CAPITAL BUDGETING
DECISIONS
DR R.S. AURORA,
FACULTY IN FINANCE
Definition of Capital Budgeting:
Charles Horngreen:
Capital Budgeting is long term planning for making
and financing proposed capital outlays.
Lynch:
Capital budgeting consists in planning development of available
capital for the purpose of maximizing the long-term profitability
of the concern.
Features of Capital Budgeting:
• Decisions essentially long-term in nature.
• Decisions involve huge investment.
• Benefits occur for a series of years.
• Involves exchange of current funds for future benefits.
• The decisions are irreversible in nature.
• Investments in such assets impact the profitability.
• Involves selection of the best investment
opportunity from alternatives available.
Importance of Capital Budgeting Decisions:
• Decisions require huge funds.
• Investment made is more or less permanent in nature.
• Decisions are irreversible in nature.
• Decisions involve future increasing uncertainty
• Affect the profitability of the firm.
• Decisions can be of national importance.
Capital Budgeting – A Process:
• Involves analyzing the pros and cons alternatives
• Costs and benefits difficult to determine in tangible
terms.
• Returns on such investment always uncertain.
• Time value of money plays an important role in
the analysis.
Steps involved in Capital Budgeting:
• Identifying the investment opportunity
• Preliminary screening
- Ascertaining the resources required and their
sources.
- Matching benefits with governmental priorities
and the environmental factors.
- Reviewing the marketing prospects.
- Undertaking cost-benefit analysis.
- Ascertaining the risk factor in the investment.
• Feasibility Analysis
- The project cost
- The mode of financing
- The benefits anticipated from the project and
- The social relevance of the project.
- Facilitates final decision on the project
• Implementation of the project:
- Arranging the resources
- Hiring personnel to man and execute the project
- Commissioning the project and undertaking a trial
run and
- Undertaking commercial production / exploitation.
• Performance review of the Project
Methods of Capital Budgeting Decisions:
Pay Back Period Method:
• Time required to recover the initial investment made
in the project.
• Deciding upon an appropriate cut-off period needed
• Accept Reject Criteria:
- Payback period of less than or equal to the cut-off
period ACCEPT others REJECT.
- Proposals ranked according to the length of the
payback period.
• Investments with a shorter payback period are
preferred to one's having a longer payback period.
• The annual cash inflows are equal to the net income
from the project after tax but before depreciation.
• Payback period where cash inflows are even:
Initial Investment / Annual Cash Flows
• Payback Period where cash inflows are uneven:
Calculation based on interpolation method
(Cost of the Asset / Sum of ACF) x Life of the Assets
Advantages of Payback period:
• Simple to calculate and easy to understand.
• Extremely useful in circumstances where
technological changes are rapid
• Stresses on the liquidity aspect of the project
• Takes care of various risks such as political
instability, introduction of a new product, etc.
• Helpful in comparing the profitability of two projects.
Disadvantages of the Payback period:
• Ignores the returns generated after the payback
period.
• Does not take into account the time value of money.
• Fails to appreciate the fact that returns from different
projects may accrue at an uneven rate.
• Ignores profitability principle for which all businesses
exist.
Average Rate of Return (ARR):
• Evaluates the project on the basis of their relative
profitability.
• Income determined over the entire life of the project.
• Calculations based on certain commonly accepted
accounting principles.
• Also known as the Accounting Rate of Return or The
Financial Statement Method.
• For the purpose of ranking a minimum rate of return
is generally fixed
• Project that generates returns at a higher rate than
the minimum rate is accepted and the others are
rejected.
ARR is calculated as:
(Annual Average Net Earnings)
-------------------------------------------- X 100
(Average Investments)
Where:
• Annual average net earning is the average profit after
depreciation and tax over the life of the asset.
• Average investment is the original investment divided
by 2. The investments are divided by '2' because fixed
assets do not involve a permanent investment of the
original amount. The amount is recovered gradually.
Advantages of ARR:
• Takes into account the savings over the entire
economic life of the asset.
• Easy to calculate and understand.
Disadvantages of ARR:
• Based on the accounting income and not the cash
inflows.
• As such it ignores the timings of cash inflows and
outflows.
• Based on the average earnings of projects that have
a varying length of economic life. This restricts the
comparability of the projects.
• Ignores the time value of money.
• Not very useful for projects involving long-term
investments.
Discounted Cash Flow Techniques:
• Compounding refers to the addition of interest to the
principal at periodic intervals. This helps in arriving
at a new value for subsequent calculations. This
process of adding interest is done till the end of the
final year.
• Compounding is done using the formula:
A = (1 + I) ^ n
• Discounting is just the opposite of compounding.
Here, one computes the present value that is expected
to be received at a future date.
• Discounting is done using the formula:
P = A (1 + I) ^ n
• In the above equations:
A = Principal + Interest N = Number of years
I = Rate of interest P = Principal amount.
Net Present Value Method (NPV):
• Cash inflows and outflows are discounted at a certain
discount factor.
• Process helps in determining the present value of the
cash flows.
• Discount factor is a rate that is acceptable to the
management.
• Sum of the present value of the cash inflows is then
subtracted from the present value of the present value
of the cost of the project.
• If the cash inflows exceed the cash outflows, the project
is accepted or else that project is rejected.
Advantages of NPV:
• Analysis is based on the entire economic life of the
asset.
• Recognizes the time value of money.
• Can be conveniently applied even in cases where
the cash inflows are uneven.
• Facilitates comparison between two projects.
Disadvantages of NPV:
• Difficult to determine the appropriate discount rate.
• Involves a lot of calculations.
• Has limited utility when projects with unequal
investments are to be compared.
Internal Rate of Return (IRR):
• Is the interest rate at which the present value of
future cash inflows equates the capital outlay of the
project.
• Determined using the trail and error method.
• Present value of cash inflows is determined using an
arbitrarily selected rate.
• Sum of the present values so obtained is compared to
the initial investment.
• If the present value is higher than the initial
investment, a higher rate is selected and the present
values are calculated again.
• Process is repeated until the equality is attained.
• If the present value is lower than the initial
investment, a lower interest rate is selected and the
process is repeated.
Advantages of IRR:
• Considers the time value of money.
• It considers the cash flows over the entire life of the
asset
Disadvantages of IRR:
• Involves elaborate calculations.
• Method not useful where two mutually exclusive
projects are to be compared.
Payback Profitability:
• Tries to ascertain the profitability of the project beyond
the PBP.
• Calculated as:
ACF (Estimated life - Pay- Back Period)
Profitability Index Number:
• Also known as ‘Benefit Cost Ratio’
• Ratio of the present value of cash inflows at the
required rate of return to the initial cash outflow
of the investment.
• Proposal is accepted if the index is more than one and
rejected if it is less than one.
• Profitability Index
= PV of Cash Inflows / Initial Cost Outlay
Capital Rationing:
• Is a situation where the management has more
profitable investment proposals requiring more amount
of finance than the funds available with the firm.
• Firm has therefore to select only the profitable
investment proposals and rank the projects from highest
to the lowest priority
• Used in situations where a firm has more investment
proposals than it can finance
• Happens when the firm has limited financial resources.
• All profitable investment proposal may not be accepted
at a given time
• The firm selects those that give the highest benefits.
This calls for rationing.
THANK YOU
