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Original Title: Capital Budgeting

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SYNOPSIS

2. FEATURES

3. KINDS OF CAPITAL EXPENDITURE

4. PROCESS OF CAPITAL BUDGETING

5. METHODS OF EVALUATION

“Capital Budgeting is an Art of Funding Assets that are worth more than they cost to

achieve a predetermined Goal” i.e. Optimising the wealth of the Business Enterprise.

projects whose returns are expected beyond one year”.

The Capital Budgeting involves a current outlay or series of outlays of cash resources in

return for an anticipated flow of future benefits. In other words, the system of Capital

Budgeting is employed to evaluate expenditure decisions which involves current outlays

but are likely to produce benefits over a period of longer than one year. These benefits

may be either in the form of increased revenues or reduction in cost.

FEATURES:

2. HIGH DEGREE OF RISK

3. LARGE ANTICIPATED BENEFITS

4. HIGH GESTATION PERIOD i.e. RELATIVE LONG TERM PERIOD BETWEEN

INTIAL OUTLAY AND ANTICIPATED RETURN

5. IRREVERSIBLE DECISION

PROPOSALS

1. MANDATORY INVESTMENTS

ex. A) Pollution control Equipments

B) Medical Dispensary

C) Fire fighting Equipments

D) Creche in Factory

2. REPLACEMENT PROJECTS: For cost reduction

3. EXPANSION PROJECT

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B) Widen the distribution network

4. DIVERSIFICATION PROJECT

Eg. Producing new product

5. RESEARCH AND DEVELOPMENT

6. STRATEGIC INVESTMENT PROJECTS

B) Do SWOT analysis

5. IMPLEMENTATION

6. FOLLOW-UP

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METHODS OF EVALUATION

METHODS OF EVALUATION

TRADITIONALMODERN

“It is the number of years required to recover the original cost invested in a project from

the cash inflow.”

By this method the investor will know how much time it will take to recover its original

cost i.e. how many years it will take for the cash benefits to pay the original cost of an

investment, normally disregarding the salvage value.

Example:

Project A Project B Project C

Initial Rs.10 Lacs Rs.20 Lacs Rs.25 Lacs

investment

Cash flow every Rs.3 Lacs Rs.5 Lacs Rs.10 Lacs

year

Life of the 10 years 10 years 10 years

project

Pay back period 10/3 = 3 1/3 yrs. 20/5 = 4 yrs. 25/10 = 2½ yrs.

Therefore,

Initial investment

Pay back period = ------------------------

Annual cash inflow

CONCLUSION:

In the above example project C has the shortest pay back and is more desirable.

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In case of uneven cash inflows the payback period is found out by adding the

inflows i.e. cumulative cash inflows.

1) FOR SINGLE PROJECT

If the pay back is less than the estimated life then accept it

If the pay back is more than estimated life then reject it.

If 2 more projects – project with the

Shortest pay back accept it.

ADVANTAGES

1. SIMPLE METHOD

This is the most simple method very easy and clear to understand. This does not

involve tedious mathematical calculation.

This method reduces the possibility of loss on account of obsolescence as the

method prefers investment in short term project.

3. CONSERVATIVE PRINCIPLES

This method makes it clear that no profit arises till the pay back period is over.

This helps the new companies they should start paying dividends.

THE PROPOSALS.

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LIMITATIONS:

This method does not consider cash inflow generated after the pay back period.

There are many capital intensive projects which generate substantial cash inflows in the

later years than the initial years. In the above example ‘project B’ which is rejected now

may generate huge cash inflows in later years but still it is rejected.

FOR EXAMPLE:-

Initial Investment Rs.10000 Rs.10000

Cash inflows

Year 1 4000 3000

Year 2 4000 3000

Year 3 2000 3000

Year 4 -- 3000

Year 5 -- 3000

Pay back period 3 years 3.3 years

In the above example project ‘A’ is having short pay back that must be accepted but is

does not give return afterwards but project ‘B’ gives constant returns even after its pay

back period. So on the whole project ‘B’ is profitable still ‘A’ is accepted under this

method.

Thus cash inflow after pay back period is ignore.

