL METHOD
1. Post pay back profitability method- this method takes in to consideration the returns receivables beyond the pay back period. These returns are called post pay back profits. formula is
PAY BACK RECIPROCAL METHOD
Pay back reciprocal method is employed to estimate the internal rate of return generated by a project. Formula is
3.RATE OF RETURN METHODThis method takes in to consideration the earnings expected from the investment
over their whole life. It is known as accounting rate of return method for the reason that under this method ,the accounting concept of profit is used rather than cash in
flows.
(A) AVERAGE RATE OF RETURN METHOD
(B) RETURN PER UNIT OF INVESTMENT METHOD
This method establishes the relationship between average annual profits to total investments. Formula is
Under this method small variation of the average rate of return method. formula is
RATE OF RETURN METHOD
© RETURN ON AVERAGE INVESTMENT METHOD
(D) AVERAGE RETURN ON AVERAGE INVESTMENT METHOD
Using of average investment for the purpose of return on investment is preferred because the original investment is recovered over the life of the asset on account of depreciation charges. Formula is
This is the most appropriate method of rate of return on investment. Formula is
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2. DISCOUNTING METHOD2. DISCOUNTING METHOD
On the other hand, the process of discounting or capitalization is to turn a future stream of services or income into its equivalent present value. When an expected future sum is turned into its equivalent present value, we say that it is discounted or capitalized.
On the other hand, the process of discounting or capitalization is to turn a future stream of services or income into its equivalent present value. When an expected future sum is turned into its equivalent present value, we say that it is discounted or capitalized.
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The present value of a single future amount
In general, present value (PV) refers to the value now of payments to be received in the future (I). The present value of I after n year at r is:
PV= I
(1+r)n
1.NET PRESENT VALUE TECHNIQUE:
Net present value (NPV) is the difference between the present value of a future cash flow and the initial cost of the investment project; a firm should adopt a project if the expected NPV is positive.
NET PRESENT VALUE
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NPV = P + I0 +
I1
(1+r)
I2
(1+r)2
+ … ++In
(1+r)n
where:
P: =capital cost, accruing in full at the beginning of the project
I1,2,…n =net cash flows arising from the project in years 1 to n
r =the opportunity cost of capital
NET PRESENT VALUE METHOD
ADVANTAGES DISADVANTAGES
RECOGNISES THE TIME VALUE OF MONEY
TAKES IN TO ACCOUNT THE EARNINGS OVER THE ENTIRE LIFE OF THE PROJECT
CONSIDERATUION OF MAXIMUM PROFITABILITY
THIS METHOD IS DIFFICULT TO UNDERSTAND &OPERATE
DOES NOT PROVIDE GOOD SOLUTION IN CASE PROJECTS WITH UNEQUAL LIVES
DOES NOT PROVIDE GOOD SOLUTION IN CASE PROJECTS WITH UNEQUAL INVESTMENT OF FUNDS
NOT EASY TO DETERMINE AN APPROPRIATE DISCOUNT RATE.
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2. INTERNAL-RATE-OF-RETURN METHOD:Internal rate of return (IRR) is the rate of return that will equate the present value of a multi-year cash flow with the cost of investing in a project.
Using the NPV equation: the IRR is the discount rate that renders the NPV of the project equal to zero.
P, n and the expected future cash returns (I) are known, we try to find IRR.
If the IRR is greater than the market rate of interest r, it implies that the present value of the capital good (PV) is greater than its purchase price (P) and the firm should invest. Conversely, if IRR is smaller than r, it implies that PV is smaller than P and the firm should not invest.
2. INTERNAL-RATE-OF-RETURN METHOD:Internal rate of return (IRR) is the rate of return that will equate the present value of a multi-year cash flow with the cost of investing in a project.
Using the NPV equation: the IRR is the discount rate that renders the NPV of the project equal to zero.
P, n and the expected future cash returns (I) are known, we try to find IRR.
If the IRR is greater than the market rate of interest r, it implies that the present value of the capital good (PV) is greater than its purchase price (P) and the firm should invest. Conversely, if IRR is smaller than r, it implies that PV is smaller than P and the firm should not invest.
INTERNAL RATE OF RETURN METHOD
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IRR =
A1
(1+r)
A2
(1+r)2
+ … ++An
(1+r)n
where:
I1,2,…n =net cash flows arising from the project in years 1 to n
r =RATE OF DISCOUNT OF INTERNAL RATE OF RETURN
The differences between NPV technique and IRR method?
