CAPITAL BUDGETINGCAPITAL BUDGETING

TITTO SUNNY

ARUN T.S

VIBIN UDAYAN

SOORAJ

SUBMITTED TO

Dr.MOHHAMED ASLAM ASWATHI UMESH

GEETHU

MBA TT 1st SEM

Capital Expenditure refers to investment in fixed assets and other development projects, launching a new product, improvisation, modernization, expansion, replacement of fixed assets etc. Most firms carefully analyse the potential projects in which they may invest. The process of evaluating opportunities is known as capital investment decision. Capital investment decision is also called Capital expenditure decision or Capital budgeting.

According to R.M. Lynch, “Capital budgeting consists in employment of available capital for the purpose of maximising the long term profitability (return on investment) of the firm”.

FEATURES OF CAPITAL BUDGETINGFEATURES OF CAPITAL BUDGETING

The main features of Capital BudgetingThe main features of Capital Budgeting

It involves the exchange of current funds for future It involves the exchange of current funds for future benefit.benefit.

The future benefits are expected to be realised over a The future benefits are expected to be realised over a series of years in future.series of years in future.

The funds are invested in long term assets.The funds are invested in long term assets. It is a long term irreversible decision.It is a long term irreversible decision. It involves huge initial funds.It involves huge initial funds. There is relatively a long gap of time between investment There is relatively a long gap of time between investment

of funds and the expected returns.of funds and the expected returns. It involves relatives a high degree of risk regarding the It involves relatives a high degree of risk regarding the

future benefits.future benefits.

STEPS IN CAPITAL STEPS IN CAPITAL BUDGETINGBUDGETING• Capital budgeting is a complex process. The following six-Capital budgeting is a complex process. The following six-

steps are involved in capital budgeting.steps are involved in capital budgeting.

• 1. Project generation1. Project generation

• 2. Project screening2. Project screening

• 3. Project evaluation3. Project evaluation

• 4. Project selection4. Project selection

• 5. Project execution and implementation.5. Project execution and implementation.

• 6. Performance review.6. Performance review.

Availability of fund. Utilisation of funds Urgency of the project. Expectation of future earnings Intangible factors Risk and uncertainty

ROLE AND IMPORTANCE OF CAPITAL ROLE AND IMPORTANCE OF CAPITAL BUDEGETINGBUDEGETING

Capital budgeting is concerned with heavy Capital budgeting is concerned with heavy expenditure decisions. The benefits of expenditure decisions. The benefits of returns from such expenditure is expected returns from such expenditure is expected to be derived over many years in future. to be derived over many years in future. This makes the capital budgeting decisions This makes the capital budgeting decisions more complex. Success or failure of an more complex. Success or failure of an enterprise is dependent up on the quality of enterprise is dependent up on the quality of the capital budgeting alone in the the capital budgeting alone in the enterprise. Therefore proper planning and enterprise. Therefore proper planning and at most care is needed while making capital at most care is needed while making capital budgeting decision. budgeting decision.

LIMITATIONS OF CAPITAL LIMITATIONS OF CAPITAL BUDGETINGBUDGETING

1.1. The result of decision taken is uncertain. This is so The result of decision taken is uncertain. This is so because it is difficult to say that present because it is difficult to say that present circumstances will exist in future also . circumstances will exist in future also .

2.2. Some factors affecting investment proposals are Some factors affecting investment proposals are not measurable ( ie cannot be expressed in not measurable ( ie cannot be expressed in money value).money value).

3.3. It is difficult to estimate the period for which It is difficult to estimate the period for which investment is to be made and income will investment is to be made and income will generate.generate.

4.4. It is difficult to estimate the rate of return because It is difficult to estimate the rate of return because future is uncertain .future is uncertain .

