ITFT -Capital Budgeting
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ITFT -Capital Budgeting

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Meaning of Capital Budgeting, Capital Budgeting Decisions, Methods of Capital Budgeting

Meaning of Capital Budgeting, Capital Budgeting Decisions, Methods of Capital Budgeting

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ITFT -Capital Budgeting ITFT -Capital Budgeting Presentation Transcript

  • Capital budgeting PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Meaning • Capital budgeting is the process of making investment decisions in capital expenditure. • A capital expenditure may be defined as an expenditure the benefits of which areexpenditure the benefits of which are expected to be received over period of time exceeding one year. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Examples • Some of the examples of capital expenditure are: • Cost of acquisition of acquiring permanent assets like land, building, plant, machinery, goodwill etc.goodwill etc. • Cost of addition, expansion, improvement or alteration in the fixed assets. • Cost of replacement of permanent assents. • Research and development project cost, etc. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Definition • According to G. C. Philippatos, “capital budgeting is concerned with the allocation of firm’s scarce financial resources among the available market opportunities.” PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Introduction • Capital budgeting addresses the issue of strategic long- term investment decisions. • Capital budgeting can be defined as the process of analyzing, evaluating, andanalyzing, evaluating, and deciding whether resources should be allocated to a project or not. • Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Importance of Capital Budgeting Decision Long-term Implications Involvement of large amount of funds Irreversible DecisionsImplications of funds Decisions Risk and uncertainty Difficult to make PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Methods of Capita Budgeting Methods Traditional Method Pay-Back Period Post- Payback Rate of Return Time Adjusted Method Net Present Value Internal Rate of Return Profitability Index PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Which Technique should we follow? • A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization. • A technique is considered consistent with• A technique is considered consistent with wealth maximization if • It is based on cash flows • Considers all the cash flows • Considers time value of money • Is unbiased in selecting projects PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Pay-Back Period • The Payback- period is the time duration required to recover the initial cash outflows. This method is based on cash flows and not on accounting data like the ARR. • Suppose somebody spent Rs.50,000 on any project and expects that within 3 year he can get back this amount, then the payback period is 3 years. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Cont… • Payback period of any proposal can be calculated as follows, • If the cash inflows are uniform then • Under this method, various investments with a shorter pay back period is preferred to the one which has longer pay back period. • Annual Net Earnings i.e before depreciation after tax PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Questions: • Q 1 A project costs Rs 1,00,000 and yields an annual cash inflow of Rs. 20,000 for 8 years. Calculate its payback period. • Q2 Determine the pay back period for a project which requires a cash outlay of Rs. 10,000 andwhich requires a cash outlay of Rs. 10,000 and generates cash inflows of Rs. 2,000, Rs. 4000. Rs. 3000, and Rs. 2000 in the first, second, third and forth year respectively. • Q 3 A project cost Rs 5,00,000 and yields annually a profit of Rs. 80,000 after depreciation @12% p.a. but before tax of 50%. Calculate the payback period. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • • There are two projects X and Y. Each project requires an investment of Rs 20,000. you are required to rank these projects according to the pay back method from the following information:information: (Net profit before depreciation after tax) Years Project X Project Y 1st 1000 2000 2nd 2000 4000 3rd 4000 6000 4th 5000 8000 5th 8000 - PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Ques: X Ltd is producing articles mostly by manual labour and is considering to replace it by a new machine. There are two alternative models M & N of the new machine. Prepare a statement of profitability showing the pay-back period from the following information: Machine M Machine N Estimated life of machine 4 years 5 years Cost of Machine Rs. 90,000 Rs. 1,80,000 Estimated savings in scrap 5,000 8,000 Estimated savings in direct wages 60,000 80,000 Additional cost of maintenance 8000 10,000 Additional cost of supervision 12,000 18,000 PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Advantages • Simple to understand and easy to calculate • It takes lesser time and labour as compared to other methods. • Due to its short term approach, this method is• Due to its short term approach, this method is particularly suited to a firm which has shortage of cash or whose liquidity position is not particularly good. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Disadvantage • It doesn’t take into consideration the cash inflows earned after the pay back period and hence the true profitability of the projects cannot be correctly assessed. • This method ignores the time value of money and does not consider the magnitude and timings of cash in flows. does not consider the magnitude and timings of cash in flows. • It may be difficult to determine the minimum acceptable pay-back period, it is usually, a subjective decision. • It does not measure the true profitability of the project as the period consider under this method is limited to short period only and not the full life of the asset. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Post Payback Period • One of the limitations of the pay-back period method is that it ignores the life of the project beyond the pay-back period. • Post pay-back period method takes into account the period beyond the pay-back method. This method is also known as surplus life over pay-backmethod is also known as surplus life over pay-back period may be accepted. