CAPITAL BUDGETING

1. CAPITAL BUDGETING Involves decision to invest current funds of a business concern most effectively in long-term activities, in anticipation of an expected flow of future benefits over a series of years in future.

2. CAPITAL BUDGETING Importance of Capital Budgeting:- • Long term implications for the firm • Involve committing large funds • They are irreversible decisions. • Among the most difficult decisions to make.

3. CAPITAL BUDGETING Features of Capital Investment Decisions:- • Exchange of current funds for future benefits. • Funds invested in long-term assets • Future benefits will occur over a series of years.

4. CAPITAL BUDGETING INVESTMENT EVALUATION CRITERIA: INVOLVES:- • ESTIMATION OF CASH FLOWS. • ESTIMATION OF REQUIRED RATE OF RETURN • APPICATION OF A DECISION TECHNIQUE FOR MAKING THE CHOICE

5. CAPITAL BUDGETING DECISION- TECHNIQUES:- TRADITIONAL • PAY-BACK METHOD • AVERGE RATE OF RETURN(ARR)- RETURN ON INVESTMENT METHOD

6. CAPITAL BUDGETING DECISION-TECHNIQUES:- DISCOUNTED-CASH FLOW(DCF)- TIME-ADJUSTED METHODS • NET PRESENT VALUE METHOD(NPV) • INTERNAL RATE OF RETURN(IRR) • TERMINAL VALUE METHOD • PROFITABILITY INDEX

7. CAPITAL BUDGETING SOME CAPITAL BUDGETING DECISIONS • Mechanisation of a Division • Replacing or modernising a process • Mutually exclusive decisions in selecting a machine • Buy or Lease decisions-comparative profitability • Business expansion by capital investments.

8. CAPITAL BUDGETING INVESTMENT DECISIONS:- PAY-BACK METHOD PAY BACK PERIOD (PBP)= TOTAL CASH OUTFLOWS ANNUAL CASH FLOWS FROM OPERATIONS If Rs. 60000 invested today yields annual cash inflow of Rs. 15000 for 6 years, the Pay Back Period= 60000/15000 = 4 years. PROJECT WITH LEAST PBP IS ACCEPTED

9. CAPITAL BUDGETING PAY BACK METHOD:- LIMITATIONS:- • Does not give weightage to total earnings • Time value of money not recognised MERITS:- • Very simple and popular. • Good in unstable conditions

10. CAPITAL BUDGETING AVERAGE RATE OF RETURN(ROI) METHOD :- Average annual profit after Tax x 100 Average investment over the life of the product Average Profit=Sum of Profits over the life of the asset / No. of years. Average investment= Original Investment-scrap value / 2

11. CAPITAL BUDGETING ARR METHOD:- Advantages:- Can be readily calculated Simple in application Entire stream of income is considered Useful as a good performance evaluation and control measure.

12. CAPITAL BUDGETING ARR METHOD:- SHORTCOMINGS:- • CASH FLOWS IGNORED • TIME VALUE OF MONEY IGNORED • AVERGE RETURNS vs. CURRENT RETURNS • LESS USEFUL FOR INVESTMENT DECISIONS.

13. CASH BUDGETING DISCOUNTED CASH FLOW METHODS:- NET PRESENT VALUE METHOD:- The difference between present value of cash inflows and cash outflows. The firm’s opportunity cost of capital being the discount rate. If Positive (> 0) = ACCEPT If Negative (< 0) = REJECT

14. CAPITAL BUDGETING PV OF FUTURE CASH INFLOWS= s (1 + r)^n Where s = Cash inflow expected r = rate of interest n = no. of years. i.e.S = P (1+ r)^n

15. CAPITAL BUDGETING NPV METHOD:- MERITS:- • Considers all cash flows. • True measure of profitability • Time value of money reckoned • Consistent with wealth maximisation principle

16. CAPITAL BUDGETING NPV METHOD:- DE-MERITS:- • TEDIOUS ESTIMATES • DISCOUNT RATE-COMPUTATION • SENSITIVE TO DISCOUNT RATES STILL REGARDED AS MOST EFFECTIVE

17. CAPITAL BUDGETING IRR METHOD( YIELD METHOD): IRR is the discount rate which equates the present value of an investment’s cash inflows and outflows. IF IRR > K(COST)-----ACCEPT IF IRR = K(COST)-----MAY ACCEPT IF IRR < K(COST)-----REJECT IF IRR = K, NPV = 0

18. CAPITAL BUDGETING IRR METHOD:- MERITS:- • Considers all Cash Flows • True measure of profitability • Time value reckoned

19. Capital Budgeting IRR METHOD:- DE-MERITS:- • TEDIOUS METHOD. • RELATIVELY DIFFICULT TO COMPUTE.

20. CAPITAL BUDGETING NPV vs IRR:- INTERPOLATION METHOD:- When one comes across two rates of NPV- One positive NPV & One negative NPV IRR by Interpolation:- Lower rate + NPV at Lower rate x rate differential. Absolute difference of both NPVs

21. CAPITAL BUDGETING IRR by INTERPOLATION- e.g.:- At 10% say NPV of cash flows = Rs. 200( +) At 12% say NPV pf cash flows = Rs. 210( -) IRR = 10% + 200 x ( 12-10) (200 + 210) 10% + 0.98 = 10.98%

22. CAPITAL BUDGETING TERMINAL VALUE METHOD:- IMPROVED DCF METHOD WITH EACH CASH FLOW RE-INVESTED FOR REMAINING YEARS. If re-invested Cash Flow > Outflow=Accept If re-invested Cash Flow < Outflow=Reject

23. CAPITAL BUDGETING PROFITABILITY INDEX:- Present Value of Cash Inflows Present Value of Cash Outflows It is a relative measure and provides solution for projects requiring initially different levels of investment APPLY WHEN NPV IS SAME IN 2 CASES

24. CAPITAL BUDGETING PROFITABILITY INDEX FOR PROJECT APPRAISAL Project-AProject-BProject-C Cash Outflows 10000 20000 40000 PV –Inflows 14000 25000 52000 NPV 4000 5000 12000 RANKING III II I P. INDEX 1.40 1.25 1.30 RANKING BY PI I III II

25. CAPITAL BUDGETINGDU-PONT ANALYSISROI ROI= PROFITABILITY x INVENTORY TURNOVER Net Profit / Sales x Sales / Total Assets = Net Profit / Total Assets = ROI Shows inter-action of profitability and activity Ratios.

26. CAPITAL BUDGETINGDU-PONT ANALYSISROI It shows that performance can be improved Either by- • Generating more sales volume per rupee of investment. OR • Increasing the profit margin per rupee of sales. A CENTRAL MEASURE OF OVERALL PROFITABILITY AND OPERATIONAL EFFICIENCY