5.5. It is difficult to estimate the cost of capital.It is difficult to estimate the cost of capital.

METHODS OF CAPITAL BUDGETTING METHODS OF CAPITAL BUDGETTING PROBLEMS & SOLUTIONSPROBLEMS & SOLUTIONS

A .TRADTIONAL METHODSA .TRADTIONAL METHODS Urgency methodUrgency method Pay back methodPay back method I. When annual cash inflows are equalI. When annual cash inflows are equal II. When annual cash inflows are unequalII. When annual cash inflows are unequal Post Pay Back Profitability methodPost Pay Back Profitability method Average Rate of Return Method.Average Rate of Return Method.

B.DISCOUNTING CRITERIA OR B.DISCOUNTING CRITERIA OR MODERN METHODS.MODERN METHODS.

Discounted pay back methodDiscounted pay back method Net present value method.Net present value method. benefit cost ratio.benefit cost ratio. internal rate of return.internal rate of return. net terminal value method.net terminal value method.

C.Other methodsC.Other methods.. The mapi formulaThe mapi formula Nomograph methodNomograph method

TRADTIONAL METHODS Traditional methods do not take into consideration the time

value of money

Important traditional methods may be discussed as follows:

1. Urgency Method Urgency is a criterion used to justify the acceptance of

capital projects on the basis of emergency requirements or under crisis conditions. Under this method, the most urgent project is taken up first.

MERITS It’s a very simple technique It is useful in case of short term projects requiring

lesser investment.

DEMERITS It is not based on scientific analysis. Selection is not made on the basis of economical

consideration but just on the basis of situation. A project, even though it is profitable, will not be

accepted for the very simple reason that it can be postponed.

PAY BACK METHODPAY BACK METHOD

Used technique of evaluating capital expenditure Used technique of evaluating capital expenditure proposals. Pay back period is the length of time proposals. Pay back period is the length of time required to recover the initial cost of the project. In required to recover the initial cost of the project. In short , it is the period required to recover the cost short , it is the period required to recover the cost of investment. Pay back method is also called ‘pay-of investment. Pay back method is also called ‘pay-out’ or ‘pay-off period’ or ‘recoupment period’ or out’ or ‘pay-off period’ or ‘recoupment period’ or ‘replacement period’.‘replacement period’.

The payback period can be calculated in two The payback period can be calculated in two different situation as follows:different situation as follows:

I. When annual cash inflows are equalI. When annual cash inflows are equal II. When annual cash inflows are unequalII. When annual cash inflows are unequal

I.I. When annual cash inflows When annual cash inflows are equalare equal

When annual cash inflows or benefit generated by a project When annual cash inflows or benefit generated by a project per year are equal or constant(ie even cash inflows). The per year are equal or constant(ie even cash inflows). The payback period is computed by dividing the initial investment payback period is computed by dividing the initial investment or cash outlay by the net annual cash inflows. It is expressed or cash outlay by the net annual cash inflows. It is expressed as as

payback period = payback period = original cost of project(cash outlay)original cost of project(cash outlay)

annual net cash inflow(net earnings)annual net cash inflow(net earnings)

For eg; if a project involves a cash outlay of RS 5,00,000 and For eg; if a project involves a cash outlay of RS 5,00,000 and generates cash inflow of RS 1,00,000 annually for 7 generates cash inflow of RS 1,00,000 annually for 7 years.years.

payback = payback = 5,00,0005,00,000 = 5 years is required to recover = 5 years is required to recover

1,00,000 original investment.1,00,000 original investment.

II. When annual cash II. When annual cash inflows are unequal.inflows are unequal.

When cash inflows in different years When cash inflows in different years are unequal (uneven),the computation are unequal (uneven),the computation of pay back period is not so easy as in of pay back period is not so easy as in the case of even cash inflowsthe case of even cash inflows

In such case, payback period In such case, payback period is calculated in the form of cumulative is calculated in the form of cumulative cash inflows. It is ascertained by cash inflows. It is ascertained by cumulating cash inflow till the time cumulating cash inflow till the time when the cumulative cash inflow when the cumulative cash inflow become equal to initial investment. become equal to initial investment.

