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Capital Budgeting
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Capital Budgeting

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  • 1. Financial Management
    ips
    An Insight to
    Capital Budgeting
    www.ipsacademy.org
  • 2. Financial Management
    OVERVIEW
    • Capital budgeting is a decision involving selection of capital expenditure proposals.
    • 3. It involves the allocation of funds to projects that will have a life of at least one year and usually much longer.
    Eg. Purchase of plant and equipment
    Introduce new product in the market
    • Essentially its goal is to determine whether the future benefits are sufficiently large enough to justify the current outlays.
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    ips
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  • 4. Financial Management
    IMPORTANCE
    • Long time period, i.e. endured for a longer period whether decision is good or bad
    • 5. Substantial expenditure
    • 6. Irreversibility
    • 7. Over and under capacity
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  • 8. Financial Management
    DIFFICULTIES
    • Uncertainties of Future.
    • 9. Difficult to measure the benefit in quantitative terms.
    • 10. Time Element: the problem of phasing properly the availability of capital assets in order to have them come ‘on stream’ at the correct time.
    ips
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  • 11. Financial Management
    CAPITAL BUDGETING PROCESS
    ips
    PROPOSALS
    NEW INVESTMENT OPPORTUNITIES
    PLANNING PHASE
    REJECTED
    OPPORTUNITIES
    IMROVEMENT IN PLANNING AND EVALUATION
    PROCEEDURE
    PROPOSALS
    EVALUATION PHASE
    REJECTED
    PROPOSALS
    PROJECTS
    SELECTION PHASE
    REJECTED
    PROJECTS
    ACCEPTED PROJECTS
    IMPLEMENTATION PHASE
    ONLINE PROJECTS
    CONTROL PHASE
    PROJECT TERMINATION
    AUDITING PHASE
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  • 12. Financial Management
    WHY CASH FLOW METHOD OF EVALUATION?
    • Accrual basis of Accounting.
    • 13. Cash flow approach takes in to account ‘time value of money’.
    • 14. In the absence of real performance improvement accountants may accelerate revenues and defer costs.
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  • 15. Financial Management
    ips
    EVALUATION CRITERIA
    NON DISCOUNTING CRITERIA
    DISCOUNTING CRITERIA
    NET PRESENT VALUE
    INTERNAL RATE OF RETURN
    DISC. PAYBACK PERIOD
    PR’ABLTY INDEX (PI)
    ACC. RATE OF RETURN
    PAYBACK PERIOD
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  • 16. Financial Management
    PAYBACK PERIOD
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    • Defined as the numbers of years required to cover the original cost outlay.
    PAYBACK PERIOD
    INITIAL INVESTMENT
    ANNUAL CASH FLOW
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  • 17. Financial Management
    ADVANTAGES AND DISADVANTAGES
    OF PAYBACK PERIOD
    ips
    • Simple.
    • 18. Emphasizes on earlier cash flows.
    • 19. Rough and ready method or dealing with risk.
    • 20. Ignores cash after the payback period.
    • 21. Fails to consider ‘time value of the money’
    DISADVANTAGES
    ADVANTAGES
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  • 22. Financial Management
    AVERAGE RATE OF RETURN
    • Investment project is judged by looking at its rate of return on book value.
    • 23. Evaluates return on accounting profits. i.e. on accrual basis
    • 24. Annual returns are expressed in percentage of net investment.
    ips
    AVERAGE PROFIT AFTER TAX
    AVERAGE RATE OF RETURN
    100
    AVERAGE INVESTMENT
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  • 25. Financial Management
    ADVANTAGES AND DISADVANTAGES OF ACCOUNTING RATE OF RETURN
    ips
    • Ignores the life of the project.
    • 26. Fails to consider ‘time value of the money’.
    • 27. Ignores the size of investment required.
    • 28. Simple.
    • 29. Considers value of project to its economic life.
    DISADVANTAGES
    ADVANTAGES
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  • 30. Financial Management
    ADVANTAGES AND DISADVANTAGES OF ACCOUNTING RATE OF RETURN
    ips
    • Affected by accounting practices; changes in method of depreciation and inventory costing affects earnings and hence ARR
    • 31. Based on accounting profits; no separate calculation required.
    DISADVANTAGES
    ADVANTAGES
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  • 32. Financial Management
    WHY ?... TIME VALUE OF MONEY
    • Opportunity cost of the money.
