CAPITAL BUDGETING

NIDHI DAS MGT1005424

MEANING
y Capital budgeting is the firms decision to invest its

funds most efficiently in long term assts against an anticipated flow of future benefits over a number of years and the project ensuring most profitable use of given resources are undertaken. y Capital budgeting is the investment decision on fixed assets whereas investment decision on current assets is known as working capital mgt.

Definition:
y According to Gitman L. J., capital budgeting refers

to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives.

Process of Capital Budgeting

The various steps involved in capital budgeting are: 1. Project generation 2. Project evaluation 3. Project selection 4. Project execution 5. Follow-up

Features of capital budgeting

y Potentially large anticipated benefits y A relatively high degree of risk y A relatively long period between initial outlay and

the anticipated return

METHODS OF APPRAISAL
The various investment criteria which are widely used are broadly classified into two groups 1. Traditional or unsophisticated method 2. Time-adjusted or sophisticated method

y Traditional method 1. 2. y 1. 2. 3. 4. 5.

Pay-back method Average Rate of Return Time adjusted rate of return method Present value method Net Present Value method Internal Rate of Return method Profitability Index method Terminal value method

PAY-BACK PERIOD
y Pay back period or pay-out method reveals the

period which is required to get back the original cost of investment by annual savings y The operating savings here means cash inflows before interest and depreciation, but after taxes, if any.

When cash flow accrues at even rate Pay-Back Period (PBP)= NI/OS NI- Net investment OS- operating savings When cash flow accrues at uneven rate Pay-Back Period (PBP)= E + B/C E- number of years immediately preceding the years of recovery B- balance amount of investment to recover C- savings during the year of final recovery

Advantages y It lays great emphasis on liquidity y Simple to operate and easy to understand y Can compare profitability of two projects y Reveals the degree of risk involved Disadvantages y It fails to consider the period over which an investment is likely to fetch income y It ignores time value of money y Wont recognize the profit earned during the working life of the asset y Does not consider cost of capital

Some modifications on traditional method includes y Pay-back profitability y Discounted pay-back period y Pay-back reciprocal

Pay-back profitability
This method recognizes that total cash flow remains after recovering the cost of investment. Post pay-back profitability = Net cash flow of savings x [expected life of the project pay-back period]

Discounted pay-back period

When pay-back period is calculated by taking into account the discounting or interest factors, it is known as discounted pay-back period

Pay-back reciprocal
y Express the profitability considering the time value

of money y Reflects the rate of return from the project y Useful where the earnings is relatively consistent and life of the asset is at least double the pay-back period y Pay-back reciprocal = 1/PBP

Average rate of return

y Also known as Accounting Rate of Return y Used to measure rate of return on investment of a

project y ARR= [Average Annual profit after tax/ average investment] X 100

Advantages y Simple to calculate and easy to understand y Considers savings over entire life of the project y Recognizes the concept of net earnings Disadvantages y Doesn't recognizes the timings of cash flows y Doesnt take into account life period of the various investments y In the case of long-term investments, it may not reveal true and fair view

Present Value Method

y Recognizes that each cash inflows and outflows at

different period differ in value y Present value of cash inflows is compared to present value of cash outflow y If the present value of cash inflow is greater than present value of cash outflows, the project would be accepted and vice-versa

Net Present Value Method

y Also known as Excess Present Value or Investors

Method y It is the time value of money approach for evaluating the investment proposal y All cash flows are discounted at a given rate and their present values are computed

NPV = Cash inflow cash outflow y If NPV is positive, project is accepted y If NPV is negative, project is rejected

Advantages y It is superior to other methods of evaluating the economic growth of investments y It recognizes the cash flows throughout the life of the project y It is generally accepted by economists y It recognizes time value of money

Profitability Index
y A time adjusted technique for evaluating proposals y A relation between present value of future net cash

flows and initial cash outlays y Expressed either in rupee or in percentage y Proposals are accepted when P. I. exceeds one ( or hundred if expressed in terms of percent)

P. I. (per rupee) = P. V. of cash inflows / P.V. of cash outflows P. I. (%) = [P. V. of cash inflows / P.V. of cash outflows] X 100

Advantages y Recognizes time value of money, totality of benefits, etc. y Computed the incremental benefit cost ratio Disadvantages y Involves more calculations y Difficult to understand

Terminal Value Method

y Cash flow of each year is re-invested in another asset

with a certain rate of return from the moment of its reception till the economic life of the project y The net cash flow and outlay are compounded and compared y If the P. V of cash inflows are greater than the P. V. of cash outflows, or the NCF has higher terminal value compared with the outlay the project should be accepted

Advantages
y Mathematically easier and simple evaluation

procedure y Simple to understand y Avoids the influence of cost of capital Disadvantages Doesnt consider comparative evaluation of two or more mutually exclusive proposals y Relates to projected rate of return at which cash inflows of different years may be re-invested

Internal Rate of Return

y Also known as yield method y Introduced by Joel Dean y Equates present value of cash inflow with present

value of cash outflow y It is actually the rate or return earned by the project y Project is accepted if the IRR greater than 1

y When savings are even

IRR = LR + [(HPV PVF)/ difference in calculated PV] X 100 y When the savings are not even IRR = LR + [(calculated PV-PV of cash outflow)/difference in calculated PV] X 100

Advantages

y Provides more precise information regarding

profitability y Helps the firm to choose among different alternatives y Recognises time value of money y Takes into account the cash flows throughout the project

Disadvantages

y Computation is quite complicated and tedious y Uses accounting information and does not explain

cash flow position y Does not provide significant answers under all situations