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- 1. CAPITAL BUDGETINGCAPITAL BUDGETING TITTO SUNNY ARUN T.S VIBIN UDAYAN SOORAJ SUBMITTED TO Dr.MOHHAMED ASLAM ASWATHI UMESH GEETHU MBA TT 1st SEM
- 2. Capital Expenditure refers to investment in fixed assets and other development projects, launching a new product, improvisation, modernization, expansion, replacement of fixed assets etc. Most firms carefully analyse the potential projects in which they may invest. The process of evaluating opportunities is known as capital investment decision. Capital investment decision is also called Capital expenditure decision or Capital budgeting.
- 3. According to R.M. Lynch, “Capital budgeting consists in employment of available capital for the purpose of maximising the long term profitability (return on investment) of the firm”.
- 4. FEATURES OF CAPITAL BUDGETINGFEATURES OF CAPITAL BUDGETING The main features of Capital BudgetingThe main features of Capital Budgeting It involves the exchange of current funds for future benefit.It involves the exchange of current funds for future benefit. The future benefits are expected to be realised over a seriesThe future benefits are expected to be realised over a series of years in future.of years in future. The funds are invested in long term assets.The funds are invested in long term assets. It is a long term irreversible decision.It is a long term irreversible decision. It involves huge initial funds.It involves huge initial funds. There is relatively a long gap of time between investment ofThere is relatively a long gap of time between investment of funds and the expected returns.funds and the expected returns. It involves relatives a high degree of risk regarding the futureIt involves relatives a high degree of risk regarding the future benefits.benefits.
- 5. STEPS IN CAPITALSTEPS IN CAPITAL BUDGETINGBUDGETING • Capital budgeting is a complex process. The following six-steps areCapital budgeting is a complex process. The following six-steps are involved in capital budgeting.involved in capital budgeting. • 1. Project generation1. Project generation • 2. Project screening2. Project screening • 3. Project evaluation3. Project evaluation • 4. Project selection4. Project selection • 5. Project execution and implementation.5. Project execution and implementation. • 6. Performance review.6. Performance review.
- 6. Availability of fund. Utilisation of funds Urgency of the project. Expectation of future earnings Intangible factors Risk and uncertainty
- 7. ROLE AND IMPORTANCE OF CAPITALROLE AND IMPORTANCE OF CAPITAL BUDEGETINGBUDEGETING Capital budgeting is concerned with heavyCapital budgeting is concerned with heavy expenditure decisions. The benefits of returnsexpenditure decisions. The benefits of returns from such expenditure is expected to be derivedfrom such expenditure is expected to be derived over many years in future. This makes theover many years in future. This makes the capital budgeting decisions more complex.capital budgeting decisions more complex. Success or failure of an enterprise is dependentSuccess or failure of an enterprise is dependent up on the quality of the capital budgeting aloneup on the quality of the capital budgeting alone in the enterprise. Therefore proper planning andin the enterprise. Therefore proper planning and at most care is needed while making capitalat most care is needed while making capital budgeting decision.budgeting decision.
- 8. LIMITATIONS OF CAPITALLIMITATIONS OF CAPITAL BUDGETINGBUDGETING 1.1. The result of decision taken is uncertain. This is soThe result of decision taken is uncertain. This is so because it is difficult to say that present circumstancesbecause it is difficult to say that present circumstances will exist in future also .will exist in future also . 2.2. Some factors affecting investment proposals are notSome factors affecting investment proposals are not measurable ( ie cannot be expressed in money value).measurable ( ie cannot be expressed in money value). 3.3. It is difficult to estimate the period for which investmentIt is difficult to estimate the period for which investment is to be made and income will generate.is to be made and income will generate. 4.4. It is difficult to estimate the rate of return because futureIt is difficult to estimate the rate of return because future is uncertain .is uncertain . 5.5. It is difficult to estimate the cost of capital.It is difficult to estimate the cost of capital.
