1. CAPITAL BUDGETING & INVESTMENT APPRAISAL METHODS
PRESENTATION BY
PROF. V.RAMACHANDRAN
SIESCOMS, NERUL, NAVI MUMBAI

2. AGENDA Concept of Capital Budgeting Capital Expenditure Budget
Importance of Capital Budgeting
Rational of Capital Expenditure
Kinds of Capital Investment Proposals
Factors affecting Investment Decision
Investment Appraisal Methods
Capital Rationing

3. Concept of Capital Budgeting
Finance Manager is concerned with Planning and Financing investment decisions.
Financing Decisions relate to determination of amount of long term finance and decision on sources for financing the same.
Investment decisions also termed as “Capital Budgeting Decisions” involve cost - benefit analysis.
Investment decisions are based on careful consideration of factors like profitability, safety, liquidity, solvency etc.

4. Why Capital Budgeting
Capital investment means investments in projects which by nature involve huge expenditure and results of the same are known only after a long time.
Why Capital investment is necessary
For investments in New Projects
Replacement of worn out/ out dated assets.
Expansion of existing capacity – To meet high demand or inadequate production capacity.
Diversification – to reduce risk
Research and Development – Ensuring updated technology.
Miscellaneous – Installation of Pollution Control equipment, other legal requirements.

5. Capital Budgeting
The term Capital Budgeting refers to long term planning for proposed capital outlays and their financing
It involves raising of long term funds and their utilization.
In other words, It is the formal process for acquisition and investment of capital.
Capital Budgeting is a many-sided activity.
It is a process of:
searching for new and more profitable investment options
by taking into account the consequences of accepting an investment proposal
by making a detailed economic analysis of the profit making potential of each investment proposal.

6. Capital Budgeting Profit potential Degree of risk
Essential features based on which decisions are taken
Profit potential
Degree of risk
Gestation period i.e time lag from the period of initial investment to anticipated returns.

7. Capital Expenditure Budget
It is the formal plan of Capital expenditure on new projects/ purchase of fixed assets.
Provides for the capital outlay available for procurement of capital assets during the Budget period.
It is prepared by taking into consideration
Future demand projections/growth of industry
the available production capacities,
allocation of existing resources and
likely improvement in production techniques.

8. Capital Expenditure Budget-objectives
Determines the When the work on capital projects can be commenced
Estimates the expenditure that would be incurred on the projects approved by the management and the sources from which finance will be obtained
Restricts capital expenditure on projects within the authorized limits

9. Importance of Capital Budgeting
One of most crucial and critical business decisions
Involvement of heavy funds- Improper and ill-advised investment and incorrect decisions can jeopardize the survival of even Biggest firm
Long – term implications- Impact of capital decisions are known after a long period. A wrong decision can prove disastrous for the long term survival of the firm
Irreversible decisions
Most difficult decisions to make – Capital Budgeting decisions require assessment of future events which are uncertain. Further assessing future costs and benefits accurately in quantitative terms is not easy. E.g KCC and Taloja
In view of the above the capital expenditure decisions are best reserved for consideration of the highest level of management

10. Kinds of Capital Investment Proposals
Independent proposals-
Don’t compete with any other proposal. They are cases of “accept or reject” proposals on the minimum return on investment cut off criteria basis.
Contingent or dependent Proposals :-
Proposals whose acceptance depends on the acceptance one or more proposals.-Substantial Expansion of plan, other capital requirement. Like township etc
Mutually exclusive proposals;-
e.g Temperature control Systems, Agitator, Valves Etc

11. Factors affecting Capital investment decisions
The amount of investment-
where no funds constraints are there proposals giving higher rate of return than the minimum cut off rate may be accepted
However where fund constraints are there, then Capital Rationing has to be resorted to.
Projects should be arranged in ascending order of capital investment and giving due consideration of priority

12. Investment Appraisal Methods
In view of the importance of Capital Budgeting decisions, it is essential that the Capital Investment appraisal method adopted must be sound.
A good appraisal method should have the features.
Clear Basis for distinguishing between acceptable and non acceptable projects
Ranking the projects on the basis of desirability
Choosing among several alternatives
A criterion applicable to any conceivable project
Recognizing bigger benefit projects are preferable to smaller ones and early benefit projects are preferable to later ones

13. Investment Appraisal Methods
In all the appraisal methods emphasis is on the return.
The basic approach to compare the investment in the project with benefits derived there from.
Following are the main methods generally used;-
Pay –back period method
Discounted Cash flow method
The Net present value method
Present value index method
IRR Method
Accounting Rate of return Method

