Capital Budgeting V3
Transcript of Capital Budgeting V3
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Group 4
Roll no: 20,21, 22, 23, and 25
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INDEXy Introduction
y Project appraisal process
y Capital Budgeting Techniquesy Pay Back Period
y Average Rate of Return (ARR)
y Net Present Value (NPV)
y Internal Rate of Return (IRR)y Take Away
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INTRODUCTION
Capital Budgeting process involves:
Identification of potential Investmentopportunities
Assembling ofInvestment proposals
Decision Ma ing
Preparation of capital budgeting andappropriations
Implementation
Performance Review
capital budgeting decisions are related to allocation of investable funds todifferent long tem assets.
Its Important for 3 Reasons
They have long termconsequences
They are difficult to reverseand
They involve substantialoutlay
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PROJECT APPRAISALy Forecast the cost and Benefits
y Apply suitable investment criteria
y Asses the riskiness of the project
y Estimate the cost of capital
y Value the options
y Consider the overall corporate
perspective
Focus onPost- Cash
Flow
easure thecash flow onIncremental
Basis
Excludefinancing
cost
TreatInflation
Consistently
COST AND BENEFIT ANALYSIS
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CAPITAL BUDGETING TECHNIQUES
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PAY BACK PERIODy Pay back period is defined as the number of years required for the proposal
cumulative cash inflow to be equal to cash outflow.
y A project is acceptable if the payback period is less than a specified time
Evaluation
Simple both in concept and application, suitable for small firms
It gives an indication of liquidity
It deals with risk too. Project with short payback period are less risky
Ignores the cash flow in the cash flow after the pay back period
It fails to consider Time Value of oney (TV )
Ignores the salvage value and economic vale of the project
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AVERAGE RATE OF RETUEN (ARR)y Also know as the Accounting Rate of Return it is defined as the annualized net income
earned on the average fund invested in a project
y Project is acceptable if its ARR is a pre specified rate of return
EqualProfits
U
nequal ProfitsAnnual profit (after tax) * 100 Average Annual profit (after tax) * 100
Average investment in project Average investment in project
Evaluation
It is simple to calculate & is based on available accounting information
It does not consider the TV an ignores future profits
Based on accounting profits which are subject to accounting policies
ARR ignores the life and salvage value of the proposal
Fails to recognize the size of the investment required for the project
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NET PRESENT VALUE (NPV)y The net present value technique is a discounted cash flow method that
considers the time value of money in evaluating capital investments
y The sum of the present values of a projects cash inflows and outflows.
y iscounting cash f lows accounts for the time value of money.
y Choosing the appropriate discount rate accounts for risk.
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Evaluation
It recognizes the time value of money
Its based on cash inflows and outflows rather than accounting profit
The discounted rate r incorporates the pure as well as the premium return to set offthe risk
Its in line with the objective of the firm i.e. maximization of wealth
It involves difficult calculations
If the value of r is incorrect the whole exercise may give wrong results
y Net Present Value is positive
NPV >= Zero ACCEPT the proposal
y Net Present Value is negative
NPV < Zero REJECT the proposal
NPV CRITERION & EVALUATION
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INTERNAL RATE OF RETURN (IRR)y The IRR of a proposal is defined as the discounted rate which produces zero NPV
y The time-schedule of occurrence of future cash flow is know but the discounted rate isascertained by trial and error method
y It is calculated with the formula:
Evaluation
It considers the time value of money
Profit oriented concept and expected at earning more than minimum ROR
Based on cash flows occurring anytime e.g. salvage value ,working capital etc
Involves tedious and complicated trial and error procedure
Can be misleading when choice is between mutually exclusive projects that havedifferent outlay
IRR being a scaled measure is biased to smaller projects which are likely to yield highpercentage returns
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TAKE AWAYBoth NPV and IRR are comprehensive and sound evaluation techniques aimingat maximizing the profits .
NPV is widely considered as a better technique of evaluation
In order to be meaningful and viable a Capital Budgeting of firm should be
Consistent with long term strategic business Plans
Compatible with resources of the firm
ust be controllable
ust be endorsed by the Executive anagement
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