FINANCIAL MANAGEMENTCAPITAL BUDGETING

PRESENTED BY :- ANIL RANA

CAPITAL BUDGETING

Capital budgeting or investment appraisal is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.

CHARACTERISTICS OF CAPITAL BUDGETING

Capital expenditure for long period Forecasting Planning asset capacities

PRINCIPLES OF CAPITAL BUDGETING

Capital budgeting has five principles that play a crucial role in the allocation of money and the process of capital budgeting.  The five principles are:-(1)decisions are based on cash flows, not accounting income, (2)cash flows are based on opportunity cost, (3) The timing of cash flows are important, (4) cash flows are analyzed on an after tax basis,(5) financing costs are reflected on project’s required rate of return.

PRINCIPLES OF CAPITAL BUDGETING

(1)    Relevant cash flows are based on incremental cash flows:- This represents the changes in cash flow if the project is undertaken.  Aspects of cash flow that affect capital budgeting are sunk costs and externalities.  These are both costs that cannot be avoided.  Sunk costs are costs that are unavoidable, even if the project is undertaken.  Externalities are side effects of a project that affect other firm cash flows.

(2)    Cash flows are based on opportunity cost:-  In other words, it is the cash flow that will be lost due to the financing of a project.  These are cash flows that are accumulated by assets the firm already owns and would be sunk if the project under consideration is undertaken.

(3)    The timing of cash flow is crucial:- because it is dependent on the time value of money.  Cash flow that is received now will be worth more in the future if it were to be received later.

PRINCIPLES OF CAPITAL BUDGETING

(4)    Cash flows are measured on an after tax basis:-  It is useless to measure cash flow before taxes because it is not its present value.  Firm’s value is based on cash flow that a firm gets to keep, not the money that is sent to the government.

(5)    Financing costs are reflected on project’s required rate of return:-  Rate of return is an aspect of financing that has potential risks.  Project’s that are expected to have a higher rate of return than their cost of capital will increase the value of the firm.

CAPITAL BUDGETING TECHNIQUES / METHODS

Payback period method Average rate of return method (ARR) Internal Rate of Return (IRR) Net present Value (NPV) Method Profitability Index (PI) Adjusted net present value Discounted benefit cost ratio Undiscounted benefit cost ratio Net terminal value Annual benefit cost ratio Net cost criterion Capital allocation Cut-off point

CAPITAL BUDGETING TECHNIQUES / METHODS

Payback period method:-This method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project.

Payback period = Cash outlay (investment) / Annual cash inflow

CAPITAL BUDGETING TECHNIQUES / METHODSAverage rate of return method (ARR)This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.

ARR= Average income/Average Investment

CAPITAL BUDGETING TECHNIQUES / METHODSInternal Rate of Return (IRR)This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment.It can be determined by solving the following equation:-

If IRR > WACC then the project is profitable.If IRR > k = acceptIf IR < k = reject

CAPITAL BUDGETING TECHNIQUES / METHODSNet present Value (NPV) MethodThis is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejectedThe equation for the net present value, assuming that all cash outflows are made in the initial year , will be:

CAPITAL BUDGETING TECHNIQUES / METHODSProfitability Index (PI)It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.

PI = PV cash inflows/Initial cash outlay A

PI = NPV (benefits) / NPV (Costs)

IMPORTANCE OF CAPITAL BUDGETING

 Long term investments involve risks: Capital expenditures are long term investments which involve more financial risks. That is why proper planning through capital budgeting is needed.

 Huge investments and irreversible ones: As the investments are huge but the funds are limited, proper planning through capital expenditure is a pre-requisite. Also, the capital investment decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall incur losses.

 Long run in the business: Capital budgeting reduces the costs as well as brings changes in the profitability of the company. It helps avoid over or under investments. Proper planning and analysis of the projects helps in the long run.

WHAT IS 'CAPITAL RATIONING'

Capital rationing is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget. Companies may want to implement capital rationing in situations where past returns of an investment were lower than expected.

TWO TYPES OF CAPITAL RATIONING

The first type of capital rationing is referred to as "HARD CAPITAL RATIONING." This occurs when a company has issues raising additional funds, either through equity or debt. The rationing arises from an external need to reduce spending, and can lead to a shortage of capital to finance future projects.The second type of rationing is called "SOFT CAPITAL RATIONING" or internal rationing. This type of rationing comes about due to the internal policies of a company. A fiscally conservative company, for example, may have a high required return on capital in order to accept a project, self-imposing its own capital rationing.

EXAMPLE OF CAPITAL BUDGETING:

Capital budgeting for a small scale expansion involves three steps: recording the investment's cost, projecting the investment's cash flows and comparing the projected earnings with inflation rates and the time value of the investment.

For example:- equipment that costs Rs15,000 and generates a Rs5,000 annual return would appear to "pay back" on the investment in 3 years. However, if economists expect inflation to rise 30 percent annually, then the estimated return value at the end of the first year ( Rs 20,000) is actually worth Rs15,385 when you account for inflation (Rs20,000 divided by 1.3 equals Rs15,385). The investment generates only Rs 385 in real value after the first year.

Conclusion:

According to the definition of Charles T. Hrongreen , “Capital Budgeting is a long-term planning for making and financing proposed capital outlays.”One can conclude that capital budgeting is the attempt to determine the future.