CAPITAL BUDGETING Involves decision to invest current funds of a business concern most effectively...
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Transcript of CAPITAL BUDGETING Involves decision to invest current funds of a business concern most effectively...
CAPITAL BUDGETING
Involves decision to invest current funds of a business concern most effectively in long-term activities, in anticipation of an expected flow of future benefits over a series of years in future.
CAPITAL BUDGETING
Importance of Capital Budgeting:-
1. Long term implications for the firm
2. Involve committing large funds
3. They are irreversible decisions.
4. Among the most difficult decisions to make.
CAPITAL BUDGETING
Features of Capital Investment Decisions:-
1. Exchange of current funds for future benefits.
2. Funds invested in long-term assets
3. Future benefits will occur over a series of years.
CAPITAL BUDGETING
INVESTMENT EVALUATION CRITERIA:
INVOLVES:-
1. ESTIMATION OF CASH FLOWS.
2. ESTIMATION OF REQUIRED RATE OF RETURN
3. APPICATION OF A DECISION TECHNIQUE FOR MAKING THE CHOICE
CAPITAL BUDGETING
DECISION- TECHNIQUES:-
TRADITIONAL
1. PAY-BACK METHOD
2. AVERGE RATE OF RETURN(ARR)-
RETURN ON INVESTMENT METHOD
CAPITAL BUDGETING
DECISION-TECHNIQUES:-
DISCOUNTED-CASH FLOW(DCF)-
TIME-ADJUSTED METHODS
1. NET PRESENT VALUE METHOD(NPV)
2. INTERNAL RATE OF RETURN(IRR)
3. TERMINAL VALUE METHOD
4. PROFITABILITY INDEX
CAPITAL BUDGETING
SOME CAPITAL BUDGETING DECISIONS1. Mechanisation of a Division2. Replacing or modernising a process3. Mutually exclusive decisions in selecting a
machine4. Buy or Lease decisions-comparative
profitability5. Business expansion by capital investments.
CAPITAL BUDGETING
INVESTMENT DECISIONS:-PAY-BACK METHOD
PAY BACK PERIOD (PBP)= TOTAL CASH OUTFLOWS ANNUAL CASH FLOWS FROM OPERATIONS
If Rs. 60000 invested today yields annual cash inflow of Rs. 15000 for 6 years, the Pay Back Period= 60000/15000 = 4 years.
PROJECT WITH LEAST PBP IS ACCEPTED
CAPITAL BUDGETING
PAY BACK METHOD:-
LIMITATIONS:-
1. Does not give weightage to total earnings
2. Time value of money not recognised
MERITS:-
a. Very simple and popular.
b. Good in unstable conditions
CAPITAL BUDGETING
AVERAGE RATE OF RETURN(ROI)
METHOD :-
Average annual profit after Tax x 100
Average investment over the life of the product
Average Profit=Sum of Profits over the life of the asset / No. of years.
Average investment= Original Investment-scrap value / 2
CAPITAL BUDGETING
ARR METHOD:-
Advantages:-
Can be readily calculated
Simple in application
Entire stream of income is considered
Useful as a good performance evaluation
and control measure.
CAPITAL BUDGETING
ARR METHOD:-SHORTCOMINGS:-1. CASH FLOWS IGNORED2. TIME VALUE OF MONEY IGNORED3. AVERGE RETURNS vs. CURRENT
RETURNS4. LESS USEFUL FOR INVESTMENT
DECISIONS.
CASH BUDGETING
DISCOUNTED CASH FLOW METHODS:-NET PRESENT VALUE METHOD:-The difference between present value of cash
inflows and cash outflows. The firm’s opportunity cost of capital being the discount rate.
If Positive (> 0) = ACCEPTIf Negative (< 0) = REJECT
CAPITAL BUDGETING
PV OF FUTURE CASH INFLOWS=
s
(1 + r)^n
Where s = Cash inflow expected
r = rate of interest
n = no. of years.
i.e. S = P (1+ r)^n
CAPITAL BUDGETING
NPV METHOD:-
MERITS:-
1. Considers all cash flows.
2. True measure of profitability
3. Time value of money reckoned
4. Consistent with wealth maximisation principle
CAPITAL BUDGETING
NPV METHOD:-
DE-MERITS:-
1. TEDIOUS ESTIMATES
2. DISCOUNT RATE-COMPUTATION
3. SENSITIVE TO DISCOUNT RATES
STILL REGARDED AS MOST EFFECTIVE
CAPITAL BUDGETING
IRR METHOD( YIELD METHOD): IRR is the discount rate which equates the
present value of an investment’s cash inflows and outflows.
IF IRR > K(COST)-----ACCEPT IF IRR = K(COST)-----MAY ACCEPT IF IRR < K(COST)-----REJECT IF IRR = K, NPV = 0
CAPITAL BUDGETING
IRR METHOD:-
MERITS:-
1. Considers all Cash Flows
2. True measure of profitability
3. Time value reckoned
CAPITAL BUDGETING
NPV vs IRR:-
INTERPOLATION METHOD:-
When one comes across two rates of NPV-
One positive NPV & One negative NPV
IRR by Interpolation:-
Lower rate + NPV at Lower rate x rate differential.
Absolute difference of both NPVs
CAPITAL BUDGETING
IRR by INTERPOLATION-
e.g.:-
At 10% say NPV of cash flows = Rs. 200( +)
At 12% say NPV pf cash flows = Rs. 210( -)
IRR = 10% + 200 x ( 12-10)
(200 + 210)
10% + 0.98 = 10.98%
CAPITAL BUDGETING
TERMINAL VALUE METHOD:-
IMPROVED DCF METHOD WITH EACH CASH FLOW RE-INVESTED FOR REMAINING YEARS.
If re-invested Cash Flow > Outflow=Accept
If re-invested Cash Flow < Outflow=Reject
CAPITAL BUDGETING
PROFITABILITY INDEX:-
Present Value of Cash Inflows
Present Value of Cash Outflows
It is a relative measure and provides solution for projects requiring initially different levels of investment
APPLY WHEN NPV IS SAME IN 2 CASES
CAPITAL BUDGETING
PROFITABILITY INDEX FOR PROJECT APPRAISAL
Project-A Project-B Project-C
Cash Outflows 10000 20000 40000
PV –Inflows 14000 25000 52000
NPV 4000 5000 12000
RANKING III II I
P. INDEX 1.40 1.25 1.30
RANKING BY PI I III II
CAPITAL BUDGETINGDU-PONT ANALYSIS
ROIROI= PROFITABILITY x INVENTORY
TURNOVERNet Profit / Sales x Sales / Total Assets= Net Profit / Total Assets = ROIShows inter-action of profitability and activityRatios.