Capital Budgeting.pptx

INTRODUCTION:-
 Capital project planning is the process by which
companies allocate funds to various investment
projects designed to ensure profitability and growth.
 Evaluations of such projects involve estimating
their future benefits to the company and comparing
these with their costs.

MEANING AND DEFINITION
 Capital budgeting refers to planning the deployment of
available capital for the purpose of maximizing the long
term profitability of the firm. It is the firm’s decision to
invest its current funds most efficiently in long term
activities in anticipation of flow of future benefits over a
series of years.
 “capital budgeting is the process to identify, analysis
and select investment projects, whose returns(cash
flows) are expected to extend beyond one year. ”

“Capital budgeting consists in planning
development of available capital for the purpose of
maximizing the long term profitability of the
concern” – Lynch

WHAT ARE THE FEATURES OF CAPITAL
BUDGETING?
 Features/nature/ Characteristics of Capital
Budgeting
 Huge Funds: Capital budgeting involves the
investment of funds currently for getting benefits in
the future.
 High Degree of Risk: To take decisions that
involve a huge financial burden can be risky for the
company.
 Affects Future Competitive Strengths: The future
benefits are spread over several years. Sensible
investing can improve its competitiveness, whereas
a wrong investment may lead to business failure.

 Difficult Decision: When the future is dependant on
capital budgeting decisions, it becomes difficult for the
management to grab the most appropriate investment
opportunity.
 Estimation of Large Profits: Each project involves a
huge amount of funds with the perspective of earning
desirable profits in the long term.
 Long Term Effect: The effect of the decisions taken, will
be visible in the future or the long term.
 Affects Cost Structure: For instance, it may increase
the fixed cost such as insurance charges, interest,
depreciation, rent, etc.
 Irreversible Decision: Capital expenditure decisions
are irreversible since it involves a high-value asset
which may not be sold at the same price once
purchased.

OBJECTIVES OF CAPITAL BUDGETING
 Control of Capital Expenditure: Estimating the cost of
investment provides a base to the management for controlling
and managing the required capital expenditure accordingly.
 Selection of Profitable Projects: The company has to select
the most suitable project out of the multiple options available
to it. For this, it has to keep in mind the various factors such
as availability of funds, project’s profitability, the rate of
return, etc.
 Identifying the Right Source of Funds: Locating and
selecting the most appropriate source of funds required to
make a long-term capital investment is the ultimate aim of
capital budgeting. The management needs to consider and
compare the cost of borrowing with the expected return on
investment for this purpose.

GENERATION AND SCREENING OF A PROJECT
IDEA
 Generation and Screening of a project idea begins
when someone with specialized knowledge or
expertise or some other competence feels that he
can offer a product or service
 ♦ Which can cater to a presently unmet need and
demand
 ♦ To serve a market where demand exceeds supply
 ♦ Which can effectively compete with similar
products or services due to its better quality/price
etc.

 An organization has to identify investment
opportunities which are feasible and promising
before taking a full fledged project analysis to know
which projects merit further examination and
appraisal.
 Generation and Screening of a project idea involves
the following tasks :-

GENERATION OF IDEAS –
A panel is formed for the purpose of identifying investment
opportunities. It involves the following tasks which must be
carried out in order to come up with a creative idea.
(a) SWOT analysis – Identifying opportunities that can be
profitably exploited
(b) Determination of objectives – Setting up operational
objectives like cost reduction, productivity improvement,
increase in capacity utilization, improvement in contribution
margin.

(c) Creating Good environment – A good organizational atmosphere
motivates employees to be more creative and encourages techniques like
brainstorming, group discussion etc. which results in development of
creative and innovative ideas.
(2) Monitoring the Environment –
An Organization should systematically monitor the environment and
assess its competitive abilities in order to profitably exploit opportunities
present in the environment. The key sectors of the environment that are to
be studied are :-
(a) Economic Sector –It includes, State of economy, Overall rate of
Growth, Growth of primary, secondary and tertiary sectors, Inflation rate,
Linkage with world economy, BOP situation, Trade Surplus / Deficit.
(b) Government Sector –It includes, Industrial policy, Government
programmes and projects, Tax framework, Subsidies,
incentives,concessions, Import and export policies,Financing norms.

