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Capital budjeting  & appraisal methods

Capital budjeting & appraisal methods






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    Capital budjeting  & appraisal methods Capital budjeting & appraisal methods Presentation Transcript

    • 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
    • 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.
    • 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.
    • 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.
    • 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 .
    • 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 .
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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.
    • 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.
    • 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.
    • 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.
    • 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
    • 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.
    • 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.