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CAPITAL BUDGETING & INVESTMENT APPRAISAL METHODS PRESENTATION  BY PROF.  V.RAMACHANDRAN SIESCOMS, NERUL, NAVI MUMBAI
AGENDA <ul><li>Concept of Capital Budgeting </li></ul><ul><li>Capital Expenditure Budget </li></ul><ul><li>Importance of C...
Concept of Capital Budgeting <ul><li>Finance Manager is concerned with  Planning and  Financing  investment decisions. </l...
Why Capital Budgeting <ul><li>Capital investment means  investments in projects  which by nature involve  huge expenditure...
Capital Budgeting <ul><li>The term Capital Budgeting refers to  long term planning  for  proposed capital outlays and thei...
Capital Budgeting <ul><li>Essential features based on which decisions are taken  </li></ul><ul><ul><li>Profit potential </...
Capital Expenditure Budget <ul><li>It is the  formal plan of Capital expenditure on new projects/   purchase of fixed asse...
Capital Expenditure Budget-objectives <ul><li>Determines the  When  the work on capital projects can be commenced </li></u...
Importance of Capital Budgeting <ul><li>One of most  crucial and critical business decisions  </li></ul><ul><li>Involvemen...
Kinds of Capital Investment Proposals <ul><li>Independent proposals-   </li></ul><ul><li>Don’t compete with any other prop...
Factors affecting Capital investment decisions <ul><li>The amount of investment- </li></ul><ul><ul><li>where  no funds con...
Investment Appraisal Methods <ul><li>In view of the importance of Capital Budgeting decisions, it is essential that the  C...
Investment Appraisal Methods <ul><li>In all the appraisal methods  emphasis is on the return.  </li></ul><ul><li>The basic...
Pay –back period method <ul><li>The term  Pay –back Period  refers to the  period  in which the project will generate the ...
Pay –back period method <ul><li>The income expressed as %of initial investment is termed as Unadjusted rate of return </li...
Pay –back period method Rs.19000 is recovered in 3years and Rs.1000 is left out of initial investment. The  cash inflow in...
Pay –back period method <ul><li>Criterion of accept or reject: </li></ul><ul><li>Reciprocal of  cost of capital  (COC). </...
Pay –back period method <ul><li>Merits </li></ul><ul><li>Useful for evaluation of  projects with high uncertainty, politic...
Pay –back period method <ul><li>Demerits </li></ul><ul><li>Ignores the returns after its pay –back period </li></ul><ul><l...
Pay –back period method <ul><li>Suitability </li></ul><ul><li>Hazy long term outlook- </li></ul><ul><li>Political or other...
Discounted Cash Flow (DCF) <ul><li>DCF Technique is an improvement on payback  period method. </li></ul><ul><li>It takes i...
NPV Method <ul><li>The cash inflows and cash outflows associated with the project are worked out. </li></ul><ul><li>The pr...
NPV Method <ul><li>Accept or reject criterion  </li></ul><ul><li>Where NPV > Zero Accept the proposal. </li></ul><ul><li>W...
Excess present value index <ul><li>This is a refinement of NPV method. </li></ul><ul><li>Instead of working out the NPV a ...
Internal rate of return (IRR) <ul><li>IRR is that rate of return at which the sum of discounted cash inflows equals the su...
Internal rate of return (IRR) <ul><li>Accept / Reject Criterion: </li></ul><ul><li>IRR is the  maximum rate of interest  w...
Accounting Rate of return (ARR) <ul><li>Under this method proposals are judged on the basis of relative profitability. </l...