Cash flow

Year 1 Rs.10000 RS.1000

Year 2 Rs.4000 Rs.4000

Year 3 Rs.1000 Rs.10000

3. PROFITABILITY

The pay back period method does not take into account the measure of

profitability. It is only concerned with the projects capital recovery.

4. TIME VALUE OF MONEY

This method does not consider time value of money i.e. it ignores the interest

which is an important factor in making sound investment decisions. A rupee

borrowed tomorrow is worth less than a rupees today.

Ex. There are projects A & B the cost of the project is Rs.30000 in each case.

Year Cashinflow

Project ‘A’ Project ‘B’

1 Rs.10000 Rs.2000

2 Rs.10000 Rs.4000

3 Rs.10000 Rs.24000

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In both the cases the pay back period is 3 years however project ‘A’ should be

preferred as compared to project ‘B’ because of speedy recovery of the initial

investment.

It gives importance only to its liquidity of the initial investment. It does not

consider the liquidity of the company’s total span of life.

TERM OUTLOOK

This method is useful in evaluating those projects which involve high risk and

uncertainty. For eg. Those projects which have the risk of rapid technological

development of cheap substitute, political instability etc. for these projects these

method is more suitable for e.g. fashion garment industry.

Firms which suffer from liquidity crisis are more interested in quick returns of

funds rather than profitability pay back period method suits them most because it

emphasizes on quick recovery of funds.

This method it suitable for firms which emphasize on short term earnings

performance rather than its long term growth.

CONCLUSION:

PROFITABILITY

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IS EXPRESSED AS NET ACCOUNTING PROFIT AS A% OF CAPITAL INVESTED.

A.R.R. = Average Annual Profits

AFTER TAX

------------------------------- x 100

AVERAGE OR

INITIAL INVESTMENT

Average Investment = COST – SALVAGE

------------------------- + SALVAGE

2

Average Investment = COST – SALVAGE Release of

-------------------------------------------- + SALVAGE + working

2 capital

NOTE: If the sum states that return is to be calculated on the original investment them

instead of Average Investment, cost itself is to be considered.

MERITS:

1) SIMPLE AND EASY TO CALCULATE

2) Consider income from the project throughout its life & not just the initial years

unlike payback period.

3) When a number of capital investments proposals are considered, a quick decision

can be taken by use of ranking the investment.

DEMERITS:

2) This method do not differentiate the projects with different size of investment may

have the same A.R.R. and the firm will not be able to take the required decision.

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PRESENT VALUE :

If you invest Rs.1000/- for 3 years in a savings A/c. that pays 10% interest per

year. If you let your interest income be reinvested, your investment will grow as follows.

Rs.

First Year Principal at the beginning 1000

Interest for the year 100

(10/100*1000)

principal at the end 1100

Interest for the year 110

(10/100*1100)

principal at the end 1210

Interest for the year 121

(10/100*1210)

principal at the end Rs.1331

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The process of investing Money as well as reinvesting the interest earned thereon is

called compounding. The future value or compounded value of an investment after ‘n’

years when the interest rate is ‘r’ is

n

F.V. = P.V. (1 + r)

N = No. of Years

P.V. = Present Value

F.V. = Future Value

Ex. You deposit Rs.1000 today in a bank which pays 10% interest compounded

annually, how much will the deposit grow to after 8 years & 12 years?

= 1000 (2.144)

= Rs.2144

= 1000 (3.138)

= Rs.3138

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Q. A firm can invest Rs.10,000 in a project with a life of 3 years. The projected cash

inflows are

Years Rs.

1 4000

2 5000

3 4000

Answer:-

The discount factor can be calculated based on Re. 1 received in with ‘r’ rate of

interest in 3 years.

1 .

(1 + r)n

(1+10/100)1

(1+10/100)2

(1+10/100)3

1 4000 0.909 3,636

2 5000 0.826 4,130

3 4000 0.751 3,004

Total P.V. 10,770

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This method recognizes that the cash flows at different point of time differ in value

and are comparable only when they are first brought down to a common denominator.

i.e. Present Values. For this purpose every cash inflow and cash outflow are first

discounted to bring them down to their present value. The discounting rate normally

equals to its opportunity cost of capital.

The NPV is the DIFFERENCE BETWEEN the present values of cash inflows and

the present values of cash outflows.