For example, if the cost of project is Rs.1,00,000 and the cash For example, if the cost of project is Rs.1,00,000 and the cash inflow are; 1inflow are; 1stst year Rs 10,000 and 2nd year Rs. 15,000,3 year Rs 10,000 and 2nd year Rs. 15,000,3rdrd year year Rs.25,000 4Rs.25,000 4thth year Rs. 30,000 and 5 year Rs. 30,000 and 5thth year Rs .30,000.pay back year Rs .30,000.pay back period to recover original investment of Rs, 100000 comes to 4 period to recover original investment of Rs, 100000 comes to 4 years and 8 months (RS 80000 is recovered in 4 years and to years and 8 months (RS 80000 is recovered in 4 years and to recover the balance RS 20000, 8 months required.recover the balance RS 20000, 8 months required.

4+4+ 20,000 20,000 = 4 + = 4 + 2 2 years or 4 years and 8 months.years or 4 years and 8 months.

30,000 3 30,000 3

pay back period can also be calculated by the following formula .pay back period can also be calculated by the following formula .

Pay back period = E + Pay back period = E + BB

CC

E = no years immediately proceeding the year of final recovery.E = no years immediately proceeding the year of final recovery.

B = Balance amount still to be recovered.B = Balance amount still to be recovered.

C = Cash flow during the year of final recovery. C = Cash flow during the year of final recovery.

POST PAY BACK METHODPOST PAY BACK METHOD

As pointed out earlier, under payback method the As pointed out earlier, under payback method the profitability( ie cash inflows)after payback period is ignored. profitability( ie cash inflows)after payback period is ignored. the post pay back method has been evolved to overcome the post pay back method has been evolved to overcome this limitation.this limitation.

under post pay back method the entire cash inflows under post pay back method the entire cash inflows generated from a project during its working life are taken generated from a project during its working life are taken into account. The post pay back profitability calculated as into account. The post pay back profitability calculated as underunder

pay back profitability = total cash inflows in life-initial cost.pay back profitability = total cash inflows in life-initial cost.

For example, if the cost of project is For example, if the cost of project is Rs.100000 and the cash inflow are; 1Rs.100000 and the cash inflow are; 1stst year Rs 10000 and year Rs. 15000,3year Rs 10000 and year Rs. 15000,3rdrd year Rs.2,5000 4year Rs.2,5000 4thth year Rs. 30,000 and year Rs. 30,000 and 55thth year Rs .30,000. year Rs .30,000.

Post pay back profitability =Post pay back profitability =

total cash inflows in life – initial cost.total cash inflows in life – initial cost.

1,10,000 -100000 = 10000.1,10,000 -100000 = 10000.

post pay back profitability = 10000post pay back profitability = 10000

Nomograph methodNomograph method

Nomograph method facilitates the rate of Nomograph method facilitates the rate of return calculations nomograph method return calculations nomograph method draws a certain kind of graph which helps to draws a certain kind of graph which helps to understand the value of other independent understand the value of other independent the variable when the value of other the variable when the value of other independent variables are given.independent variables are given.

this method is useful for quick this method is useful for quick calculation. This is a time saving method. it calculation. This is a time saving method. it is a simple method as well.hence,only is a simple method as well.hence,only minimum effort is required for the minimum effort is required for the preparation of this graph.preparation of this graph.

The mapi techniqueThe mapi technique This technique has been offered by George terborgh in his book “ This technique has been offered by George terborgh in his book “

business investment policy". he is the chief economist of the business investment policy". he is the chief economist of the machinery allied product institute (mapi) of Washington D.C .machinery allied product institute (mapi) of Washington D.C .

A Firm has to consider the following 5 factors to make use of A Firm has to consider the following 5 factors to make use of MAPI techniques; MAPI techniques;

a)a) Operating advantage from the new equipmentOperating advantage from the new equipment

b)b) Magnitude of the capital consumption avoided.Magnitude of the capital consumption avoided.

c)c) Subtraction of consuming capital.Subtraction of consuming capital.

d)d) Cost of consuming capital.Cost of consuming capital.

e)e) Net investment in the project.Net investment in the project.