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Capital budjeting & appraisal methods

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Capital budjeting & appraisal methods

  1. 1. CAPITAL BUDGETING & INVESTMENT APPRAISAL METHODS PRESENTATION BY PROF. V.RAMACHANDRAN SIESCOMS, NERUL, NAVI MUMBAI
  2. 2. AGENDA <ul><li>Concept of Capital Budgeting </li></ul><ul><li>Capital Expenditure Budget </li></ul><ul><li>Importance of Capital Budgeting </li></ul><ul><li>Rational of Capital Expenditure </li></ul><ul><li>Kinds of Capital Investment Proposals </li></ul><ul><li>Factors affecting Investment Decision </li></ul><ul><li>Investment Appraisal Methods </li></ul><ul><li>Capital Rationing </li></ul>
  3. 3. Concept of Capital Budgeting <ul><li>Finance Manager is concerned with Planning and Financing investment decisions. </li></ul><ul><li>Financing Decisions relate to determination of amount of long term finance and decision on sources for financing the same. </li></ul><ul><li>Investment decisions also termed as “Capital Budgeting Decisions” involve cost - benefit analysis . </li></ul><ul><li>Investment decisions are based on careful consideration of factors like profitability, safety, liquidity, solvency etc. </li></ul>
  4. 4. Why Capital Budgeting <ul><li>Capital investment means investments in projects which by nature involve huge expenditure and results of the same are known only after a long time . </li></ul><ul><li>Why Capital investment is necessary </li></ul><ul><ul><li>For investments in New Projects </li></ul></ul><ul><ul><li>Replacement of worn out/ out dated assets. </li></ul></ul><ul><ul><li>Expansion of existing capacity – To meet high demand or inadequate production capacity. </li></ul></ul><ul><ul><li>Diversification – to reduce risk </li></ul></ul><ul><ul><li>Research and Development – Ensuring updated technology. </li></ul></ul><ul><ul><li>Miscellaneous – Installation of Pollution Control equipment, other legal requirements. </li></ul></ul>
  5. 5. Capital Budgeting <ul><li>The term Capital Budgeting refers to long term planning for proposed capital outlays and their financing </li></ul><ul><li>It involves raising of long term funds and their utilization . </li></ul><ul><li>In other words, It is the formal process for acquisition and investment of capital. </li></ul><ul><li>Capital Budgeting is a many-sided activity. </li></ul><ul><li>It is a process of: </li></ul><ul><ul><li>searching for new and more profitable investment options </li></ul></ul><ul><ul><li>by taking into account the consequences of accepting an investment proposal </li></ul></ul><ul><ul><li>by making a detailed economic analysis of the profit making potential of each investment proposal. </li></ul></ul>
  6. 6. Capital Budgeting <ul><li>Essential features based on which decisions are taken </li></ul><ul><ul><li>Profit potential </li></ul></ul><ul><ul><li>Degree of risk </li></ul></ul><ul><ul><li>Gestation period i.e time lag from the period of initial investment to anticipated returns . </li></ul></ul>
  7. 7. Capital Expenditure Budget <ul><li>It is the formal plan of Capital expenditure on new projects/ purchase of fixed assets . </li></ul><ul><li>Provides for the capital outlay available for procurement of capital assets during the Budget period. </li></ul><ul><li>It is prepared by taking into consideration </li></ul><ul><ul><li>Future demand projections/growth of industry </li></ul></ul><ul><ul><li>the available production capacities , </li></ul></ul><ul><ul><li>allocation of existing resources and </li></ul></ul><ul><ul><li>likely improvement in production techniques . </li></ul></ul>
  8. 8. Capital Expenditure Budget-objectives <ul><li>Determines the When the work on capital projects can be commenced </li></ul><ul><li>Estimates the expenditure that would be incurred on the projects approved by the management and the sources from which finance will be obtained </li></ul><ul><li>Restricts capital expenditure on projects within the authorized limits </li></ul>