 (c) Technological Sector – It includes, State of
technology, Emergence of new technology,
Receptiveness of the industry, Access to technical
know how.
 (d) Socio-demographic sector –It Includes,
Population trends, Income distribution, Educational
profile, Employment of women, Attitude towards
consumption and investment.
 (e) Competition Sector –It includes, No. of firms and
their market share, Degree of homogeneity and
production differentiation, Entry barriers, Marketing
policies and prices, Comparison with substitutes in
terms of quality/price/appeal etc.

 (f) Supplier Sector – Availability and cost of raw material,
energy and money
 (3) Corporate Appraisal –It involves identification of
corporate strengths and weaknesses. The important aspects
that are to be considered are:-
 (a) Market and Distribution –
i. Market Image
ii. Market share
iii. Marketing and Distribution cost
iv. Product line
v. Distribution Network
vi. Customer loyalty
 (b) Production and Operations –
i. Condition and capacity of plant and machinery
ii. Availability of raw materials and power
iii. Degree of vertical integration
iv. Location advantage
v. Cost structure – Fixed and Variable costs

 (3) Corporate Appraisal – It involves identification of
corporate strengths and weaknesses. The important
aspects that are to be considered are:-
 (a) Market and Distribution –
i. Market Image
ii. Market share
iii. Marketing and Distribution cost
iv. Product line
v. Distribution Network
vi. Customer loyalty
 (b) Production and Operations –
i. Condition and capacity of plant and machinery
ii. Availability of raw materials and power
iii. Degree of vertical integration
iv. Location advantage
v. Cost structure – Fixed and Variable costs

 (c) Research and Development –
i. Research capabilities of a firm
ii. Track record of new product developments
iii. Laboratories and testing facilities
iv. Coordination between research and other of
departments the organization
 (d) Corporate Resources and Personnel –
i. Corporate Image
ii. Clout with government and regulatory agencies
iii. Dynamism of top management
iv. Competence and commitment of employees
v. State of industrial relations

 (e) Finance and Accounting –
i. Financial leverage and borrowing capacity
ii. Cost of capital
iii. Tax situation
iv. Relations with shareholders and creditors
v. Accounting and control system
vi. Cash flows and liquidity

 Tools for identifying investment opportunities
 (a) Porter 5 forces Model → It helps in analyzing profit
potential of an industry depending upon strength of –
 i. Threat of new entrants
 ii. Rivalry amongst existing companies
 iii. Pressure from substitute products
 iv. Bargaining power of buyer
 v. Bargaining power of seller

(B) LIFE CYCLE APPROACH → THERE ARE FOUR STAGES
A PRODUCT GOES THROUGH DURING
 his life cycle each stage represents different investment and net
profit value
 (a) Pioneering Stage – In this stage the technology and product
is new, there is high competition and very few entrants survive
this stage.
 (b) Rapid Growth Stage – This stage witnesses a significant
expansion in sales and profit.
 (c) Maturity Stage – It marks developed industries with mature
product and steady growth rate.
 (d) Decline Stage – Due to introduction of new products and
changes in customer preference the industry incur a decline in
market share and profits.
 (c) Experience Curve Experience curve analyzes how cost per
unit changes with respect to accumulated volume of production.
Investment must be such that reduces costs.

 (4) Looking for Project Ideas –
 Various sources to look for good project ideas
include:-
i. Trade fairs and exhibitions
ii. Studying Government plans and guidelines
iii. Suggestion of financial institutions and
development agencies
iv. Investigating local materials and resources
v. Analyzing performance of existing industries
vi. Analyzing social and economic trends
vii. Analyzing new technological developments
viii. Studying the consumption pattern of people
abroad
ix. Stimulating creativity to produce new ideas
x. Reducing exports and imports

(5) PRELIMINARY SCREENING –
It refers to elimination of project ideas which are not promising.
The factors to be
considered while screening for ideas are:-
♦ Compatibility with the promoter – The idea must be consistent
with the interest,personality and resources of entrepreneur.
♦ Consistency with Government priorities – The idea must be
feasible with national goals and government regulations.
♦ Availability of inputs – Availability of power, raw material,
capital requirements,technology.
♦ Adequacy of Market – Growth in market, prospect of adequate
sale, reasonable
Return on Investment.
♦ Reasonableness of cost – The project must be able to make
reasonable profits with respect to the costs involved.

