The document discusses capital budgeting, which refers to the planning process used to determine whether long-term investments are worth funding with cash. It defines capital budgeting, outlines its key characteristics and process, and describes various techniques used, including payback period, accounting rate of return, net present value, internal rate of return, and profitability index. It also discusses determining relevant cash flows, the cost of capital, and calculating the weighted average cost of capital.

1. INTRODUCTION:
Investment and financing funds are two crucial functions of
finance manager. The investment of funds requires a number of
decisions to be taken in a situation in which funds are invested
and benefits are expected over a long period. The finance
manager of concern has to decide about the asset composition of
the firm. The assets of the firm are broadly classified into two
categories viz., fixed and current. The aspect of taking the
financial decision with regard to fixed assets is known as capital
budgeting.

2. WHAT IS CAPITAL BUDGETING?
Capital budgeting, and investment appraisal, is the
planning process used to determine whether an
organization's long term investments such as new
machinery, replacement of machinery, new plants, new
products, and research development projects are worth the
funding of cash through the firm's

3. DEFINE CAPITAL BUDGETING?
“Capital Budgeting consists in planning for development
of available capital for the purpose of maximizing the
long-term profitability of the firm”
-R. M. Lynch

4. WHAT ARE THE CHARACTERISTICS / FEATURES / NATURE OF
CAPITAL BUDGETING?
Capital budgeting involves investment of funds in the present for achieving future
benefits.
The future benefits are usually spread over several years in the future.
The investment of funds is in long term activities which are usually non-flexible.
The projects in which investment is to be made will determine the financial future
of the organisation.
Each project involves huge amount of funds.
Capital expenditure decisions are irreversible.

5. EXPLAIN THE PROCESS OF CAPITAL
BUDGETING?

6. CONT….
Evaluation
 Independent proposals
 Contingent of dependent proposals
 Partially exclusive proposals.
Final approval
 Profitability
 Economic constituents
 Financial violability
 Market conditions.

7. PRINCIPLES OF CAPITAL BUDGETING
Estimation of costs and benefits
Required rate of return
Selection of appropriate technique
Incremental cash flows
Taxation

8. BRING OUT THE IMPORTANCE OF CAPITAL BUDGETING
DECISIONS.
Cost
Time
Irreversibility
Complexity

9. WHAT ARE THE VARIOUS TYPES OF CAPITAL
INVESTMENT DECISIONS?

10. EXPLAIN THE MEANS OF IDENTIFYING RELEVANT CASH
FLOW/ESTIMATION OF CASH FLOWS?
One of the most important capital budgeting tasks for the
evaluation of the project capital investments is the
estimation of the relevant cash flows for each project,
which refers to the incremental cash flow arising from
each project. Because companies rely on accrual
accounting rather than cash accounting, adjustments are
necessary, to derive the cash flows from the conventional
financial accounting records.

11. ELEMENTS OF CASH FLOW STREAM
Initial Investment
Operating Cash Inflows
Terminal Cash Inflow
 The salvage value
 Taxes
 Any project termination related change in working capital

12. TIME HORIZON FOR CASH
FLOW ANALYSIS
Physical Life of the Plant
Technological Life of the Plant
Product Market Life of the Plant
Investment Planning Horizon of the Firm

13. GUIDELINES FOR ESTIMATING PROJECT CASH
FLOWS
Identify Incremental Cash flows
Focus on After-Tax Flows
Postpone Considering Financing Costs

14. OTHER CASH FLOW CONSIDERATIONS
Net Operating Working Capital
Sunk Costs
Opportunity Costs
Allocated Overhead
Side Effects

15. CAPITAL BUDGETING TECHNIQUES
Three steps are involved in the evaluation of an investment.
 Estimation of Cash Flows.
 Estimation of the required rate of returns.
 Application of a decision rule for making the choice.

16. ANY APPRAISAL METHOD SHOULD PROVIDE FOR
THE FOLLOWING:
1. A basis of distinguishing between acceptable and non-acceptable projects.
2. Ranking of projects in order of their desirability.
3. Choosing among several alternatives.
4. A criterion which is applicable to any conceivable project.
5. Recognizing the fact that bigger benefits are preferable to smaller ones and early benefits
are preferable to later one.

17. CONT…

18. TRADITIONAL (OR) NON TIME VALUE METHOD (OR)
NON DISCOUNTED.
❖ Pay-back period
Improvement of Traditional Approach to Pay-back period method
❖ Post Pay-back Profitability method
❖ Discounted Pay-back period
❖ Reciprocal Pay-back period method
❖ Average / Accounting Rate of Return.

