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PREPARED BY : Swapnil Keyur Nikhil Manjiri Nikita Asad (3) (10) (14) (18) (27) (30)
Outline
Meaning of Capital Budgeting Significance of Capital Budgeting Analysis Traditional Capital Budgeting Techniques
Payback Period Approach Discounted Payback Period Approach Discounted Cash Flow Techniques
Net Present Value Internal Rate of Return Profitability Index Net Present Value versus Internal Rate of Return
Due to the above factors, capital budgeting decisions become critical and must be evaluated very carefully. Any firm that does not follow the capital budgeting process will not be maximizing shareholder wealth and management will not be acting in the best interests of shareholders. RJR Nabisco s smokeless cigarette project example Similarly, Euro-Disney, Concorde Plane, Saturn of GM all faced problems due to bad capital budgeting, while Intel became global leader due to sound capital budgeting decisions in 1990s.
Classification Of Projects
The Capital budgeting process may be less or more ,it depends on the type of the projects :
NEW PROJECTS - Ex: establishment of a paper manufacturing company requires machinery to produce paper ,which may require investment of some crores of rupees. EXPANSION PROJECTS- Ex: same company which is currently producing 20,000 tones of paper may increase its plant capacity by 10,000 tonnes per year. DIVERSIFICATION PROJECTS- Ex: Reliance ,marketer of textiles, entering into petroleum business.
REPLACEMENT & MODERNISATION PROJECTS - Ex: A cement manufacturing concern is planning to go for modernization where it is changing its drying process from semi-automatic to fully automatic drying equipment or replacement of manually operated machinery by the fully automatic machinery.
R & D PROJECTS - Majority of the large firms are setting up their own R & D departments.
MISCELLANEOUS PROJECTS
Ex: Reliance ,marketer of textiles, entering into petroleum business.
CAPITAL RATIONING DECISIONS-Arises when a firm has unlimited funds & several profitable investment projects.
CONTINGENT INVESTMENTS-Contingent projects are dependent investment, acceptance of one option needs to understand one or more other projects Ex: location of a factory in a backwards area, instead of industrial area or urban ,may need to construct roads, quarters for employees ,hospitals, schools, without which it is very difficult to attract employees.
Decision Rule
Accept: Cal PBP < Standard PBP Reject: Cal PBP > Standard PBP
Advantages of PBP Very simple and easy to understand Cost involvement in calculating PBP is much less when
compared to modern methods.
Limitations of PBP It ignores cash flows after pay back period. It is not an appropriate method of measuring the profitability of a project, as it does not consider all cash inflows yielded by the investment. It does not take into consideration time value of money. There is no rationale basis for setting a minimum pay back period. It is not consistent with the objective of maximising shareholders wealth since share value does not depend on pay back periods of investments projects.
Accounting Rate of Return (ARR) Accounting rate of return method uses accounting information as revealed by financial statements, to measure the profitability of the investment proposals. It is also known as the Return on Investment (ROI). It is calculated in two ways: i. Whenever it is clearly mentioned as Accounting Rate of Return
Accounting Rate of Return(ARR)= Average Annual EAT or PAT 100 Original Investment (OI) OI= Original investment + additional NWC + Installation Charges + Transportation Charge
ii. Whenever it is clearly mentioned as Average Rate of Return Average Rate of Return = Average Annual EAT 100 Average Investment (AI) AI = (Original investment Scrap value)1/2+Additional NWC + Scrap Value
Decision Rule Accept: Cal ARR > Predetermined ARR or Cut-off rate Reject: Cal ARR < Predetermined ARR or Cut-off rate
Advantages of ARR method Very simple to understand and easy to calculate. Information can easily can be drawn from accounting records. It takes into account all profits of the projects life period. Cost involvement in calculating ARR is much less is comparision with the modern methods, since it saves analysts time
Limitations of ARR method Accounting profits are inappropriate for evaluating and accepting projects, Since they are computed based on arbitrary assumptions and choices and also include non-cash items. It ignores the concept of time value of money. It does not allow the fact that the profits can be reinvested. It does not differentiate between the size of the investment required for each project. It does not take into consideration any benefits, which can accrue to the firm from the sale of abundance of equipment, which is replaced by the new investment. It feels that 10% rate of return for 10 years is more beneficial than 8% rate of return for 25 years.
Advantages
It takes in to account the time value of money It is particularly useful for the selection of mutually exclusive project it is consistent with the objective of maximization of shareholders wealth It takes into consideration the changing discount rate
Disadvantages
It is difficult to understand when compared with PBR and ARR It does not give satisfactory result s when comparing two projects with different life period In cash of project involving different cash outlays NPV method may not give dependable results
Advantages
It takes in to account the time value if money It considers cash flows throughout the project life It gives more psychological satisfaction to the user It is consistent with the objective of shareholders wealth maximization
Disadvantages
It is difficult to understand and to calculate since it involves tedious calculation It implies that profits can be reinvested at internal rate of return which is not logical It produce multiple rate of return which can be confusing
Advantages
It gives due consideration to time value of money. It considers all cash flows to determine PI. It will help to rank projects according to their PI. It can also be used to choose mutually exclusive projects by calculating the incremental benefit cost ratio.
Q) A Project costs rs. 20 lakhs and yields annually profit of Rs. 3 lakhs after depreciation at 12.5% but before tax at 50%. Calc Pay Back Period & suggest whether it should be accepted or rejected based on 6-year standard pay back period. Q) A company is considering expanding its production. It can go either for an automatic machine costing Rs 2,24,000 with an estimated life of 5 years or an ordinary machine costing Rs 60,000 having an estimated life of 8 years. The annual sales and costs are estimated as follows:
Sales Costs: Materials: Labour: Variable overHs: 50,000 12,000 24,000 50,000 60,000 20,000 Auto machine 1,50,000 Ordinary mach 1,50,000
Perspectives of risk
Three different perspectives
Standalone risk - It refers to the risk of a project when it is viewed in isolation. Firm risk It is the project s risk to the corporation , that affects firm s earnings. Market risk It refers to the risk of a project from the viewpoint of a diversified investor.
Thank You!