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CAPITAL BUDGETING

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Meaning of Capital Expenditure
 It is the process of making investment decisions in capital expenditures.
 A capital exp.- May be defined as an expenditure the benefits of which are
expected to be received over a period of time exceeding one year.

It may be in the form of following:


 Cost of acquisition of permanent assets as land and building, plant &
machinery, goodwill etc.

 Cost of addition, expansion, improvement or alteration in the fixed assets.

 Cost of replacement of permanent assets.

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IMPORTANCE OF CAPITAL BUDGETING

IMPORTANCE

Difficulties of
Large
Investment
Investments
Decisions

Long term Long-term


Effect on commitment
Profitability of funds

Irreversible
nature

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CAPITAL BUDGETING PROCESS

IDENTIFY
REVIEW
INVESTMENT
PERFORMANCE
PROPOSAL

REVIEW SCREEN
PERFORMENCE PROPOSAL

PROCESS

EVALUATE
IMPLEMENT
VARIOUS
THE PROPOSAL
PROPOSALS

FINAL FIX
APPROVAL PRIORITIES

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KINDS OF CAPITAL BUDGETING OR EVALUATION OF INVT
PROPOSALS

ACCEPT REJECT DECISIONS

MUTUALLY EXCLUSIVE
CAPITAL RATIONING PROJECT
DECISION DECISIONS

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CAPITAL BUDGETING TECHNIQUES

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TRADITIONAL METHODS
PAY- BACK PERIOD METHOD:

The Pay-Back period method is that method in which the


total investment in permanent assets pays back itself.
the pay-back period can be ascertained in the following
manner:
1) Calculate annul of the net earning (profit) before
depreciation and after taxes these a called annual cash
inflows.
2) Divide the initial outlay (cost) of the project by the cash
inflow, where the project generates constant annual cash
inflows.

Pay Back Period = Cash outlay of the project or the original 7


cost /
ADVANTAGES
 Simple And Easy To Understand
 Saves in cost, requires lesser time
 Shorter pay back is preferred to the longer pay back period and it
reduces the lost.
 Suitable for the shorter firm

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DISADVANTAGES
 Does not take into account the after pay back period
inflows.
 Ignores the time value of money.
 Does not consider the cost of capital
 A subjectible decision
 Treats each asset individually.
 Does not measure the actual profitability.

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Pay- Back Reciprocal Method
 It is employed to estimate the Internal rate of return:
Pay back reciprocal = Annual Cash Inflow
Total Invt.
Applied only when:
- Equal cash inflows are there
- The project has a long life.

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Post pay Back Period Method

 Under this method the post pay back period is considered. Due to
the limitation of Pay back period method the project having the
greater post pay back period is to be considered

Discounted Pay back Method


Under this method the present value of cash inflows and outflows
is calculated at an appropriate discounted rate. the time period in
which the present value of inflows equates the present value of
outflows is the discounted pay back period.

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RATE OF RETURN METHOD
AVERAGE RATE OF RETURN

ARR = Average annual profits


Net Invt in the project

Average annual profits= Total profits (after dep and taxes)


No of years

RETURN PER UNIT OF INVT.

Return per unit of invt.= TOTAL PROFITS (after dep. and taxes) *
100
Net Invt in the project

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? To solve….
 A project requires an invt of Rs 5,00,000 and has a scrap value of
Rs 20000 after 5 yrs. It is expected to yield a profit after dep. And
taxes during 5 yrs amounting to Rs 40000, 60000, 50000 and
20000.
 Calculate the average rate of return.

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RETURN ON AVERAGE INVT METHOD:

Here we use the average invt for the purpose of return on invt is
preferred

RETURN ON AV INVT METHOD.= Total profits (after dep and taxes)


Average Invt.

Average Return On Average Invt Method:

ARAI = Average annual Profit (after dep and Taxes)


Average Investment ( Net Invt/ 2)

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Eg:
A machine costs 100000 Rs and has no scrap value after 5 years. It is
depreciated on straight line method:
Beginning of the first year: 100000
At the end of 2nd year: 80000
At the end of 3rd year: 60000
At the end of 4th year: 40000
At the end of 5th year: 20000
At the end of 6th year: -

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ACCEPT REJECT CRITERIA in ARR
 As an accept/ reject rule the ARR would be compared with the
predetermined or a minimum required rate of return or cut off rate
 A project will be qualify if actual ARR is higher than the minimum
desired ARR
 Otherwise rejected.
 Or ranking method can be followed.

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EVALUATION OF ARR METHOD
 Easy Calculation
 Simple to understand and easy to use
 Total benefits associated with the project are taken into account.

But a coin has always two sides, so here ARR has some deficiencies
also, as

 it uses accounting income rather then cash inflows.


 it ignores time value of money.
 it does not differentiate between size of investment.

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ANNUITY TABLE

Year 5% 6% 8% 10% 12% 14%


1 0.952 0.943 0.926 0.909 0.893 0.877

2 1.859 1.833 1.783 1.736 1.69 1.647

3 2.723 2.676 2.577 2.487 2.402 2.322

4 3.546 3.465 3.312 3.17 3.037 2.914

5 4.33 4.212 3.993 3.791 3.605 3.433

6 5.076 4.917 4.623 4.335 4.111 3.889

7 5.786 5.582 5.206 4.868 4.564 4.288

8 6.463 6.21 5.747 5.335 4.968 4.639

9 7.109 6.802 6.247 5.759 5.328 4.946

10 7.722 7.36 6.71 6.145 5.65 4.216

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