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Capital Budgeting Decisions may be defined as the firms decision to invest its current funds most efficiently in

the long- term assets in anticipation of an expected flow of benefits over a series of years.

1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc.

2. The expenditure relating to addition, expansion, improvement and alteration to the fixed assets.

3. The replacement of fixed assets.

4. Research and development project

According to the definition of Charles T. Hrongreen, capital budgeting is a long-term planning for making and

financing proposed capital out lays.

According to the definition of Lyrich, capital budgeting consists in planning development of available capital

for the purpose of maximizing the long-term profitability of the concern.

1. Huge investments: Capital budgeting requires huge investments of funds, butthe available funds are

limited, therefore the firm before investing projects, plan are control its capital expenditure.

2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore financial risks

involved in the investment decision are more. If higher risks are involved, it needs careful planning of capital

budgeting.

3. Irreversible: The capital investment decisions are irreversible, are not changed back. Once the decision

is taken for purchasing a permanent asset, it is very difficult to dispose off those assets without involving

huge losses.

4. Long-term effect: Capital budgeting not only reduces the cost but also increases the revenue in longterm and will bring significant changes in the profit of the company by avoiding over or more investment or

under investment. Over investments leads to be unable to utilize assets or over utilization of fixed assets.

Therefore before making the investment, it is required carefully planning and analysis of the project

thoroughly.

1.Identification

of various

investments

proposals

2. Screening

or matching

the proposals

3. Evaluation

4. Fixing

property

5. Final

approval

6.

Implementing

7.

Performance

review of

feedback

Non- Discounted

Cash Flows

Discounted

Cash Flows

Net Present Value

This is one of the Discounted Cash Flow technique which explicitly recognizes the time value of money. In this

method all cash inflows and outflows are converted into present value (i.e., value at the present time) applying an

appropriate rate of interest (usually cost of capital).

In other words, Net Present Value Method discount inflows and outflows to their present value at the appropriate

cost of capital and set the present value of cash inflow against the present value of outflow to calculate Net Present

Value. Thus, the Net Present Value is obtained by subtracting the present value of cash outflows from the present

value of cash inflows.

NPV < Zero Reject the Proposal

(1) It recognizes the time value of money and is thus scientific in its approach.

(2) All the cash flows spreadover the entire life of the project are used for calculations.

(3) It is consistent with the objectives of maximizing the welfare of the owners as it depicts the positive or

otherwise present value of the proposals.

Disadvantages

(1) This method is comparatively difficult to understand or use.

(2) When the projects in consideration involve different amounts of investment, the Net Present Value Method

may not give satisfactory results.

Solution :

Internal Rate of Return Method is also called as "Time Adjusted Rate of Return Method." It is defined as the rate which equates

the present value of each cash inflows with the present value of cash outflows of an investment. In other words, it is the rate at

which the net present value of the investment is zero.

Horngren and Foster define Internal Rate of Return as the rate of interest at which the present value of expected cash inflows

from a project equals the present value of expected cash outflows of the project.

The Internal Rate of Return can be found out by Trial and Error Method. First, compute the present value of the cash flow from an

investment, using an arbitrarily selected interest rate, for example 10%. Then compare the present value so obtained with the

investment cost.

If the present value is higher than the cost of capital, try a higher interest rate and go through the procedure again. On the other

hand if the calculated present value of the expected cash inflows is lower than the present value of cash outflows, a lower rate

should be tried. This process will be repeated until and unless the Net Present Value becomes zero. The interest rate that brings

about this equality is defined as the Internal Rate of Return.

Alternatively, the internal rate can be obtained by Interpolation Method when we come across 2 rates. One with

positive Net Present Value and other with negative Net Present Value. The IRR is considered as the highest rate of

interest which a business is able to pay on the funds borrowed to finance the project out of cash inflows generated by

the project.

The Interpolation formula can be used to measure the Internal Rate of Return as follows :

A firm has an investment opportunity involving Rs.50000. The cost of capital is 10%. From

the details given find out the IRR and see whether the project is acceptable.

Cash flow for the 1st year

- Rs.5000

2nd year - Rs.10000

3rd year - Rs.15000

4th year - Rs.25000

Discount factors

Year

1

2

3

4

5

10%

0.909

0.826

0.751

0.683

0.621

15%

0.870

0.756

0.658

0.572

0.497

20%

0.833

0.694

0.579

0.482

0.402

25%

0.800

0.640

0.512

0.410

0.328

discounted PV factor

discounted

at 15%

cash inflow

5000

0.870

4350

0.833

4165

10000

0.756

7560

0.694

6940

15000

0.658

9870

0.579

8685

25000

0.572

14300

0.582

12000

30000

0.497

14910

0.402

12060

50990

43900

Thus the actual rate of return is between 15% and 20%. The actual rate of

return can be found out by interpolation

IRR = L + P1 Q x D

P1 P2

P1 = P. V at lower rate

P2 = P.V at higher rate

Q = actual investment

D = difference in rate

IRR = 15 + 50990 50000 x 5

50990- 43900

= 15.7%

Average Rate of Return Method (ARR) or Accounting Rate of Return Method: Average Rate of Return

Method is also termed as Accounting Rate of Return Method. This method focuses on the average net income

generated in a project in relation to the project's average investment outlay. This method involves accounting

profits not cash flows and is similar to the performance measure of return on capital employed.

The average rate of return. can be determined by the following equation:

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