Capital Budgeting

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

Pay back Period

PBP measures the length of time required to recover the initial outlay in the project.in order to use PBP as a decision rule for accepting or rejecting the projects,the firm has to decide upon an appropriate cut-off period. It is simple in both concept and application It helps in weeding out risky projects by favouring only those projects which generate substantial inflows in earlier years. (No time value of money and Inflows after recovering initial investment are not considered)

 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.

Average Rate of Return or Book Rate of Return

ARR=Average profit After Tax/Average Book Value of investment Arr is simple.It considers the returns over the entire life of the project and serves as a measure of profitability(unlike PBp only a measure of capital recovery). To use it as an appraisal criteria ARR of a project is compared with ARR of the firm as a whole or against some external yard stick like the ARR for the industry as a whole.

 This suffers from several seroius defects.It ignores time value of money.ARR depends on accounting income and not on the cash flows.

Net Present Value

The NPV of aproject is the sum of the present values of all the cash flows-positive as well as negative-that are expected to occur over the life of the project. The NPV represents the net benefitover and above the compensation for time and risk.Accept project if the NPV is positive and reject the project if the NPV is negative.If the NPV is zero ,it is a matter of indifference.

 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.

Internal Rate of Return (IRR)

This method also considers time value of money.In case of NPV the discount rate is the required rate of returnand being predetermined rate usually cost of capital its determinants are external to the proposal on the other hand IRR is based on facts which are internal to the proposal. It is defined as the discount rate which equates the aggregate present value of the net cash inflows (CFAT) with the aggregate pv of cash outflows of a project.It is that rate which gives the project NPV of zero.

 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)