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In most situations, the IRR method will yield the same results as the NPV method. But:
•there may be more than one value for the IRR that satisfies the NPV equation; if the sign of cash flows changes more than once in the life of the project, there may be multiple solutions
•the NPV rule uses actual opportunity cost of capital as the discount rate; the IRR rule assumes the shareholders can invest at the IRR
•IRR is expressed in terms of a percentage rate of return, it ignores the project’s absolute effect on the wealth of shareholders
In most situations, the IRR method will yield the same results as the NPV method. But:
•there may be more than one value for the IRR that satisfies the NPV equation; if the sign of cash flows changes more than once in the life of the project, there may be multiple solutions
•the NPV rule uses actual opportunity cost of capital as the discount rate; the IRR rule assumes the shareholders can invest at the IRR
•IRR is expressed in terms of a percentage rate of return, it ignores the project’s absolute effect on the wealth of shareholders
DETERMINATION OF INTERNAL RATE OF RETURN
1. WHEN THE ANNUAL NET CASH FLOWS ARE EQUAL OVER THE LIFE OF THE ASSET
. 2. WHEN THE ANNUAL NET CASH FLOWS ARE UNEQUAL OVER THE LIFE OF THE ASSET
THE FORMULA IS STEPS- 1. PREPARE CASH FLOW BY ASSUMING DISCOUNT RATE
2. FIND NPV 3. IF NPV IS POSITIVE APPLY HIGHER RATE 4. IF STILL HIGH APPLY ANOTHER HIGHER
RATE UNTILL NPV BECOME NEGATIVE AFTER NEGATIVE NPV CALCULATE IRR AS
FOLLOWS
INTERNAL RATE OF RETURN
ADVANTAGES DISADVANTAGES
IT TAKES TIME VALUE OF MONEY
CONSIDER THE PROFITABILITY OF THE PROJECT FOR ITS ENTIREECONOMIC LIFE
DERTEMINATION OF COST OF CAPITAL
UNIFORM RANKINGS OF THE PROJECTS
COMPATIBLE WITH THE OBJECT OF MAXIMUM PROFITABILITY.
DIFFICULTY TO UNDERSTAND & OPERATE
BASED ON THE ASSUMPTION THAT EARNING CAN BE REINVESTED
The result of NPV &IRR MAY DIFFER
PROFITABILITY INDEX METHOD
It is also time adjusted method of evaluating the investment proposals. It shows the relationship between present value of cash inflows out flows. Thus
Advantages- slight modification of NPV method. it can significantly rank the various investments.
Disadvantages- difference in ranking of NPV& PI methods.
FACTORS INFLUENCING CAPITAL EXPENDITURE DECISION
1. URGENCY
2. DEGREE OF CERTAINITY
3. INTANGIBLE FACTORS
4. LEGAL FACTORS
5. AVAILABILITY OF FUNDS
6. FUTURE EARNINGS
7. OBSOLESCENCE
8.RESEARCH & DEVELOPMENT PROJECTS
9. COST CONSIDERATION
CAPITAL EXPENDITURE CONTROLCAPITAL EXPENDITURE INVOLVES NON-FLEXIBLE LONG TERM COMMITMENT OF FUNDS. THE SUCCESS OF THE FIRM DEPENDS UPON THAT HOW WE UTILISE OUR CAPITAL EXPENDITURE.
OBJECTIVES STEPS
TO MAKE ESTIMATE OF CAPITAL EXPENDITURE
TO CHECK TOTAL CASH OUTLAY TO ENSURE TIMELY CASH
INFLOWS TO ENSURE THAT ALL CAPITAL
EXPENDITURE PROPERLY SANCTIONED
TO CO-ORDINATE THE PROJECTS OF VARIOUS DEPARTMENT
FIX PRIORITIES AMONG VARIOUS PROJECTS
TO MEASURE THE PERFORMANCE OF THE PROJECT
TO PREVENT OVER- EXPANSION
1. PREPARATION OF CAPITAL
EXPENDITURE BUDGET
2. PROPER AUTHORISATION
OF CAPITAL EXPENDITURE
3. RECORDING &CONTROL OF EXPENDITURE
EVALUATION OF THE
FERFORMANCE OF THE PROJECT