1. CAPITAL BUDGETING
CAPITAL BUDGETING

2. CAPITAL BUDGETING IS THE PROCESS OF MAKING
DEFINATION
CAPITAL BUDGETING IS THE PROCESS OF MAKING
INVESTMENTS DECISIONS IN CAPITAL EXPENDITURE.
CAPITAL BUDGETING IS LONG TERM PLANNING FOR
MAKING AND FINANCING PROPOSED CAPITAL OUTLAYS.

3. EXPENDITURE WHY DO WE NEED CAPITAL WEAR AND TEAR OF ASSETS.
2. OBSOLESCENCE.
3. CHANGE IN VOLUME OF PRODUCTION.
4. EXPANSION.
5. CHANGE OF PLANT SITE.
6. DIVERSIFICAITON.

4. re
EXAMPLES OF LONG TERM
CAPITAL EXPENDITURE

5. CAPITAL BUDGETING
FOLLOWING POINTS DISTINGUISH CAPITAL BUDGETING DECISION FROM ORDINARY DAY TO DAY DECISIONS:-
INVOLVES EXCHANGE OF CURRENT ASSETS FOR BENEFITS TO BE ACHIEVED IN FUTURE.
2. FUNDS ARE INVESTED IN NON-FLEXIBLE AND LONG TERM ACTIVITIES.
3. INVOLVES HUGE FUNDS.
4. THE DECISIONS ARE IRREVERSIBLE.
5. STRATEGIC INVESTMENT DECISIONS.
6. RISKY DECISIONS.

6. PROCESS IDENTIFICATION OF INVESTMENT PROPOSALS.
2. SCREENING THE PROPOSALS.
3. EVALUATION OF VARIOUS PROPOSALS.
4. FIXING PRIORITIES.
5. FINAL APPROVAL.
6. IMPLEMENTING THE PROPOSALS.
7. REVIEWING THE PROPOSALS.
PROCESS

8. KINDS OF CAPITAL BUDGETING
DECISIONS
ACCEPT OR REJECT DECISIONS.
2. MUTUALLY EXCLUSIVE DECISIONS.
3. CAPITAL RATIONING DECISIONS.

9. DIFFERENCE BETWEEN INDEPENDENT
AND MUTUALLY EXCLUSIVE PROJECTS
PROJECTS ARE:
INDEPENDENT, IF THE CASH FLOW OF ONE ARE UNAFFACTED BY THE ACCEPTANCE OF THE OTHER.
MUTUALLY EXCLUSIVE, IF THE CASH FLOW OF ONE CAN BE ADVERSELY IMPACTED BY THE ACCEPTANCE OF THE OTHER.

10. CAPITAL BUDGETING: METHODS DECISION CRITERIA METHODS
TIME ADJUSTED/DISCOUNTED METHOD
TRADITIONAL METHOD
PAY BACK PERIOD METHOD
RATE OF RETURN METHOD
NET PRESENT VALUE
INTERNAL RATE OF RETURN
PROFITABILITY INDEX
IMPROVMENTS
POST PAY BACK PROFITABILITY INDEX
DISCOUNTED PAY BACK PERIOD METHOD

11. The number of years required to recover a project’s cost, or
WHAT IS THE PAY BACK PERIOD?
The number of years required to recover
a project’s cost, or
how long does it take to get the business’s
money back?

12. PAY BACK PERIOD METHOD
Calculate annual net earnings before depreciation and after taxes.
Divide the initial outlay of the project by annual cash inflow if the project generates constant cash inflow.
Where the annual cash outlaw are unequal the pay back period is calculated by adding the cash inflows.

13. 2.4 1 2 3 CFt -100 10 60 100 80 Cumulative -100 -90 -30 50 PaybackL =
CALCULATION PAY BACK
PERIOD 1 2
2.4 3
CFt
-100 10 60
100 80
Cumulative
-100
-90
-30 50
PaybackL =
2 + 30/ = years

14. STRENGTHS OF PAY BACK
1. Provides an indication of a project’s risk and liquidity.
Easy to calculate and understand.
Ignores the TVM.
2. Ignores CFs occurring after the payback period.
WEAKNESSES OF PAY BACK

15. This method is also known as Surplus Life over pay back method.
POST PAY BACK
PROFITABILITY
Post pay back period method takes into account the period beyond the pay back method.
This method is also known as Surplus Life over pay back method.
According to this method, the project which gives the greatest post pay back period may be accepted.

16. DISCOUNTED PAY BACK PERIOD
METHOD
Under this method the present value of all cash outflows and inflows are computed at an appropriate discount rate.
The present values of all inflows are cumulated in order of time. The time period at which the cumulated present value of cash inflows equals the present value of cash outflows is known as discounted pay back period.
The project which gives a shorter discounted pay back period is accepted.