According to MAPI method ,the rate of return from According to MAPI method ,the rate of return from the next year is calculated, while evaluating project profitability.the next year is calculated, while evaluating project profitability.

Discounted cash flow techniqueDiscounted cash flow technique

Payback method & average rate of return method do not consider Payback method & average rate of return method do not consider the time value of money .the initial amount incurred for acquisition the time value of money .the initial amount incurred for acquisition of assets to implement a project and income received from the of assets to implement a project and income received from the project in future is given equal importance under the other project in future is given equal importance under the other methods. But in fact the value of money received in future is not methods. But in fact the value of money received in future is not equivalent to the value of money invested today .in other words a equivalent to the value of money invested today .in other words a rupee in hand now is nor valuable than a rupee to be received in rupee in hand now is nor valuable than a rupee to be received in future because cash in hand can be invested elsewhere and future because cash in hand can be invested elsewhere and interest can be earned on it .for eg; if rupees 100 is invested at the interest can be earned on it .for eg; if rupees 100 is invested at the annual interest of 10 %,it will increased as under;annual interest of 10 %,it will increased as under;

RS 100 today is equal to RS 100 today is equal to

RS 110 after 1 year(100+10 of interest)RS 110 after 1 year(100+10 of interest)

RS 121 after 2 years (110+11 of interest).RS 121 after 2 years (110+11 of interest).

RE 1 After 1 year equal to RS RE 1 After 1 year equal to RS 100100= 0.909= 0.909

110 110

Internal rate of Internal rate of return(IRR)return(IRR)

Net present value method indicate the net Net present value method indicate the net present value of cash flows of a project at a pre-present value of cash flows of a project at a pre-determined interest rate, but it doesn’t indicate determined interest rate, but it doesn’t indicate the rate of return of the project . In order to find the rate of return of the project . In order to find out the rate of return of the project, estimated out the rate of return of the project, estimated cash inflows of each year are discounted at cash inflows of each year are discounted at various rates till a rate is obtained at which the various rates till a rate is obtained at which the present value of cash inflow is equal to the initial present value of cash inflow is equal to the initial investment or the net present value comes to investment or the net present value comes to zero. Such a rate is called internal rate of return zero. Such a rate is called internal rate of return or marginal rate of return . or marginal rate of return .

The concept of rate of return is quite The concept of rate of return is quite simple to understand in the case of a simple to understand in the case of a 1 period project.1 period project.

assume that you deposit RS 10000 with assume that you deposit RS 10000 with a bank and would get back RS 10800 a bank and would get back RS 10800 after 1 year. The true rate of return on after 1 year. The true rate of return on your investment would be your investment would be

Rate of return =Rate of return =10800-10000 10800-10000 = .08 = = .08 = 8%8%

1000010000

Average rate of return Average rate of return method(ARR)method(ARR)

This method is also known as accounting This method is also known as accounting rate of return method or return on rate of return method or return on investment method or unadjusted rate of investment method or unadjusted rate of return method. under this method average return method. under this method average annual profit(after tax)is expressed as annual profit(after tax)is expressed as percentage of investment.ARR is found out percentage of investment.ARR is found out by dividing average income by the average by dividing average income by the average investment.ARR is calculated with the help investment.ARR is calculated with the help of the following formula ; of the following formula ;

ARR = ARR = Average income or return Average income or return × 100 × 100

average investmentaverage investment

Average investment = Average investment =

original investment +scrap value original investment +scrap value

22

OROR

= = original investment – scrap valueoriginal investment – scrap value

22

For eg; X YFor eg; X Y

capital cost 40000 capital cost 40000 6000060000

earnings after depreciation earnings after depreciation

1 st year 5000 8000 1 st year 5000 8000

2 nd year 7000 2 nd year 7000 1000010000

3 rd year 6000 3 rd year 6000 7000 7000

4 th year 6000 4 th year 6000 50005000

The average earningsThe average earnings

of project X = of project X = 2400024000 = RS 6000. = RS 6000.

