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1902capital budgeting (1)


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1902capital budgeting (1)

  2. 2. INTRODUCTION Capital budgeting is concerned with the allocation of firm's scarce financial resources among the available market opportunities  Likely to produce benefits over a period of time longer than one year.  The basic features of capital budgeting are: • potentially large anticipated benefits • a relatively high degree of risk • a relatively long time period between initial outlay and anticipated returns. 
  3. 3. DEFINITION  Lynch - "Cash budgeting consists in planning, development of available capital for the purpose of maximizing the long term profitability in the concern.”
  4. 4. IMPORTANCE Affects the profitability of firm  It has its effects over a long time span and inevitably affects the company’s future cost structure  Capital investment decision once made are not easily reversible without much financial loss to the firm  Capital investment involves cost and the majority of the firms have scarce capital resource.  Over / Under capacity - To improve timing and quality of asset acquisition, the capital expenditure decision must be carefully drawn. 
  5. 5. CAPITAL BUDGETING PROCESS Identification of investment proposals  Screening the proposals  Evaluation of various proposals  Fixing priorities  Final approval and preparation of capital exp budget  Implementing proposals  Performance review 
  6. 6. PROBLEMS IN CAPITAL BUDGETING  Future uncertainty  Time element  Measurement problem
  7. 7. CAPITAL BUDGETING DECISIONS Replacement / modification of fixed assets  Expansion  Modernization of investment expenditure  Strategic investment proposal  Diversification of business  Research and development 
  8. 8. CAPITAL BUDGETING TECHNIQUES Non-time Adjusted Time Adjusted Payback period method  Average rate of return   Net present value  Internal rate of return  Profitability index
  9. 9. PAYBACK PERIOD METHOD o o o o Quantitative method This method answers the question - how many years will it take for cash benefits to pay the original cost of an investment normally disregarding salvage value. There are two ways of calculating the payback period. The riskier the project is, the shorter the required payback will be.
  10. 10. PAYBACK PERIOD METHOD 1st method  constant annual cash flow  PB=investment/consta nt annual cash flow 2nd method  Variable cash flows  situation payback is calculated by the process of accumulating cash flows till the time when cumulative cash flows are equal to original investment outlay
  11. 11. PBP STRENGTHS AND WEAKNESS Strengths Easy to use and understand  Can be used as a measure of liquidity  Lay more emphasis on short-term run earning performance rather than its long-term growth  No profits arise till the payback period is over. This helps companies in deciding when they should start paying dividends 
  12. 12. ACCEPT AND REJECT CRITERIA  Projects with a payback less than a specified cutoff period are accepted whereas those with a payback beyond this figure are rejected.
  13. 13. . :FOR EXAMPLE: ORIGINAL COST OF BOTH THE MACHINES IS RS. 56,125. CASH FLOW OF THE FIFTH YEAR INCLUDES RS 3,000 SALVAGE VALUE. CASH INFLOWS ARE AS UNDER. CALCULATE PAYBACK PERIOD YEAR MACHINE A (cash flow) Cumulative cash flows MACHINE B Cumulative (cash flow) cash flows 1 14000 14000 22000 22000 2 16000 30000 20000 42000 3 18000 48000 18000 60000 4 20000 68000 16000 76000 5 25000 93000 17000 93000
  14. 14. CASH FLOW ADJUSTED TECHNIQUE OF FIFTH YEAR INCLUDES RS. 3,000 SALVAGE VALUE. THE INVESTED INVESTMENT OF RS. 56,125 ON MACHINE A WILL BE RECEIVED BETWEEN 3 TO 4 YEARS. PAYBACK PERIOD MAKES THREE YEARS PLUS A FRACTION OF A YEAR. • • • • Machine A 56,125 - 48,000 = 8,125 (Balance of 8,125 >> received of fourth year) 8,125 / 20,000 = 0.406 years + 3 preceding years = 3.406 years Machine B 2 years + (14,125 / 18,000) = 2.785 years It shows that machine B should be preffered.
  15. 15. LIMITATIONS OF PAYBACK PERIOD • • • • It ignores all cash inflows after the payback period. It does not take into consideration the entire life of the project during which cash flows are generated. It does not reflect all the relevant dimensions of profitability It does not consider time value of money
  16. 16. AVERAGE RATE OF RETURN • • Also known as average rate of return or average return on book value It is the ratio of average after tax profit to average book investment (the initial investment less accumulated depreciation) n ARR t 1 ( AfterTaxpr ) / n ofit ( InitialOutlay EndingBook Value) / 2
  17. 17. STRENGTHS AND WEAKNESSES OF ACCOUNTING RATE OF RETURN  Strengths • • • • It is simple to apply It gives due weightage for the profitability of project. Based on financial data Considers entire cashflows
  18. 18. WEAKNESS • • • • It ignores the time value of money It is based on accounting income rather than cash flow. Cash flow and reported income often differ It does not take into consideration any benefits which can accrue to the firm from the sale or abandonment of equipment which is replaced by the new investment. This method cannot be applied to a situation where investment in a project is to be made in parts
  19. 19. ACCEPT AND REJECT CRITERIA Investments yielding a return greater than this standard are accepted, whereas those falling below it would be rejected.
  20. 20. DISCOUNTED CASH FLOW METHODS 1: Net Present Value Method it takes into account time value of money. NPV is found by subtracting present value of cash outflows from cash inflows
  21. 21. MERITS/ DEMERITS Merits: Recognizes the time value of money  A sound method of appraisal  Shareholder’s wealth maximization Demerits:  Difficult to calculate  It involves calculations of the required rate of return to discount the cash flows  It is an absolute measure 
  22. 22. 2: PROFITABILITY INDEX  Profilabity index= Present value of cash inflows/ present value of cash outflows  Decisions 1. If PI > 1, accept the proposal 2. If PI< 1, reject the proposal 3. If PI =1, indifference
  23. 23. MERITS/ DEMERITS Merits 1. shareholder’s wealth maximization 2. Uses cash fow 3. Recognise time value of money • Demerits 1. Requires detailed long term forecast of incremental benefits and costs •
  24. 24. Presented by-: Anuj Arshdeep Ashok Avai