- 9. METHODS OF CAPITAL BUDGETTINGMETHODS OF CAPITAL BUDGETTING PROBLEMS & SOLUTIONSPROBLEMS & SOLUTIONS A .TRADTIONAL METHODSA .TRADTIONAL METHODS Urgency methodUrgency method Pay back methodPay back method I. When annual cash inflows are equalI. When annual cash inflows are equal II. When annual cash inflows are unequalII. When annual cash inflows are unequal Post Pay Back Profitability methodPost Pay Back Profitability method Average Rate of Return Method.Average Rate of Return Method. B.DISCOUNTING CRITERIA ORB.DISCOUNTING CRITERIA OR MODERN METHODS.MODERN METHODS. Discounted pay back methodDiscounted pay back method Net present value method.Net present value method. benefit cost ratio.benefit cost ratio. internal rate of return.internal rate of return. net terminal value method.net terminal value method. C.Other methodsC.Other methods.. The mapi formulaThe mapi formula Nomograph methodNomograph method
- 10. TRADTIONAL METHODS Traditional methods do not take into consideration the time value of money Important traditional methods may be discussed as follows: 1. Urgency Method Urgency is a criterion used to justify the acceptance of capital projects on the basis of emergency requirements or under crisis conditions. Under this method, the most urgent project is taken up first.
- 11. MERITS It’s a very simple technique It is useful in case of short term projects requiring lesser investment. DEMERITS It is not based on scientific analysis. Selection is not made on the basis of economical consideration but just on the basis of situation. A project, even though it is profitable, will not be accepted for the very simple reason that it can be postponed.
- 12. PAY BACK METHODPAY BACK METHOD Used technique of evaluating capital expenditureUsed technique of evaluating capital expenditure proposals. Pay back period is the length of time requiredproposals. Pay back period is the length of time required to recover the initial cost of the project. In short , it is theto recover the initial cost of the project. In short , it is the period required to recover the cost of investment. Pay backperiod required to recover the cost of investment. Pay back method is also called ‘pay-out’ or ‘pay-off period’ ormethod is also called ‘pay-out’ or ‘pay-off period’ or ‘recoupment period’ or ‘replacement period’.‘recoupment period’ or ‘replacement period’. The payback period can be calculated in two differentThe payback period can be calculated in two different situation as follows:situation as follows: I. When annual cash inflows are equalI. When annual cash inflows are equal II. When annual cash inflows are unequalII. When annual cash inflows are unequal
- 13. I.I. When annual cash inflows areWhen annual cash inflows are equalequal When annual cash inflows or benefit generated by a project per yearWhen annual cash inflows or benefit generated by a project per year are equal or constant(ie even cash inflows). The payback period isare equal or constant(ie even cash inflows). The payback period is computed by dividing the initial investment or cash outlay by the netcomputed by dividing the initial investment or cash outlay by the net annual cash inflows. It is expressed asannual cash inflows. It is expressed as payback period =payback period = original cost of project(cash outlay)original cost of project(cash outlay) annual net cash inflow(net earnings)annual net cash inflow(net earnings) For eg; if a project involves a cash outlay of RS 5,00,000 andFor eg; if a project involves a cash outlay of RS 5,00,000 and generates cash inflow of RS 1,00,000 annually for 7 years.generates cash inflow of RS 1,00,000 annually for 7 years. payback =payback = 5,00,0005,00,000 = 5 years is required to recover= 5 years is required to recover 1,00,000 original investment.1,00,000 original investment.
- 14. II. When annual cash inflowsII. When annual cash inflows are unequal.are unequal. When cash inflows in different years areWhen cash inflows in different years are unequal (uneven),the computation of payunequal (uneven),the computation of pay back period is not so easy as in the case ofback period is not so easy as in the case of even cash inflowseven cash inflows In such case, payback period isIn such case, payback period is calculated in the form of cumulative cashcalculated in the form of cumulative cash inflows. It is ascertained by cumulatinginflows. It is ascertained by cumulating cash inflow till the time when thecash inflow till the time when the cumulative cash inflow become equal tocumulative cash inflow become equal to initial investment.initial investment.
