Chapter - 5

Capital Budgeting

Introduction n  Capital Budgeting is a process of planning capital

expenditure which is to be made to maximize long term profitability of the organization.

n  Capital budgeting may also be defined as careful planning, evaluation & selection of capital expenditure proposals.

n  Such decisions are involving : - Long time period - substantially heavy expenditure - Irreversibility - Risk & uncertainty.

Investment Appraisal Methods Traditional Techniques

n  Pay back period n  Accounting Rate of

Return

Discounted Techniques

n  Net Present Value n  Internal Rate of Return n  Profitability Index n  Discounted Payback

IRR & NPV- comparative study NPV

n  All projects with +NPV will be accepted.

n  NPV takes into account both quality & scale.

n  Ranking may vary here according to rate of discount used.

n  If the objective is to maximise firms wealth, ranking of project NPVs is correct measure.

IRR n  The projects which earns IRR

higher than COC of firm will be accepted.

n  IRR measures only the quality of investment.

n  Rankings of the set of projects

obtained from IRR may not agree with NPV.

n  IF the objective is to maximise rate of profitability per unit of capital invested, IRR provides correct measure.

Capital Rationing n  It is situation where a constraint or budget

ceiling is placed on the total size of capital expenditure during a particular period.

n  It refers to the selection of investment proposals in situation of constraints on availability of capital funds, by maximising the wealth of the company by selecting those projects which will maximise the overall NPV of the company.

Capital Rationing

n  In capital rationing situation a company may have to forgo some of the projects whose IRR is more than COC due to ceiling on budget allocation.

n  A company can not undertake all + NPV

projects because of shortage of funds.

Factors leading to Capital Rationing n  External Factors : - Imperfections of capital market - Lack of availability of cheap funds. n  Internal Factors : - Reluctance to broaden equity share base - financing by external equities is not planned - Top management philosophy towards capital spending - funds provided by current operations - the feasibility required in acquiring new capital

Capital Budgeting During Inflation n  Inflation can be simply defined as increase in the

average price of goods & services.

n  Changes in the prices of various factors which may up the cost of project under consideration.

n  Change in wages rates, sale prices, material cost, power costs, transportation charges etc.

n  Overall estimations on the basis of RPI are likely to be inaccurate & misleading.

n  Therefore every attempt to be made to estimate specific inflation in project related affairs.

Synchronized & differential Inflation

n  Differential inflation is where cost & revenues change at deferring rates of inflation i.e. The various items of cost & revenue move at different rates.

n  Under synchronized inflation the elements of cost & revenue rise at the same rate, which may not be encountered in practice.