CAPITAL
BUDGETING
Gurunath Waghale
Assistant Professor
MIT ADT University
DEFINATION
• Capital: Operating assets used for production.
• Budget: A plan that details projected cash flows during some
period.
• Capital Budgeting: Process of analyzing projects and deciding
which ones to include in capital budget.
• Capital Budgeting is the process of making investments
decisions in capital expenditure.
• Capital Budgeting is long term planning for making and
financing proposed capital outlays.
Examples of Long Term Capital
Expenditure
CASES FOR CAPITAL BUDGETING-
Replacement
Expansion
Diversification
Research and development
Miscellaneous
IMPORTANCE OF CAPITAL
BUDGETING-
INVOLVEMENT OF HEAVY FUND-
Capital budgeting decisions require large capital outlays. It is therefore
absolutely necessary that the firm should carefully plan they are put to
most profitable use.
LONG TERM IMPLICATION-
The effect of capital budgeting decision will be felt by the firm over a long
period and therefore they have decisive influence on the rate and
direction of the growth of the firm.
CONT.
.
IRREVERSIBLE DECISION-
In most cases, capital budgeting decisions are irreversible.
This is because it is very difficult to find a market for the
capital assets. The only alternative will be to scrap the capital
assets so purchased or sell them at a substantial loss in the
event of the decision being proved wrong.
MOST DIFFICULT TO MAKE-
The capital budgeting decision require an assessment of
future events which are uncertain . It is really difficult task to
estimate the probable future events, the probable benefits
and cost accurately in quantitative terms because of
economic ,political, social , and technological factors.
PROCESS OF CAPITAL BUDGETING-
Capital budgeting is a difficult process to the investment of available
funds. The benefit will attained only in the near future but, the future
is uncertain.
Identification of various investments proposals
Screening or matching the proposals
Evaluation
Fixing priority
Final approval
Implementing
Performance review of feedback
The Position of Capital Budgeting
Financial Goal of the Firm:
Wealth Maximisation
Investment Decison Financing Decision Dividend Decision
Long Term Assets Short Term Assets Debt/Equity M ix Dividend Payout Ratio
Capital Budgeting
KINDS OF CAPITAL BUDGETING DECISIONS
(Proposals / Projects)
1. ACCEPT OR REJECT DECISIONS:- INDEPENDENT PROJECT /
PROPOSALS.
2. MUTUALLY EXCLUSIVE DECISIONS: - MUTUALLY EXECUTIVE
PROJECTS /
PROPOSALS.
3. CAPITAL RATIONING DECISIONS: - DEPENDENT PROJECTS
/PROPOSALS. (WHEN
FUND HAS TO BE
DISTRIBUTED IN
MULTIPLE PROJECTS)
Capital Budgeting: Project Categorization
• Establishment of New Products & Services
• Replacement Projects: Maintenance or Cost Reduction
• Expansion of Existing Projects
• Research and Development Projects
• Long Term Contracts
• Safety and/or Environmental Projects
TECHNIQUES (METHODS) OF CAPITAL
BUDGETING-
CAPITAL
BUDGETING
TECHNIQUES
Non- Discounting
Discountin criteria
g Criteria
Pay- NP Profitabilit IR
AR
Back y Index
R V R
Period
Suggested Cash Flow
PAY BACK PERIOD
The payback period is the length of time required to recover the initial cost
of the project. The payback period is the length of time required to recover
the initial cost of the project. The payback period therefore can be looked
upon as the length of time required for a proposal to break even on its
net investment.
CALCULATION OF PAYBACK PERIOD-
When Annual Inflow are Equal.
PBP = CF0 / CFn
When the Annual Cash Inflow are Unequal
Remaining Amount to be recovered
PBP = Minimum Full / Whole Years require + -----------------------------
Cash Inflow of next year
Project Acceptance criteria.
1. Lower the PBP – Accept the project
2. Higher the PBP – Reject the project
Merits of PBP
1. Simple to calculate
2. Liquidity Indications
3. Break even of investment can be calculated.
Demerits of PBP
1. Ignores the profitability factor.
2. Its is the method of recovery.
3. Ignores salvage Value.
4. Ignores the time value of money.
EXAMPLE-
CONT…
DISCOUNTED PAY BACK PERIOD METHOD
• Under this method the present value of all cash outflows and
inflows are computed at an appropriate discount rate.
• The present values of all inflows are cumulated in order of time.
The time period at which the cumulated present value of cash
inflows equals the present value of cash outflows is known as
discounted pay back period.
• The project which gives a shorter discounted pay back period is
accepted.