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Ques: For each of the following projects compute (i) pay back period, (ii) post-back period profitability, (iii) post-back profitability index: (a) Initial outlay Rs. 50,000 Annual Cash Inflow (after tax & before dep.) Rs. 10,000 Estimated Life 8 years (b) Initial outlay Rs. 50,000 Annual Cash Inflow (after tax & before dep.) First three years Rs. 15,000 Next five years Rs. 5,000 Estimated Life 8 years PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Rate of Return or Accounting Rate of Return • This method takes into account the earnings expected from the investment over their whole life. • It is known as accounting rate of return method for the reason that under this method the accounting concept of profit (net profit after tax for the reason that under this method the accounting concept of profit (net profit after tax and depreciation) is used rather than cash inflows. • The project with the higher rate of return than the minimum rate specified by the firm also known as cut off rate, is accepted and the other which gives a lower expected rate of return than the minimum rate is rejected. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • This Method can be Used in Several WaysSeveral Ways PDF created with pdfFactory Pro trial version www.pdffactory.com
  • 1. Average Rate of Return Method • Under this method average profit after tax and depreciation is calculated and then it is divided by the total capital outlay or total investment in the project. In other words, it establishes the relationship between average annual profits torelationship between average annual profits to total investments. • Thus, PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Q. A project requires an investment of Rs 5,00,000 and has a scrap value of Rs. 20,000 after 5 years. It is expected to yield profits after depreciation and taxes during the 5 years amounting to Rs. 40,000, Rs. 60,000, Rs. 70,000, Rs. 50,000 and Rs. 20,000. Calculate average rate of return on the20,000. Calculate average rate of return on the investment. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • 2. Return per unit of investment method • This method is small variation of the average rate of return method. In this method the total profit after tax and depreciation is divided by the total investment, i.e., PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Q. A project requires an investment of Rs 5,00,000 and has a scrap value of Rs. 20,000 after 5 years. It is expected to yield profits after depreciation and taxes during the 5 years amounting to Rs. 40,000, Rs. 60,000, Rs. 70,000, Rs. 50,000 and Rs. 20,000. Calculate averageRs. 50,000 and Rs. 20,000. Calculate average rate of return on the investment. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • 3. Return on average investment method ¨ In this method the return on average investment is calculated. Using of average investment for the purpose of return on investment is preferred because the original investment is recovered over the life of theinvestment is recovered over the life of the asset on account of depreciation charges. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Q. A project requires an investment of Rs 5,00,000 and has a scrap value of Rs. 20,000 after 5 years. It is expected to yield profits after depreciation and taxes during the 5 years amounting to Rs. 40,000, Rs. 60,000, Rs. 70,000, Rs. 50,000 and Rs. 20,000. Calculate average rate of return onRs. 20,000. Calculate average rate of return on the investment. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • 4. Average return on average investment method • This is the most appropriate method of rate of return on investment. Under this method, average profit after depreciation and taxes id divided by the average amount of investment; thus:thus: PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Q. A project requires an investment of Rs 5,00,000 and has a scrap value of Rs. 20,000 after 5 years. It is expected to yield profits after depreciation and taxes during the 5 years amounting to Rs. 40,000, Rs. 60,000, Rs. 70,000, Rs. 50,000 and Rs. 20,000. Calculate average rate of return onRs. 20,000. Calculate average rate of return on the investment. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Q. Calculate the average rate of return for projects A & B from the following: Project A Project B Investments Rs. 20,000 Rs. 30,000 Expected Life (No Salvage value) 4 years 5 years Projected Net Income (After interest, depreciation and taxes) Years Project A Project B 1 2,000 3,000 2 1,500 3,000 3 1,500 2,000 4 1,000 1,000 5 - 1,000 If the required rate of return is 12%, which project should be undertaken PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Advantages of Rate of Return Method • It is very simple to understand and easy to operate • It uses the entire earnings of a project in calculating rate of return and not only thecalculating rate of return and not only the earnings upto pay-back period and hence gives a better view of profitability as compared pay-back period method. • As this method is based upon accounting concept of profits, it can be readily calculated from the financial data. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Disadvantages of Rate of Return Method • It ignores time value of money as profits earns at different point of time are given equal weight by averaging the profits. • It doesn’t take into consideration the cash• It doesn’t take into consideration the cash flows which are important the accounting profits. • This method cannot be applied to a situation where investment in a project is to be made in parts. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Time Adjusted Method or Modern Method • This method takes into consideration the profitability and time value of money (the fact that a rupee earned today has more value than a rupee earned after 5 years.)value than a rupee earned after 5 years.) PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Net Present Value (NPV) • It is net present value of all the cash flows that occur during the entire life span of a project. • The outflows will have negative values while the inflows will have positive values. • Obviously, if the present value of inflows is greater than outflows, we get a positive NPV and • Obviously, if the present value of inflows is greater than outflows, we get a positive NPV and if the present value of outflows is greater than inflows, we get a negative NPV. • The positive NPV means a net gain in value maximization and, therefore, any project which gives a positive NPV is an acceptable project and if it gives a negative NPV, then the project should not be accepted. