Fix this especially the tables and remove unwanted characters. Please retain the original text: Capital Budgeting

An Investment Decision Method

 
90: NM EN a & WW

Definition of Budget

Budget Sector and Types of Budget
Capital Budgeting

Importance of Capital Budgeting

Capital Budgeting : Project Categorization
Capital Budgeting: Eight Steps

Evaluation Criteria: Capital Investment Appraisals

Conclusions
 
Definition of Budget

*Budgeting is a management tool for planning and

controlling future activity.

Financial Buzz Words: A plan for saving, borrowing and spending.
*Budget is a financial plan and a list of all planned

expenses and revenues.

 
Buisness
o start-up â€”
budget

Corporate/
o Buisness
budget

Budget Sector Budget Types

CEâ€”â€” Se
Basis of Flexibility : Fixed and Variable Budget

Basis of Time Period : Short-Term and

Government
budget

a Management Samy

Personal /
Family budget

Long â€”Term Budget

Basis of Functionality: Sales budget,
Production budget , Marketing budget, Project
budget, Revenue budget, Cash flow/cash
budget etc.

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Capital Budgeting

Capital: Operating assets used for production.

Budget: A plan that details projected cash flows during some period.

Capital Budgeting: Process of analyzing projects and deciding which
ones to include in capital budget.

BE sie SR =
A+ | Should we 1 x
5 ( buldthis 05
LS Â¢ plant? 4

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Importance of Capital Budgeting

@Â® Growth

Â® Large Amount

@Â® Irreversibility

@Â® Complexity

Â® Risk

@Â® Long term implications

Benefits of Capital Budgeting Decision:
Capital Budgeting decisions evaluate a proposed project to forecast
return from the project and determine whether return from the Project is

adequate.

Capital Budgeting decisions evaluate expenditure decisions which
involve current outflow of funds but are likely to produce benefits over a
period of time more than one year.

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Capital Budgeting: Project Categorization

+ Establishment of New Products & Services

* Replacement Projects: Maintenance or Cost Reduction
Â» Expansion of Existing Projects

+ Research and Development Projects

* Long Term Cotracts

Â« Safety and/or Environmental Projects

 
Broad Prospective

Capital Budgeting is the planning process used to determine a firmâ€™s
long term investments such as new machinery, replacement machinery,
new plants, new products and research & development projects.

Capital Budgeting: eight steps

i â€
i Tir
i

1 Have a good
idea/realise the

need for a project

3 Identify and
consider
alternatives

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Fourth Important Step of capital budgeting:
carry out Financial Analysis

Evaluation Criteria: Capital Investment Proposal

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Â©
 
Non discounting: Pay-Back Period

1. Pay-Back Period Method- It is defined as the
number of years required to recover original cost
invested in a project. It has two conditions

Â» When cash inflow is constant every year
PBP= Cash outflow/cash inflow (p.a.)

Â» When cash inflow are not constant every year

Required inflow . 12

+
PER = Competed Year Â¥ oF net ver

 
Non discounting Criteria: Annual Rate of Return

2.Average Rate of Return Method - ARR means the
average annual earning on the project. Under this method,
profit after tax and depreciation is considered. The average
rate of return can be calculated in the following two ways.

Average Profit After Tax
Average Investment

ARR on Average investment = 100

ARR on Initial investment Average Profit After Tax

Initial Investment 100

 
Discounting Criteria: Pay-Back Period

3. Discounted Pay-Back Period Method - In discounted
pay- back period method, the cash inflows are discounted
by applying the present value factors for different time
periods. For this, discounted cash inflows are calculated
by multiplying the P.V. factors into cash inflows.

Required inflow

Dis. PBP = Completed years + * 12

In flow of next year

 
Discounting Criteria: Net Present Value

4. Net Present Value Method:- It is the best method for
evaluation of investment proposal. This method takes into
account time value of money.

NPV= PV of inflows- PV of outflows

Â» Evaluation of Net Present Value Method:- Project
with the higher NPV should be selected.

Accept if NPV>0
Reject NPV<0
May or may not accept NPV=0

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Discounting Criteria: Profitability Index

5. Profitability Index Method - As the NPV method it is
also shows that project is accepted or not. If Profitability
index is higher than 1, the proposal can be accepted.

Accepted PI>1
Rejected PI<l

Total Cash Inflows

Profitability index =
Total Cash Outflows

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Discounting Criteria: Internal Rate of Return

5. Internal Rate of Return Method:- IRR is the rate of
return that a project earns. The rate of discount calculated by
trial and error , where the present value of future cash flows is
equal to the present value of outflows, is known as the Internal

Rate of Return.

NPV of Higher Rate â€œ
Difference in cash flows

IRR = Higher Rate - Difference in Rate

NPV of Lower Rate
Difference in cash flows

IRR = Lower Rate + Difference in Rate

 
Example

The expected cash flows of a project are:-

Year Cash Flows ( Rs.)

1 20,000
2 30,000
3 40,000
4 50,000
5 30,000

The cash outflow is Rs. 1,00,000

The cost of capital is 10%

Calculate the following:

a) NPV b) Profitability Index

Â¢) IRR

d) Pay-back period Â¢) Discounted Pay-back Period

 
wv bh WwW

Total Cash Inflow

Less: Cash
Outflows

NPV
Pl.

751
.683
.620

â€” 0 LOW ra,

30,040

34,150

18,600
1,25,750
1,00,000

25,750
1.2575

 
Computation of IRR

Year Cash PV Factors pV of Cash pV Factors pV of Cash
Flows (Rs.) | @19% Flows (Rs.) @18% Flows (Rs.)

1 20000 84 16800 847 16,940
2 30,000 706 | 21,180 718 | 21,540
is | 40,000 593 | 23720 609 | 24,360
4 | 50,000 499 24,950 516 25,800
5 30000 42 | 12,600 437 13,110
Total Cash Inflow 99,250 1,01,750
Less Cash Outflows Â© 1,00,000 1,00,000
NPV | (so | (+)1750

 
Computation of IRR Contd..

NPV of HigherRate ~~

Difference in cash flows CRIoicE Rm

IRR = Higher Rate .

ag
RR= 18" ps ~ | = 187%

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Computation of non discounting pay-back period

Year Cash Flows (Rs.) Cumulative Cash Flow
1 20,000 20,000
2 30,000 50,000
a 40,000 90,000
4 50,000 1,40,000
5 30,000 1,70,000

Completed years + Required inflow *12
PBP = Inflow of Next year

= 3years+ (1.00.000-90.000) *12
50,000

= 5.4 years

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Computation of discounted pay-back period

Year Cash Flows PV PV of Cash Cumulative
(Rs.) Factors@10% Flows (Rs.) Cash Flows
1 20,000 .909 18,180 18,180
2 30,000 .826 24,780 42,960
3 40,000 751 30,040 73,000
4 50,000 .683 34,150 | 1,07,150
5 30,000 .620 18,600  1,25,750
Completed years + Required inflow *12
PBP = Inflow of Next year

3years+ (1,00.000-73.000)*12

34150
12.48 years

 
Conclusions

We have Studied various evaluation criteria for Capital
Budgeting.

â€œGenerally an impression created that the firm should
use NPV method for decision making.

**Most of the large companies consider all the measures
because each one provides somewhat different piece of

relevant information to the decision maker.