CAPITAL

BUDGETING
AGENDA :

1) Capital Budgeting
2) Capital Budgeting Process
3) Techniques of Capital Budgeting
4) The Cost of Capital
5) Capital Budgeting Extensions
Capital Budgeting
 is the process of evaluating and selecting
long term investments that are consistent
with the goal of shareholders (owners )
wealth maximization
 is the planning process used to determine a
firms long term investments. Such as new
machinery, replacement machinery, new
products, R&D projects
 is otherwise called as INVESTMENT APPRAISAL
Capital expenditure
 is an outlay of funds that is expected to
produce benefits over a period of time
exceeding one year. These benefits may
be either in the form of increased revenues
or reduced costs
Sources of Financing Capital Budgeting
Decision/Project finance:
 Capital budgeting decisions are financed
using long term sources

The various types of long term sources are:

•Equity Capital - Equity Shares or Ordinary Shares
•Hybrid Capital - Preference Shares
•Debit Capital - Debentures/Bonds and Term
Loans
Stages of Capital Budgeting process:
A. Planning
B. Analysis
1) Market analysis
2) Technical analysis
3) Financial analysis
4) Economic analysis
5) Ecological analysis
C. Selection
D. Implementation
E. Review
 Capital Budgeting Evaluation Techniques

Non-Discounting Techniques Discounting techniques

ignores the Time Value of Money
1) Average Rate Return
/Accounting
rate of return (ARR)
2) Pay back period (PBP)
Considers the time value of money
1) Net present value (NPV)
2) Internal Rate of Return (IRR)
3) Profit index or Benefit-cost
Ratio (BCR)
Pay Back Period (PBP)
 is used as a first screening method, it gives
an indication of rough measure of liquidity.
Under this method accumulation of cash flows
is made year after year until it meets the initial
capital outlay, to identify the recovery time of
the capital amount invested

PBP = Initial Investment / Annual Cash in Flow

 If PBP > Target period – Accept the proposal

 If PBP < Target period – Reject the proposal

 If PBP = Target period – Further analysis is

required

Target period
 is the minimum period targeted by
management to cover initial investment
Average Rate of Return (ARR)
 also known as accounting rate of return
 is defined as average cash inflows
(Benefits) against unit investment
 is otherwise called as RETURN ON
CAPITAL EMPLOYED METHOD

ARR = Average cash inflows (Benefits )*100

/ Initial investment
 If ARR > Target rate – Accept the proposal

 If ARR < Target rate – Reject the proposal

 If ARR = Target rate – Further analysis is

required

Target Rate
 is the minimum rate of return targeted by
management
Discounting Techniques
 Under discounted cash flow techniques, the future
net cash flows generated by a capital project are
discounted to ascertain their present values .
NPV: Net present value

 Under NPV method future cash flows are

discounted at minimum required rate of return of
the project and then deduct it from initial out lay to
arrive at the NPV of the project
NPV = PV (Benefits) – Initial investment
 If NPV > 0 – Accept

 If NPV < 0 – Reject

 If NPV = 0 - May accept or Reject

Internal rate of return (IRR)
is a percentage discount rate used in
capital investment appraisals which
equates the present value of anticipated
cash inflows with initial capital outlay
 it is that discount rate at which NPV = 0.
Discount rate is ascertained by trail and
error method
 If IRR > K – Accept

 IF IRR < K – Reject

 If IRR = K - May accept or Reject

Profitability Index
 is the present value of an anticipated cash in
flows divided by the initial investment
 it is a method of assessing capital expenditure
opportunities in the profitability index

Profitability Index (PI) = Present Value of Cash

Inflows / Present Value of Cash Out Flows

 This method is also called COST BENEFIT RATIO

OR DESIRABILITY RATIO