19. DISCOUNTED CASH FLOW METHODS/TIME ADJUSTED
METHODS/PRESENT VALUE METHOD.
❖Net present value
❖Profitability index.
❖Internal rate of return

20. PAYBACK METHOD:
The payback period refers to the length of time which will be required for the sum of annual
net cash benefits to equal the initial investment.
Pay back period may be defined as the period of time. i.e. the number of years
required for cash inflow to get back the original cost of the project. According to this method,
every capital expenditure pays itself back over a number of years. This method is also known
as pay off period, break even period (or) Recoupment period.

21. (A) WHEN ANNUAL INFLOWS ARE EQUAL:
When the cash inflows being generated by a proposal are equal per time
period i.e., the cash inflow are in the form are annual, the pay-back period can
be computed by dividing the cash outflows by the amount of annuity.
Initial Investment
Payback period = ---------------------------
Annual cash
inflow

22. WHEN ANNUAL INFLOWS ARE UNEQUAL:
In such a case, payback period is computed by the process of cumulating cash
inflows till the time when cumulative cash inflows becomes equal to the original
investment outlay. In the formula form
Payback period = E + B/C
E  No. of years immediately proceeding the year of recovery.
B  Balance of amount of Investment to be recovered.
C  Savings (Cash inflow) during the year of final recovery.

23. ACCEPT OR REJECT CRITERION: UNDER WHICH
CIRCUMSTANCES, THE PAYBACK METHOD IS
ADVISABLE?
1. When the cost of the project is small.
2. When the project requires shorter period to accomplish.
3. When the project goes for immediate production.
4. When the promoter thinks that competition may damage the prospects of the concern.
5. When the promoter considers that the industry may face technological competition and
problem of obsolescence.
6. When the project lacks long term stability.

24. AVERAGE RATE OF RETURN (ARR) OR ACCOUNTING
RATE OF RETURN:
Accounting / Average Rate of Return means the average annual yield on the
project. In this method, profits after taxes are used for evaluation.
It may be defined as the annualized net income earned on the
average funds invested in a project. In other words, the annual returns of a
project are expressed as a percentage of the net Investment in the project.

25. DISCOUNTED CASH FLOW TECHNIQUES (DCF):
Investments are essentially current capital expenditure incurred at
present in anticipation of future returns. Hence, the timing of
expected future cash flow is important in the investment decision.
For example, investors play a higher value on recent returns than
on future ones. Hence, the technique that discounts the future
value into them present values at a specified time value (discount
rate) is called as DCF technique.

26. NET PRESENT VALUE (NPV):
The Net Present Value of an Investment proposal is defined as
the sum of the present value of all future cash inflows less the sum
of the present values of all cash outflows associated with the
proposal.
NPV=Discounted Cash Inflows less discounted Cash Outflows.

27. PROFITABILITY INDEX (PI):
Where different investment proposals each involving different initial investments and cash inflows are
to be compared, the technique of Profitability Index (PI) is used.
Profitability Index (PI) = Total of Discounted Cash Inflows
Total of Discounted Cash Outflows

28. ACCEPT OR REJECT CRITERION:
PI represents the amount obtained at the end of the
project life, for every rupee invested in the project at the
initial state. Hence, Projects with PI > 1 are accepted and
PI < 1 are rejected.

29. INTERNAL RATE OF RETURN (IRR):
Internal Rate of Return is the rate at which the sum total of
discounted cash inflows equals the discounted cash outflows. The
Internal rate of return of a project is the discount rate which makes
net present value of the project equal to zero.

30. ACCEPTANCE RULE:
 If IRR > Cut Off rate i.e., Cost of Capital, then accept the
project.
 If IRR = Cut Off rate i.e., Cost of Capital, then the firm is
indifferent, either accept (or) reject the project.
 If IRR < Cut Off rate i.e., Cost of Capital, then reject the project.

31. WHAT IS CAPITAL RATIONING?
When necessary funds are available; the management can take up all profitable projects.
When funds are insufficient, the firm has to choose some more profitable projects and reject some less
profitable investment proposals.
Thus, because of lack of funds, the firm is able to invest in all profitable projects the extent to which the
funds are sufficient. Moreover, the executives with the required managerial skills to fruitfully utilize the funds
may also be a constraint. This situation is described as a capital rationing.
Capital rationing refers to a situation where the firm is constrained for external or internal reasons to
secure the necessary funds to invest in all profitable investment proposals.

