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Capital budjeting  & appraisal methods
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Capital budjeting & appraisal methods


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  • 2. AGENDA
    • Concept of Capital Budgeting
    • Capital Expenditure Budget
    • Importance of Capital Budgeting
    • Rational of Capital Expenditure
    • Kinds of Capital Investment Proposals
    • Factors affecting Investment Decision
    • Investment Appraisal Methods
    • Capital Rationing
  • 3. Concept of Capital Budgeting
    • Finance Manager is concerned with Planning and Financing investment decisions.
    • Financing Decisions relate to determination of amount of long term finance and decision on sources for financing the same.
    • Investment decisions also termed as “Capital Budgeting Decisions” involve cost - benefit analysis .
    • Investment decisions are based on careful consideration of factors like profitability, safety, liquidity, solvency etc.
  • 4. Why Capital Budgeting
    • Capital investment means investments in projects which by nature involve huge expenditure and results of the same are known only after a long time .
    • Why Capital investment is necessary
      • For investments in New Projects
      • Replacement of worn out/ out dated assets.
      • Expansion of existing capacity – To meet high demand or inadequate production capacity.
      • Diversification – to reduce risk
      • Research and Development – Ensuring updated technology.
      • Miscellaneous – Installation of Pollution Control equipment, other legal requirements.
  • 5. Capital Budgeting
    • The term Capital Budgeting refers to long term planning for proposed capital outlays and their financing
    • It involves raising of long term funds and their utilization .
    • In other words, It is the formal process for acquisition and investment of capital.
    • Capital Budgeting is a many-sided activity.
    • It is a process of:
      • searching for new and more profitable investment options
      • by taking into account the consequences of accepting an investment proposal
      • by making a detailed economic analysis of the profit making potential of each investment proposal.
  • 6. Capital Budgeting
    • Essential features based on which decisions are taken
      • Profit potential
      • Degree of risk
      • Gestation period i.e time lag from the period of initial investment to anticipated returns .
  • 7. Capital Expenditure Budget
    • It is the formal plan of Capital expenditure on new projects/ purchase of fixed assets .
    • Provides for the capital outlay available for procurement of capital assets during the Budget period.
    • It is prepared by taking into consideration
      • Future demand projections/growth of industry
      • the available production capacities ,
      • allocation of existing resources and
      • likely improvement in production techniques .
  • 8. Capital Expenditure Budget-objectives
    • Determines the When the work on capital projects can be commenced
    • Estimates the expenditure that would be incurred on the projects approved by the management and the sources from which finance will be obtained
    • Restricts capital expenditure on projects within the authorized limits
  • 9. Importance of Capital Budgeting
    • 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
  • 10. Kinds of Capital Investment Proposals
    • Independent proposals-
    • 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
  • 12. Investment Appraisal Methods
    • In view of the importance of Capital Budgeting decisions, it is essential that the Capital Investment appraisal method adopted must be sound.
    • A good appraisal method should have the features.
      • Clear Basis for distinguishing between acceptable and non acceptable projects
      • Ranking the projects on the basis of desirability
      • Choosing among several alternatives
      • A criterion applicable to any conceivable project
      • Recognizing bigger benefit projects are preferable to smaller ones and early benefit projects are preferable to later ones
  • 13. Investment Appraisal Methods
    • In all the appraisal methods emphasis is on the return.
    • The basic approach to compare the investment in the project with benefits derived there from .
    • Following are the main methods generally used;-
    • Pay –back period method
    • Discounted Cash flow method
      • The Net present value method
      • Present value index method
      • IRR Method
    • Accounting Rate of return Method
  • 14. Pay –back period method
    • 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)
    Initial investment Annual cash Flow
  • 15. Pay –back period method
    • 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
  • 17. Pay –back period method
    • Criterion of accept or reject:
    • Reciprocal of cost of capital (COC).
    • for e.g If COC is 20% the maximum acceptable Pay-back period would be 5 years (i.e.100/20)which can also be termed as cut off point.
    • May be a predetermined Criteria by management i.e.say Reciprocal of COC -Safety Margin.
    • 5 years -1= 4
    • Refer to illustration 5.4 and 5.5
  • 18. Pay –back period method
    • Merits
    • Useful for evaluation of projects with high uncertainty, political instability, obsolescence of Technology etc
    • Method based on the assumption that no profit arises till initial capital is recovered. Suitable of new companies
    • Simple to understand and to workout
    • Reduces the possibility of loss due to obsolescence as the investment is made only on short term projects
  • 19. Pay –back period method
    • Demerits
    • Ignores the returns after its pay –back period
    • Projects with long gestation period will never be taken up though they yield better returns
    • The method ignores the time value of money
  • 20. Pay –back period method
    • Suitability
    • Hazy long term outlook-
    • Political or other conditions are hazy this method is suitable
    • Firms suffering from liquidity crises
    • Firms dependent on short term performances
  • 21. Discounted Cash Flow (DCF)
    • DCF Technique is an improvement on payback period method.
    • It takes into account Time Value of money i.e interest factor as well as the returns after the payback period.
    • The method involves 3 stages
      • Calculation of cash flows (both inflow and outflow preferably after tax for full life of the project).
      • Discounting cash flows by applying a discount factor.
      • Aggregation of discounted cash flows and ascertainment of net cash flow.
  • 22. NPV Method
    • 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.
  • 23. NPV Method
    • Accept or reject criterion
    • Where NPV > Zero Accept the proposal.
    • Where NPV < Zero Reject the proposal.
    • Refer illustration 5.6 , 5.7 and 5.8.
  • 24. Excess present value index
    • This is a refinement of NPV method.
    • 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.
    • Refer illustration 5.10.
  • 25. Internal rate of return (IRR)
    • IRR is that rate of return at which the sum of discounted cash inflows equals the sum of cash outflows.
    • In other words it is the rate which discounts the cash flows to zero.
    • It can be stated in the form of formula as under.
    • =1
    Cash inflows Cash outflows
  • 26. Internal rate of return (IRR)
    • Accept / Reject Criterion:
    • IRR is the maximum rate of interest which an organization can afford to pay on capital invested in a project.
    • A Project would qualify only if IRR exceeds the cut-off rate.
    • A project giving higher IRR than cut-off rate would be preferred.
    • Refer e.g. 5.12 & 5.13.
  • 27. Accounting Rate of return (ARR)
    • Under this method proposals are judged on the basis of relative profitability.
    • It is calculated on the following basis.
    • (Annual Average net earnings / original investments)*100
    • Annual Average net earnings is the average net earnings after depreciations and tax for the entire life of the project.
    • Refer illustration 5.16.