Capital Budgeting (ARR)

8/10/2019 Capital Budgeting (ARR)

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The word capital refers to be the total investment of a company of firm in money, tangible an

Capital Budgeting Decisions may be defined as the firms decision to invest its current funds

the long- term assets in anticipation of an expected flow of benefits over a series of years.

The examples of capital expenditure:

1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc.

2. The expenditure relating to addition, expansion, improvement and alteration to the fixed as

3. The replacement of fixed assets.

4. Research and development project


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According to the definition of Charles T. Hrongreen, capital budgeting is a long-term planning

financing proposed capital out lays.

According to the definition of Lyrich, capital budgeting consists in planningdevelopment of av

for the purpose of maximizing the long-term profitability of the concern.


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1. Huge investments: Capital budgeting requires huge investments of funds, butthe availab

limited, therefore the firm before investing projects, plan are control its capital expenditure.

2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore f

involved in the investment decision are more. If higher risks are involved, it needs careful pla

budgeting.

3. Irreversible: The capital investment decisions are irreversible, are not changed back. Onc

is taken for purchasing a permanent asset, it is very difficult to dispose off those assets witho

huge losses.4. Long-term effect: Capital budgeting not only reduces the cost but also increases the reve

term and will bring significant changes in the profit of the company by avoiding over or more

under investment. Over investments leads to be unable to utilize assets or over utilization of

Therefore before making the investment, it is required carefully planning and analysis of the

thoroughly.


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1.Identificationof various

investmentsproposals

2. Screeningor matching

the proposals

3. Evaluation4. Fixing

property

5. Final

approval

6.

Implementing


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Non- Discounted

Cash Flows


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Net Present Value

This is one of the Discounted Cash Flow technique which explicitly recognizes the time valu

method all cash inflows and outflows are converted into present value (i.e., value at the pre

appropriate rate of interest (usually cost of capital).

In other words, Net Present Value Method discount inflows and outflows to their present val

cost of capital and set the present value of cash inflow against the present value of outflow

Value. Thus, the Net Present Value is obtained by subtracting the present value of cash out

value of cash inflows.

NPV > Zero Accept the proposal

NPV < Zero Reject the Proposal

Net Present Value (


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Advantages of Net Present Value Method

(1) It recognizes the time value of money and is thus scientific in its approach.

(2) All the cash flows spreadover the entire life of the project are used for calculations.

(3) It is consistent with the objectives of maximizing the welfare of the owners as it depicts the pos

otherwise present value of the proposals.

Disadvantages

(1) This method is comparatively difficult to understand or use.

(2) When the projects in consideration involve different amounts of investment, the Net Present Va

may not give satisfactory results.


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IF CASH INFLOWS ARE GIVEN


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Solution:


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Internal Rate of Return Method is also called as "Time Adjusted Rate of Return Method."It is defined

the present value of each cash inflows with the present value of cash outflows of an investment. In other w

which the net present value of the investment is zero.

Horngren and Foster define I nternal Rate of Return as the rate of interest at whi ch the present value

from a proj ect equals the present value of expected cash outf lows of the project.

The Internal Rate of Return can be found out by Trial and Error Method. First, compute the present value

investment, using an arbitrarily selected interest rate, for example 10%. Then compare the present value s

investment cost.

If the present value is higher than the cost of capital, try a higher interest rate and go through the procedur

hand if the calculated present value of the expected cash inflows is lower than the present value of cash ou

should be tried. This process will be repeated until and unless the Net Present Value becomes zero. The in

about this equality is defined as the Internal Rate of Return.


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Alternatively, the internal rate can be obtained by Interpolation Method when we come across 2 r

positive Net Present Value and other with negative Net Present Value. The IRR is considered as th

interest which a business is able to pay on the funds borrowed to finance the project out of cash in

the project.

The Interpolation formula can be used to measure the Internal Rate of Return as follows :


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A firm has an investment opportunity involving Rs.50000. The cost of capital is 10%. From

the details given find out the IRR and see whether the project is acceptable.

Cash flow for the 1styear - Rs.5000

2ndyear - Rs.10000

3rd

year - Rs.15000

4thyear - Rs.25000

5thyear - Rs.30000

Discount factors

Year 10% 15% 20% 25%1 0.909 0.870 0.833 0.800

2 0.826 0.756 0.694 0.640

3 0.751 0.658 0.579 0.512

4 0.683 0.572 0.482 0.410

5 0.621 0.497 0.402 0.328


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Year cash inflow PV factor discounted PV factor discounted

at 15% cash inflow at 20% cash inflow

1 5000 0.870 4350 0.833 4165

2 10000 0.756 7560 0.694 6940

3 15000 0.658 9870 0.579 8685

4 25000 0.572 14300 0.582 12000

5 30000 0.497 14910 0.402 12060

50990 43900

Thus the actual rate of return is between 15% and 20%. The actual rate of

return can be found out by interpolation

IRR = L + P1Q x D

P1P2


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L = lower discount rate

P1 = P. V at lower rate

P2 = P.V at higher rate

Q = actual investment

D = difference in rate

IRR = 15 + 50990 50000 x 5

50990- 43900

= 15.7%

As the IRR is higher than cost of capital the project is accepted.


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Average Rate of Return Method (ARR) or Accounting Rate of Return Method: Average Rat

Method is also termed as Accounting Rate of Return Method. This method focuses on the a

generated in a project in relation to the project's average investment outlay. This method in

profits not cash flows and is similar to the performance measure of return on capital employ

The average rate of return. can be determined by the following equation:


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Capital Budgeting (ARR)

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