Live as if you were to die tomorrow & Learn as if you were to live for ever

By- ANKITA JAIN

CONTENTS What is capital Budgeting ? Features and Significance. Types of Capital budgeting Decision. Capital Budgeting Process. Methods of Capital Budgeting. Capital Budgeting Practices In India.

What is Capital Budgeting Capital budgeting means planning for capital assets. It involves planning of such expenditures which provide yield over a number of years. Capital budgeting is concern with the allocation of the firm’s scare financial resource among available market opportunities.

Features and Significance Large Investment. Long Term Effect On Profitability. Substantial Commitment. Irreversible Decision. National Importance.

Types of Capital budgeting Decision  From firms existence point of view: * Replacement & Modernization * Expansion * Diversification  From decision situation point of view: * Mutually exclusive decision * Accept-Reject decision * Contingent decision

Capital Budgeting Process

Methods Of Evaluation Non Discounting Discounting Pay-back period Accounting rate of return Discounted Pay-back period Net present value Profit- ability index Internal Rate of return

Pay-back period It is also know as payoff or payout period method also. It is defined as a number of year required for the proposal cumulative cash inflows to be equal to its cash outflow. it is calculated on profit after tax before depreciation. Calculations:- Pay back= cash outlay or original cost Initial outlay (When cash flows are equal) payback= Completed years + required inflows ×12 Inflows of next year (When cash flows are not equal)

Example A company is considering to purchase a machine costing Rs.2,50,000.the machine has a life of 5 years and no salvage value. the company tax rate is 40%.the cashflows after tax and depreciation are as follows- YEAR C\F86,00092,0001,04,0001,10,0001,40,000 Payback = 2 years = yrs.

Advantages Simple to understand & easy to calculate. It saves in cost, as required less time and labour. It gives an indication of liquidity. In a broader sense, the payback period deals with the risk also. The project with shorter payback period will be less risky as compared with a longer payback period.

Disadvantage Ignore time value of money. Ignores many of cash inflows occurring after payback period. It all ignores the salvage value and total economic life of the project.

Accounting rate of return It takes into account the earning expected from the investment over their whole life. it is known as ARR for the reason that under this method, the accounting concept of profit is used rather than cash inflows. It is calculated on profit after tax and depreciation. ARR = Average annual profit ×100 Net investment

Example YEAR CF DEP. CFAT 186,00050,00036, ,00050,00042,000 31,04,00050,00054,000 41,10,00050,00060,000 51,40,00050,00090,000 2,82,000 Average profit = = 56,400 5 ARR = × 100 =22.56%

Advantage Simple to understand &easy to operate. It uses entire earning of a project,so it gives better view of profitability. Relevant data and information required for calculation is readily available in accounting record.

Disadvantage It ignores time value of money. It does not consider cash flows which are more important than accounting profit. ARR also ignores life of proposal.

Discounted cash flows or Time value of money Money has a time value. cash flows that occur earlier in time are worth more than cash flows that occur later, difference are accentuated as inflation and interest rate. Discounted rate of return may be defined as the minimum rate of return which a firm wants to earn on the amount invested in capital budgeting proposal.

Net present value method NPV may be defined as the sum of the present value of all the cash inflows less the sum of all cash out flows associated with the proposal. A rate of discount must be specified and applied to both inflows and outflows in order to find out their present value. It is calculated on CF before dep and after tax. Note: If the total investment is to be made in the initial years the present value should be the same as the cost of investment. NPV = p\v of inflows – p\v of outflows

Example YEARS CASH INFLOWS P.V. AT 10%PRESENT VALUE 186, , , ,992 31,04, ,104 41,10, ,130 51,40, ,940 3,94,340 NPV = =1,44,340

Advantage It recognize time value of money. It takes into a\c the earning over the entire life of the project. It takes into consideration the objective of maximum profitability.

Disadvantage As compared to traditional method,it is more difficult to understand and operate. It is not easy to determine an appropriate discount rate. It may not give good result while comparing project with unequal life.

Internal rate of return The IRR of a proposal is defined as the discount rate which produce a zero NPV i.e. IRR is the discount rate which will equate the p\v of cash inflows with the p\v of cash out flows. In this rate of discount is found by trial and error procedure. It is calculated on cash flows before dep and after tax. IRR = p\v of cash inflows = p\v of cash outflows.

Example 20% 30% P.V. 186, , , , , ,464 31,04, , ,320 41,10, , ,500 51,40, ,280 3,05, ,660 2,4,4078 IRR = × 10 =

Advantage Takes into a\c time value of money. Consider all cash flows occurring through out life. Determination of COC is not a prerequisite so it is better than NPV.

Disadvantage It involves tedious and complicated trial and error procedure, An imp. drawback of IRR is that it makes a assumption that the future cash flows are reinvested at a rate equal to IRR. The result of NPV and IRR may differ when the project under evaluation differ in size,,ife and timing of cash flows.

Profitability index PI is defined as the benefit per rupee invested n the proposal. this technique which is a variant of the NPV is also known as “Benefit cost ratio” or “Desirability factor”. it is extension of NPV. PI = Total p\v of cash inflows Total p\v of cash outflows

Example YEARS CASH INFLOWS P.V. AT 10%PRESENT VALUE 186, , , ,992 31,04, ,104 41,10, ,130 51,40, ,940 3,94,340 PV = =

Advantage Method is slight modification of NPV. Easy to rank project when the cost of projects differ significantly. Disadvantage Same as that of NPV.

Capital Budgeting Practices In India Capital budgeting practiced by corporate enterprises in India is as follows: 1.The discounted cash flow techniques are more popular. 2. The corporate firm use multiple criteria in their project selection decision. vast majority of the sample corporate use a combination of traditional as well as DFC techniques. 3. The IRR is most frequently used (85%) CBT. 4. The NPV technique is also equally popular method of project selection (68%) 5. The corporate are not guided by ad-hoc approach and they follow systematic approach of CB.

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