NPV = Σ PV of inflow – Σ PV of outflow

DECISION RULE

ACCEPT : if NPV is positive i.e. NPV > 0

REJECT : if NPV is negative i.e. NPV < 0

DEFINITION:

The NPV of an investment proposal may be defined as “The sum of the Present

Values of all the cash inflows – The sum of the Present Values of all the cash

outflows”

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If NPV of inflow > NPV of outflow

Then Accept the project.

i.e. If NPV of a project is positive Accept the project & If NPV of a project is negative

reject the project.

MERITS:

1. Considers Time Value of Money.

2. Considers Total Cash Inflows. i.e. entire life.

3. Best Decision Criteria for Mutually Exclusive Project.

4. NPV technique is based on the cash flows rather than the Accounting profits and

thus helps in analyzing the effect of the proposal on the wealth of the

shareholders in a better way.

Thus, it satisfies one of the basic objective of Financial Management i.e. Wealth

Maximization

LIMITATIONS:

The NPV is expressed in absolute terms rather than relative term. Project A may

have a NPV of Rs.5000/- while project B has a NPV of Rs.2,500/-, but project a may

require an investment of Rs.50,000 whereas project B may require an investment

of just Rs.10,000. Advocate of NPV argue that what maths is the surplus value

irrespective of what the investment outlay is.

The NPV method do not consider the life of the project. Hence when mutually

exclusive projects with different lives are being considered, the NPV rule is biased

in favour of long-term project.

4. Calculation of the desired rate of return presents serious problems. Generally cost

of Capital is the basis of determining the desired rate. The calculation of cost of

Capital is itself complicated. Moreover desired rate of return will vary term year to

year.

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1) Calculation of cash flows i.e. both Inflow & Outflow (preferably after tax) over the

full life of the Asset.

2) Discounting the Cash flows by the disc factor.

3) Aggregating of discounted Cash inflow

4) Sept 3 – Outflow (i.e. total present value of cash inflow – total present value of

cash outflow)

a. If positive in step 4. Accept the project

b. If negative in step 4. Reject the project

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• IT IS A VARIANT OF NPV TECHNIQUE WHICH IS ALSO KNOWN AS BENEFIT COST

RATIO OR PRESENT VALUE INDEX OR EXCESS PRESENT VALUE INDEX.

P/I = ---------------------------------------------------

TOTAL OF P.V. OF CASH OUTFLOW

ACCEPT THE PROJECT IF P/I > 1

REJECT THE PROJECT IF P/I < 1

ADVANTAGES:

1. THE NPV DO NOT GIVE TRUE PICTURE WHEN SELECTION AMONG THE PROJECTS

HAS TO BE MADE AND THE INVESTMENT SIZE IS DIFFERENT.

A PROJECT A & B HAVING COST RS.1,00,000 AND 80,000 RESPECTIVELY.

PRESENT VALUE OF INFLOW OF THE PROJECT ARE RS.1,20,000 & RS.1,00,000

BOTH HAVE NPV OF RS.20,000 AND AS PER NPV THEY ALIKE.

HERE P/I TECHNIQUE SEEMS TO GIVE A BETTER RESULT.

1,20,000 1,00,000

P/I (A) = --------------- = 1.20 P/I (B) = ------------- = 1.25

1,00,000 80,000

CONCLUSION: IN TERMS OF NPV BOTH PROJECT ARE EQUAL BUT IN TERM OF P/I ACCEPT

PROJECT B.

2. IT CONSIDERS TIME VALUE OF MONEY.

3. IT CONSIDERS THE ENTIRE CASH INFLOW AND ALL CASH OUTFLOW IRRESPECTIVE

OF THE TIMING OF THE OCCURRENCE.

4. IT IS BASED ON CASH OUTFLOW RATHER THAN THE ACCOUNTING PROFIT AND

THUS HELPS IN ANALYZING THE EFFECT OF THE PROPOSAL ON THE WEALTH OF

THE SHAREHOLDER.

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DISADVANTAGES:

1. IT INVOLVES DIFFICULT CALCULATION.

2. THIS BEING AN EXTENTION OF NPV WHERE THE PREDETERMINATION OF THE

REQUIRED RATE OF RETURN ‘K’ ITSELF IS A DIFFICULT JOB. IF THE VALUE OF

‘K’ IS NOT CORRECTLY TAKEN THEN WHOLE EXERCISE OF NPV MAY GO

WRONG.

