Capital Budgeting

Capital BudgetingTapen GuptaHIM Kala Amb




Introdction

Assets acquired 2 categories
Short term or current assets
Long term or fixed assets

Short term
Current assets mgt. (working capital mgt.)
Long term
Capital budgeting (capital expenditure decisions)

Meaning of capital budgeting
Process of making investment decision in capital expenditure
The expenditure the benefits received over period of time
Cost of acquisition of permanent assets
Cost of addition & expansion
Cost of replacement of permanent assets
Non flexible long term commitment

Meaning of capital budgeting
Non flexible long term commitment of fund
Planning & control of capital expenditure
Also know as
Investment decision making
Capital expenditure decision
Planning capital expenditure
Analysis of capital expenditure
Definitions
" It is long term planning for making & financing proposed capital outlays" by charles
" It involves the planning of expenditures for assets the returns from will be realized in future time periods" by Spencer
" It consists in planning the deployment of available capital for the purpose of maximizing the long term profitability of the firm" by R.M. lynch
Features
Funds are invested in long term assets
Funds are invested in present times in anticipation of future profits
The future profits will occur to the firm over a series of years
It involves a degree of risk
They are irreversible decisions
Large funds
Importance
Such decisions affect the profitability of firm
Long time periods
Irreversible decisions
Involvement of large amount of funds
Risk
Most difficult to make
Difficulties of investment decisions
Capital budgeting process
Kinds of capital budgeting decisions
2 basis categories
Those which inc. revenue
Those which reduce cost
For investment proposal point
Accept Reject decisions
Mutually exclusive project decisions
Capital rationing decisions

Accept – Reject Decisions
Independent projects
Decisions on minimum basis of return
Higher accepted
Lower rejected
Mutually exclusive project decisions
Acceptance of one will lead to rejection of other
X acceptance will lead to y rejection
Capital rationing decisions
Limited funds to invest
Combination Greatest profitability

Methods of capital budgeting / evaluating of investment proposals
Number of proposals
Limited funds
Selective highest benefits project
Allocation of available resources to various proposals
Consideration both profitability & risk
Methods of evaluating profitability
Traditional methods
Time – adjusted method or discounted methods
Traditional methods
Pay – back period method
Improvement of traditional approach to pay back period method
Rate of return method
Pay – Back period method
Also called as pay out or pay off period method
Period in which the total investment in assets pays back itself
Measures the period of time for the original cost
Project are ranked according to the length of their pay back period
Pay – Back period method
Calculate annual net earnings before dep. & after taxes
Divide the initial outlay of the project by the annual cash inflows
pay – back period=
cash outlay of the project or original cost of assets
annual cash inflows
Pay – Back period method
Project cost Rs. 100000
Annual cash inflows Rs. 20000
For 8 years
Pay back period
= 100000 = 5 years
20000
Pay – Back period method
When the annual cask inflows are unequal the pay back period can be found by adding up the cash inflows until the total equal to initial cash outlay of the project
Pay – Back period method
Project X
Investment = 20000
Years profits
1st 1000
2nd 2000
3rd 4000
4th 5000
5th 8000
Ppm=1000+2000+4000+5000+8000=
20000
5 years
Project Y
Investment = 20000
Years profits
1st 2000
2nd 4000
3rd 6000
4th 8000
5th -
Ppm= 2000+4000+6000+8000=
20000
4 years
Advantages
Simple to understand
Easy to calculate
Saves cost
Lesser time & labour
Reduces loss through obsolescence

shortcoming
Non consideration of inflows after pay back period
Ignores time value of money
Non consideration of cost of capital
Difficult to determine the minimum acceptable pay back period
Improvement in traditional approach to pay back period method
Post pay back profitability method
Post pay back profitability index=
post pay-back profits*100
investment
Post pay back profitability method
A) Initial outlay 50000
Annual cash inflow (ATBD) 10000
Estimated life 8 years
B) Initial outlay 50000
Annual cash inflow (ATBD)
1st three years 15000
Next five years 5000
Estimated life 8 years
Salvage 8000
Post pay back profitability method
A) i) pay – back period =
= 50000 = 5 years
10000
ii) Post pay back profitability =
= 10000 (8-5) = 30000
iii) Post pay back profitability index=
= 30000 *100=60%
50000
Post pay back profitability method
B) pay back period
1st year 15000
2nd year 15000
3rd year 15000
4th year 5000
50000
post pay back profitability = 5000*4=20000
Post pay back profitability index= 20000*100
50000
= 40%
Pay-back reciprocal method
Pay-back reciprocal method
pay back reciprocal= annual cash inflow
Total investment
Two condition to be satisfied
Equal cash inflows are generated ever year
The project under consideration has along life which must be at least twice the pay back period
Post pay back period method
Ignores the life of the project beyond the pay back period
Also know as surplus life over pay back method
Greatest post pay back period accepted
Discounted pay back method
Pay back period method ignores time value of money
Discounted rate
Cost of project 600000
Life of the project 5 years
Annual cash inflows 200000
Cut off rate 10 %

