PRESENTATION OF FINANCIAL MANAGEMENT

INTRODUCTION

Capital budgeting is concerned with the allocation of firm's scarce financial resources among the available market opportunities

Likely to produce benefits over a period of time longer than one year.

The basic features of capital budgeting are:• potentially large anticipated benefits• a relatively high degree of risk• a relatively long time period between initial outlay and

anticipated returns.

DEFINITION

Lynch - "Cash budgeting consists in planning, development of available capital for the purpose of maximizing the long term profitability in the concern.”

IMPORTANCE

Affects the profitability of firm It has its effects over a long time span and

inevitably affects the company’s future cost structure

Capital investment decision once made are not easily reversible without much financial loss to the firm

Capital investment involves cost and the majority of the firms have scarce capital resource.

Over / Under capacity - To improve timing and quality of asset acquisition, the capital expenditure decision must be carefully drawn.

CAPITAL BUDGETING PROCESS

Identification of investment proposals Screening the proposals Evaluation of various proposals Fixing priorities Final approval and preparation of capital exp

budget Implementing proposals Performance review

PROBLEMS IN CAPITAL BUDGETING

Future uncertainty Time element Measurement problem

CAPITAL BUDGETING DECISIONS

Replacement / modification of fixed assets Expansion Modernization of investment expenditure Strategic investment proposal Diversification of business Research and development

CAPITAL BUDGETING TECHNIQUES

Payback period method

Average rate of return

Net present value Internal rate of

return Profitability index

Non-time Adjusted Time Adjusted

PAYBACK PERIOD METHOD

o Quantitative methodo This method answers the question - how

many years will it take for cash benefits to pay the original cost of an investment normally disregarding salvage value.

o There are two ways of calculating the payback period.

o The riskier the project is, the shorter the required payback will be.

PAYBACK PERIOD METHOD

1st method constant annual

cash flow PB=investment/

constant annual cash flow

2nd method Variable cash flows situation payback is

calculated by the process of accumulating cash flows till the time when cumulative cash flows are equal to original investment outlay

PBP STRENGTHS AND WEAKNESS

Easy to use and understand Can be used as a measure of liquidity Lay more emphasis on short-term run earning performance

rather than its long-term growth No profits arise till the payback period is over. This helps

companies in deciding when they should start paying dividends

Strengths

ACCEPT AND REJECT CRITERIA

Projects with a payback less than a specified cutoff period are accepted whereas those with a payback beyond this figure are rejected.

:FOR EXAMPLE: ORIGINAL COST OF BOTH THE MACHINES IS RS. 56,125. CASH FLOW OF THE FIFTH YEAR INCLUDES RS 3,000 SALVAGE VALUE. CASH INFLOWS ARE AS UNDER. CALCULATE PAYBACK PERIOD

YEAR MACHINE A (cash flow)

Cumulative cash flows

MACHINE B (cash flow)

Cumulative cash flows

1 14000 14000 22000 22000

2 16000 30000 20000 42000

3 18000 48000 18000 60000

4 20000 68000 16000 76000

5 25000 93000 17000 93000

.

CASH FLOW ADJUSTED TECHNIQUE OF FIFTH YEAR INCLUDES RS. 3,000 SALVAGE VALUE. THE INVESTED INVESTMENT OF RS. 56,125 ON MACHINE A WILL BE RECEIVED BETWEEN 3 TO 4 YEARS. PAYBACK PERIOD MAKES THREE YEARS PLUS A FRACTION OF A YEAR.

• Machine A56,125 - 48,000 = 8,125

• (Balance of 8,125 >> received of fourth year)8,125 / 20,000 = 0.406 years + 3 preceding years = 3.406 years

• Machine B2 years + (14,125 / 18,000) = 2.785 years

• It shows that machine B should be preffered.

LIMITATIONS OF PAYBACK PERIOD

• It ignores all cash inflows after the payback period.

• It does not take into consideration the entire life of the project during which cash flows are generated.

•  It does not reflect all the relevant dimensions of profitability

• It does not consider time value of money

AVERAGE RATE OF RETURN

• Also known as average rate of return or average return on book value

• It is the ratio of average after tax profit to average book investment (the initial investment less accumulated depreciation)

2/)(

/)(1

ValueEndingBooklayInitialOut

nofitAfterTaxprARR

n

t

STRENGTHS AND WEAKNESSES OF ACCOUNTING RATE OF RETURN

Strengths• It is simple to apply• It gives due weightage for the profitability of

project.• Based on financial data• Considers entire cashflows

WEAKNESS

• It ignores the time value of money• It is based on accounting income rather than

cash flow. Cash flow and reported income often differ

• It does not take into consideration any benefits which can accrue to the firm from the sale or abandonment of equipment which is replaced by the new investment.

• This method cannot be applied to a situation where investment in a project is to be made in parts

ACCEPT AND REJECT CRITERIA

Investments yielding a return greater than this standard are accepted, whereas those falling below it would be rejected.

DISCOUNTED CASH FLOW METHODS

1: Net Present Value Method

it takes into account time value of money. NPV is found by subtracting present value of cash outflows from cash inflows

MERITS/ DEMERITSMerits: Recognizes the time value of money A sound method of appraisal Shareholder’s wealth maximizationDemerits: Difficult to calculate It involves calculations of the required rate of

return to discount the cash flows It is an absolute measure

2: PROFITABILITY INDEX

Profilabity index= Present value of cash inflows/ present value of cash outflows

Decisions1. If PI > 1, accept the proposal2. If PI< 1, reject the proposal3. If PI =1, indifference

MERITS/ DEMERITS

• Merits1. shareholder’s wealth

maximization2. Uses cash fow3. Recognise time value of money• Demerits1. Requires detailed long term

forecast of incremental benefits and costs

Presented by-:AnujArshdeepAshokAvai