PROJECT A PROJECT B

Initial cash outflow 1,50,000 1,10,000

P.V. of cash inflow 2,10,000 1,65,000

NPV 60,000 55,000

AS PER NPV ACCEPT PROJECT A

P/I 2,10,000 = 1.4:1 1,65,000 = 1.5:1

1,50,000 1,10,000

AS PER P/I ACCEPT PROJECT B

IN SUCH A CASE FOLLOW NPV UNLESS THERE IS CAPITAL RATIONING. THIS IS BECAUSE

IF THE FIRM HAS FUNDS OF RS.1,50,000 TO INVEST THEN AS PER NPV TECHNIQUE

PROJECT A IS TO BE ACCEPTED BECAUSE IT WILL RESULT IN INCREASE IN

SHAREHOLDERS WEALTH TO THE EXTENT OF RS.60,000 AGAINST PROJECT B WHICH

WILL INCREASE IN SHAREHOLDERS WEALTH ONLY BY RS.55,000.

THE BETTER PROJECT IS ONE, WHICH ADDS MORE TO THE WEALTH OF THE SHARE

HOLDER.

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• The other variant of the NPV technique is known as terminal value technique.

• Here the future cash inflows are discounted to make them comparable.

• In terminal value technique the future cash flows are first compounded at the

expected rate of interest for the period from their occurrence till the end of the

economic life of the project.

• The compound values are then discounted at an appropriate discount rate to find

out the present value.

• Then the present value is compared with initial outflow to find out the suitability of

the project.

Steps:

1. Find the compounded value

Year Cash inflow Remaining year P.V. factor Compounded

value

1 3

2 2

3 1

4 0

Σ

2. The above compound value to be discounted at a discount factor and the P.V. is to

be found out.

3. The above (2) to be compared with initial investment to get NPV.

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The IRR is that rate at which the sum of discounted cash inflows equals to the sum of

discounted cash outflows.

In other words, it is the rate at which it discounts the cash flow to zero.

Σ Cash inflow

Or = 1

Σ Cash outflow

Thus I.R.R. is also known as marginal rate of return or time adjusted rate or return.

Thus under this method the discount rate is not known but the cash inflow and

cash outflow are known.

For Eg

IF a sum of Rs.800 is invested in a project and become Rs.1000 at the end of a year, the

rate of return come to 25% which is calculated as under:

I= C

(1 + r)

I = Initial investment

C = Cash inflow

R = I.R.R.

(1 = r)

800 (1 + r) = 1000

800 + 800r = 1000

800r = 200

800 4

In order to make a decision on the basis of IRR technique the firm has to determine in

the first instance, its own required rate of return.

This rate ‘K’ is also known as cut off rate or the hurdle rate. A particular proposal may be

accepted.

If its IRR ‘r’ is MORE THAN the MINIMUM REQUIRED RATE ‘K’ ACCEPT IT.

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IF the IRR ‘r’ is just Equal To the Minimum Required Rate ‘K’ than the firm may be

INDIFFERENT.

If the IRR ‘r’ is LESS THAN the MINIMUM REQUIRED RATE ‘K’ the project is altogether

rejected.

In case of mutually exclusive project the project with highest IRR is given top

priority.

MERITS:

1. The method considers the entire economic life of the project.

2. It gives due weightage to time factor. I.e. It consider time value of money.

3. Like NPV technique, the IRR technique is also based on the consideration of all the

cashflows occurring at any time. The salvage value, the working capital used and

released etc. are also considered.

4. IRR is based on cashflows rather than accounting profit.

DEMERITS:

1. It involves complicated trial and error procedure.

2. It makes an implied assumption that the future cash inflows of a proposal are

reinvested at a rate equal to IRR for ex. In case of mutual exclusive proposal say A

& B, having IRR of 18% and 16% respectively, the IRR technique make an implied

assumption that the future cash inflows of project A will be reinvested at 18%

while the cash inflow of project B will reinvested at 16%.

3. It is imaginary to think that the same firm will have different reinvestment

opportunities depending upon the proposal accepted.

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