Capital Budgeting

Definition Capital budgeting is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

Characteristics 1.Investment for long term benefits 2.Sacrifice of current funds 3.Benefits are to be realized over a series of years 4.It involves huge funds 5.Irreversible decision 6.It has direct impact on shareholders wealth

Capital Budgeting Process Identify Investment Proposals Screening Of Proposals Evaluate various Proposals Fixing Priorities Final Approval Implement the Proposal Review the Performance Corrective Action from the previous step

Kinds of Capital Budgeting Decisions 1.Mutually Exclusive Investments– Best 2.Independent Investments – Accept/Reject

Methods of Capital Budgeting Traditional Method Discounted Method Average Rate of Return Method Payback Period Method Profitability Index Method Internal Rate of Return Net Present Value

Payback Period Method Payback is the number of years required to recover the original cash outlay invested in the project. Payback(PB) = Initial Investment / Annual Cash Inflow Cash Flows after tax before depreciation Constant Cash Flows For e.g. : The project cost = Annual cash flow =12500 for 7 years. The PB in this case is 50000/12500=4 yrs

Payback Period Method Uneven Cash Flows Eg: The initial project cost is Rs and the Inflows is as below Year Cash Inflow ( Rs) The PB = 3 years and 4 months. That is 19000( ) is recovered in the first 3years and 1000 is recovered in the 4 th Year. Assuming 3000 is recovered evenly during the year 1000/3000 X 12 = 4.

Average Rate of Return Also known as accounting rate of return, is the ratio of the average after tax profit divided by the average investment. ARR = Average Annual Profits after Taxes X 100 Average Investment over the life of the project Cash Flows after tax and Depreciation

Average Rate of Return Eg: Project Cost : EBIT during the first 5 years is expected to be Rs 10000, Rs 12000, Rs 14000, Rs and Rs Assume a 50 percent tax rate and depreciation on straight line basis. Cash Inflow(Rs) Depreciation ( Rs 40000/5)EBTTaxPAT Total3200 Average Investment = ( )/2 = ARR=Average Income/Average Investment = 3200/20000=16 per cent

Net Present Value It is a summation of the present value of cash inflows in each year minus the summation of the present value of the net cash outflows in each year. Cash Flow after Tax before Depreciation

Net Present Value E.g.: Project cost = 2500 and the opportunity cost is 10 %. YearCash InflowPV Factor ( 1/(1+R)^NNet Present Value Total Since the inflow of Rs 2725 is greater than the outflow Rs 2500 by Rs 225, the Project can be accepted

Profitability Index Method It is the benefit cost ratio or present value of cash inflow to the initial cash outflow of the investment. Cash Flow after Tax before Depreciation Formula PI = PV of cash inflows / Cash Outflow For eg : In the NPV example PV of Inflow was 2725 and the PV of outflow is 2500.Therefore the PI is 2725/2500 = 1.09 As long as the Index is more than 1, the project can be accepted.

Internal Rate of Return It is a rate that equated the investment outlay with the present value of cash inflow received after one period. It is also known as the rate of return ( discount rate which makes NPV = 0) Cash Flow after Tax before Depreciation

Internal Rate of Return Year Cash Flow Discount Rate (10%) Discount Rate (20%) Discount Rate (16%) Sum

Capital Budgeting Practices in India PI techniques is used more by public sector than by Pvt sector. Large firms use NPV Small firms use PBP High growth firms use IRR IRR is preferred over NPV

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