32. REASONS FOR CAPITAL RATIONING
The situation of capital rationing may arise due to both:
1.External factors; or
2.Internal constrains imposed by the management

33. CONCEPT AND MEASUREMENT OF COST OF CAPITAL
Generally, most of the companies are financed by way of debt, bonds and
equity. An investor’s investment in long-term funds such as shares,
debentures, public deposits, etc. of a company are on the basis of expecting
good rate or return. It is important because acceptance or rejection of an
investment decision depends on the cost of capital of a firm.
Thus, to the company, the cost of capital is the minimum rate of return
that the company must earn on its investments to satisfy the expectations of
its investors.

34. WHAT DO YOU MEAN BY COST OF CAPITAL?
DEFINE IT.
The term cost of capital refers to the rate of return on investment projects
necessary to leave unchallenged the market price of a firm’s stocks. It is the
rate of return required by those who supply the capital. The cost of capital is
a weighted average of the cost of each type of capital.
In simple words, cost of capital refers to minimum rate of return a firm
must earn on its investment so that the market value of the company’s equity
shares does not fall. This is consonance with the overall firm’s objective of
wealth maximization.

35. DEFINITION:
“The cost of capital is the minimum required rate of earnings or
the cut-off rate for the allocation of capital to investments of
projects. It is the rate of return on a project that will leave
unchanged the market price of the stock”
- James C.

36. EXPLAIN THE CONCEPTS OF
COST OF CAPITAL?
Cost of capital is not a cost as such: A firms cost of capital is
really the rate of return that it requires on the projects available.
It is merely a hurdle rate. Of course such rate may be calculated
on the basis of actual cost of different components of capital.
It is the minimum rate of return: A firm of capital represents
the minimum rate of return that will result in at least maintaining
(if not increasing) the vale of its equity shares.

37. IT COMPRISES OF THREE COMPONENTS:
Return at zero risk level
The premium for business risk
The premium for financial risk

38. EXPLAIN THE FACTORS AFFECTING THE COST
OF CAPITAL OF A FIRM?
Risk-free Interest Rate
Real interest rate
Purchasing power risk premium
Business risk
Financial risk
Other Considerations

39. WHAT ARE THE TYPES OF COST?
Explicit Cost and Implicit cost
Future and Historical Cost
Specific Cost and Combined Cost
Average Cost and Marginal Cost

40. WHAT ARE THE PROBLEMS INVOLVED IN
DETERMINATION OF COST OF CAPITAL?
1. Conceptual controversies regarding the relationship
between the Cost of Capital and the Capital structure
2. Historic cost and Future cost
3. Problem in computation of Cost of Equity
4. Problems in computation of cost of retained earnings
5. Problems in assigning weights

41. EXPLAIN THE VARIOUS METHODS OF COMPUTING COST
OF CAPITAL.
A.Computation of cost of specific source of finance, and
B.Computation of weighted average cost of capital.

42. STATE THE COST OF VARIOUS SOURCES OF FINANCE?
Firms obtain capital from two kinds of sources: lenders and equity
investors. From the perspective of capital providers, lenders seek to be
rewarded with interest and equity investors seek dividends and/or
appreciation in the value of their investment (capital gain). From a firm's
perspective, they must pay for the capital it obtains from others, which is
called its cost of capital. Such costs are separated into a firm's cost of debt
and cost of equity and attributed to these two kinds of capital sources.

43. CONT….
Cost of various Sources of Finance
Cost of Equity Capital Cost of Preference Capital Cost of Debt Cost of Weighted Average Cost of
Capital

44. COST OF EQUITY CAN BE CALCULATED FROM
THE FOLLOWING APPROACHES:
Dividend price (D/P) approach
Dividend price plus growth (D/P + g) approach
Earning price (E/P) approach
Realized yield approach.

45. WEIGHTED AVERAGE COST OF CAPITAL
Meaning:
It is also called as weighted average cost of capital and
composite cost of capital. It is the average cost of the company’s
finance (equity, bonds, bank loans) weighted according to the
proportion each element bears to the total pool of capital.

46. WHAT ARE THE STEPS TO CALCULATE OVERALL
COST OF CAPITAL?
The computation of the overall cost of capital (Ko) involves the
following steps.
Assigning weights to specific costs.
Multiplying the cost of each of the sources by the appropriate weights.
Dividing the total weighted cost by the total weights