44

The average investment =The average investment =

cost at the begining+cost at the end of the lifecost at the begining+cost at the end of the life..

22

40000+0 40000+0 = RS 20000.= RS 20000.

22

ARR =ARR =6000 6000 × 100 = 30 %× 100 = 30 %

2000020000

Average earnings of project y = Average earnings of project y = 3000030000

4 = RS 7500.4 = RS 7500.

Average investment =Average investment = 60000+0 60000+0 = 30000.= 30000.

22

ARR = ARR = 7500 7500 × 100 = 25 %× 100 = 25 %

3000030000

Net Present ValueNet Present Value

DefinitionDefinitionNPV. The NPV. The present value of an investment's future of an investment's future net cash flows minus the initial minus the initial investment. If positive, the investment should be . If positive, the investment should be made (unless an even better investment exists), otherwise it made (unless an even better investment exists), otherwise it should not.should not.

The total discounted value of all of the cash inflows and outflows The total discounted value of all of the cash inflows and outflows from a project or investment.from a project or investment.

This method is used only when the rate of return on investment is This method is used only when the rate of return on investment is predetermined by management under the net persent value predetermined by management under the net persent value method, the present value of all cash inflows (stream of method, the present value of all cash inflows (stream of benefits) is compared against the present value of all cash benefits) is compared against the present value of all cash outflows(cash outlays or cost of investment). The difference outflows(cash outlays or cost of investment). The difference between the present value of cash inflows and cash outflows is between the present value of cash inflows and cash outflows is called the net present value.the discount rate for obtaining the called the net present value.the discount rate for obtaining the present value is some desired rate of return which may be equal present value is some desired rate of return which may be equal to the cost of capital to the cost of capital

COMPUTATION OF CASH INFLOW & OUTFLOWS.COMPUTATION OF CASH INFLOW & OUTFLOWS.

Present value = Present value =

CC11 + + C C22 + + C C33 + ……………… + ……………… CCnn

( 1+r)( 1+r) (1+r)(1+r)2 2 ( 1+r) ( 1+r)22 ( 1+r) ( 1+r)22

Year Investment & cash

flow

Discount factor at 15%

Present

value

Investment and cash

Discount factor at15%

Present value

0 100000 ……….. 100000 100000 ………….. 100000

1 30000 0.870 26100 20000 0.870 1740

2 40000 0.756 30240 30000 0.756 22680

3 40000 0.658 26320 50000 0.658 32900

4 30000 0.572 17160 40000 0.572 22880

5 30000 0.497 14910 30000 0.497 14910

SUM 170000 ……….. 114730 170000 110770

ProjectProject A A ProjectProject BB

PROJECT APROJECT APresent value of cash outflow=100000Present value of cash outflow=100000Present value of cash inflow =114730Present value of cash inflow =114730

Net present value=114730-Net present value=114730-100000=14730100000=14730

PROJECT BPROJECT B

Present value of cash outflow =100000Present value of cash outflow =100000

Present value of cash inflow =110770Present value of cash inflow =110770

Net present value =110770-Net present value =110770-100000=10770100000=10770

Difference between NPV & Difference between NPV & IRRIRR

Npv

IRR

The minimum desired rate of return(cost of capital)is assumed to be known.

The minimum desired rate of return is to be determined

It implies that the cash inflows are invested at the rate of firm’s cost of capital.

It implies that cash inflows are reinvested at the IRR of the project.

It gives absolute return. It gives percentage return.

The NPV of different project can be added.

The IRR of the different project can not be added.

REFERENCE:REFERENCE:1.WWW.WIKIPEDIA.ORG

2.2.FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT

AUTHOR: VINOD (BBA CALICUT UTY)AUTHOR: VINOD (BBA CALICUT UTY)