(7) SOURCES OF THE NET PRESENT VALUE
 In order to select a profitable and feasible project, a project
manager must carry out a fundamental analysis of the product
and factor market to know about entry barriers which lead to
positive net present value. There are six entry barriers which
result in a positive NPV project.
They are –
i. Economies of scale
ii. Product differentiation
iii. Cost advantage
iv. Marketing reach
v. Technological edge
vi. Government policy

 Acceptability of risk level – The desirability of the project also
depends upon risks involved in executing it. In order to
access risk the following factors must be considered:-
-Project`s vulnerability to business cycles
-Change technology
-Competition from substitutes
-Government`s control over price and distribution
-Competition from imports

(6) PROJECT RATING INDEX →
 It is a tool used for evaluating large number of project ideas. It helps in
streamlining the process of preliminary screening. Hence a preliminary
evaluation may be converted in project rating index.
 Steps to calculate project rating index→
 I. Identifying the factors relevant for project rating
 II. Assigning weights to these factors according to their relative
importance(FW)
 III. Rate the project proposal on various factors using suitable rating
scale (FR) (5 point scale or 7 point scale)
 IV. For each factor multiply the factor rating with factor weight to get
factor scores (FR X FW = FS)
 V. All the factor scores are added to get the overall project rating index.
Organization determines a cut off value and the project below this cut
off value are rejected.

(8)ENTREPRENEURIAL SKILLS →
An individual must possess the following traits and qualities in order
to be a successful entrepreneur –
i. He must be Willing to make sacrifices
ii. He must be a good Leader
iii. He must be able to make quick and rational decisions
iv. He must have confidence in the project
v. He must able to exploit market opportunities
vi. He must have strong ego in order to survive ups and downs of a
business

CAPITAL BUDGETING TECHNIQUE
CAPITAL BUDGETING
Discount cash flow
technique
Traditional
Technique
Payback Period
Method
Accounting Rate of
Return
Net Present Value Internal Rate of Return Profitability Index

TRADITIONAL METHOD
 Pay back period Method: the pay back period is the
length of time require to recover the initial cash outlay
on the project. It can be calculated as follow:
 Payback period = Cash outlay
Annual cash inflow
The method can be understood as follow :
If a project involves a cash outlay of Rs 6,00,000 and
generates cash inflow of Rs. 1,00,000, Rs 1,50,000,
Rs. 1,50,000 and Rs 2,00,000 in the first, second,
third and fourth Year respectively

 A project which has an annual cash outlay Rs 10,00,000 and a
constant annual cash inflow of Rs 3,00,000 has a pay back
period = 10,00,000/3,00,000 = 3(1/3) year
EXAMPLE :-
ADVANTAGES :
1. It is a ready method, both in concept and application. It does not
use involved concepts and tedious calculations assumptions. and
has few hidden
2. Since it emphasizes earlier cash inflows, it may be sensible
criterion when the firm is pressed with problems of liquidity.
3. It is a rough and ready method for dealing with risk. It favors
projects which generate substantial cash inflows in earlier years
and discriminates against projects which bring substantial cash
inflows in later years but not in earlier years.

DISADVANTAGES:
1. A company can have more favourable short-run earnings for
share by selling up a shorter pay back period. It however, be
remembered that this may not be a wise long term policy as
the company may have to sacrifice its future growth for
current earnings.
2. The emphasis in pay back is on the early recovery of the
investment. Thus, it give an insight to the liquidity of the
project. The funds so released can be put to other uses.
3. The riskiness of the project can be tackled by having a
shorter pay back period as it may ensure guarantee against
loss. Company has to invest in many such projects where
the cash inflows and life expectancies are highly uncertain

PRACTICAL PROBLEMS
1. A Project cost Rs 100000 and yield an annual cash inflow of Rs
20,000 for eight years. Calculate the pay back period.
2. There are two project X and Y . Each project requires an investment
of Rs 20,000. you are require to rank these projects according to the
payback period method from the following information
Years
Net Profit before depreciation and after tax
Project “x” Project “y”
1st 1000 2000
2nd 2000 4000
3rd 4000 6000
4th 5000 8000
5th 8000 -----

SOLLUTION
Answer 1.
Payback period = Initial outlay of the project
Annual Cash flow
= 1,00,000/20,000 = 5 years
Answer : 2
The payback period for project X is 5 year
(Rs 1000+2000+4000+5000+8000) = 20000
The payback period for project Y is 5 year
(Rs 2000+4000+6000+8000) = 20000
Hence project y should be preferred or rank first.