- 15. For example, if the cost of project is Rs.1,00,000 and the cash inflow are;For example, if the cost of project is Rs.1,00,000 and the cash inflow are; 11stst year Rs 10,000 and 2nd year Rs. 15,000,3year Rs 10,000 and 2nd year Rs. 15,000,3rdrd year Rs.25,000 4year Rs.25,000 4thth year Rs.year Rs. 30,000 and 530,000 and 5thth year Rs .30,000.pay back period to recover originalyear Rs .30,000.pay back period to recover original investment of Rs, 100000 comes to 4 years and 8 months (RS 80000 isinvestment of Rs, 100000 comes to 4 years and 8 months (RS 80000 is recovered in 4 years and to recover the balance RS 20000, 8 monthsrecovered in 4 years and to recover the balance RS 20000, 8 months required.required. 4+4+ 20,00020,000 = 4 += 4 + 22 years or 4 years and 8 months.years or 4 years and 8 months. 30,000 330,000 3 pay back period can also be calculated by the following formula .pay back period can also be calculated by the following formula . Pay back period = E +Pay back period = E + BB CC E = no years immediately proceeding the year of final recovery.E = no years immediately proceeding the year of final recovery. B = Balance amount still to be recovered.B = Balance amount still to be recovered. C = Cash flow during the year of final recovery.C = Cash flow during the year of final recovery.
- 16. POST PAY BACK METHODPOST PAY BACK METHOD As pointed out earlier, under payback method the profitability( ie cashAs pointed out earlier, under payback method the profitability( ie cash inflows)after payback period is ignored. the post pay back methodinflows)after payback period is ignored. the post pay back method has been evolved to overcome this limitation.has been evolved to overcome this limitation. under post pay back method the entire cash inflows generated from aunder post pay back method the entire cash inflows generated from a project during its working life are taken into account. The post payproject during its working life are taken into account. The post pay back profitability calculated as underback profitability calculated as under pay back profitability = total cash inflows in life-initial cost.pay back profitability = total cash inflows in life-initial cost.
- 17. For example, if the cost of project isFor example, if the cost of project is Rs.100000 and the cash inflow are; 1Rs.100000 and the cash inflow are; 1stst yearyear Rs 10000 and year Rs. 15000,3Rs 10000 and year Rs. 15000,3rdrd yearyear Rs.2,5000 4Rs.2,5000 4thth year Rs. 30,000 and 5year Rs. 30,000 and 5thth year Rsyear Rs .30,000..30,000. Post pay back profitability =Post pay back profitability = total cash inflows in life – initial cost.total cash inflows in life – initial cost. 1,10,000 -100000 = 10000.1,10,000 -100000 = 10000. post pay back profitability = 10000post pay back profitability = 10000
- 18. Nomograph methodNomograph method Nomograph method facilitates the rate of returnNomograph method facilitates the rate of return calculations nomograph method draws a certaincalculations nomograph method draws a certain kind of graph which helps to understand the valuekind of graph which helps to understand the value of other independent the variable when the valueof other independent the variable when the value of other independent variables are given.of other independent variables are given. this method is useful for quick calculation.this method is useful for quick calculation. This is a time saving method. it is a simpleThis is a time saving method. it is a simple method as well.hence,only minimum effort ismethod as well.hence,only minimum effort is required for the preparation of this graph.required for the preparation of this graph.
- 19. The mapi techniqueThe mapi technique This technique has been offered by George terborgh in his book “ businessThis technique has been offered by George terborgh in his book “ business investment policy". he is the chief economist of the machinery allied productinvestment policy". he is the chief economist of the machinery allied product institute (mapi) of Washington D.C .institute (mapi) of Washington D.C . A Firm has to consider the following 5 factors to make use of MAPIA Firm has to consider the following 5 factors to make use of MAPI techniques;techniques; a)a) Operating advantage from the new equipmentOperating advantage from the new equipment b)b) Magnitude of the capital consumption avoided.Magnitude of the capital consumption avoided. c)c) Subtraction of consuming capital.Subtraction of consuming capital. d)d) Cost of consuming capital.Cost of consuming capital. e)e) Net investment in the project.Net investment in the project. According to MAPI method ,the rate of return from the nextAccording to MAPI method ,the rate of return from the next year is calculated, while evaluating project profitability.year is calculated, while evaluating project profitability.