  9. 9. Importance of Capital Budgeting <ul><li>One of most crucial and critical business decisions </li></ul><ul><li>Involvement of heavy funds- Improper and ill-advised investment and incorrect decisions can jeopardize the survival of even Biggest firm </li></ul><ul><li>Long – term implications- Impact of capital decisions are known after a long period. A wrong decision can prove disastrous for the long term survival of the firm </li></ul><ul><li>Irreversible decisions </li></ul><ul><li>Most difficult decisions to make – Capital Budgeting decisions require assessment of future events which are uncertain. Further assessing future costs and benefits accurately in quantitative terms is not easy. E.g KCC and Taloja </li></ul><ul><li>In view of the above the capital expenditure decisions are best reserved for consideration of the highest level of management </li></ul>
  10. 10. Kinds of Capital Investment Proposals <ul><li>Independent proposals- </li></ul><ul><li>Don’t compete with any other proposal. They are cases of “ accept or reject ” proposals on the minimum return on investment cut off criteria basis. </li></ul><ul><li>Contingent or dependent Proposals :- </li></ul><ul><li>Proposals whose acceptance depends on the acceptance one or more proposals.-Substantial Expansion of plan, other capital requirement. Like township etc </li></ul><ul><li>Mutually exclusive proposals;- </li></ul><ul><li>e.g Temperature control Systems, Agitator, Valves Etc </li></ul>
  11. 11. Factors affecting Capital investment decisions <ul><li>The amount of investment- </li></ul><ul><ul><li>where no funds constraints are there proposals giving higher rate of return than the minimum cut off rate may be accepted </li></ul></ul><ul><ul><li>However where fund constraints are there, then Capital Rationing has to be resorted to. </li></ul></ul><ul><ul><li>Projects should be arranged in ascending order of capital investment and giving due consideration of priority </li></ul></ul>
  12. 12. Investment Appraisal Methods <ul><li>In view of the importance of Capital Budgeting decisions, it is essential that the Capital Investment appraisal method adopted must be sound. </li></ul><ul><li>A good appraisal method should have the features. </li></ul><ul><ul><li>Clear Basis for distinguishing between acceptable and non acceptable projects </li></ul></ul><ul><ul><li>Ranking the projects on the basis of desirability </li></ul></ul><ul><ul><li>Choosing among several alternatives </li></ul></ul><ul><ul><li>A criterion applicable to any conceivable project </li></ul></ul><ul><ul><li>Recognizing bigger benefit projects are preferable to smaller ones and early benefit projects are preferable to later ones </li></ul></ul>
  13. 13. Investment Appraisal Methods <ul><li>In all the appraisal methods emphasis is on the return. </li></ul><ul><li>The basic approach to compare the investment in the project with benefits derived there from . </li></ul><ul><li>Following are the main methods generally used;- </li></ul><ul><li>Pay –back period method </li></ul><ul><li>Discounted Cash flow method </li></ul><ul><ul><li>The Net present value method </li></ul></ul><ul><ul><li>Present value index method </li></ul></ul><ul><ul><li>IRR Method </li></ul></ul><ul><li>Accounting Rate of return Method </li></ul>
  14. 14. Pay –back period method <ul><li>The term Pay –back Period refers to the period in which the project will generate the necessary cash to recoup the initial investment </li></ul><ul><li>For e.g- if a project requires Rs.20000 as initial investment and it will generate an annual cash flow of Rs.5000 for ten years, the pay-back period will be 4 years, calculated as follows </li></ul><ul><li>Pay –back period = </li></ul><ul><li>The Annual cash flow is calculated on the basis of Net income before depreciation but after considering the tax. (PAT+Depreciation) </li></ul>Initial investment Annual cash Flow
  15. 15. Pay –back period method <ul><li>The income expressed as %of initial investment is termed as Unadjusted rate of return </li></ul><ul><li>Unadjusted Return = x100 </li></ul><ul><li>= x100 =25% </li></ul><ul><li>Uneven cash flow:- If a project requires an initial investment of Rs.20000 and annual cash inflows for 5 years are Rs.6000,Rs.8000,Rs.5000,Rs.4000 and Rs.4000 respectively ,the pay –back period will be calculated as follows </li></ul>Annual return Initial Investment 5000 20000
  16. 16. Pay –back period method Rs.19000 is recovered in 3years and Rs.1000 is left out of initial investment. The cash inflow in 4 th year is Rs.4000 which indicates that pay-back period is in between 3 rd and 4 th year.i.e.3+(1000/4000) = 3.25 years Year Cash Inflows Cumulative cash inflows 1 6000 6000 2 8000 14000 3 5000 19000 4 4000 23000 5 4000 27000