14. Pay –back period method
The term Pay –back Period refers to the period in which the project will generate the necessary cash to recoup the initial investment
For e.g- if a project requires Rs as initial investment and it will generate an annual cash flow of Rs.5000 for ten years, the pay-back period will be 4 years, calculated as follows
Pay –back period =
The Annual cash flow is calculated on the basis of Net income before depreciation but after considering the tax. (PAT+Depreciation)
Initial investment Annual cash Flow

15. Pay –back period method
The income expressed as %of initial investment is termed as Unadjusted rate of return
Unadjusted Return = x100
= x100 =25%
Uneven cash flow:- If a project requires an initial investment of Rs and annual cash inflows for 5 years are Rs.6000,Rs.8000,Rs.5000,Rs.4000 and Rs.4000 respectively ,the pay –back period will be calculated as follows
Annual return
Initial Investment
5000
20000

16. Pay –back period method
Year
Cash Inflows
Cumulative cash inflows 1
6000 2
8000
14000 3
5000
19000 4
4000
23000 5
27000
Rs is recovered in 3years and Rs.1000 is left out of initial investment. The cash inflow in 4th year is Rs.4000 which indicates that pay-back period is in between 3rd and 4th year.i.e.3+(1000/4000) = 3.25 years

17. Pay –back period method
Criterion of accept or reject:
Reciprocal of cost of capital (COC).
for e.g If COC is 20% the maximum acceptable Pay-back period would be 5 years (i.e.100/20)which can also be termed as cut off point.
May be a predetermined Criteria by management i.e.say Reciprocal of COC -Safety Margin.
5 years -1= 4
Refer to illustration 5.4 and 5.5

18. Pay –back period method
Merits
Useful for evaluation of projects with high uncertainty, political instability, obsolescence of Technology etc
Method based on the assumption that no profit arises till initial capital is recovered. Suitable of new companies
Simple to understand and to workout
Reduces the possibility of loss due to obsolescence as the investment is made only on short term projects

19. Pay –back period method
Demerits
Ignores the returns after its pay –back period
Projects with long gestation period will never be taken up though they yield better returns
The method ignores the time value of money

20. Pay –back period method
Suitability
Hazy long term outlook-
Political or other conditions are hazy this method is suitable
Firms suffering from liquidity crises
Firms dependent on short term performances

21. Discounted Cash Flow (DCF)
DCF Technique is an improvement on payback period method.
It takes into account Time Value of money i.e interest factor as well as the returns after the payback period.
The method involves 3 stages
Calculation of cash flows (both inflow and outflow preferably after tax for full life of the project).
Discounting cash flows by applying a discount factor.
Aggregation of discounted cash flows and ascertainment of net cash flow.

22. NPV Method
The cash inflows and cash outflows associated with the project are worked out.
The present value of these cash flows is calculated at a rate of return acceptable to the management ( Cost of capital suitably adjusted for risk element)
The net present value (NPV) i.e. difference between total present value of cash inflow and total present value of cash outflow is ascertained.

23. NPV Method Accept or reject criterion
Where NPV > Zero Accept the proposal.
Where NPV < Zero Reject the proposal.
Refer illustration 5.6 , 5.7 and 5.8.

24. Excess present value index
This is a refinement of NPV method.
Instead of working out the NPV a present value index is worked out by comparing total present value of future cash inflows and total present value of future cash outflows.
Refer illustration 5.10.

25. Internal rate of return (IRR)
IRR is that rate of return at which the sum of discounted cash inflows equals the sum of cash outflows.
In other words it is the rate which discounts the cash flows to zero.
It can be stated in the form of formula as under. =1
Cash inflows
Cash outflows

26. Internal rate of return (IRR)
Accept / Reject Criterion:
IRR is the maximum rate of interest which an organization can afford to pay on capital invested in a project.
A Project would qualify only if IRR exceeds the cut-off rate.
A project giving higher IRR than cut-off rate would be preferred.
Refer e.g & 5.13.

27. Accounting Rate of return (ARR)
Under this method proposals are judged on the basis of relative profitability.
It is calculated on the following basis.
(Annual Average net earnings / original investments)*100
Annual Average net earnings is the average net earnings after depreciations and tax for the entire life of the project.
Refer illustration 5.16.

28. CAPITAL BUDGETING & INVESTMENT APPRAISAL METHODS
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