FINANCIAL MANAGEMENT

1. CAPITAL
BUDGETING
FINANCIAL MANAGEMENT

2. CAPITAL BUDGETING
Capital budgeting means planning the capital expenditure in acquisition of
fixed(capital) assets such as land, building, plant or new projects as whole.
DEFINITION OF CAPITAL BUDGETING
“Capital budgeting is the long term planning for making and financing
proposed capital outlays”
- CHARLES T.HORNGREN
“Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the
available market opportunities. The consideration of investment opportunities involves the comparison of
the expected future streams of earnings from a project, with the immediate and subsequent streams of
expenditure for it”
- GC.PHILOPPATOS
OBJECTIVES OF CAPITAL BUDGETING
◦ Capital budgeting aims at deciding the most profitable among the numerous investment proposals
available.
◦ It decides the most suitable among different sources of finance on the basis of capital market constraints.
◦ The growth and expansion of the firm and modernization can be taken care of .

3. PRINCIPLES OF CAPITAL BUDGETING
1. Decisions are based on cash flows, not accounting income,
2. Cash flows are based on opportunity cost,
3. The timing of cash flows are important,
4. Cash flows are analyzed on an after tax basis,
5. Financing costs are reflected on project's required rate of return.
TECHNIQUES OF CAPITAL BUDGETING
1. Traditional (or) Non-Discounting methods
 Payback period method
Accounting or Average rate of return method
2. Discounted cash flow (or) Time adjusted methods
Net present value method
Internal rate of return method
Profitability index method

4. NATURE OF CAPITAL BUDGETING
◦ Investments
◦ Long term
◦ Forecasting
◦ Serious consequences
IDENTIFYING RELEVANT CASH FLOWS
Relevant Cash Flows—the incremental cash flows that must be
evaluated in capital budgeting decisions. those the firm already owns—that is, the next best
return the firm can earn if the funds are not invested in the proposed capital budgeting project.
PAYBACK PERIOD METHOD
This method, sometimes called the payout or pay off or replacement period method, determines
the length of time required to recover the initial outlay of a project.

5. PROBLEMS IN PAYBACK PERIOD METHOD
This method fails to take into account the time value of money.
It does not measure the profitability of a project.
It does not differentiate between projects requiring different cash investments and thus it does not
provide a meaningful and comparable criterion.
It does not indicate any cut-off period for the purpose of investment decision.
A slight change in operation cost will affect the cash inflows and as such payback period shall also be
affected.
Neither allowance is made for taxation nor is any capital allowance made.
ACCOUNTING RATE OF RETURN(ARR)
ARR is the annualized net income earned on the average funds invested in a
project. It is a measure based on the accounting profit rather than the cash flows
and is very similar to the measure of rate of return on capital employed, which is
generally used to measure the overall profitability of the firm.

6. THE FORMULA FOR CALCULATING THE ARR ARE :
Annual return on original investment method
Annual return on average investment method
PROBLEMS IN ARR
It ignores the time value of money and considers the profit earned in the 1st year as equal to the profits
earned in later years.
It does not consider the length of project life.
It ignores salvage value of the proposal.
It also fails to recognise the size of investment required for the project particularly, in case of mutually
exclusively proposals, the two projects having significantly different initial costs, may have same ARR

7. NET PRESENT VALUE (NPV) METHOD
It is one of the DCF methods in which both future cash inflows and outflows from a project are discounted at
a cost of capital rate. This gives present value of cash inflows and outflows is called
Net present value (NPV).
PROBLEM IN NET PRESENT VALUE
This method assumes that the discount rate i.e., firm’s cost of capital is known. But the cost of capital is
difficult to understand and measure in practice.
It may not give reliable answers while dealing with alternative projects under the conditions of unequal
lives of projects.
Decisions arrived at may not be satisfactory when projects being compared involve different amounts of
investments.
INTERNAL RATE OF RETURN (IRR) METHOD
IRR is the rate of return at which the sum of discounted cash inflows
equal the sum of discounted cash outflows. It is the rate at which the
NPV of the investment is zero . It is called internal rate because it depends mainly on the outlay and proceeds
associated with the project and not on any rate determined outside the investment

8. PROBLEM IN INTERNAL RATE OF RETURN
Computation of IRR is quite tedious and it is difficult to understand.
Both NPV and IRR assume that the cash inflows can be reinvested at the discounting rate in the new
projects.
It may give results inconsistent with NPV method . This is especially true in case of mutually exclusive
projects i.e., projects where acceptance of one would result in the rejection of the other. Such conflict of
results arise due to the following:
• Differences in cash outlays.
• Unequal lives of projects.
• Different pattern of cash flows.
PROBABILITY INDEX (PI) METHOD
This method is a variant of the NPV method . It is also known as benefit cost ratio or present value index.
It is also based on the basic concept of discounting the future cash flows and is ascertained by comparing
the present value of cash inflows with the present value of cash outflows.

9. PROBLEM IN PROBABILITY INDEX
The PI as a guide in resolving capital rationing, fails where projects are indivisible. Once a single large
project with high NPV is selected, possibility of accepting several small projects with together may have
higher NPV than the single project is excluded.
Situations may arise where a project with a lower PI selected may generate cash flows in such a way
that another project can be taken up one or two years later, the total NPV in such case being more than
the one with a project with highest PI.

10. CONCEPT OF COST OF CAPITAL
For financing its operations, a firm can raise long term funds through a combination of (i) Debt , (ii)
Preference share capital , and (iii) Equity share capital . The firm has to service these funds by paying
interest, preference dividend and equity dividend respectively. The payment made by the firm
constitutes the cost of obtaining/utilizing that source of finance.
DEFINITION OF COST OF CAPITAL
“Cost of capital is the minimum rate of return which a firm requires as a condition for undertaking an
investment .“ - MILTON H.SPENCER
“The cost of capital is the minimum required rate of return, the hurdle or target rate, the cut-off rate or
the financial standard of performance of a project.”
- GC.PHILLIOPPATUS
OBJECTIVES OF COST OF CAPITAL
◦ Capital budgeting decision
◦ Designing the capital structure
◦ Deciding about the method of financing
◦ Performance of top management
◦ Other areas of decisions making

11. MEASUREMENT OF COST OF CAPITAL
Cost of debt
Cost of preference share capital
Cost of equity capital
Cost of retained earnings
Weighed average cost of capital(WACC)
Marginal cost of capital ( MCC)
SPECIFIC COST OF CAPITAL
The cost of each component of capital is known as specific Capital Costs. Companies raise capital from
different sources such as equity, debentures, loan etc. It is the cost of equity capital, cost of debentures, etc.,
individually.
PROBLEM IN SPECIFIC COST OF CAPITAL
1.Conceptual Controversies Regarding the Relationship between the Cost of Capital and the Capital
Structure
2.Historic Cost and Future Cost
3.Problems in Computation of Cost of Equity
4.Problems in Computation of Cost of Retained Earnings
5.Problems in Assigning Weights

12. PROBLEM IN OVERALL COST OF CAPITAL