V Capital budgeting (or investment appraisal) is

the planning process used to determine

whether a firm's long term investments such
as new machinery, replacement machinery,
new plants, new products, and research
development projects are worth pursuing. It
is budget for major capital, or investment,
expenditures.
Rs soon as a company reaches to a decision
to invest abroad, the firm evaluate projects
and selects one or more of them that ranks
high from the viewpoint of adding to the
corporate wealth.
The process is known as @
 
 
 

 

The method of evaluation of investment
proposals are grouped in two methods:-

˜
  ˜


V ëon-discounting methods are simple.
V One such method involves the average rate of return
earned by the project.
V It represents the mean profit on account of
investment prior to interest and tax payment.
V The mean is compared with required rate of return.
V R project is acceptable if the mean profit is higher
than the required rate of return.
j

  
  
V It is based on the accounting income and not
on the cash flow.
V It considers profit before tax, rather than
post-tax profit.
V It ignores time value.
V ˜iscounting methods take normally four
forms:-
1. ëet present value (ë
) method
2. rofitability index ( I) method
3. Internal rate of return (IRR) method
4. The Rdjusted resent
alue (R
) Rpproach
V ë
is the residue after deducting the initial
investment from the present value of future
cash flows relating to a project.
V ositive ë
means additions to the corporate
wealth therefore accept the project; if not
reject the project.
V The equation is:-
   
ë
=  


@
  r ër 

V I is the ratio between the present value of
the future cash flows and the initial
investment.
V It shows the relative gains and would be
expressed as the following equation :-

 Y

 ër Y

 
  r 
V IRR is the discount rate equating the present
value of future cash flows and the initial
investment.
V For accepting a project, IRR > hurdle rate
(required rate of return).
V Expressed as an equation:

 
@ ÿ  
@ ÿ[
  ÿ
 @



 R


å If incentives exist to finance with debt - tax shields or
interest subsidies - Rdjusted resent
alue (R
) should
be used.
å If tax treatments are symmetric, and if uncovered
interest parity is expected to hold, tax shields will have
identical value whether debt is raised in host or home
country.
å Low capital gains taxes, high deductibility of interest
payments, negative failure of UI , and subsidized
interest rates will all favor financing in depreciating
currencies.
V arent cash flows are different from project
cash flows.
V Rll cash flows from the foreign projects must
be covered into the currency of the parent
firm.
V rofits remitted to the parent are subject to 2
jurisdictions r the parent country and the
host country.
V The possibility of foreign exchange risk and
its effect on the parentǯs cash flows.
V If the host country provides concessionary
financing arrangements or/and benefits, the
profitability of the foreign project may go up.
V Initial investment in the host country may
benefit from the partial or total release of
blocked funds.
V The host country may impose restrictions on
the distribution of cash flows generated from
foreign projects.
V The foreign exchange risk
V Remittance restrictions
V The tax issue
V roject v/s parent cash flows
V Cash flows v/s ˜iscount rate adjustment
V Financing arrangement
V Blocked funds
V Inflation
V Uncertain salvage value
V The above discussion was limited to the
numerator of the ë
- rule equation.
V The denominator of the equation ,which is
known as the discount rate or hurdle rate
which is based on the risk- adjusted cost of
capital ,is also very significant for the
computation of cash flow.
V R  
 
:- it represents the
weighted average of the cost of equity and
cost of debt.
 
V 
˜
:- interest is the cost of debt
adjusted for taxes because interest is tax-deductible
and debited in the income statement before tax is
calculated.
d= Interest/principal*(1-t)
V 

:- ˜ividend is the cost of equity shares.
The price of equity share is equal the present value of the
expected dividend resulting the risk-adjusted rate required
by the investors.
= ˜/ o
V 

   :- funds for
investment normally comes from the
retained earnings. The after-tax cost of
retained earnings is calculated.
= ke*(1-t)
V Real options is a different way of thinking
about investment values.
V Rt its core, it is a cross between decision-tree
analysis and pure option-based valuation.
V Real option valuation also allows us to
analyze a number of managerial decisions
that in practice characterize many major
capital investment projects
Real options start when there is expected a
change in cash flow from that originally
anticipated.

They are concerning (related to) :-

postponement/abandonment/expansion/
contraction of the operation.
V Investment timing option (postponement)
r Evaluate additional information
V Rbandonment option
r Reduce downside risk
V ·rowth options(expansion)
r Research programs, expand a small plant, or
strategic acquisition
V Xhutdown options
r Temporarily
Rodriguez and Carter (1984) group these
factors as ëon-Financial factors influencing
capital budgeting decision are :-

1. Behavioural characteristics of the

organisation.
2. Business strategy

These factors influence the final decision about

taking up of the project.
V
arsha Chaurasiya 07
V Rnas Choudhary 10
V Rvani ·andhi 16
V Rashmi ·upta 19
V ëilofar Rayani 42
V Xalman Xhah 45