One of most crucial and critical business decisions
Involvement of heavy funds- Improper and ill-advised investment and incorrect decisions can jeopardize the survival of even Biggest firm
Long – term implications- Impact of capital decisions are known after a long period. A wrong decision can prove disastrous for the long term survival of the firm
Irreversible decisions
Most difficult decisions to make – Capital Budgeting decisions require assessment of future events which are uncertain. Further assessing future costs and benefits accurately in quantitative terms is not easy. E.g KCC and Taloja
In view of the above the capital expenditure decisions are best reserved for consideration of the highest level of management
Don’t compete with any other proposal. They are cases of “ accept or reject ” proposals on the minimum return on investment cut off criteria basis.
Contingent or dependent Proposals :-
Proposals whose acceptance depends on the acceptance one or more proposals.-Substantial Expansion of plan, other capital requirement. Like township etc
Mutually exclusive proposals;-
e.g Temperature control Systems, Agitator, Valves Etc
11.
Factors affecting Capital investment decisions
The amount of investment-
where no funds constraints are there proposals giving higher rate of return than the minimum cut off rate may be accepted
However where fund constraints are there, then Capital Rationing has to be resorted to.
Projects should be arranged in ascending order of capital investment and giving due consideration of priority
The term Pay –back Period refers to the period in which the project will generate the necessary cash to recoup the initial investment
For e.g- if a project requires Rs.20000 as initial investment and it will generate an annual cash flow of Rs.5000 for ten years, the pay-back period will be 4 years, calculated as follows
Pay –back period =
The Annual cash flow is calculated on the basis of Net income before depreciation but after considering the tax. (PAT+Depreciation)
The income expressed as %of initial investment is termed as Unadjusted rate of return
Unadjusted Return = x100
= x100 =25%
Uneven cash flow:- If a project requires an initial investment of Rs.20000 and annual cash inflows for 5 years are Rs.6000,Rs.8000,Rs.5000,Rs.4000 and Rs.4000 respectively ,the pay –back period will be calculated as follows
Annual return Initial Investment 5000 20000
16.
Pay –back period method Rs.19000 is recovered in 3years and Rs.1000 is left out of initial investment. The cash inflow in 4 th year is Rs.4000 which indicates that pay-back period is in between 3 rd and 4 th year.i.e.3+(1000/4000) = 3.25 years Year Cash Inflows Cumulative cash inflows 1 6000 6000 2 8000 14000 3 5000 19000 4 4000 23000 5 4000 27000
The cash inflows and cash outflows associated with the project are worked out.
The present value of these cash flows is calculated at a rate of return acceptable to the management ( Cost of capital suitably adjusted for risk element)
The net present value (NPV) i.e. difference between total present value of cash inflow and total present value of cash outflow is ascertained.
Instead of working out the NPV a present value index is worked out by comparing total present value of future cash inflows and total present value of future cash outflows.