    • 33. Inflationary pressures.
    • 34. Uncertainty of the future. i.e. preference of current consumption than future consumption.
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  • 35. Financial Management
    WHY ?... TIME VALUE OF MONEY
    • In 1624, the Red Indians sold Manhattan Island at the ridiculously low figure of $24.
    Was the amount really ridiculous?
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  • 36. Financial Management
    WHY ?... TIME VALUE OF MONEY
    • If the Red Indians had merely taken the $24 (Rs.1200) and reinvested it at 6 percent annual interest up to 1992, they would have had $50 billion (Rs. 25 lakhcrore ), an amount sufficient to repurchase most of New York City.
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  • 37. Financial Management
    DISCOUNTED PAYBACK METHOD
    • Improvement over ‘payback period method’, considers ‘time value of money’.
    • 38. It surmounts the objection that equal weight is given to all flows starting year one to the cut off date.
    • 39. In other words, it discounts the cash inflow by applying the present value factors for different periods.
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  • 40. Financial Management
    DISCOUNTED PAYBACK METHOD
    • The discounted payback rule asks, “How many periods does the project have to last in order to make sense in terms of net present value?”
    • 41. Calculated by counting the years the discounted cash flows add up to the initial investment.
    • 42. Still takes no account of cash flow after the cut-off date.
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  • 43. Financial Management
    NET PRESENT VALUE METHOD
    • Its the difference between the total discounted inflows and outflows.
    • 44. Depends solely on the forecasted cash flows and the opportunity cost of capital.
    • 45. Opportunity cost of capital is the expected rate of return on investment of equivalent risks.
    • 46. Present value of cash flows is calculated using opportunity cost of capital at discount rate.
    ips
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  • 47. Financial Management
    NET PRESENT VALUE METHOD
    • Ideal for mutually exclusive projects.
    • 48. Projects are ranked in the order of highest ‘Net Present Values'
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  • 49. Financial Management
    ADVANTAGES AND DISADVANTAGES OF
    NET PRESENT VALUE METHOD
    ips
    • Difficult to ascertain future cash flows.
    • 50. Biased towards longer term projects.
    • 51. Considers‘time value of money’.
    • 52. Relies on discount rate and estimated cash flows.
    DISADVANTAGES
    ADVANTAGES
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  • 53. Financial Management
    INTERNAL RATE OF RETURN METHOD
    • Also known as the ‘Marginal Rate of Return’ or ‘Time Adjusted Rate of Return’.
    • 54. It is the discount rate at which the present value of cash flows equals the present value of cash outflows. i.e. NPV = 0
    • 55. In other words, IRR is the rate of return the project earns.
    • 56. The rate of discount is determined by the ‘trial and error method’ .
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  • 57. Financial Management
    • The point of intersection represents the IRR; where NPV is equal to zero.
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    NET PRESENT VALUES
    DISC. RATE
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  • 58. Financial Management
    ADVANTAGES AND DISADVANTAGES OF INTERNAL RATE OF RETURN METHOD
    ips
    • Lengthy, based on ‘trial and error method’.
    • 59. Assumes that future cash flows are reinvested at a rate equal to IRR.
    • 60. Considers Working Capital and Scrape Value
    • 61. Considers cash flows during the whole economic life.
    DISADVANTAGES
    ADVANTAGES
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  • 62. Financial Management
    DIFFERENCE BETWEEN NPV METHOD AND
    IRR METHOD
    ips
    • Assumes that NPV is zero.
    • 63. Figures out discount rate that makes NPV zero.
    • 64. Assumes that cost of capital is known.
    • 65. Calculates NPV, given the discount rate.
    NET PRESENT VALUE
    INTERNAL RATE OF RETURN
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  • 66. Financial Management
    PROFITABILITY INDEX
    • The profitability index (or the benefit cost ratio) is the present value of forecasted future cash flows divided by the initial investment:
    • 67. The profitability index rule tells us to accept all projects with an index greater than 1. If the profitability index is greater than 1, the present value PV of Ci is greater than the initial investment - C0 and so the project must have a positive net present value.
    ips
    P/V OF CASH INFLOW
    PROFITABILITY INDEX
    INITIAL CASH OUTFLOW
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  • 68. Financial Management
    ips
    Thank You
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