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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.