Presented by: Vidhya G.

Nair Sumina Latheef

Capital Expenditure refers to investment in fixed assets and other development projects, launching a new product, improvisation, modernization, expansion, replacement of fixed assets etc. Most firms carefully analyse the potential projects in which they may invest. The process of evaluating opportunities is known as capital investment decision. Capital investment decision is also called Capital expenditure decision or Capital budgeting.

According to R.M. Lynch, Capital budgeting consists in employment of available capital for the purpose of maximising the long term profitability (return on investment) of the firm.

The main features of Capital Budgeting

It involves the exchange of current funds for future benefit. The future benefits are expected to be realised over a series of years in future. The funds are invested in long term assets. It is a long term irreversible decision. It involves huge initial funds. There is relatively a long gap of time between investment of funds and the expected returns. It involves relatives a high degree of risk regarding the future benefits.

Capital budgeting is a complex process. The following sixsteps are involved in capital budgeting.
1. Project generation 2. Project screening 3. Project evaluation 4. Project selection 5. Project execution and implementation. 6. Performance review.

Availability of fund. Utilisation of funds Urgency of the project. Expectation of future earnings Intangible factors Risk and uncertainty

Capital budgeting is concerned with heavy expenditure decisions. The benefits of returns from such expenditure is expected to be derived over many years in future. This makes the capital budgeting decisions more complex. These decisions affect the long term flexibility and profitability of the enterprise. Success or failure of an enterprise is dependent up on the quality of the capital budgeting alone in the enterprise. Therefore proper planning and at most care is needed while making capital budgeting decision.

1.

HUGE INVESTMENT: Capital budgeting decisions involves huge

investment in permanent assets. Hence it requires careful planning and appraisal. A mistake in capital budgeting can prove fatal to the enterprise.

2.

LONG TERM IMPLICATIONS: Capital budgeting decision have

long term effects on the future profitability and cost structure of the firm. A right decision may bring amazing returns, while a wrong decision may endanger the survival of the firm.

3.

IRREVERSIBLE DECISION: Capital investment decisions one

made cannot be reversed back easily. This is because it is difficult to dispose off fixed assets once they have been acquired.

4.

RISK: Long term commitment of funds involve greater risk and

uncertainty. The longer is the period of project ,the greater may be the risk and uncertainty.

5. 6.

GROWTH: the capital budgeting decisions affect the rate and

direction of growth of a firm.

IMPACT ON FIRMS COMPETITIVE STRENGTH: The capital

budgeting decision affect the capacity and strength of a firm to face competition. It is so because the capital investment decisions affect the future profits and cost of the firm.

7.

MOST DIFFICULT DECISION: Capital budgeting decisions are

very difficult to make. These decision involve forecasting of future conditions for estimating the future cash flows ( benefits) and cost of different projects.

8.

COST CONTROL: In capital budgeting there is a regular

comparison of budgeted and actual expenditures. Therefore cost control is facilitated through capital budgeting.

9.

WEALTH MAXIMISATION: The basic objective of financial

management is to maximize the wealth of the shareholders. Capital budgeting helps to achieve the this basic to objective.

1.

2.

3.

4. 5.

The result of decision taken is uncertain. This is so because it is difficult to say that present circumstances will exist in future also . Some factors affecting investment proposals are not measurable ( ie cannot be expressed in money value). It is difficult to estimate the period for which investment is to be made and income will generate. It is difficult to estimate the rate of return because future is uncertain . It is difficult to estimate the cost of capital.

1.

2.

TACTICAL INVESTMENT DECISION These involve relatively small capital outlays.they do not result in a major change in the firms products production method .sale of operations etc.decision to invest is relatively minor tools, purchase of water cooler ,typewriter calculating machines etc.are examples of tactical decisions. STRATEGIC INVESTMENT DECISIONS. These involve relatively large capital outlays. They have far reaching impact on the firms future growth and profitability. These relate to important areas such as new products, major product improvements, new research and developments etc.

3.CONVENTIONAL INVESTMENT DECISIONS

These involve one or more installments of capital outlays followed by one or a series of cash inflows. 4. NON-CONVENTIONAL INVESTMENT DECISIONS These involve cash outflow over a period of time followed by a series of cash inflows. 5. ECONOMICAL INDEPENDENT INVESTMENT DECISIONS. In these investment decisions management has no alternative investment opportunities .This means there is only one project in which management has to decide whether to invest in or not. 6. ECONOMICAL DEPENDENT INVESTMENT DECISIONS. These involve choice from among no a of alternative investment decisions .These may be complementary. Joint or mutually exclusive . mutually exclusive decisions compete with each other .if one is undertaken the others will have to be rejected.