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Steps for Calculating NPV • First of all determine the appropriate rate of interest that should be selected as the minimum required rate of return called cut off rate or discount rate. The rate should be the minimum rate of return below which the investor considers that it doesn’t pay him to invest. The discount rate should be the actual rate of interest in therate should be the actual rate of interest in the market on long-term loans or it should reflect the opportunity cost of capital of the investor. • Compute the present value of the total investment outlay, i.e. cash outflows at the determined discount rate. If the total investment is to be made in the initial year, the present value shall be the same as the cost of investment. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • • Compute the present values of total investment proceeds, i.e., cash inflows, (profit before depreciation and after tax) at the above determined discount rate. • Calculate the net present value of each project by substracting the present value of cash inflows from the present value of cash outflows for eachfrom the present value of cash outflows for each project. • If the NPV is positive or zero the proposal may be accepted and vice versa. • In case of mutually exclusive projects, projects should be ranked in order of net present values. The project with high NPV should be given highest rank and so on. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • The Present Value of Re 1 due in any number of years can be found with the use of the following mathematical formula: PV = 1/(1+r)n Where, PV = Present value r = rate of interest / discount rate n = number of yearsn = number of years The present value for all the cash inflows for a number of years is thus found as follows: However as n becomes large, the calculation of (1+r)n become difficult. PV can also be found by the use of PV tables. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Internal Rate of Return • Under this method, the cash flow of a project are discounted at a suitable rate by hit and trial method, which equates the NPV so calculated to the amount of the investment. Under this method, since the discount rate isUnder this method, since the discount rate is determined internally, this method is called as the internal rate of return method. The IRR can be defined as that rate of discount at which the PV of cash inflows is equal to the PV of cash outflows. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • It can be calculated with the help of following formula: • C = initial outlay at time zero • A1, A2, A3… An = future net cash flows at• A1, A2, A3… An = future net cash flows at different periods • 2, 3……, = number of years • r = Rate of discount of IRR PDF created with pdfFactory Pro trial version www.pdffactory.com
  • The IRR can also be cal. with the help of PV tables. The following steps are required to practice the IRR method. • Determine the future net cash flows during the entire economic life of project. The cash inflows are estimated for future profits before depreciation but after tax • Determine the rate of discount at which the value of cash inflows is equal to the values of cash outflows. • Determine the rate of discount at which the value of cash inflows is equal to the values of cash outflows. • Accept the proposal if the IRR is higher than or equal to the minimum required rate of return i.e. the cost of capital or cut off rate and reject the proposal if the IRR is lower than the cost of cut off rate. • In case of alternative proposals select the proposal with the highest rate of return as the rates are higher than the cost of capital or cut-off rate. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Determination of IRR • When the annual cash flows are equal over the life of the asset: firstly, find out present value factor by dividing initial outlay (cost of the investment) by annual cash flow, i.e. Present Value Factor = Initial Outlay / Annual cash flow PDF created with pdfFactory Pro trial version www.pdffactory.com
  • • In case annual cash flows are unequal over the life of the asset, the IRR cant be determined according to the technique suggested above. In such cases, the IRR is calculated by hit and trial an that is why this method is also known as hit and trial yield method. We may start any assumed that is why this method is also known as hit and trial yield method. We may start any assumed discount rate and find out the total PV of cash outflows which is equal to the cost of initial investment where total investment is to be made in the beginning. The rate at which the total PV of all cash inflows equals the initial outlay, is the IRR. Several discount rates may have to be tried until the appropriate rate is found. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • The calculation process may be summed up as follows: • Prepare the cash flow table using arbitrary assumed discount rate to discount the net cash flows to the PV. • Find out the NPV by deducting from the PV of total cash flows calculated in above the initial cost of investmentinvestment • If the NPV is positive, apply higher rate of discount • If the higher discount rate still gives a positive NPV, increase the discount rate further until the NPV becomes negative • If the NPV is negative at this higher rate, the internal rate of return must be between these 2 rates. PDF created with pdfFactory Pro trial version www.pdffactory.com
  • Profitability Index • NPV is an absolute value and therefore is not appropriate for comparing the relative profitability between different projects. In order to overcome this limitation of NPV, we make one modification in it to make it amake one modification in it to make it a relative measurement. This is called Profitability Index (P.I.) or Benefit Cost Ratio (B-C Ratio). The P.I. is as follows: PDF created with pdfFactory Pro trial version www.pdffactory.com
  • PDF created with pdfFactory Pro trial version www.pdffactory.com