Capital Budgeting

Capital Budgeting refers to planning the deployment of available capital for the purpose of maximizing the long term profitability of the firm. It is the firms decision to invest its current funds most efficiently in the long term activities in anticipation of flow of future benefits over a series of years.

Capital Budgeting
• Capital Budgeting involves : • Search of new and more profitable investment proposals • The making of an economic analysis to determine the profit potential of each investment proposals.

Examples of Capital budgeting
• (a) Introduction of a new product • (b) Expansion of business by investing in plant and machinery • (c) Mechanization of process • (d) Choice between alternative machines • (e) Replacing and modernizing a process

Capital budgeting process
• • • • Project Generation Project Evaluation Project selection Project execution

Project Generation
• Project Generation: • (a) proposal to add new product to the product line. • proposal to expand capacity In existing product lines. • (b) Proposal to reduce the cost of output of existing products without altering the scale of operation.

Project Evaluation
• Project Evaluation • Involves 2 steps: • (i) Estimation of benefit and cost in terms of cash flows • (ii) Selection of appropriate criterion to judge the desirability of the project

Project selection & execution
• • • • • Project selection: Project is screened at multiple levels And selected by the top management Project execution: To be done as per the capital budget

Capital Budgeting Appraisal Methods
• 1) Traditional Methods: • a. Payback period Method • b. Accounting Rate of Return Method • 2) Discounted Cash Flow Method • a. Net present Value Method • b. Internal Rate of Return • c. Profitability index or benefit cost ratio

Payback period Method
• Payback period Method
• The term pay back ( or payout or pay-off) is defined as the length of time, required for the stream of cash proceeds produced by an investment equal to the original cash outlay required by the investment.This method is also known as the payout method. • Payback period= Initial Investment(cash outlay) Annual Cash inflow

Accounting Rate of Return Method
• Accounting Rate of Return Method • ARR= Average income • Average investment

Net present Value Method
• Net present Value Method • NPV method is one of the Discounted Cash Flow(DCF) techniques explicitly recognizing the time value of money • One of the best methods for Capital investment projects

Internal Rate of Return
• Internal Rate of Return • It is that rate at which the sum of discounted cash inflow (DCF) equals the sum of Discounted cash out flow • It is the rate at which NPV = 0

Profitability index or benefit cost ratio
• Profitability index or benefit cost ratio • It is the ratio of present value of future cash benefits at the required rate of return at the initial cash outflow of investment. • PI= P V of cash inflows Initial cash outlay