A .TRADTIONAL METHODS

Urgency method Pay back method I. When annual cash inflows are equal II. When annual cash inflows are unequal Post Pay Back Profitability method Average Rate of Return Method.

B.DISCOUNTING CRITERIA OR MODERN METHODS.

Discounted pay back method Net present value method. benefit cost ratio. internal rate of return. net terminal value method.

C.Other methods.

The mapi formula Nomograph method

TRADTIONAL METHODS

Traditional methods do not take into consideration the time value of money

Important traditional methods may be discussed as follows: 1. Urgency Method Urgency is a criterion used to justify the acceptance of capital projects on the basis of emergency requirements or under crisis conditions. Under this method, the most urgent project is taken up first.

MERITS

Its a very simple technique

It is useful in case of short term projects requiring lesser investment.

DEMERITS

It is not based on scientific analysis. Selection is not made on the basis of economical consideration but just on the basis of situation. A project, even though it is profitable, will not be accepted for the very simple reason that it can be postponed.

Used technique of evaluating capital expenditure proposals. Pay back period is the length of time required to recover the initial cost of the project. In short , it is the period required to recover the cost of investment. Pay back method is also called pay-out or pay-off period or recoupment period or replacement period.
The payback period can be calculated in two different situation as follows: I. When annual cash inflows are equal II. When annual cash inflows are unequal

When annual cash inflows or benefit generated by a project per year are equal or constant(ie even cash inflows). The payback period is computed by dividing the initial investment or cash outlay by the net annual cash inflows. It is expressed as payback period = original cost of project(cash outlay) annual net cash inflow(net earnings) For eg; if a project involves a cash outlay of RS 5,00,000 and generates cash inflow of RS 1,00,000 annually for 7 years. payback = 5,00,000 = 5 years is required to recover 1,00,000 original investment.

 When

cash inflows in different years are unequal (uneven),the computation of pay back period is not so easy as in the case of even cash inflows In such case, payback period is calculated in the form of cumulative cash inflows. It is ascertained by cumulating cash inflow till the time when the cumulative cash inflow become equal to initial investment.

For example, if the cost of project is Rs.1,00,000 and the cash inflow are; 1st year Rs 10,000 and 2nd year Rs. 15,000,3rd year Rs.25,000 4th year Rs. 30,000 and 5th year Rs .30,000.pay back period to recover original investment of Rs, 100000 comes to 4 years and 8 months (RS 80000 is recovered in 4 years and to recover the balance RS 20000, 8 months required. 4+ 20,000 = 4 + 2 years or 4 years and 8 months. 30,000 3 pay back period can also be calculated by the following formula .

Pay back period = E + B C E = no years immediately proceeding the year of final recovery. B = Balance amount still to be recovered. C = Cash flow during the year of final recovery.

As pointed out earlier, under payback method the profitability( ie cash inflows)after payback period is ignored. the post pay back method has been evolved to overcome this limitation. under post pay back method the entire cash inflows generated from a project during its working life are taken into account. The post pay back profitability calculated as under

pay back profitability = total cash inflows in life-initial cost.

 For

example, if the cost of project is Rs.100000 and the cash inflow are; 1st year Rs 10000 and year Rs. 15000,3rd year Rs.2,5000 4th year Rs. 30,000 and 5th year Rs .30,000. Post pay back profitability = total cash inflows in life initial cost. 1,10,000 -100000 = 10000. post pay back profitability = 10000

 Nomograph

method facilitates the rate of return calculations nomograph method draws a certain kind of graph which helps to understand the value of other independent the variable when the value of other independent variables are given. this method is useful for quick calculation. This is a time saving method. it is a simple method as well.hence,only minimum effort is required for the preparation of this graph.