- 20. Discounted cash flow techniqueDiscounted cash flow technique Payback method & average rate of return method do not consider the timePayback method & average rate of return method do not consider the time value of money .the initial amount incurred for acquisition of assets tovalue of money .the initial amount incurred for acquisition of assets to implement a project and income received from the project in future is givenimplement a project and income received from the project in future is given equal importance under the other methods. But in fact the value of moneyequal importance under the other methods. But in fact the value of money received in future is not equivalent to the value of money invested today .inreceived in future is not equivalent to the value of money invested today .in other words a rupee in hand now is nor valuable than a rupee to be receivedother words a rupee in hand now is nor valuable than a rupee to be received in future because cash in hand can be invested elsewhere and interest canin future because cash in hand can be invested elsewhere and interest can be earned on it .for eg; if rupees 100 is invested at the annual interest of 10be earned on it .for eg; if rupees 100 is invested at the annual interest of 10 %,it will increased as under;%,it will increased as under; RS 100 today is equal toRS 100 today is equal to RS 110 after 1 year(100+10 of interest)RS 110 after 1 year(100+10 of interest) RS 121 after 2 years (110+11 of interest).RS 121 after 2 years (110+11 of interest). RE 1 After 1 year equal to RSRE 1 After 1 year equal to RS 100100= 0.909= 0.909 110110
- 21. Internal rate ofInternal rate of return(IRR)return(IRR) Net present value method indicate the net present valueNet present value method indicate the net present value of cash flows of a project at a pre-determined interestof cash flows of a project at a pre-determined interest rate, but it doesn’t indicate the rate of return of therate, but it doesn’t indicate the rate of return of the project . In order to find out the rate of return of theproject . In order to find out the rate of return of the project, estimated cash inflows of each year areproject, estimated cash inflows of each year are discounted at various rates till a rate is obtained at whichdiscounted at various rates till a rate is obtained at which the present value of cash inflow is equal to the initialthe present value of cash inflow is equal to the initial investment or the net present value comes to zero. Suchinvestment or the net present value comes to zero. Such a rate is called internal rate of return or marginal rate ofa rate is called internal rate of return or marginal rate of return .return .
- 22. The concept of rate of return is quite simpleThe concept of rate of return is quite simple to understand in the case of a 1 periodto understand in the case of a 1 period project.project. assume that you deposit RS 10000 with aassume that you deposit RS 10000 with a bank and would get back RS 10800 after 1bank and would get back RS 10800 after 1 year. The true rate of return on youryear. The true rate of return on your investment would beinvestment would be Rate of return =Rate of return =10800-1000010800-10000 = .08 = 8%= .08 = 8% 1000010000
- 23. Average rate of returnAverage rate of return method(ARR)method(ARR) This method is also known as accounting rate ofThis method is also known as accounting rate of return method or return on investment method orreturn method or return on investment method or unadjusted rate of return method. under thisunadjusted rate of return method. under this method average annual profit(after tax)ismethod average annual profit(after tax)is expressed as percentage of investment.ARR isexpressed as percentage of investment.ARR is found out by dividing average income by thefound out by dividing average income by the average investment.ARR is calculated with theaverage investment.ARR is calculated with the help of the following formula ;help of the following formula ; ARR =ARR = Average income or returnAverage income or return × 100× 100 average investmentaverage investment
- 24. Average investment =Average investment = original investment +scrap valueoriginal investment +scrap value 22 OROR == original investment – scrap valueoriginal investment – scrap value 22 For eg; XFor eg; X YY capital cost 40000capital cost 40000 6000060000 earnings after depreciationearnings after depreciation 1 st year 50001 st year 5000 80008000 2 nd year 70002 nd year 7000 1000010000 3 rd year 60003 rd year 6000 70007000 4 th year 60004 th year 6000
