By Anup K Suchak

Meaning
y Capital Budgeting is a process of long range planning

involving investment of funds in long term activities whose benefits are expected over series of years. For example, setting up of factories, installing a machinery, creating additional capacity to manufacture a part which at present is purchased from outside.

Significance of Capital Budgeting
y Long term growth and effects on risk and return

composition of the firm y Large amount of funds involved y Risk Involved y Irreversible Decisions y Affect the Capacity and Strength to Compete

Problems and Difficulties in Capital Budgeting y Future Uncertainty y Time Element y Measurement Problem .

Modernization Decision II. Accept Reject Decisions (for Independent Projects) 3. Cost Reduction Decision 1. Mutually Exclusive Decisions (for Complementary Projects) 2. Contingent Decisions (for Mutually Exclusive Projects) . Expansion Decision 4. Revenue Expansion Decision 3. Diversification Decision 5. Set up of New Business Decisions 1.Capital Budgeting Decisions On the basis of Firm s Existence On the basis of Decision Situation I. Replacement Decision 2.

Replacement Decisions y Meaning:. y Purpose:.Replacement of a Machinery on the expiry of its useful life.To improve operating efficiency and to reduce cost. y Example:.The existing firms take such decisions .Replacing a fixed asset due to expiry of economic life of the asset. y Who takes such decisions:.

y Purpose:.Replacing a fixed asset due to technological obsolescence.Replacement of a Pentium IV computer by Intel Centrino Duo Computer y Who takes the Decisions:.To improve operating efficiency and to reduce cost.The existing firms takes such decisions . y Example:.Modernization Decisions y Meaning:.

To avoid shortage or delay in the delivery of the products/services and to meet growth in demand of products/services and to increase revenue thereby y Example:.Increasing Oil Refining Capacity from 1000 tonnes to 2000 tonnes y Who takes such Decision:.Expansion Decisions y Meaning:.Increasing existing production capacity y Purpose:.The existing firms takes such decisions .

y Who takes such Decisions:.Diversification Decisions y Meaning:.To reduce the risk of reduction in revenues of existing product/service lines or to capture the new investment opportunities and to increase revenue thereby y Example:.Commencing new product/service lines y Purpose:. .The existing firms take such decisions.Starting an Insurance Business by ICICI Bank.

The decisions are said to be mutually exclusive if two or more alternative proposals are such that the acceptance of one proposal will exclude the acceptance of the other alternative proposals. Firm s decision to purchase Machine A will exclude the acceptance of Machine B . These proposals compete with each other.Mutually Exclusive Decisions y Meaning:.A firm is considering the purchase of Machine A or Machine B. y Example:.

.Accept Reject Decisions y Meaning:. 18% and 14% respectively. Project A and B can be accepted but project C is to be rejected. y Example:. If firm s minimum required rate of return is 15%. B and C are generating return of 20%.Project A.The decisions are said to be accept-reject decisions if two or more independent proposals are such that they do not compete with each other and any one or more of these proposals which meet the decision criterion adopted by the firm can be accepted subject to availability of funds.

y Example:. .g.The decisions are said to be contingent decisions/Complimentary decision if two or more independent proposals are such that the acceptance of one proposal requires the acceptance of one or more other proposals.Contingent Decisions y Meaning:. it may have to invest in other infrastructure proposals e. building of roads. houses of employees etc.If a company accepts a proposal to set up a factory in remote area.

Techniques of Capital Budgeting Traditional Techniques/ Non Time Adjusted Techniques Accounting Rate of Return (ARR) Discounted ay ac eriod Discounted Cash Flow Techniques/ Time Adjusted Techniques ay ac eriod Net resent Value (N V) Internal Rate of Return (IRR) rofita ility Index .

In other words. The ARR may be defined as the anuualized net income earned on the average funds invested in a project. .Accounting/Average Rate of Return y The ARR is based on the accounting concept of return on investment or rate of return. the annual returns of a project are expressed as a percentage of the net investment in the project.

ARR = Average Annual Profit after Tax Average Investment in the Project x 100 y Accept the project if ARR Minimum Acceptable Rate of Return y Reject the project if ARR < Minimum Acceptable Rate of Return .Computation of ARR y Symbolically.

Merits of ARR y It is Easy to understand and calculate y It considers the entire profits over the entire life of the projects. y It uses the accounting data with which managers are familiar. .