This technique has been offered by George terborgh in his book business investment policy". he is the chief economist of the machinery allied product institute (mapi) of Washington D.C .
A Firm has to consider the following 5 factors to make use of MAPI techniques; Operating advantage from the new equipment Magnitude of the capital consumption avoided. Subtraction of consuming capital. Cost of consuming capital. Net investment in the project. According to MAPI method ,the rate of return from the next year is calculated, while evaluating project profitability.

a)
b) c) d) e)

Payback method & average rate of return method do not consider the time value of money .the initial amount incurred for acquisition of assets to implement a project and income received from the project in future is given equal importance under the other methods. But in fact the value of money received in future is not equivalent to the value of money invested today .in other words a rupee in hand now is nor valuable than a rupee to be received in future because cash in hand can be invested elsewhere and interest can be earned on it .for eg; if rupees 100 is invested at the annual interest of 10 %,it will increased as under; RS 100 today is equal to RS 110 after 1 year(100+10 of interest) RS 121 after 2 years (110+11 of interest). RE 1 After 1 year equal to RS 100= 0.909 110

Net present value method indicate the net present value of cash flows of a project at a predetermined interest rate, but it doesnt indicate the rate of return of the project . In order to find out the rate of return of the project, estimated cash inflows of each year are discounted at various rates till a rate is obtained at which the present value of cash inflow is equal to the initial investment or the net present value comes to zero. Such a rate is called internal rate of return or marginal rate of return .

 The

concept of rate of return is quite simple to understand in the case of a 1 period project. assume that you deposit RS 10000 with a bank and would get back RS 10800 after 1 year. The true rate of return on your investment would be Rate of return =10800-10000 = .08 = 8% 10000

 This

method is also known as accounting rate of return method or return on investment method or unadjusted rate of return method. under this method average annual profit(after tax)is expressed as percentage of investment.ARR is found out by dividing average income by the average investment.ARR is calculated with the help of the following formula ; ARR = Average income or return 100 average investment

Average investment =
original investment +scrap value 2 OR

= original investment scrap value

2 For eg; X Y

capital cost
earnings after depreciation 1 st year 2 nd year 3 rd year 4 th year

40000
5000 7000 6000 6000

60000
8000 10000 7000 5000

= 24000 = RS 6000. 4 The average investment = cost at the begining+cost at the end of the life. 2 40000+0 = RS 20000. 2 ARR =6000 100 = 30 % 20000 Average earnings of project y = 30000 4 = RS 7500.

The average earnings of project X

Average investment = 60000+0 2

ARR = 7500 100 = 25 % 30000

= 30000.

Definition

NPV. The present value of an investment's future net cash flows minus the initial investment. If positive, the investment should be made (unless an even better investment exists), otherwise it should not.

The total discounted value of all of the cash inflows and outflows from a project or investment. This method is used only when the rate of return on investment is predetermined by management under the net persent value method, the present value of all cash inflows (stream of benefits) is compared against the present value of all cash outflows(cash outlays or cost of investment). The difference between the present value of cash inflows and cash outflows is called the net present value.the discount rate for obtaining the present value is some desired rate of return which may be equal to the cost of capital

COMPUTATION OF CASH INFLOW & OUTFLOWS. Present value =

C1

C2

+
( 1+r)2

C3

+
( 1+r)2

Cn

( 1+r) (1+r)2

Project A Year Investment & cash flow 100000 30000 40000 40000 30000 30000 Discount factor at 15% .. 0.870 0.756 0.658 0.572 0.497 Present value 100000 26100 30240 26320 17160 14910 Investment and cash 100000 20000 30000 50000 40000 30000

Project B Discount factor at15% .. 0.870 0.756 0.658 0.572 0.497 Present value 100000 1740 22680 32900 22880 14910

0 1 2 3 4 5

170000

..

114730

170000

110770

PROJECT A Present value of cash outflow=100000 Present value of cash inflow =114730 Net present value=114730-100000=14730 PROJECT B Present value of cash outflow =100000 Present value of cash inflow =110770 Net present value =110770-100000=10770

Npv
The minimum desired rate of return(cost of capital)is assumed to be known. It implies that the cash inflows are invested at the rate of firms cost of capital.

IRR
The minimum desired rate of return is to be determined It implies that cash inflows are reinvested at the IRR of the project.

It gives absolute return.

The NPV of different project can be added.

It gives percentage return.

The IRR of the different project can not be added.

REFERENCE: 1. WWW.WIKIPEDIA.ORG 2. FINANCIAL MANAGEMENT AUTHOR: VINOD (BBA CALICUT UTY)