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    Capital Budgeting: Mrs Smita Dayal

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    karan kataria
    The document discusses capital budgeting, which involves selecting projects for long-term investment. It defines capital budgeting and outlines the typical process, which includes generating ideas, analyzing proposals, prioritizing projects, and monitoring results. Tools for evaluating projects are also covered, such as payback period, accounting rate of return, net present value, and internal rate of return. The advantages and disadvantages of each tool are provided.

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    Capital Budgeting: Mrs Smita Dayal

    Uploaded by

    karan kataria
    67 views23 pages
    The document discusses capital budgeting, which involves selecting projects for long-term investment. It defines capital budgeting and outlines the typical process, which includes generating ideas, analyzing proposals, prioritizing projects, and monitoring results. Tools for evaluating projects are also covered, such as payback period, accounting rate of return, net present value, and internal rate of return. The advantages and disadvantages of each tool are provided.

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    The document discusses capital budgeting, which involves selecting projects for long-term investment. It defines capital budgeting and outlines the typical process, which includes generating ideas, analyzing proposals, prioritizing projects, and monitoring results. Tools for evaluating projects are also covered, such as payback period, accounting rate of return, net present value, and internal rate of return. The advantages and disadvantages of each tool are provided.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    67 views23 pages

    Capital Budgeting: Mrs Smita Dayal

    Uploaded by

    karan kataria
    The document discusses capital budgeting, which involves selecting projects for long-term investment. It defines capital budgeting and outlines the typical process, which includes generating ideas, analyzing proposals, prioritizing projects, and monitoring results. Tools for evaluating projects are also covered, such as payback period, accounting rate of return, net present value, and internal rate of return. The advantages and disadvantages of each tool are provided.

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    © All Rights Reserved
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    of 23

    Capital Budgeting

    Mrs Smita Dayal


    Meaning

     Capital Budgeting is a project selection exercise


    performed by the business enterprise.

     Capital budgeting uses the concept of present value to


    select the projects.

     Capital budgeting uses tools such as pay back period,


    net present value, internal rate of return, profitability
    index to select projects.
    Characteristics of Capital Budgeting

     Benefits for future: Capital is invested with a view to gain benefits for
    future.

     Huge Funds: Generally capital budgeting involves huge amount of


    funds.

     Irreversible Decisions: Decisions once taken cannot be changed, if we


    have already started work on our decision.

     Investment of funds: Capital budgeting is mainly related with the


    investment of capital for long term profit.

     Non-flexible Activities:  Funds are invested for non-flexible activities.

     Decision for long term: In capital budgeting decisions are taken for long
    term profit or for long term commitment of funds
    Capital Budgeting Process

     Generation of Ideas: The generation of good quality


    project ideas is the most important capital budgeting
    step. Ideas can be generated through a number of
    sources like senior management, employees and
    functional divisions or even from outside the company.

     Analysis of Proposals: The basis of accepting or


    rejecting a capital project is the project’s expected
    cash flows in the future. Hence, all the project
    proposals are analysed by forecasting their cash flows
    to determine expected the profitability of each project.
    Capital Budgeting Process
    Cont...
     Creating the Corporate Capital Budget: Once the profitable
    projects are shortlisted, they are prioritized according to the available
    company resources, a timing of the cash flows of the project and the
    overall strategic plan of the company. Some projects may be
    attractive on their own, but may not be a fit to the overall strategy.

     Monitoring and Post-Audit: A follow up on all decisions is equally


    important in the capital budgeting process. The analysts compare the
    actual results of the projects to the projected ones and the project
    managers are responsible if the projections match or do not match
    the actual results. A post-audit to recognize systematic errors in the
    cash flow forecasting process is also essential as the capital
    budgeting process is as good as the inputs’ estimates into the
    forecasting model.
    Capital Budgeting Projects

     Replacement Projects for Maintaining Business:


    Such projects are implemented without any detailed
    analysis. The only issues pertaining to these types of
    projects are first whether the existing operations
    continue and, if they do so, whether the existing
    processes should be changed or maintained as such.

     Replacement Projects for Reducing Cost: Such


    projects are implemented after a detailed analysis
    because these determine whether the obsolete, but
    still operational, equipment should be replaced.
    …Cont..

     Expansion Projects: Such projects require a very


    detailed analysis. These projects are undertaken to
    expand the business operations and involve a process
    of making complex decisions as they are based on an
    accurate forecast of future demand.

     New Product/Market Development: Such projects


    also consist of making complex decisions that require a
    detailed analysis as there is a great amount of
    uncertainty involved.
    …Cont…

     Mandatory Projects: Such projects are required by an


    insurance company or a governmental agency and
    often involve environmental or safety-related concerns.
    These projects will not generate any revenue, but they
    surely accompany new projects started by the company
    to produce revenue.

