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Capital Budgeting Decision

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Capital Budgeting Decision

  1. 1. Capital Budgeting Decision
  2. 2. <ul><li>A Capital Budgeting Decision may be defined as the firm’s decision to invest its current funds (Cash Flows) most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. </li></ul><ul><li>Investment Decisions include </li></ul><ul><ul><li>Expansion </li></ul></ul><ul><ul><li>Acquisition </li></ul></ul><ul><ul><li>Modernisation </li></ul></ul><ul><ul><li>Replacement </li></ul></ul><ul><ul><li>New Product Investment </li></ul></ul><ul><ul><li>Obligatory & Welfare Investment </li></ul></ul><ul><li>It also include Outflows on R&D and major advertising campaign. </li></ul>
  3. 3. <ul><li>Investment Decisions can also be categorized as </li></ul><ul><li>Conventional Projects </li></ul><ul><li>Non Conventional Projects </li></ul><ul><li>Features of Capital Budgeting Decision </li></ul><ul><li>They have long term consequences. </li></ul><ul><li>They often involve substantial outlays. </li></ul><ul><li>They may be difficult or expensive to reverse. </li></ul><ul><li>“ Expenditure & Benefits of an Investment should be measured in cash and not in accounting profits.” </li></ul><ul><li>Why Cash Flows provide a better estimate of project’s true return </li></ul><ul><li>Accounting profits are the end result of a number of accounting decisions. These can be manipulated through the use of creative accounting. </li></ul><ul><li>No business accepts profits as payment for goods & services delivered .All of them require cash. Thus cash flows provide a better estimates of a project’s true return. </li></ul>
  4. 4. <ul><li>Investment Evaluation Criteria </li></ul><ul><li>Estimation of Cash Flows. </li></ul><ul><li>Estimation of cost of Capital. </li></ul><ul><li>Application of a decision rule for making the choice. </li></ul><ul><li>Capital Budgeting Decision Techniques </li></ul><ul><li>Discounted Cash Flow Techniques </li></ul><ul><li>Net Present Value (NPV) </li></ul><ul><li>Internal Rate of Return (IRR) </li></ul><ul><li>Modified Internal Rate of Return (MIRR) </li></ul><ul><li>Profitability Index (PI) </li></ul><ul><li>Non Discounted Cash Flow Techniques </li></ul><ul><li>Payback Period (PB) </li></ul>
  5. 5. <ul><li>Net Present Value </li></ul><ul><li>NPV of a Project is the sum of the PVs of all cash flows – positive as well as negative – that are expected to occur over the life of the project. </li></ul><ul><li>NPV Profile </li></ul><ul><li>A graph showing the NPVs at various discount rates and helping in computation of IRR.It is curvilinear relationship between NPV for a project and the discount rate employed. When discount rate is zero,NPV is highest. As discount rate increases ,NPV profile curve slopes downward to right. At the point where NPV curve intersects the horizontal axis on the graph, the NPV is zero and by definition ,this is IRR for the project. </li></ul><ul><li>Properties of NPV rule </li></ul><ul><li>a. NPVs are additive. </li></ul><ul><li>b. Intermediate Cash flows are invested at cost of capital. </li></ul><ul><li>c.NPV calculations permits time varying discount rates. </li></ul><ul><li>2. Internal Rate of Return </li></ul><ul><li>IRR of a project is the discount rate which makes its NPV equal to zero. It is the rate of return that the project earn. </li></ul><ul><li>Important to Note </li></ul><ul><li>a. The Cash flows are conventional types of cash flows where initial flow is negative and subsequent flows are positive. </li></ul><ul><li>b. Sum of all flows exceeds the cash inflows. </li></ul><ul><li> </li></ul>
  6. 6. <ul><li>c. The project is independent and does not come into the category of mutually exclusive projects. </li></ul><ul><li>d. The project is not of a borrowing lending project ,i.e. Leasing projects. </li></ul><ul><li>3. Profitability Index </li></ul><ul><li>Profitability Index computes the PV per rupee of initial outflow. Profitability Index is helpful when there is capital rationing. At the time of capital rationing when there is limitation on the investment programs and not all available projects can be taken up, Firm can not choose between projects solely on the basis of NPV method. Only those projects must be chosen that offer the highest NPV per rupee of initial outflow or in other words which have the highest Profitability Index. </li></ul><ul><li>PROFITABILITY INDEX WILL NOT BE USEFUL IF PROJECT HAS OTHER LIMITATIONS BESIDES CAPITAL RATIONING ,i.e., IF THE PROJECTS IS MUTUALLY EXCLUSIVE ALSO. </li></ul><ul><li>4. Payback Period </li></ul><ul><li>Payback period provides to the firm an estimate how rapidly a project payback its initial investment. This method does not consider the time value of money. </li></ul>
  7. 7. <ul><li>PITFALLS OF IRR </li></ul><ul><li>There are certain categories of projects where IRR is not able to provide correct results: </li></ul><ul><li>Non Conventional Projects </li></ul><ul><li>Lending or Borrowing </li></ul><ul><li>Mutually Exclusive Projects </li></ul><ul><ul><li>Projects of different Scale </li></ul></ul><ul><ul><li>Projects with different useful life and cash flow pattern </li></ul></ul>

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