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Capital budgeting is the process of making investment decisions in capital expenditures. capital budgeting is long term planning for making and financing proposed capital outlays. Examples of Capital Expenditure.1)cost of acquisition of permanent assets L&B,P&M etc.2)Cost of addition ,expansion ,improvement or alteration in the fixed assets.3)Cost of replacement of permanent assets.4)Research and Development project cost,etc.
CEdecisions are important for the following reasons. once the decision is taken ,it has far reaching consequences which extend over a considerably long period These decision involve huge amounts of money. These decisions are irreversible once taken.
Time value of money is relevant here for the following reasons. -The benefits of capital expenditure are expected to occur for a number of years in the future which is highly uncertain. Because the costs and benefits occur at different points of time ,investment proposal,for a proper analysis of the viability of all these have to be brought to the common frame.
Appraisal Criteria
The project has to be examined from the point of view of financially desirable or not. Evaluation Criteria 1.Non-discounting 2.discounting criteria 1.a.Payback period 2.a.NPV b.ARR b.BCR/PI c.IRR d.Annual Capital Charge
Discounted payback period i.e. to incorporate time value of money. Discount cash flows before the computation of PBP. Companies do not give much importance to the payback period as an appraisal criteria.
This suffers from several seroius defects.It ignores time value of money.ARR depends on accounting income and not on the cash flows.
NPV is a sound criteria because it takes into account the time value of money and considers cash flows.It considers the total benefits arising out of the proposal over its life time.This method is particularly useful for the selection of mutually exclusive projects. Value of the firm= present value of projects plus NPV of expected future projects(Assetsin in its place and value of growth opportunities)
Demerits /Shortcomingsthe minor flaw difficult to calculate.To discount the cash flows.This method will favour the project which has higher pv but project may involve larger outlay.A project which has a higher pv may also have a larger economic life so that the funds will remain invested for a longer period while the alternative proposal may have shorter life but smaller present value.
To determine the IRR compute NPV of the project for different rates of interest until we find that rate of interest at which the NPV of the project is equal to zeroor sufficiently close to zero. Problem:A project costs Rs.36,000 and id expected to generate cash flows of Rs.11,200 annually for 5 years.Calculate the IRR of the project.
Merits-It takes into a/c the time value of money.It considers the cash flow stream over the entire investment horizon.Like ARR,it makes sense to businessmen who prefer to think in terms of rate of return on capital employed. Limitations:Useful for simple investments. (Cash outflow followed by cash inflows ).If the cash flow stream has one or more cash outflows for such a project IRR cannot be meaningful criterion of appraisal.
To use IRR as an appraisal criterion,we require information on the cost of capital or funds employed in the project.If we define IRR asrand cost of funds employed ask,then the decision rule based on IRR will be:Accept the project if r is greater than kand reject the project if r is less than k.(If r=k,it is matter of indifference)