capita budgeting-18-1-2011

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- Long term planning for proposed capital

outlays and their financing.

CAPITAL BUDGETING


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DEFINITION:

Capital Budgeting decision may be defined as

the firms decision to invest its current fund

more efficiently in long-term activities in

anticipation of an expected flow of future

benefit over a series of years.


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Capital Budgeting is a complex process which may

be divided into the following phases :-

y Identification of potential investment opportunities.

y Assembling of proposed investments.

y Decision Making

y Preparation of Capital Budget and appropriations

y Implementation

y Performance Review.


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BASIC FEATURES OF CAPITAL BUDGETING

DECISIONS :-

y Current funds are exchanged for future benefits;

y Investment in long-term activities; and

yFuture benefits will occur to the firm over series

of years.


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Whatarethe factorsthat giveriseto

the need forcapital investments ?


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y Wear and tear of old equipments.

y Obsolescence.

y Variation in product demand necessitating change in

volume of production.

y Product improvement requiring capital additions.

y Learning-curve effect.

y Expansion

y Change of plant site.

y Diversification.

y Productivity improvement.


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IMPORTANCE OF CAPITAL BUDGETING :-

y Long-term implications;

y Involvement of large amount of funds;

y Irreversible decisions;

y Risk and uncertainty;

y Difficult and Complicated exercise.


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INVESTMENT DECISION MAKING


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FACTORS INFLENCING INVESTMENT DECISION:-

y Management outlook;

y Competitors Strategy;

y Opportunities created by technological change;

y Market forecast;

y Fiscal incentives;

y Cash flow budget;

y

Non-Economic factors.


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Rationaleof Capital Budgeting Decisions:-

The main rationale is EFFICIENCY.

The main objective of the firm is to maximize profit

either by way of increased revenue or by cost

reduction.


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KINDS OF

CAPITAL BUDGETING DECISIONS


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Business firmsare generallyconfronted with

these 3 typesof Capital Budgeting Decisions:

y Accept Reject decisions

y Mutually exclusive decisions

y Capital Rationing decisions


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ACCEPT-REJECT DECISIONS :

If the proposal is accepted, the firm incurs the

investment and not otherwise.

Broadly, all those investment proposals which yield a

rate of return greater than cost of capital are accepted

and the others are rejected.


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MUTUALLY EXCLUSIVE DECISIONS :

It includesallthoseprojects whichcompete with

eachother in a way,thatacceptanceof one

precludestheacceptanceof otherorothers.

Thus,sometechniquehasto be used forselecting the

bestamong allandeliminatesotheralternatives.


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CAPITAL RATIONING DECISIONS :

Referstothesituations wherethe firmhavemore

acceptable investmentsrequiring greateramountof

financethan isavailable withthe firm.

It isconcerned withtheselection of a groupof

investmentsoutof many investmentproposals

ranked in thedescending orderof therateof return.


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In evaluating acapitalexpenditureproposal, 2

broadphasesare involved:-

yDefining the stream of costs and benefits

associated with the investment, and

yAppraising the stream of costs and benefits to

determine the worthwhileness of the investment.


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In defining the costs and benefits of a capital

expenditure proposal, the following principles must be

borne in mind:-

y Cash Flow Principle

y post-tax Principle

y incremental Principle

y long-term funds Principle

y interest exclusion Principle.


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To evaluate the stream of costs and benefits, several

appraisal criteria have been suggested. The important

ones are as follows:-

y Payback Period

y Average Rate of Return

y Net Present Value

y Benefit Cost Ratio

y Internet Rate of Return.


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The NET PRESENT VALUE of a project is equal to the

sum of the present values of all the cash flows(outflows

and inflows) associated with the project.

A Project is acceptable if its net present value exceeds

zero.


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The BENEFIT COST RATIO,also referred to as

Profitability Index, is defined as :

Present Value of BenefitsPresent Value of costs

A project is acceptable if its Benefits Cost Ratio > 1.


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The INTERNAL RATE OF RETURN ,of a project is the

discount rate which makes its net present value = 0.

A project is acceptable if its IRR > the cost of capital.


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The PAYBACK PERIOD ,is the length of time required

to recover the initial cash outlay on the project.

According to this criterion, a project is acceptable if its

payback period is less than a certain specified

Payback Period.


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The AVERAGE RATE OF RETURN ,also called the

Accounting Rate of Return, may be defined as :-

Profit after taxes

Book Value of the investment

Project is acceptable if its ARR exceeds certain cut-off

rate of return.


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CHOICE OF METHODS


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Business enterprise is confronted with large number of

investment criteria for selection of investment

proposals. It should like to choose the best among all.


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If a choice is to be made, the NET PRESENT

VALUE method generally is considered to be

superior theoretically because :-


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y It is simple to operate as compared to InternalRate of Return method ;

y It does not suffer from the limitations of multiplerates;

y The reinvestment assumption of the Net PresentValue Method is more realistic than internal

Rate of Return Method.


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On the other hand, some scholars have

advocated for Internal Rate of Return method on

the following grounds :


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y It is easier to visualize and to interpret as

compared to Net Present Value method;

y It suggests the max. rate of return and even in

the absence of cost of capital, it gives goodidea of the projects profitability.

y The IRR method is preferable over NPV methodin the evaluation of risky projects.


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A wide variety of measures are used in practice for

appraising investments. These include measures

suggested by capital budgeting literature and several

non-standard measures.


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The most commonly used method for evaluating small-

size investments is the payback method.

For larger investments, the Average Rateof Return

and, in more recent years, discounted cash flow

methods are commonly employed.


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ANY QUESTIONS?ANY QUESTIONS?


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capita budgeting-18-1-2011

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