CAPITAL BUDGETING

- Long term planning for proposed capital outlays and their financing.

DEFINITION:

Capital Budgeting decision may be defined as ´ the firm·s decision to invest its current fund more efficiently in long-term activities in anticipation of an expected flow of future benefit over a series of years.µ

Capital Budgeting is a complex process which may be divided into the following phases :-

y Identification of potential investment opportunities. y Assembling of proposed investments. y Decision Making y Preparation of Capital Budget and appropriations y Implementation y Performance Review.

BASIC FEATURES OF CAPITAL BUDGETING DECISIONS :- y Current funds are exchanged for future benefits. and y Future benefits will occur to the firm over series of years. . y Investment in long-term activities.

What are the factors that give rise to the need for capital investments ? .

y Expansion y Change of plant site. y Learning-curve effect.y Wear and tear of old equipments. y Variation in product demand necessitating change in volume of production. y Product improvement requiring capital additions. y Productivity improvement. y Diversification. y Obsolescence. .

y Risk and uncertainty. y Irreversible decisions. y Difficult and Complicated exercise. . y Involvement of large amount of funds.IMPORTANCE OF CAPITAL BUDGETING :- y Long-term implications.

INVESTMENT DECISION MAKING .

y Opportunities created by technological change. y Cash flow budget. y Non-Economic factors. y Fiscal incentives.FACTORS INFLENCING INVESTMENT DECISION:y Management outlook. . y Competitor·s Strategy. y Market forecast.

.Rationale of Capital Budgeting Decisions:- The main rationale is EFFICIENCY. The main objective of the firm is to maximize profit either by way of increased revenue or by cost reduction.

KINDS OF CAPITAL BUDGETING DECISIONS .

Business firms are generally confronted with these 3 types of Capital Budgeting Decisions: y Accept ² Reject decisions y Mutually exclusive decisions y Capital Rationing decisions .

Broadly. all those investment proposals which yield a rate of return greater than cost of capital are accepted and the others are rejected. . the firm incurs the investment and not otherwise.ACCEPT-REJECT DECISIONS : If the proposal is accepted.

some technique has to be used for selecting the best among all and eliminates other alternatives.MUTUALLY EXCLUSIVE DECISIONS : It includes all those projects which compete with each other in a way. Thus. that acceptance of one precludes the acceptance of other or others. .

. It is concerned with the selection of a group of investments out of many investment proposals ranked in the descending order of the rate of return.CAPITAL RATIONING DECISIONS : Refers to the situations where the firm have more acceptable investments requiring greater amount of finance than is available with the firm.

and y Appraising the stream of costs and benefits to determine the worthwhileness of the investment.In evaluating a capital expenditure proposal. 2 broad phases are involved:y Defining the stream of costs and benefits associated with the investment. .

. the following principles must be borne in mind:y Cash Flow Principle y post-tax Principle y incremental Principle y long-term funds Principle y interest exclusion Principle.In defining the costs and benefits of a capital expenditure proposal.

several appraisal criteria have been suggested. The important ones are as follows:y Payback Period y Average Rate of Return y Net Present Value y Benefit Cost Ratio y Internet Rate of Return.To evaluate the stream of costs and benefits. .

The NET PRESENT VALUE of a project is equal to the sum of the present values of all the cash flows(outflows and inflows) associated with the project. . A Project is acceptable if its net present value exceeds zero.

. is defined as : Present Value of Benefits Present Value of costs A project is acceptable if its Benefits Cost Ratio > 1.The BENEFIT COST RATIO. also referred to as Profitability Index.

The INTERNAL RATE OF RETURN . . of a project is the discount rate which makes its net present value = 0. A project is acceptable if its IRR > the cost of capital.

The PAYBACK PERIOD . . a project is acceptable if its payback period is less than a certain specified Payback Period. is the length of time required to recover the initial cash outlay on the project. According to this criterion.

may be defined as :Profit after taxes Book Value of the investment Project is acceptable if its ARR exceeds certain cut-off rate of return. also called the Accounting Rate of Return. .The AVERAGE RATE OF RETURN .

CHOICE OF METHODS .

It should like to choose the best among all. .Business enterprise is confronted with large number of investment criteria for selection of investment proposals.

the NET PRESENT VALUE method generally is considered to be superior theoretically because :- .If a choice is to be made.

. y It does not suffer from the limitations of multiple rates. y The reinvestment assumption of the Net Present Value Method is more realistic than internal Rate of Return Method.y It is simple to operate as compared to Internal Rate of Return method .

some scholars have advocated for Internal Rate of Return method on the following grounds : .On the other hand.

y It suggests the max. rate of return and even in the absence of cost of capital. .y It is easier to visualize and to interpret as compared to Net Present Value method. y The IRR method is preferable over NPV method in the evaluation of risky projects. it gives good idea of the projects profitability.

A wide variety of measures are used in practice for appraising investments. . These include measures suggested by capital budgeting literature and several non-standard measures.

in more recent years. discounted cash flow methods are commonly employed.The most commonly used method for evaluating smallsize investments is the payback method. . the Average Rate of Return and. For larger investments.

ANY QUESTIONS? .