Capital is essential factor of Prduction Function

1. Capital Budgeting

2. • The investment decision relates to the selection of assets in which
funds will be invested by a firm. The assets as per their duration
of benefits, can be categorized into two groups:
• long-term assets which yield a return over a period of time in
future
• short-term or current assents which in the normal course of
business are convertible into cash usually with in a year
Investment Decision
Long term assets - Capital budgeting
Short term assets - Working capital

3. Working capital cycle

4. Components of working capital

5. Importance of Capital Budgeting
Long term
Goals
Involvement
of Large
amount of
funds
Difficulties in
Investment
Decision
Controling
Expenditure
Maximization
of wealth
Irreversable
Decision
Capital
Budgeting

6. Capital Budgeting
The main elements of the capital budgeting decision are:
(i) The total assets and their composition
(ii) The business risk complexion of the firm, and
(iii) concept and measurement of the cost of capital.

7. Unlimited funds versus capital rationing
– Unlimited funds is the financial situation in which a firm is
able to accept all independent projects that provide an
acceptable return.
– Capital rationing is the financial situation in which a firm has
only a fixed number of dollars available for capital
expenditures, and numerous projects compete for these
dollars.

8. Steps in the capital budgeting Process
1
• Proposal generation: Proposals for new investment projects are made
at all levels within a business organization and are reviewed by
finance personnel.
2
• Review and analysis. Financial managers perform formal review and
analysis to assess the merits of investment proposals
3
• Decision making. Firms typically delegate capital expenditure decision
making on the basis of dollar limits
4
• Implementation. Following approval, expenditures are made and
projects implemented. Expenditures for a large project often occur in
phases.
5
• Follow-up. Results are monitored and actual costs and benefits are
compared with those that were expected. Action may be required if
actual outcomes differ from projected ones.

9. Independent versus Mutually Exclusive Projects
 Independent projects are projects whose cash flows are
unrelated to (or independent of) one another; the
acceptance of one does not eliminate the others from
further consideration.
 Mutually exclusive projects are projects that compete with
one another, so that the acceptance of one eliminates from
further consideration all other projects that serve a similar
function.

10. Accept-Reject Approach
• An accept–reject approach is the evaluation of capital
expenditure proposals to determine whether they meet the firm’s
minimum acceptance criterion.
• A capital expenditure is an outlay of funds by the
firm that is expected to produce benefits over a
period of time greater than 1 year.
Capital
expenditure
• An operating expenditure is an outlay of funds by
the firm resulting in benefits received within 1 year.
Operating
expenditure

11. Methods of capital budgeting
Methods of
capital
budgeting
Traditional
Methods
Pay Back
Period
Discounted
Payback
ARR
Time-Adjusted
Methods or
Discounted
Methods
NPV IRR PI

12. Payback Period
The payback method is the amount of time required for a firm to
recover its initial investment in a project, as calculated from cash inflows.
Decision criteria:
1. The length of the maximum acceptable payback period
2. If the payback period is less than the maximum acceptable payback
period, accept the project.
3. If the payback period is greater than the maximum acceptable
payback period, reject the project.
Even Cash Flows
Company C is planning to undertake a project requiring initial
investment of $105 million. The project is expected to generate $25
million per year in net cash flows for 7 years.
Payback Period= Initial Investment ÷ Annual Cash Flow
= $105M ÷ $25M
= 4.2 years

13. Capital Budgeting Techniques
Bennett Company is a medium sized metal fabricator that is currently
contemplating two projects: Project A requires an initial investment
of $42,000, project B an initial investment of $45,000. The relevant
operating cash flows for the two projects are presented in Table 10.1
and depicted on the time lines in Figure 10.1.
Company cash flows

14. Bennett Company’s Projects A and B
SOLUTION

15. DISCOUNTED PAYBACK PERIOD
This method is the same as the payback period method. The only
difference in payback period & discounted payback period is, it
considers the discounted cash flow for finding payback period.
Year Revenue
Operating
cost Profit
Discounting
factor @
10%
Discounted
Cashflow
Cumulative
discounted
cash flow
1 $ 5 $ 1 $ 4 0.9091 3.6364 3.6364
2 $ 5 $ 1 $ 4 0.8264 3.3056 6.9420
3 $ 3 $ 1 $ 2 0.7513 1.5026 8.4446
4 $ 3 $ 1 $ 2 0.6830 1.3660 9.8106
5 $ 2 $ 1 $ 1 0.6209 0.6209 10.4315

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