capital budgeting overview
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Prepared By Nethra. Reference from “Financial Management”, K Y Khan and P K Jain Page 1
CAPITAL BUDGETING
We can explain it as that decisions which are taken for buying long term and fixed assets.
Working capital decisions and current assets investment decision do not come under capital
budgeting.
When we take the decision whether particular fixed asset should be purchased or not, its
planning will be capital budgeting. In capital budgeting, we fix our total investment in best
project which will provide us higher return. For capital budgeting, we use
different techniques for evaluating different projects. All techniques are called capital
budgeting techniques.
Capital: operating assets used in production.
Budget: Plan that details projected cash flows during some period.
Capital Budgeting: Process of analyzing projects and deciding which ones to include in the
capital budget.
Criteria: project should maximize shareholder’s value.
Definition:
“Capital budgeting decisions relate to long-term assets which are in operation and yield a
return over a period of time. They, therefore involve current outlays in return for series of
anticipated flow of future benefits.”
“A firms decision to invest its current funds most efficiently in long term assets in
anticipating of an expected flow of benefits over a series of years”
Importance of capital Budgeting:
Huge Investment - Capital budgeting requires huge investments of funds, but funds
are limited therefore the firm before investing projects; plan on control its capital
expenditure.
E.g. purchase of fixed assets land & building, Relating to expansion, addition of fixed
assets.
Defines the firm’s strategic direction- What project should be done defines the
direction either to expand the business or not to expand.
Long term affect-Capital budgeting decision have long term impact for many years
hence it is import to make right decision before taking up the project .
Risk involved- Capital expenditure involves higher risk hence careful planning of
capital budgeting is needed.
Irreversible-Wrong decision can have serious consequences and are irreversible.
Once decision is taken for purchasing a permanent asset, it is very difficult to dispose
of those assets without involving huge losses.
Difficulties:
Capital expenditure decisions are of considerable significance.
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Prepared By Nethra. Reference from “Financial Management”, K Y Khan and P K Jain Page 2
Risk –future is uncertain benefits from investments are received in some future period
which is uncertain.
Failure to forecast- correctly will lead to errors which can be corrected at
considerable expense.
Different time periods - cost incurred and benefits received at different time period
hence cannot be comparable due to time value of money.
Calculation is not possible – It is not possible to calculate in strict quantitative terms
all the benefits or the costs relating to a particular investment decision.
Evaluation Techniques:
It is included in the methods of appraising an investment proposal such as objective,
quantified and based on economic costs and benefits. The methods of appraising capital
expenditure proposal can be classified into two broad categories.
TRADITIONAL (NON DISCOUNTED CASH FLOW)
Average Rate of Return
The average rate of return method of evaluating proposed capital expenditure is also known
as the accounting rate of return method. It means the average rate of return or profit taken for
considering the project evaluation. It is simply the return on investment.
ARR= Profit after tax (Net profit)
Book value of investment (original investment over the life of the project)
Accept /Reject criteria
If the actual accounting rate of return is more than the predetermined required rate of Return,
the project would be accepted. If not it would be rejected.
Pay-back Period
Pay-back period is the time required to recover the initial investment in a project. It is the
exact amount of time required for a firm to recover its initial investment in a project as
calculated from cash inflows.
Payback period = Initial investment
Annual cash inflows
Accept /Reject criteria
Shorter the payback period more desirable the project is.
METHODS
TRADITIONAL
(NON DISCOUNTED CASH FLOW)
Payback period method
Average Rate of Return method
TIME ADJUSTED
(DISCOUNTED CASH FLOW)
Net Present Value
Internal rate of return
Profitability Index
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Prepared By Nethra. Reference from “Financial Management”, K Y Khan and P K Jain Page 3
DISCOUNTED CASHFLOW (Time Adjusted)
Net Present Value
It is one of the modern methods for evaluating the project proposals.
In this method cash inflows are considered with the time value of the money.
It is found by subtracting a projects initial investment from the present value of its cash
inflows discounted at the firm’s cost of capital.
n
t
- Initial investment
Ct=cash flow at the end of the year t.
n=life of the project.
k=discount rate.
Accept/Reject criteria
NPV >0, accept and NPV <0, reject.
Internal Rate of Return
Internal rate of return is time adjusted technique and covers the disadvantages of the
traditional techniques. It is the discounted rate that equates the present values of the cash
inflows with the initial investment associated with a project, thereby causing NPV =0.
Rate of return the project earns.
nvestment
n
t
= internal rate of return.
Accept/Reject criteria
If the present value of the sum total of the compounded reinvested cash flows is greater than
the present value of the outflows, the proposed project is accepted. If not it would be rejected.
Profitability index or benefit-cost ratio
It is similar to NPV approach. It measures the present value if returns per rupee invested,
while NPV is based on the difference between the present value of the future cash inflows
and the present value if cash outlays.
PI = Present value cash inflows (Benefit)
Present value if cash outflows (cost)
Accept/Reject criteria
PI value exceeds one; project is accepted .PI equals one the firm is indifferent to project.