Calculation present value of cash inflows
Discounted pay back period=
3 years+ 102800 = 3.75
136600
Rate of return method
Also know as accounting Rate of return
Accounting concept of profit (net profit after tax & dep.)
Ranked acc to rate of earning
Higher rate of return selected
Average rate of return method
Average profit after tax & dep.
Divide it by total capital outlay
Average rate of return method =
Total profit (after dep. & taxes) * 100
net investment in project * no of years
Or
Average annual profits * 100
Net investment in the project
Investment 500000
Scrap value 20000
Profit after dep. & taxes
40000
60000
70000
50000
20000
Total profit
40000+60000+70000+50000+20000= 240000
Average profit= 240000/ 5 =
48000
Net investment = 500000-20000= 480000
ARR= 48000/480000*100=
10%
Rate on average investment method
Consideration of Dep.
Machine cost Rs 100000
No scrap value after 5 years (straight line method)

Beginning of the first year 100000
End of 1st year 80000
End of 2nd year 60000
End of 3rd year 40000
End of 4th year 20000
End of 5th year --------------
300000
Average investment = 300000/6=
50000
Average return on average investment method
Average profit after dep. & taxes
Divide by the average amount of investment
Average return on average investment =
Average annual profit after dep & taxes *100
average investment
Or
= Average Annual Profit * 100
Net investment
2
= 48000 *100
480000
= 48000 *100=20%
240000
Advantages / Disadvantages
Advantages
Simple to understand
Easy to operate
Use entire earning
Accounting concept of profits
Disadvantages
Ignores time value of money
No consideration cash flow
Cannot applied where projects is there in parts
Time – adjusted or Discounted cash flow method
Don’t take care of time value of money
Take into account the profitability & time value of money
Modern methods
Types
Net present value method
Internal rate of return method
Profitability index method or benefit cost ratio
Net present value method
Time value of money
Entire life of the project
Following steps to be followed
Select app. Or minimum required Rate of return know as cut off rate or discount rate
Present value of total investment outlay
Present value of total investment proceeds
Calculate net present value subtracting iii – ii
Project ranked acc to value
Calculate formula
Initial investment (X) 20000
Estimated life 5 years
Scrap value 1000
Profit BDAT
Year 1st 5000
Year 2nd 10000
Year 3rd 10000
Year 4th 3000
Year 5th 2000
Initial investment (y) 30000
Estimated life 5 years
Scrap value 3000
Profit BDAT
Year 1st 20000
Year 2nd 10000
Year 3rd 5000
Year 4th 3000
Year 5th 2000

Yr cash dis present
inflow 10% value
1 5000 .909 4545
2 10000 .826 8260
3 10000 .751 7510
4 3000 .683 2049
5 2000 .621 1242
1000 .621 621
24227
Less present initial inv. 20000
Present value 4227
Yr cash dis present
inflow 10% value
1 20000 .909 18180
2 10000 .826 8260
3 5000 .751 3775
4 3000 .683 2049
5 2000 .621 1242
2000 .621 1242
34728
Less present initial inv. 30000
Present value 4728
Advantages / Disadvantages
Advantages
Recognizes time value of money
Unequal profit for years
Entire life time profits
Obj maximum profitability
Disadvantages
More difficult to understand
With unequal life
Not easy to determine discount rate
Internal rate of return
Time value of money
Also know as time adjusted rate of return , yield method , trail & error yield method
Predetermined cut off rate in NPV
Hit & trail method

Internal rate of return
A) when annual net cash flows are equal over the life of the assets
Present value factor = initial outlay / annual cash flow
Initial outlay 50000
Life of the assets 5 years
Estimated annual cash flow 12500
Present value factor = 50000/12500= 4
Then search value in net present value table
Which is equal to 8%
When the annual cash inflows are not equal
Yr cash dis present dis value dis value dis value
inflow 10% value 12% 14% 15%
1 15000 .909 13635 .892 13380 .877 13155 .869 13035
2 20000 .826 16520 .797 15490 .769 15380 .756 15120
3 30000 .751 22530 .711 21330 .674 20220 .657 19710
4 20000 .683 13660 .635 12700 .592 11840 .571 11420
66345 63350 60595 59285
The rate is to be between 14% & 15% so it is going to be 14.5%
Advantages / Disadvantages
Advantages
Time value of money
Uneven cash inflow
Entire economic life
Obj of maximum profitability

Disadvantages
Difficult to understand
Result may diff of NPV & IRR (size, life, timings)
Profitability index method
Also know as benefit cost ratio or desirability factor
Profitability index = present value of cash inflows
present value of cash outflows or PI = PV of cash inflows
Initial cash outlay
or PI = NPV
initial cash outlay
Net profitability index = PI - 1
Comparison between NPV & IRR
Time value of money
Discounted cash inflow techniques
Difference between NPV & IRR
Discounting rate
Market rate of return
Reinvested at cut off rate Vs IRR
More reliable cut off rate
Factor influencing capital expenditure decision
Urgency
Degree of certainty
Intangible factor (safety , welfare of worker)
Legal factor
Availability of funds
Future earnings
Obsolescence
Cost considerations
Limitation of capital budgeting
Projects are mutually exclusive
Future uncertain , estimation of cash inflow & outflow
Urgency
Uncertainty & risk
Capital expenditure control
Non flexible long term commitment
Economic health of enterprise
Inc profitability of concern
Objective of control
Properly sanctioned
Time cash inflow
Estimate of capital expenditure
Properly co-ordinate
Fix priorities among various project
Measure of performance of project
Sufficient amount of capital
Steps involved in controlling of CB
Preparation of capital expenditure budget
Proper authorization of capital expenditure
Recording & control of expenditure
Evaluation of performance of the project