Budgeting

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Budgeting

© All Rights Reserved

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A capital expenditure may be defined as an expenditure

the benefits out of which are expected to be received over

a period of time.

The main characteristic of a capital expenditure is

incurred at one point of time whereas benefits of the

expenditure are realized at different points of time in

future.

Meaning

Examples of Capital Expenditures

Cost of acquisition of permanent assets as land and

building, plant and machinery, goodwill etc

Cost of addition, expansion, improvement or

alternation in the fixed asset

Cost of replacement of permanent assets

Research and development project cost etc

Large Investments:

Long-term commitment of funds

Irreversible nature

Need and Long-term effect on profitability

Importance Difficulties of Investment Decisions

National Importance

Project

Classification

Mandatory Investments

These are expenditures required to comply statutory

requirements

Examples of such investment are pollution control equipment,

medical dispensary, fire fighting equipment

These are often non-revenue producing investments

In analyzing such investments the focus is mainly on finding

the most cost-effective way of fulfilling a given statutory need

Replacement Projects

The objective of such investments is to reduce

costs, increase yield and improve quality

Expansion Projects

These investments are meant to increase

capacity/ or widen the distribution network

Project

Classification

Diversification Projects

These investments are aimed at producing new

products or services or entering into entirely new

geographical areas

Miscellaneous Projects

Identification of Investment Proposals

Capital Budgeting

Process Fixing Priorities

Expenditure budget

Implementing Proposals

Performance Review

Methods of Capital Budgeting or

Evaluation of Investment Proposal

Average

Pay-back Net Present Internal Rate Benefit

Accounting

Period Value of Return Cost Ratio

Period

The payback period is the length of time required

to recover the initial cash outlay on the project

the payback period is simply the initial outlay

divided by the annual cash inflow.

According to the payback criterion, the shorter

the payback period, the more desirable the

projects.

Pay-Back Period Advantages:

It is simple in concept, application and calculation

It favors projects which generate substantial cash

inflows in earlier years and discriminates against

projects which bring substantial cash flows in later

years

Sine it emphasizes earlier cash inflows

• Pay-Back

Period

Advantages:

It is simple in concept, application and calculation

It favors projects which generate substantial cash

inflows in earlier years and discriminates against projects

which bring substantial cash flows in later years

Sine it emphasizes earlier cash inflows

Dis-advantages:

It fails to consider the time value of money

It ignores cash flows beyond the payback period

• Evaluation of

Pay-Back

Simplicity payback

Administrative

Liquidity difficulties

Cost-effective

ignored

The accounting rate of return is also called the average

rate of return

statements, to measure the profitability of an

investment

after tax profits divided by the average investment

Accounting Rate of

Return The average investment would be equal to half of the

original investment if it were depreciated constantly.

Alternatively, it can be found out by dividing the total of

the investment's book values after depreciation by the

life of the project

and can be found by: ARR= (Average Income/Average

Investment)

If you invest Rs. 5,000 today at a compound interest of 9

percent, what will be its futures value after 75 years?

Hints: (1.09)30 =13.268 and (1.09)15 =3.642

from now, if the discount rate is 10 percent?

Hints: (1.10)30 = 17.449

How long would it take to double the

amount at a given interest rate

with the use of the future value interest

factor model?

period

According to the rule of thumb, the

doubling period is obtained by dividing 72

by the interest rate

doubling period is about 9 years

Rule of 69

According to this rule of thumb, thee doubling

period is equal to = 0.35 + (69/Interest Rate)

doubling as per the rule of 72 and the rule of 69

respectively?

What is Salvage Value?

Salvage value is the estimated resale value of an asset at

the end of its useful life.

Salvage value is subtracted from the cost of a fixed asset

to determine the amount of the asset cost that will

be depreciated.

Thus, salvage value is used as a component of the

depreciation calculation.

and estimates that its salvage value will be $10,000 in five

years, when it plans to dispose of the asset. This means that

ABC will depreciate $90,000 of the asset cost over five

years, leaving $10,000 of the cost remaining at the end of

that time. ABC expects to then sell the asset for $10,000,

which will eliminate the asset from ABC's accounting

records.

Net Present Value

cash flows occurring over multiple periods

The NPV of a project is the sum of the present Value of all cash flows-

Positive as well as Negative- that are expected to occur over the life of

the project

Properties of Net

Present Value

is simply the sum of Net present Values of Individual Projects

included in the package

Intermediate Cash Flows are invested a the cost of Capital: The NPV

Rule assumes that the intermediate cash flows of a project – that is,

cash flows that occur between the initiation and the termination of

the project- are reinvested at a rate of return equal to the cost of

Capital

Limitations of Net Present

Value

and hence does not factor the scale of investment.

The NPV rule does not consider the life of the project. Hence, when

mutually exclusive projects with different lives are being considered,

the NPV is biased in favor of longer term project.

Internal Rate of Return (IRR)

The IRR of a project is the discount rate which makes its NPV equal

to Zero.

It is the discount rate which equates the present value of future cash

flows with the initial investment.

The IRR can be defined as that rate of discount at which the present

value of cash inflows is equal to the present value of cash outflows.

Example

Year 0 1 2 3 4

Cash Flows -100,000 30,000 30,000 40,000 45,000

Benefit-Cost Ratio

BCR = PVB/I = Present Value of Benefits/ Initial Investment

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