Procurement of fund+ Allocation of funds

Investment in various assets

1. Funds are invested in long term assets.2. Funds are invested in present times in anticipating of future profit.3. Such decision affect profitability of the firm.4. Involvement of large amount of funds.5. Irreversible nature.6. Difficult to make investment decisions.

1. Accept Reject decision. 2.Mutually competitive decisions.3. Priority order decisions.

Methods of capital budgeting

Accounting profit criteria

Cash flow criteria

Average rate of return

(A R R METHOD)

Discounted cash flow methods

Payback period method

Net present value method

Profitability index method

Internal rate of return method (I R R method)

Capital Budgeting - Methods

1. Average Return on Investment

2. Payback

3. Net Present Value

4. Internal Rate of Return

5. Modified IRR

Net Present Value

This method takes into consideration the time value of money & attempts to calculate the return on investment by introducing the factor of time element.

NPV = Present Value of Cash Flows - Present value of cash out flow.

NPV= (Cash inflow of 1st year * PVF 1st) + (cash inflow of 2nd year * PVF 2ND) + …………….+ (Cash inflow of nth year * PVF nth) – (Cash outflow PVF 0)

If PVF is not given than:PVF1= 1/(1+r)1

PVF2= 1/(1+r)2

PVF3= 1/(1+r)3

PVF4= 1/(1+r)4

PVF4= 1/(1+r)5

…………………………. r= rate of incestment

Net Present Value1. If NPV is +ve, than project may be accepted.2. If NPV is –ve, than project may be Rejected.

3. If NPV=0, than Project may be accepted only if non financial benefits are there.

4. If there are various proposals, than project with highest NPV is preferred & project with lowest NPV would be ranked at last.

Net Present Value - Example

Year CF Disc. Factor PV

0 -100000 1 -

1 26000 1/1.1 = .9091 23637

2 28000 1/(1.1)2 = .8264 23139

3 31000 1/(1.1)3 = .7573 23290

4 33000 1/(1.1)4 = .6830 22539

5 36000 1/(1.1)5 = .6209 22352

6 18000 1/(1.1)6 = .5645 10161

NPV = 25121

Net Present Value

Advantages1.It recognize the time value of money.2.It takes into consideration the objective of maximum profit.3.Full life of the project is taken into consideration.Disadvantages1.It is difficult method.2.It is not easy to determinate the appropriate discount rate.

It is also time adjusting method of evaluating the investment proposals. Profitability index also called as benefit cost ratio or ‘desirability factor’ is the relationship between present value of cash inflow and present value of cash outflow. Profitability index = Present value of cash inflows

Present value of cash outflows

IFPI>1 Than AcceptedPI<1 Than RejectedPI=1 It may be accepted or rejected

Profitability Index

Advantages:This method is the improvement in net present

value method. It also take into account the time value of money.

Disadvantages: It is similar to the net present value method,

it can not determine the discount rate.