Capital Budgeting

MEANING of Capital Budgeting  

The investment decisions of a firm are generally known as Capital Budgeting. In the words of LYNCH capital budgeting consists in planning development of available capital for the purpose of maximising the long term profitability of the concern

Importance of Capital Budgeting       Large investments Long term commitment of funds Irreversible nature Long term effect on profitability Difficulties of investment decisions National importance .

Process of Capital Budgeting        Identification of investment proposals Screening the proposals Evaluation of various proposals Fixing priorities Final approval and preparation of capital expenditure budget Implementing proposal Performance review .

Evaluation criteria Discounted Cash Flow (DCF) Criteria: Criteria: Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) NonNon-Discounted Cash Flow Criteria: Criteria: Payback Period (PB) Discounted Payback Period (DPB) Accounting Rate of Return (ARR) .

Net Present Value Method  Cash flows of the investment project should be forecasted based on realistic assumptions.. The appropriate discount rate is the project s opportunity cost of capital. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.e. NPV>0)    . The project should be accepted if NPV is positive (i. Appropriate discount rate should be identified to discount the forecasted cash flows.

the one with higher NPV should be selected. .Acceptance Rule     Accept the project when NPV is positive NPV > 0 Reject the project when NPV is negative NPV < 0 May accept the project when NPV is zero NPV = 0 The NPV method can be used to select between mutually exclusive projects.

Evaluation of NPV Method Merits: Merits: Time Value Measure of True Profitability Value Additivity Shareholder Value De-merits: De-merits: Involved cash flow estimation Discount rate is difficult to determine Mutually exclusive projects Ranking of Projects .

This also implies that the rate of return is the discount rate which makes NPV = 0  .Internal Rate of Return  The Internal Rate of Return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period.

Evaluation of IRR Method Merits: Merits: Time Value Profitability measure Acceptance rule Shareholder value De-merits: De-merits: Multiple rates Mutually exclusive projects Value additivity .

at the required rate of return.Profitability Index  Profitability Index is the ratio of the present value of the cash inflows. . to the initial cash outflow of the investment.

Acceptance Rule     Accept the project when PI is greater than one. PI = 1 The project with positive NPV will have PI greater than one. . PI < 1 May accept the project when PI is equal to one. PI > 1 Reject the project when PI is less than one. PI less than one means that the project s NPV is negative.

. PI criteria also requires calculation of cash flows and estimate of the discount rate. It is consistent with the shareholder value maximization principle. it is relative measure of a project s profitability. Like the NPV Method. In the PI Method. since the present value of cash inflows is divided by the initial cash outflow.Evaluation of PI Method     It recognizes the Time Value of money.

the Payback period can be computed by dividing cash outlay by annual cash inflow  . If a project generates constant annual cash inflows.Payback  Payback is the number of years required to recover the original cash outlay invested in a project.

which has the shortest payback period and lowest ranking to the project with highest payback period. it gives highest ranking to the project. As a ranking method.Acceptance Rule  The project would be accepted if its Payback period is less than the maximum or Standard Payback period set by the mgmt.  .

Evaluation of Payback Certain Virtues: Virtues: Simplicity Cost effective Short term effects Risk shield Liquidity Serious Limitations: Limitations: Cash flows after payback Cash flows ignored Cash flows patterns Administrative difficulties Inconsistent with shareholder value .

 .Accounting Rate of Return Method  The Accounting rate of return is the ratio of the average after-tax profit divided by the average afterinvestment. A variation of the ARR method is to divide average earnings after taxes by the original cost of the project instead of the average cost. The average investment would be equal to half of the original investment if it were depreciated constantly.

 .Acceptance Rule  The method will accept all those projects whose ARR is higher than the minimum rate established by the mgmt and reject those projects which have ARR less than the minimum rate. This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.

Evaluation of ARR Method Merits: Merits: Simplicity Accounting Data Accounting Profitability De-merits: De-merits: Cash flows ignored Time value ignored Arbitrary cut-off cut- .

the discount rate is not predetermined It does not consider the market rate of interest The intermediate cash inflows The intermediate cash flows are reinvested at a cut off are presumed to be reinvested rate at the IRR It is more reliable It is less reliable .NPV versus IRR NPV Here. the present value is determined by discounting the future cash flows of a project at a predetermined rate It recognises the importance of market rate of interest IRR Here.

RISK AND UNCERTAINTY IN CAPITAL BUDGETING       Expected economic life of the project Selling price of the product Production cost Depreciation rate Rate of taxation Future demand of the product .

LIMITATIONS OF CAPITAL BUDGETING      Not practically true Requires estimation of future cash inflows and outflows Cannot be correctly quantified Urgency Uncertainty and risk pose .

Thank You .

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