capital budgeting
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Financial
Management
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An Insight to
Capital Budgeting
Financial
Management
OVERVIEW
Capital budgeting is a decision involving selection of capital expenditure proposals.
It involves the allocation of funds to projects that will have a life of at least one year and usually much longer.
Eg. Purchase of plant and equipment Introduce new product in the market
Essentially its goal is to determine whether the future benefits are sufficiently large enough to justify the current outlays.
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Financial
Management
IMPORTANCE
Long time period, i.e. endured for a longer period whether decision is good or bad
Substantial expenditure
Irreversibility
Over and under capacity
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Financial
Management
DIFFICULTIES
Uncertainties of Future.
Difficult to measure the benefit in quantitative terms.
Time Element: the problem of phasing properly the availability of capital assets in order to have them come ‘on stream’ at the correct time.
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SELECTION PHASE
Financial
Management
CAPITAL BUDGETING PROCESS
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PLANNING PHASE
PROPOSALS
ONLINE PROJECTS
PROJECTS
ACCEPTED PROJECTS
PROJECT TERMINATION
PROPOSALSIM
ROVE
MEN
T IN
PLA
NN
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AN
D E
VALU
ATIO
NPR
OCE
EDU
RE
NEW
INVE
STM
ENT
OPP
ORT
UN
ITIE
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REJECTED
OPPORTUNITIES
EVALUATION PHASE
IMPLEMENTATION PHASE
CONTROL PHASE
AUDITING PHASE
REJECTED
PROPOSALS
REJECTED
PROJECTS
Financial
Management
WHY CASH FLOW METHOD OF EVALUATION?
Accrual basis of Accounting.
Cash flow approach takes in to account ‘time value of money’.
In the absence of real performance improvement accountants may accelerate revenues and defer costs.
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Financial
Management
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EVALUATION CRITERIA
DISCOUNTING CRITERIA
NON DISCOUNTING CRITERIA
NET PRESENT
VALUE
INTERNAL RATE OF RETURN
DISC. PAYBACK PERIOD
ACC. RATE OF
RETURN
PAYBACK PERIOD
PR’ABLTY INDEX
(PI)
Financial
Management
PAYBACK PERIOD• ips
Defined as the numbers of years required to cover the original cost outlay.
PAYBACK PERIOD INITIAL INVESTMENTANNUAL CASH FLOW
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Financial
Management
ADVANTAGES AND DISADVANTAGES OF PAYBACK PERIOD
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Simple.
Emphasizes on earlier cash flows.
Rough and ready method or dealing with risk.
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ADVA
NTA
GES
DIS
ADVA
NTA
GES Ignores cash after
the payback period.
Fails to consider ‘time value of the
money’
Financial
Management
AVERAGE RATE OF RETURN
Investment project is judged by looking at its rate of return on book value.
Evaluates return on accounting profits. i.e. on accrual basis
Annual returns are expressed in percentage of net investment.
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AVERAGE PROFIT AFTER TAX
AVERAGE INVESTMENT
AVERAGE RATE OF RETURN 100
Financial
Management
ADVANTAGES AND DISADVANTAGES OF ACCOUNTING RATE OF RETURN
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Simple.
Considers value of project to its economic life.
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ADVA
NTA
GES
DIS
ADVA
NTA
GES
Ignores the life of the project.
Fails to consider ‘time value of the
money’. Ignores the size of investment required.
Financial
Management
ADVANTAGES AND DISADVANTAGES OF ACCOUNTING RATE OF RETURN
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Based on accounting profits; no separate calculation required.
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ADVA
NTA
GES
DIS
ADVA
NTA
GES
Affected by accounting practices; changes in method of depreciation and inventory costing affects earnings and hence ARR
Financial
Management
WHY ?... TIME VALUE OF MONEY
Opportunity cost of the money.
Inflationary pressures.
Uncertainty of the future. i.e. preference of current consumption than future consumption.
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Financial
Management
WHY ?... TIME VALUE OF MONEY
In 1624, the Red Indians sold Manhattan Island at the ridiculously low figure of $24.
Was the amount really ridiculous?
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Financial
Management
WHY ?... TIME VALUE OF MONEY
If the Red Indians had merely taken the $24 (Rs.1200) and reinvested it at 6 percent annual interest up to 1992, they would have had $50 billion (Rs. 25 lakh crore ), an amount sufficient to repurchase most of New York City.
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Financial
Management
DISCOUNTED PAYBACK METHOD
Improvement over ‘payback period method’, considers ‘time value of money’.
It surmounts the objection that equal weight is given to all flows starting year one to the cut off date.
In other words, it discounts the cash inflow by applying the present value factors for different periods.
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Financial
Management
DISCOUNTED PAYBACK METHOD
The discounted payback rule asks, “How many periods does the project have to last in order to make sense in terms of net present value?”
Calculated by counting the years the discounted cash flows add up to the initial investment.
Still takes no account of cash flow after the cut-off date.
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Financial
Management
NET PRESENT VALUE METHOD
Its the difference between the total discounted inflows and outflows.
Depends solely on the forecasted cash flows and the opportunity cost of capital.
Opportunity cost of capital is the expected rate of return on investment of equivalent risks.
Present value of cash flows is calculated using opportunity cost of capital at discount rate.
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Financial
Management
NET PRESENT VALUE METHOD
Ideal for mutually exclusive projects. Projects are ranked in the order of highest
‘Net Present Values'
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Difficult to ascertain future cash flows.
Biased towards longer term projects.
Financial
Management
ADVANTAGES AND DISADVANTAGES OFNET PRESENT VALUE METHOD
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Considers‘time value of money’.
Relies on discount rate and estimated cash flows.
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ADVA
NTA
GES
DIS
ADVA
NTA
GES
Financial
Management
INTERNAL RATE OF RETURN METHOD Also known as the ‘Marginal Rate of Return’
or ‘Time Adjusted Rate of Return’. It is the discount rate at which the present
value of cash flows equals the present value of cash outflows. i.e. NPV = 0
In other words, IRR is the rate of return the project earns.
The rate of discount is determined by the ‘trial and error method’ .
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Financial
Management
The point of intersection represents the IRR; where NPV is equal to zero.
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NET
PRE
SEN
T VA
LUES
DISC. RATE
Lengthy, based on ‘trial and error method’.
Assumes that future cash flows are reinvested at a rate equal to IRR.
Financial
Management
ADVANTAGES AND DISADVANTAGES OF INTERNAL RATE OF RETURN METHOD
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Considers Working Capital and Scrape Value
Considers cash flows during the whole economic life.
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ADVA
NTA
GES
DIS
ADVA
NTA
GES
Financial
Management
DIFFERENCE BETWEEN NPV METHOD ANDIRR METHOD
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Assumes that cost of capital is known.
Calculates NPV, given the discount rate.
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NET
PRE
SEN
T VA
LUE
INTE
RNAL
RAT
E O
F RE
TURN Assumes that NPV
is zero.
Figures out discount rate that makes NPV zero.
Financial
Management
PROFITABILITY INDEX
The profitability index (or the benefit cost ratio) is the present value of forecasted future cash flows divided by the initial investment:
The profitability index rule tells us to accept all projects with an index greater than 1. If the profitability index is greater than 1, the present value PV of Ci is greater than the initial investment - C0 and so the project must have a positive net present value.
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PROFITABILITY INDEX
P/V OF CASH INFLOW
INITIAL CASH OUTFLOW
Financial
Management
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