  17. 17. Pay –back period method <ul><li>Criterion of accept or reject: </li></ul><ul><li>Reciprocal of cost of capital (COC). </li></ul><ul><li>for e.g If COC is 20% the maximum acceptable Pay-back period would be 5 years (i.e.100/20)which can also be termed as cut off point. </li></ul><ul><li>May be a predetermined Criteria by management i.e.say Reciprocal of COC -Safety Margin. </li></ul><ul><li>5 years -1= 4 </li></ul><ul><li>Refer to illustration 5.4 and 5.5 </li></ul>
  18. 18. Pay –back period method <ul><li>Merits </li></ul><ul><li>Useful for evaluation of projects with high uncertainty, political instability, obsolescence of Technology etc </li></ul><ul><li>Method based on the assumption that no profit arises till initial capital is recovered. Suitable of new companies </li></ul><ul><li>Simple to understand and to workout </li></ul><ul><li>Reduces the possibility of loss due to obsolescence as the investment is made only on short term projects </li></ul>
  19. 19. Pay –back period method <ul><li>Demerits </li></ul><ul><li>Ignores the returns after its pay –back period </li></ul><ul><li>Projects with long gestation period will never be taken up though they yield better returns </li></ul><ul><li>The method ignores the time value of money </li></ul>
  20. 20. Pay –back period method <ul><li>Suitability </li></ul><ul><li>Hazy long term outlook- </li></ul><ul><li>Political or other conditions are hazy this method is suitable </li></ul><ul><li>Firms suffering from liquidity crises </li></ul><ul><li>Firms dependent on short term performances </li></ul>
  21. 21. Discounted Cash Flow (DCF) <ul><li>DCF Technique is an improvement on payback period method. </li></ul><ul><li>It takes into account Time Value of money i.e interest factor as well as the returns after the payback period. </li></ul><ul><li>The method involves 3 stages </li></ul><ul><ul><li>Calculation of cash flows (both inflow and outflow preferably after tax for full life of the project). </li></ul></ul><ul><ul><li>Discounting cash flows by applying a discount factor. </li></ul></ul><ul><ul><li>Aggregation of discounted cash flows and ascertainment of net cash flow. </li></ul></ul>
  22. 22. NPV Method <ul><li>The cash inflows and cash outflows associated with the project are worked out. </li></ul><ul><li>The present value of these cash flows is calculated at a rate of return acceptable to the management ( Cost of capital suitably adjusted for risk element) </li></ul><ul><li>The net present value (NPV) i.e. difference between total present value of cash inflow and total present value of cash outflow is ascertained. </li></ul>
  23. 23. NPV Method <ul><li>Accept or reject criterion </li></ul><ul><li>Where NPV > Zero Accept the proposal. </li></ul><ul><li>Where NPV < Zero Reject the proposal. </li></ul><ul><li>Refer illustration 5.6 , 5.7 and 5.8. </li></ul>
  24. 24. Excess present value index <ul><li>This is a refinement of NPV method. </li></ul><ul><li>Instead of working out the NPV a present value index is worked out by comparing total present value of future cash inflows and total present value of future cash outflows. </li></ul><ul><li>Refer illustration 5.10. </li></ul>
  25. 25. Internal rate of return (IRR) <ul><li>IRR is that rate of return at which the sum of discounted cash inflows equals the sum of cash outflows. </li></ul><ul><li>In other words it is the rate which discounts the cash flows to zero. </li></ul><ul><li>It can be stated in the form of formula as under. </li></ul><ul><li> =1 </li></ul>Cash inflows Cash outflows
  26. 26. Internal rate of return (IRR) <ul><li>Accept / Reject Criterion: </li></ul><ul><li>IRR is the maximum rate of interest which an organization can afford to pay on capital invested in a project. </li></ul><ul><li>A Project would qualify only if IRR exceeds the cut-off rate. </li></ul><ul><li>A project giving higher IRR than cut-off rate would be preferred. </li></ul><ul><li>Refer e.g. 5.12 & 5.13. </li></ul>
  27. 27. Accounting Rate of return (ARR) <ul><li>Under this method proposals are judged on the basis of relative profitability. </li></ul><ul><li>It is calculated on the following basis. </li></ul><ul><li>(Annual Average net earnings / original investments)*100 </li></ul><ul><li>Annual Average net earnings is the average net earnings after depreciations and tax for the entire life of the project. </li></ul><ul><li>Refer illustration 5.16. </li></ul>
  28. 28. CAPITAL BUDGETING & INVESTMENT APPRAISAL METHODS Thank you

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