.Demerits of ARR y It ignores the time value of money. y It does not use the cash flows. y There is no objective way to determine the minimum acceptable rate of return.

the payback period is the length of time required to recover the initial cost of the project. In other words. y Accept the project if Payback period Maximum Acceptable Payback period y Reject the project if Payback period > Maximum Acceptable Payback period . Cash inflow means earnings after tax but before depreciation y Payback period is defined as the number of years required for the proposal s cumulative cash inflows to be equal to its cash outflows.Pay Back Period y Pay back period refers to the period within which the entire cost of the project is expected to be completely recovered by way of cash inflows.

y It enables the management to cope with the risk associated with the project by having a shorter payback period y Payback period deals with the risk also.Advantages of Payback Period y It is easy to understand and calculate. y It emphasizes liquidity by stressing earlier cash inflows. . The project with a shorter payback period will be less risky as compared to projects with a longer payback period as the cash inflows which arise further in the future will be less certain and hence more risky.

y It is not a measure of profitability since the cash flows occurring after the payback period are ignored. y There is no objective way to determine the maximum acceptable payback period.Demerits of Payback Period y It ignores the time value of money. y It does not necessarily maximize the wealth of the shareholders. y It ignores the cash flows occurring after the payback period. .

. y Cash inflows means earnings after tax but before depreciation. y Discounted cash inflow means present value of cash inflows using cost of capital as discount rate.Discounted Payback Period y Discounted Payback period refers to the period within which the entire cost of the project is expected to be completely recovered by way of discounted cash inflows.

.Accept / Reject Rule y Accept the project if Discounted Payback Period Maximum Acceptable Payback Period. y Reject the project if Discounted Payback Period > Maximum Acceptable Payback Period.

y It emphasizes liquidity by stressing earlier cash inflows. y It enables the management to cope with the risk associated with the project by having a shorter payback period. y It uses the cash flows rather than accounting data.Merits of Discounted Payback Period y It is easy to understand and calculate. . y It uses time value of money.

y There is no objective way to determine the maximum acceptable payback period. y It does not necessarily maximize the wealth of the shareholders.Demerits of Discounted Payback period y It ignores the cash flows occurring after the payback period. . y It is not a measure of profitability since the cash flows occurring after the payback period are ignored.

NPV is used simply to weigh the elements of trade-off between investment outlays and the future benefits in equivalent terms. and to determine whether the net balance of the present values is favorable or not.Net Present Value Method (NPV) y The NPV is the first and the foremost of the discounted cash flow techniques. y Net Present Value refers to the difference between the present value of all the cash inflows and the present value of all cash outflows associated with the project. y The present value is ascertained using the firm s overall cost of capital as the discounted rate. .

.Computation of NPV NPV = Present Value of Cash inflows Less Present Value of Cash outflows y Accept the project if NPV > 0. y If NPV = 0. reject the project if NPV < 0. the management would be indifferent as to whether to accept/reject the project.

. y It is consistent with the objective of maximizing the wealth of owners since NPV may be interpreted as an immediate increase in firm s wealth if the project is accepted.Merits of NPV y It considers the time value of money. y It is measure of profitability since entire cash flows over entire life of the project are considered. y It considers entire cash flows over entire life of the project.

size of different projects. It ignores the different in initial cash outflows. y It is an absolute measure. y It requires the computation of the cost of capital to be used as discount rate. . etc.Demerits of NPV y It requires the estimation of cash inflows and cash outflows. y Projects involving different amount of cash outflows and having different live3s y The ranking of projects depends upon the discount rate. which is a difficult task. y It may not provide satisfactory results in case of:y Projects involving different amount of cash outflows y Projects having different lives. while evaluating mutually exclusive projects.

y The IRR of a proposal is defined as the discount rate which produces a zero NPV i. y The IRR is also known as Marginal Rate of Return or Time Adjusted Rate of Return. the IRR is the discount rate which will equate the present value of cash inflows with the present value of cash outflows. y It is called an internal rate because it depends solely upon the cash inflows and the cash outflows associated with the project and not on any rate determined outside the project. .Internal Rate of Return (IRR) y The other important discounted cash flow technique of evaluation of capital budgeting proposals is known as IRR technique.e.

y Symbolically. CO0 = Cash outflow at time 0 CF1 = Cash inflow at different point of time n = Life of the project r = Rate of discount (yet to be calculated) SV & WC = Salvage Value and Working Capital at the end of the n years. . the IRR is equal to the value of r n the following equation: CF0 CF1 CFn SV+WC CO0 = + + ----+ (1+r)0 (1+r)1 (1+r)n (1+r)n Where.

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