17. Recover invest. + cap. costs in 2.7 yrs.
CALCULATION OF DISCOUNTED PAY
BACK PERIOD 1 2 3
10%
CFt
-100 10 60 80
PVCFt
-100
9.09
49.59
60.11
Cumulative
-100
-90.91
-41.32
18.79
Discounted
payback =
/ = yrs
Recover invest. + cap. costs in 2.7 yrs.

18. RATE OF RETURN METHOD
The accounting rate of return or the average rate of return is the ratio of the average cash inflow to the average amount invested. In order to arrive at the average cash inflow, depreciation on the straight – line method is deducted from the gross profit.
1. Simple to understand and easy to operate.
2. Uses the entire earnings of a project, not only the earnings upto pay back period.
3. Based upon accounting concept of profit.

19. Here profit after taxes are used instead of cash flow
CALCULATION OF RATE OF
RETURN METHOD
Here profit after taxes are used instead of cash flow
Rate of return = Avg. profit after tax x100
Investment
There are many variants of rate of return ,above formula is more useable .Other formulas are:-
ROI = Avg. profit after tax x 100
Avg. Investment
ROI = Profit after tax x 100
ROI = Profit after tax x 100

20. Where K= Cost of capital
NET PRESENT VALUE
METHOD
It is the excess of present value of cash inflow over present value of cash outflow
NPV= At _ Outlay
(1+K)t
Where K= Cost of capital
N=Life of project
A=Annual Cash Inflow
Strength:-
Recognizes time value of money
Recognizes quality of benefits
No ambiguity
4. Recognizes entire life
Compatible with maximization of wealth principle
Weakness:-
Difficult to calculate
Cost of capital may not be right discount rate
3. It may give good results while comparing projects with unequal lives

21. CALCULATION OF NET PRESENT
VALUE
Project: L 1 2 3
10% 10 60 80
9.09
49.59
60.11
= NPVL
NPVS = $19.98.

22. NPV: Sum of the PVs of inflows and outflows.
CALCULATION OF NET PRESENT
VALUE
NPV: Sum of the PVs of inflows and outflows.
Cost often is CF0 and is negative.

23. SOLUTION OF NET PRESENT VALUE Solution of Net Present Value
Enter in CFLO for L:
-100 10 60 80
CF0
CF1
CF2
CF3 I
NPV
= = NPVL

24. IMPLICATION OF NET PRESENT
VALUE
NPV = PV inflows - Cost
= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually exclusive projects on basis of higher NPV.

25. INTERNAL RATE OF RETURN METHOD
IRR is that discount rate which bring down the value of net cash inflow during the life of the project so that it is equal to the value of initial investment. It can be expressed in the form of equation as follow:

26. If the projects are independent, accept because IRR > k.
IRR is the rate at which present value of cash inflow is equal to the present value of cash outflow
CALCULATION OF INTERNAL
RATE OF RETURN 1 2 3
18.01% 10 60 80 PV PV PV
100.06
If the projects are independent, accept because IRR > k.

27. PROFITABILITY INDEX METHOD
The profitability index, or PI, method compares the present value of future cash inflows with the initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows (PVCF) to the initial investment of the project.

28. CALCULATION OF PROFITABILITY
INDEX 1 2 3
10% 10 60 80 PV PV PV
118.79 =
Accept project if PI > 1.
Reject if PI < 1.0

29. IMPLICATION OF PROFITABILITY
INDEX
A project with a PI greater than 1 is accepted, but a project is rejected when its PI is less than 1.
Note that the PI method is closely related to the NPV approach. In fact, if the net present value of a project is positive, the PI will be greater than 1.
On the other hand, if the net present value is negative, the project will have a PI of less than 1.

30. SUMMARY
The process of evaluation of proposals from the viewpoint of long term investment is known as capital budgeting. It is significant from the view point of maximising corporate wealth.
Proposals relate either to the expansion of existing activities or to replacement of assets or to some strategic activities, such as investment on research and development or to safety and the environment. The consecutive steps in this process are identification of long – term goals, screening of proposals, project evaluation, project implementation, control and project audit. The project to be evaluated are either independent projects or dependent project, such as complementary projects, substitute projects and mutually exclusive projects.
The entire evaluation is based on the cash inflow and cash outflow. The cash flow is divided into initial cash flow. It is computed on an after – tax basis. It does not include depreciation and the financing cost.
The evaluation criteria based on discounting of cash flow are NPV, discounted benefit cost ratio and IRR. The non-discounting method are pay back period and accounting rate of return. Projects are accepted when: NPV is positive; or IRR is higher than the firm’s cost of capital; or when the discounted benefit cost ratio is greater than 1; or the initial investment is recovered with in the target pay back period.

31. THANKS
DR. RAKESH KUMAR
ASST. PROF.BUSINESS ADMINISTRATION
PGGC-11 ,CHANDIGARH