- 25. The average earningsThe average earnings of project X =of project X = 2400024000 = RS 6000.= RS 6000. 44 The average investment =The average investment = cost at the begining+cost at the end of the lifecost at the begining+cost at the end of the life.. 22 40000+040000+0 = RS 20000.= RS 20000. 22 ARR =ARR =60006000 × 100 = 30 %× 100 = 30 % 2000020000 Average earnings of project y =Average earnings of project y = 3000030000 4 = RS 7500.4 = RS 7500. Average investment =Average investment = 60000+060000+0 = 30000.= 30000. 22 ARR =ARR = 75007500 × 100 = 25 %× 100 = 25 %
- 26. Net Present ValueNet Present Value DefinitionDefinition NPV. TheNPV. The present valuepresent value of an investment's futureof an investment's future net cash flowsnet cash flows minus the initialminus the initial investmentinvestment . If positive, the. If positive, the investment should be made (unless an even better investmentinvestment should be made (unless an even better investment exists), otherwise it should not.exists), otherwise it should not. The total discounted value of all of the cash inflows and outflowsThe total discounted value of all of the cash inflows and outflows from a project or investment.from a project or investment. This method is used only when the rate of return on investment isThis method is used only when the rate of return on investment is predetermined by management under the net persent valuepredetermined by management under the net persent value method, the present value of all cash inflows (stream ofmethod, the present value of all cash inflows (stream of benefits) is compared against the present value of all cashbenefits) is compared against the present value of all cash outflows(cash outlays or cost of investment). The differenceoutflows(cash outlays or cost of investment). The difference between the present value of cash inflows and cash outflows isbetween the present value of cash inflows and cash outflows is called the net present value.the discount rate for obtaining thecalled the net present value.the discount rate for obtaining the present value is some desired rate of return which may bepresent value is some desired rate of return which may be equal to the cost of capitalequal to the cost of capital
- 27. COMPUTATION OF CASH INFLOW & OUTFLOWS.COMPUTATION OF CASH INFLOW & OUTFLOWS. Present value =Present value = CC11 ++ CC22 ++ CC33 ++ ……………………………… CCnn ( 1+r)( 1+r) (1+r)(1+r)22 ( 1+r)( 1+r)22 ( 1+r)( 1+r)22
- 28. Year Investmen t & cash flow Discoun t factor at 15% Presen t value Investment and cash Discount factor at15% Present value 0 100000 ……….. 100000 100000 ………….. 100000 1 30000 0.870 26100 20000 0.870 1740 2 40000 0.756 30240 30000 0.756 22680 3 40000 0.658 26320 50000 0.658 32900 4 30000 0.572 17160 40000 0.572 22880 5 30000 0.497 14910 30000 0.497 14910 SUM 170000 ……….. 114730 170000 110770 ProjectProject AA ProjectProject BB
- 29. PROJECT APROJECT A Present value of cash outflow=100000Present value of cash outflow=100000 Present value of cash inflow =114730Present value of cash inflow =114730 Net present value=114730-100000=14730Net present value=114730-100000=14730 PROJECT BPROJECT B Present value of cash outflow =100000Present value of cash outflow =100000 Present value of cash inflow =110770Present value of cash inflow =110770 Net present value =110770-100000=10770Net present value =110770-100000=10770
- 30. Difference between NPV & IRRDifference between NPV & IRR Npv IRR The minimum desired rate of return(cost of capital)is assumed to be known. The minimum desired rate of return is to be determined It implies that the cash inflows are invested at the rate of firm’s cost of capital. It implies that cash inflows are reinvested at the IRR of the project. It gives absolute return. It gives percentage return. The NPV of different project can be added. The IRR of the different project can not be added.
- 31. REFERENCE:REFERENCE: 1.1. WWW.WIKIPEDIA.ORGWWW.WIKIPEDIA.ORG 2.2. FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT AUTHOR: VINOD (BBA CALICUT UTY)AUTHOR: VINOD (BBA CALICUT UTY)

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