• Calculation Table:- Eg. and Then use same PBP formula to
calculate it
Year Cash PV Factor Present Cumulativ
Inflow Value @ Value of e P.V. of
8% Cash Cash
Inflow Inflow
AVERAGE (ACCOUNTING) RATE OF RETURN (ARR)
Average rate of return means the average rate of return or profit taken
for considering the project evaluation.
It measures the profitability of the investment (project) using information
taken from financial statements.
This method is one of the traditional methods for evaluating the project
proposals:
Under this method, profit after tax and depreciation is considered.
Formula-
MERITS-
1.It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.
DEMERITS-
It ignores the time value of money.
It ignores the reinvestment potential of a project.
Project Acceptance criteria.
Higher the ARR Percentage – Accept the Project
Lower the ARR percentage – Reject the Project
EXAMPLE-
NET PRESENT VALUE (NPV)
It is the excess of present value of cash inflow over
present value of cash outflow.
It is difference between present value of future
expected cash flows and cash outflow (initial
investment).
It is the best method for evaluation of investment proposal.
This method consists Time value of money.
P.V. Factor:-
r – discounting rate
n – number of year (for which PV is to be
calculated)
Formula
NPV = Present Value of Cash Inflow – Cash Outflow
Project Acceptance criteria
A. For independent proposal
1. If NPV is Positive – Accept
2. If NPV is Negative – Reject
3. If NPV is Zero - Accept
A. For Mutually Exclusive proposal
1. Project with higher positive value – Accept
2. Project with lower positive value – Reject
3. Project with higher negative value – Reject
4. Project with lower negative value – Accept
MERITS-
1. Recognizes time value of money
2. Recognizes quality of benefits
3. No ambiguity
4. Recognizes entire life
5. Compatible with maximization of wealth principle
DEMERITS-
6. Difficult to calculate
2. Cost of capital may not be right discount rate
3. It may give good results while comparing projects with
unequal lives
EXAMPLE-
Internal Rate of Return (IRR)
• IRR is that discount rate which bring down the value of net cash
inflow during the life of the project so that it is equal to the value of
initial investment.
• IRR is the rate of return that a project earns.
• The rate of discount calculated by trial and error , where the present value of
future cash flows is equal to the present value of outflows, is known as the
Internal Rate of Return.
Formula-
Positive NPV
IRR = Higher Rate - ------------------------------------- * Difference in Discounting Rate
Difference in cash Flows
Project Acceptance criteria
1. IRR > k (Require Rate of Return) – Accept the project
2. IRR = k (Require Rate of Return) – Accept the project
3. IRR < k (Require Rate of Return) – Reject the project
Relation between NPV & IRR
• NPV > 0, then IRR > k
• NPV = 0, then IRR = k
• NPV<0, then IRR<k
MERITS-
• Finds the Time Value of Money
• Simple to Use and Understand
• Hurdle Rate (Cost of capital / discounting factor) Not Required
DEMERITS-
• Ignores Size of Project
• Ignores Future Costs
• Ignores Reinvestment Rates
Example
The expected cash flows of a project are:-
Year Cash Flows ( Rs.)
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
• The cash outflow is Rs. 1,00,000
• Calculate the IRR
Computation of IRR
Cash Flows PV Factors PV of Cash PV Factors PV of Cash
(Rs.) @19% Flows (Rs.) @18% Flows (Rs.)
20,000 .84 16,800 .847 16,940
30,000 .706 21,180 .718 21,540
40,000 .593 23,720 .609 24,360
50,000 .499 24,950 .516 25,800
30,000 .42 12,600 .437 13,110
Total Cash Inflow 99,250 1,01,750
Less Cash Outflows 1,00,000 1,00,000
NPV (-)750 (+)1750
Computation of IRR Contd..
Profitability Index (PI)
It is also a time adjusted method of evaluating investment proposal .
Profitability index also called as Benefit- Cost ratio or desirability factor is
relationship between present value of cash inflow and the present value of
cash outflow.
PI is the ratio of the present value of cash flows (PVCF) to the initial
investment of the project.
FORMULA-
Present Value of Cash
Inflow
Profitability Index =
Present Value of Cash Outflow
/ Investment
Project Acceptance criteria
• Higher the PI – Accept the Project
• Lowe the PI – Reject the Project
MERITS-
It is consistent with goal of maximizing the shareholders
wealth.
It uses cash flow.
It recognized the time value of money.
DEMERITS-
• The main demerit of this method is that is requires detailed long
term forecast of incremental benefits and costs.
• Its also have the difficulty in determining appropriate discount rate.
EXAMPLE-
REFERENCES-
• FINANCIAL MANAGEMENT
BY PROF. DR. SATISH INAMDAR
• FINANCIAL MANAGEMENT
BY C. PARAMASIVAN
• FINANCIAL MANAGEMENT BY KHAN & JAIN
THANK YOU….
