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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
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.
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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, 4 other legal requirements.
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.
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Capital Budgeting
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.
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.
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
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 9 level of management
Dont 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
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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
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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
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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;1. Pay back period method 2. Discounted Cash flow method
a)
b)
c)
The Net present value method Present value index method IRR Method
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3.
the project will generate the necessary cash to recoup the initial investment For e.g- if a project requires Rs.20000 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 =
Initial investment Annual cash Flow
Unadjusted rate of return Unadjusted Return = Annual return x100 Initial Investment
Uneven cash flow:- If a project requires an initial investment of Rs.20000 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
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4 5
4000 4000
23000 27000
Rs.19000 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 16
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
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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.
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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.
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NPV Method
Accept or reject criterion
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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.
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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.
Cash inflows =1 Cash outflows
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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. 5.12 & 5.13.
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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.
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