Click to edit Master subtitle style Unit 5 Capital & Capital Budgeting

 Capital forms the base for the business.  Capital, in general does not mean only money. It may refer to money’s worth also.  Capital has different forms. Creativity, innovation, new ideas can be considered as one form of capital.  Some people have ideas but they may not have money. There are some others who have only money. The combination for business is to have both.

INTRODUCTION TO CAPITAL  Capital is defined as wealth, which is created over a period of time through abstinence of spend.  Capital is the aggregate of funds used in short run and long run.  Capital is the total amount of finances required by the business to conduct its business operations both in short run and long run.

 An economist views capital as the total assets available with the business.  An accountant views capital as the difference between the assets and liabilities.  It is the capital that keeps any business going on.  There are number of instances where the business is closed for want of capital.

SIGNIFICANCE/ IMPORTANCE OF CAPITAL  Capital plays crucial role in the modern production system. It is very difficult to imagine the production process without the capital. Capital has a strategic role in enhancing the productivity.

NEED FOR CAPITAL The business needs for capital are varied. They are:  To promote a business.  To conduct business operations smoothly.  To expand and diversify.  To meet contingencies.  To replace the assets.  To support welfare programs.  To wind up.  To pay taxes.  To pay dividends and interests

Capital Budgeting  Capital Budgeting is the process of evaluating the relative worth of the long term investment proposals on the basis of their respective profitability.  Long-term investment proposals require larger investment, this requires careful analysis of cash outflows & cash inflows associated with the investment proposals.

Click icon to add table WHY CAPITAL BUDGETING ? MACHINE 1MACHINE 2MACHINE 3 INVESTMENT 50,00055,00051,000 1ST YEAR CASH INFLOWS ND YEAR CASH INFLOWS LIFE OF THE ASSET 2 YEARS SALVAGE VALUE

Methods or Techniques of Capital budgeting  Capital budgeting methods are classified in to two types 1. Traditional methods (Non discounting cash flow methods) 2. Modern methods (Discounted cash flow methods)

Non discounting cash flow methods 1. Pay back period method (PBP) 1. Accounting rate of return (ARR) (average rate of return)

Discounted cash flow methods 1. INTERNAL RATE OF RETURN (IRR) 1. NET PRESENT VALUE (NPV) 1. PROFITABILITY INDEX (PI)

1. Pay back period method (PBP)  Pay back period refers to the period, with in which the original cost of the project is recovered.  Formula to calculate PBP (when cash inflows are equal) Cost of the project / annual cash inflows.  Decision rule Accept the project with shorter pay back period.

Problems on PBP 1. An investment of Rs 50,000 is made on a project, the annual cash inflows for the next four years are Rs.25,000,Calculate PBP.

2.An investment proposal requires cash out flow of Rs 1,00,000.  It is expected, the investment generates cash inflows of 25,000. each year.  Estimated life 5 years  Depreciation on straight line method  Calculate PBP

3.An investment proposal requires cash out flow of Rs 5,00,000. It is expected to generate the following cash inflows for the next 6 years. calculate PBP YearAnnual cash inflows 12,00,000 21,50,000 31,00, , , ,000

4.Mohan & Co. is considering the purchase of machine. Two machines X and Y each Costing Rs.50, 000 are available. Earnings after taxes before depreciation are expected to be as under: Year Machine ’X’ (Rs.) Machine ’Y’ (Rs.) Estimate the two alternatives according to: (a) Payback method, and (b) NPV method a discount rate of 10% is to be used.

Accounting Rate of Return (ARR)  Accounting rate of return is also called as average rate of return.  It refers to the ratio of average annual profits after tax to the average investment.  Decision rule ARR is compared with pre specified rate of return, if ARR is greater then pre specified rate of return then the project is accepted & vice versa.

 Formula to calculate ARR  ARR = Average profits / Average investment  Average profits = Total profits of all years / Number of years  Average investment = Initial investment + closing investment / 2 (or)  1/ 2 (initial investment + installation expenses – salvage value) + salvage value

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2.Cost of the asset 3,00,000 Life 4 years Scrap value 60,000 Income tax rate 50 % Additional working capital brought in 2,50,000 Cash in flows after tax are as follows 1st year 2,00,000, 2nd yr 2,50,000, 3rd yr 3,00,000, 4th yr 1,50,000. Calculate ARR

3.A project costs Rs 1,00,000 Residual value 10,000 Profits before depreciation & tax for five years are as follows 20,000; 25,000; 30,000; 35,000; 40,000. Assume 35% of Tax & depreciation on straight line basis. calculate ARR

Internal Rate of Return (IRR)  Internal rate of return is that rate of return at which PRESENT VALUE OF CASH INFLOWS (PVCIF) exactly equals the original investment or cash out flows (PVCOF)  IRR is the cut off point at which income equals the investment (Break even)  At IRR, the NPV of a investment proposal is zero (since NPV = PVCIF –PVCOF)

 Decision Rule for IRR :  IRR is compared with the cost of capital (Ke) or required rate of return (ROR)  If IRR is greater then ROR or Ke then accept the project and vice versa

 Formula to calculate IRR (interpolation method) Ri + Ri – PVCOF (Rh – Ri ) Ri – Rh Ri = lower rate of interest Rh = higher rate of interest PVCIF = Present value of cash inflows PVCOF = Present value of cash outflows

 Problems on IRR method 1.Cost of the project is Rs 1,44,000.  Annual cash inflows after tax before depreciation are 45,000 for a period of 5 years.  Calculate IRR, if the cost of capital is 20 %, suggest your comments.

Net Present Value (NPV)  It refers to the difference between (PVCIF – PVCOF) present value of cash inflows and present value of cash out flows.  Formula NPV = PVCIF – PVCOF  Decision rule Accept the proposal if NPV is positive Reject the proposal if NPV is negative

Profitability index (PI)  It is the ratio between the present value of cash inflows and present value of cash out flows.  Formula PI = PVCIF PVCOF  Decision rule Accept the proposal if PI is greater than or equal to 1(> or = 1) Reject the proposal if PI is less than 1(<1)

1.Consider the case of the company with the following two investment proposals, each costing 18 Lakhs. The details of the cash inflows are as follows: Year Project 1 Project 2 1 6,00,000 12,00, ,00,000 8,00, ,00,000 6,00,000 The cost of capital is 10% per year. Which one will you choose under NPV method?

2. A company has two proposals each costing Rs.9 Lakhs. The details of the cash inflows are as follows: Year Project 1 Project2 1 3,00,000 6,00, ,000 4,00, ,00,000 3,00, ,00,000 2,00,000  The cost of capital is 10% per year.  Which one will you choose under NPV method. Also calculate P I.

3. A firms cost of capital is 10% and tax rate is 50%, it is considering two mutually exclusive projects X & Y, the details of these projects are as follows. Cash flows before tax are as follows (CFBT) Year Project X Project Y 1 20,000 30, ,000 27, ,000 22, ,000 25, ,000 20,000  Calculate NPV for both the projects.  Which one will you choose under NPV method.

4. Examine the following 3 project proposals and evaluate them based on (a) PBP Method (b) ARR Method. (ARR on original investment) Initial Investment is Rs. 10,00,000/- each for all the three projects Cash inflows (Rs.) Year Project-A Project-B Project-C 1 5,00,000 6,00,000 2,00, ,00,000 2,00,000 2,00, ,00,000 2,00,000 6,00, ,00,000 4,00,

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