ACCOUNTING RATE OF RETURN TECHNIQUE (ARR)
 Accounting Rate of Return Technique (ARR): Also called as
average rate of return is primarily based on accounting
approach rather than cash flow approach. The accounting rate
of return is found out by dividing the average income after
taxes by average investment.
 ARR = Average Income after taxes
Average Investment
or
Average income after taxes
Original investment + salvage value
2

QUESTION :
 A project require an investment of Rs 500000 and has a scrap of
Rs 20000 after 5 years. It is expected to yield profit after
depreciation and taxes during the five years accounting to Rs
40,000, Rs 60000, Rs 70000, Rs. 50000 and Rs 20000. calculate
the average rate of return on the investment .
 Solutaion
 Totalprofit=40,000+60,000+70,000+50,000+20,000 =2,40,000
 Average profit = 240000/5 =48,000
 Net investment project =5,00,000-20,000 =4,80,000
 Average rate of return =
 (Average annual profit/ Net investment in project )*100
 = (48,000/480000)*100 = 10%

MERITS:
 1. Net earnings after depreciation are considered under this
method and this of vital importance in the appraisal of
investment proposals.
 2. It is an easy method to adopt and simple to understand.
 3. It considers the earnings over the life span of the project
and as such superior to pay back method.
DEMERITS:
 1. This method like the pay back method does not consider
the time value of money.
 2. It does not differentiate between the size of investment
required for investment proposals. Investment proposals may
have the same ARR but may require different average
investment. In such a situation the method is of no use for the
firm can not precisely decide on the implementation of any
specific proposal.

MODERN METHOD
Net Present Value (NPV )Method: This method is one of the
discounted cash flow technique that takes into consideration the
time value of money. It recognizes that cash flow streams at
different time periods differ in value and can be compared only
when they are expressed in terms of a common denominator i.e.
present values.
Discounted cash flow technique
Net Present Value Internal Rate of Return Profitability Index

PROCEDURE FOR CALCULATING NPV:
THE PROCESS OF CALCULATING NPV IS AS FOLLOWS:
The annual net cash flow expected from a project
is calculated by estimating all cash receipts and
deducting from them all expenditure arising out of
the project.
The net cash flow is then discounted to give its
present value. The rate used to discount the cash flow
is required rate of return i.e. the minimum rate of
return expected to be earned from the investment
projects.
The NPV of an investment proposal is then
computed. It is equal to the sum of the present
value of its annual net cash flows after tax less the
investment's initial outlay.

NPV = Rt
(1+i)t
NPV = net present value
Rt= net cash flow at time t
i = Discount rate
t = Time of the cash flow
Thus, the NPV method is the process of calculating the
present value of cash flows (inflows and outflows) of an
investment proposal, using the opportunity cost of capital
as the appropriate discounting rate, and finding out the
net present value by subtracting out the present value of
cash outflows from the present value of cash inflows.

FEATURES OF NPV METHOD:
 1. The NPV of simple project monotonically decreases as the
discount rate increases. The decrease in the NPV, however, is
at a decreasing rate.
 2. The NPV method is based on the assumption that the
intermediate cash inflows of the project are re-invested at a
rate of return equal to the firm's cost of capital.
MERITS
 1. It considers the cash flow stream in its entirety.
 2. The net present value of various projects measured as they are
in today's rupees can be added. For example, the net present value
of a package consisting of two projects, A and B will simply be the
sum of the net present value.
 3. It takes into account the time value of money.
 4. It squares neatly with the financial objective of maximization of
the wealth of stockholders. The net present value represents the
contribution to the wealth of stockholders.

INTERNAL RATE OF RETURN (IRR) METHOD
 It is another DCF technique which takes into
account the time value of money. This technique is
also known as yield on investment, marginal
productivity of capital, time adjusted rate of return,
marginal efficiency of capital, rate of return etc.

Capital Budgeting.pptx

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Capital Budgeting.pptx