     Other Projects: Some projects that cannot be easily


    analyzed fall into this category. A pet project involving
    senior management or a high-risk project that cannot
    be analyzed easily with typical assessment methods
    are included in such projects.
    Budgeting Tools

     Payback Period

     Accounting Rate of Return

     Discounted Payback period

     Net Present Value

     Internal Rate of Return

     Profitability Index
    Payback Period

     Payback period is the time duration required to recoup


    the investment committed to a project. Business
    enterprises following payback period use "stipulated
    payback period", which acts as a standard for
    screening the project.
    Computation of payback period

     Computation Of Payback Period

    When the cash inflows are uniform the formula for payback
    period is cash outflow divided by annual cash inflow

     Computation Of Payback Period

    When the cash inflows are uneven, the cumulative cash


    inflows are to be arrived at and then the payback period has
    to be calculated through interpolation.

    Here payback period is the time when cumulative cash


    inflows are equal to the outflows.
    Decision rules for payback
    period
     Capital Rationing Situation

     Select the projects which have payback periods lower


    than or equivalent to the stipulated payback period.

     Arrange these selected projects in increasing order of


    their respective payback periods.

     Select those projects from the top of the list till the
    capital Budget is exhausted.
    Decision Rules Cont…

     Mutually Exclusive Projects

    In the case of two mutually exclusive projects, the one


    with a lower payback period is accepted, when the
    respective payback periods are less than or equivalent to
    the stipulated payback period.
    Advantages of Payback period
     It is easy to understand and apply. The concept of recovery is
    familiar to every decision-maker.

     Business enterprises facing uncertainty - both of product and


    technology - will benefit by the use of payback period method
    since the stress in this technique is on early recovery of
    investment. So enterprises facing technological obsolescence
    and product obsolescence - as in electronics/computer industry
    - prefer payback period method.

     Liquidity requirement requires earlier cash flows. Hence,


    enterprises having high liquidity requirement prefer this tool
    since it involves minimal waiting time for recovery of cash
    outflows as the emphasis is on early recoupment of investment.
    Disadvantages of Payback Period

     The time value of money is ignored. For example, in


    the case of project

     A Rs.500 received at the end of 2nd and 3rd years are


    given same weightage. Broadly a rupee received in the
    first year and during any other year within the payback
    period is given same weight. But it is common
    knowledge that a rupee received today has higher
    value than a rupee to be received in future.
    Accounting rate of return

     Accounting rate of return is the rate arrived at by


    expressing the average annual net profit (after tax) as
    given in the income statement as a percentage of the
    total investment or average investment. The
    accounting rate of return is based on accounting
    profits. Accounting profits are different from the cash
    flows from a project and hence, in many instances,
    accounting rate of return might not be used as a
    project evaluation decision. Accounting rate of return
    does find a place in business decision making when
    the returns expected are accounting profits and not
    merely the cash flows.
    Computation of ARR

     The accounting rate of return using total investment.

     Formula: Net Profit after Tax/ Total Investment

     Sometimes average rate of return is calculated by


    using the following

     formula: Net Profit after Tax/ Average Investment

     Where average investment = total investment divided


    by 2
    Decision Rules for ARR
     Capital Rationing Situation

    Select the projects whose rates of return are higher than the
    cut-off rate Arrange them in the declining order of their rate of
    return and Select projects starting from the top of the list till
    the capital available is exhausted.

     No Capital Rationing Situation

    Select all projects whose rate of return are higher than the
    cut-off rate

     Mutually Exclusive Projects

    Select the one that offers highest rate of return


    Advantages of ARR

     It Is Easy To Calculate.

     The Percentage Return Is More Familiar To The


    Executives.
    Disadvantages of ARR

     The definition of cash inflows is erroneous; it takes into


    account profit after tax only. It, therefore, fails to
    present the true return.

     Definition of investment is ambiguous and fluctuating.


    The decision could be biased towards a specific
    project, could use average investment to double the
    rate of return and thereby multiply the chances of its
    acceptances.

     Time value of money is not considered here.


    Net Present Value

     Net present value of an investment/project is the


    difference between present value of cash inflows and
    cash outflows. The present values of cash flows are
    obtained at a discount rate equivalent to the cost of
    capital.
    Computation of NPV

     Let 'b' be the cash outflow in period 't' where t =


    0,1,2,....n

     'B' be the present value of cash outflows

     'c' be the cash inflow in period 't'=0,1,2,........n

     'C' be the present value of cash inflows

     'K' be the cost of capital

     Then: Present value of Cash Inflows- Present value of


    Cash Outflows
    Decision Rules of NPV
     Capital Rationing Situation

    Select projects whose NPV is positive or equivalent to


    zero. Arrange in the descending order of NPVs.
    Select Projects starting from the list till the capital budget
    allows.

     No Capital Rationing Situation

    Select every project whose NPV >= 0

     Mutually Exclusive projects

    Select the one with a higher NPV.

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