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Capital budgeting is the process of making investment

decisions in capital expenditures.


A capital expenditure may be defined as an expenditure
the benefits out of which are expected to be received over
a period of time.
 The main characteristic of a capital expenditure is
incurred at one point of time whereas benefits of the
expenditure are realized at different points of time in
future.
Meaning
Examples of Capital Expenditures
Cost of acquisition of permanent assets as land and
building, plant and machinery, goodwill etc
 Cost of addition, expansion, improvement or
alternation in the fixed asset
Cost of replacement of permanent assets
Research and development project cost etc
Large Investments:
Long-term commitment of funds
Irreversible nature
Need and Long-term effect on profitability
Importance Difficulties of Investment Decisions
National Importance
Project
Classification
Mandatory Investments
These are expenditures required to comply statutory
requirements
Examples of such investment are pollution control equipment,
medical dispensary, fire fighting equipment
These are often non-revenue producing investments
In analyzing such investments the focus is mainly on finding
the most cost-effective way of fulfilling a given statutory need

Replacement Projects
The objective of such investments is to reduce
costs, increase yield and improve quality

Expansion Projects
 These investments are meant to increase
capacity/ or widen the distribution network
Project
Classification

Diversification Projects
These investments are aimed at producing new
products or services or entering into entirely new
geographical areas

Research and Development Projects

Miscellaneous Projects
Identification of Investment Proposals

Screening the Proposals

Evaluating various Proposals

Capital Budgeting
Process Fixing Priorities

Final Approval and Preparation of Capital


Expenditure budget

Implementing Proposals

Performance Review
Methods of Capital Budgeting or
Evaluation of Investment Proposal

Non-Discounted Methods Discounted Methods

Average
Pay-back Net Present Internal Rate Benefit
Accounting
Period Value of Return Cost Ratio
Period
The payback period is the length of time required
to recover the initial cash outlay on the project

When the annual cash inflow is a constant sum,


the payback period is simply the initial outlay
divided by the annual cash inflow.
According to the payback criterion, the shorter
the payback period, the more desirable the
projects.
Pay-Back Period Advantages:
It is simple in concept, application and calculation
It favors projects which generate substantial cash
inflows in earlier years and discriminates against
projects which bring substantial cash flows in later
years
Sine it emphasizes earlier cash inflows
• Pay-Back
Period
Advantages:
It is simple in concept, application and calculation
It favors projects which generate substantial cash
inflows in earlier years and discriminates against projects
which bring substantial cash flows in later years
Sine it emphasizes earlier cash inflows

Dis-advantages:
It fails to consider the time value of money
It ignores cash flows beyond the payback period
• Evaluation of
Pay-Back

Cash Flow after


Simplicity payback

Administrative
Liquidity difficulties

Time value of money


Cost-effective
ignored
The accounting rate of return is also called the average
rate of return

It uses accounting information, as revealed by financial


statements, to measure the profitability of an
investment

The accounting rate of return is the ratio of the average


after tax profits divided by the average investment
Accounting Rate of
Return The average investment would be equal to half of the
original investment if it were depreciated constantly.
Alternatively, it can be found out by dividing the total of
the investment's book values after depreciation by the
life of the project

The accounting rate of return, thus, is an average rate


and can be found by: ARR= (Average Income/Average
Investment)
 If you invest Rs. 5,000 today at a compound interest of 9
percent, what will be its futures value after 75 years?
Hints: (1.09)30 =13.268 and (1.09)15 =3.642

 what is the present value of Rs 1,000,000 receivables 60 years


from now, if the discount rate is 10 percent?
Hints: (1.10)30 = 17.449
How long would it take to double the
amount at a given interest rate

Is there a rule of thumb which dispenses


with the use of the future value interest
factor model?

Doubling Yes, it is called rule of 72


period
According to the rule of thumb, the
doubling period is obtained by dividing 72
by the interest rate

Example: If the interest rate is 8 percent, the


doubling period is about 9 years
Rule of 69
According to this rule of thumb, thee doubling
period is equal to = 0.35 + (69/Interest Rate)

If the interest rate is 12 per cent, what are the


doubling as per the rule of 72 and the rule of 69
respectively?
What is Salvage Value?
Salvage value is the estimated resale value of an asset at
the end of its useful life.
Salvage value is subtracted from the cost of a fixed asset
to determine the amount of the asset cost that will
be depreciated.
Thus, salvage value is used as a component of the
depreciation calculation.

For example, ABC Company buys an asset for $100,000,


and estimates that its salvage value will be $10,000 in five
years, when it plans to dispose of the asset. This means that
ABC will depreciate $90,000 of the asset cost over five
years, leaving $10,000 of the cost remaining at the end of
that time. ABC expects to then sell the asset for $10,000,
which will eliminate the asset from ABC's accounting
records.
Net Present Value

It is used to evaluate investment and financing decisions that involve


cash flows occurring over multiple periods

The NPV of a project is the sum of the present Value of all cash flows-
Positive as well as Negative- that are expected to occur over the life of
the project
Properties of Net
Present Value

Net Present Values are additive: The NPV of a package of projects


is simply the sum of Net present Values of Individual Projects
included in the package

Intermediate Cash Flows are invested a the cost of Capital: The NPV
Rule assumes that the intermediate cash flows of a project – that is,
cash flows that occur between the initiation and the termination of
the project- are reinvested at a rate of return equal to the cost of
Capital

NPV calculations Permits Time Varying Discount Rates:


Limitations of Net Present
Value

The NPV is expressed in absolute terms rather than relative terms


and hence does not factor the scale of investment.

The NPV rule does not consider the life of the project. Hence, when
mutually exclusive projects with different lives are being considered,
the NPV is biased in favor of longer term project.
Internal Rate of Return (IRR)

The IRR of a project is the discount rate which makes its NPV equal
to Zero.
It is the discount rate which equates the present value of future cash
flows with the initial investment.
The IRR can be defined as that rate of discount at which the present
value of cash inflows is equal to the present value of cash outflows.

Example
Year 0 1 2 3 4
Cash Flows -100,000 30,000 30,000 40,000 45,000
Benefit-Cost Ratio

It is also called profitability index


BCR = PVB/I = Present Value of Benefits/ Initial Investment