capital budgeting v3

8/6/2019 Capital Budgeting V3

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Group 4

Roll no: 20,21, 22, 23, and 25


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INDEXy Introduction

y Project appraisal process

y Capital Budgeting Techniquesy Pay Back Period

y Average Rate of Return (ARR)

y Net Present Value (NPV)

y Internal Rate of Return (IRR)y Take Away


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INTRODUCTION

Capital Budgeting process involves:

Identification of potential Investmentopportunities

Assembling ofInvestment proposals

Decision Ma ing

Preparation of capital budgeting andappropriations

Implementation

Performance Review

capital budgeting decisions are related to allocation of investable funds todifferent long tem assets.

Its Important for 3 Reasons

They have long termconsequences

They are difficult to reverseand

They involve substantialoutlay


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PROJECT APPRAISALy Forecast the cost and Benefits

y Apply suitable investment criteria

y Asses the riskiness of the project

y Estimate the cost of capital

y Value the options

y Consider the overall corporate

perspective

Focus onPost- Cash

Flow

easure thecash flow onIncremental

Basis

Excludefinancing

cost

TreatInflation

Consistently

COST AND BENEFIT ANALYSIS


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CAPITAL BUDGETING TECHNIQUES


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PAY BACK PERIODy Pay back period is defined as the number of years required for the proposal

cumulative cash inflow to be equal to cash outflow.

y A project is acceptable if the payback period is less than a specified time

Evaluation

Simple both in concept and application, suitable for small firms

It gives an indication of liquidity

It deals with risk too. Project with short payback period are less risky

Ignores the cash flow in the cash flow after the pay back period

It fails to consider Time Value of oney (TV )

Ignores the salvage value and economic vale of the project


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AVERAGE RATE OF RETUEN (ARR)y Also know as the Accounting Rate of Return it is defined as the annualized net income

earned on the average fund invested in a project

y Project is acceptable if its ARR is a pre specified rate of return

EqualProfits

U

nequal ProfitsAnnual profit (after tax) * 100 Average Annual profit (after tax) * 100

Average investment in project Average investment in project

Evaluation

It is simple to calculate & is based on available accounting information

It does not consider the TV an ignores future profits

Based on accounting profits which are subject to accounting policies

ARR ignores the life and salvage value of the proposal

Fails to recognize the size of the investment required for the project


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NET PRESENT VALUE (NPV)y The net present value technique is a discounted cash flow method that

considers the time value of money in evaluating capital investments

y The sum of the present values of a projects cash inflows and outflows.

y iscounting cash f lows accounts for the time value of money.

y Choosing the appropriate discount rate accounts for risk.


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Evaluation

It recognizes the time value of money

Its based on cash inflows and outflows rather than accounting profit

The discounted rate r incorporates the pure as well as the premium return to set offthe risk

Its in line with the objective of the firm i.e. maximization of wealth

It involves difficult calculations

If the value of r is incorrect the whole exercise may give wrong results

y Net Present Value is positive

NPV >= Zero ACCEPT the proposal

y Net Present Value is negative

NPV < Zero REJECT the proposal

NPV CRITERION & EVALUATION


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INTERNAL RATE OF RETURN (IRR)y The IRR of a proposal is defined as the discounted rate which produces zero NPV

y The time-schedule of occurrence of future cash flow is know but the discounted rate isascertained by trial and error method

y It is calculated with the formula:

Evaluation

It considers the time value of money

Profit oriented concept and expected at earning more than minimum ROR

Based on cash flows occurring anytime e.g. salvage value ,working capital etc

Involves tedious and complicated trial and error procedure

Can be misleading when choice is between mutually exclusive projects that havedifferent outlay

IRR being a scaled measure is biased to smaller projects which are likely to yield highpercentage returns


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TAKE AWAYBoth NPV and IRR are comprehensive and sound evaluation techniques aimingat maximizing the profits .

NPV is widely considered as a better technique of evaluation

In order to be meaningful and viable a Capital Budgeting of firm should be

Consistent with long term strategic business Plans

Compatible with resources of the firm

ust be controllable

ust be endorsed by the Executive anagement


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capital budgeting v3

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