Capital budgeting and it's strategies.pptx

Everything related to capital budgeting

1. Capital Budgeting

2. Learning Outcome: After this lecture students will be able to Understand meaning of Capital budgeting Understand importance of Capital budgeting Decisions Understand Types of Capital Budgeting Decisions Evaluate Payback Period, Accounting Rate of Return, Net Present Value, IRR and Profitability index

3. Investment Decisions The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. A capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years.

4. The long-term assets are those that affect the firm’s operation beyond the one-year period. The firm’s investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. 

5. M ean i n g T h e p r o ces s t h r oug h w h i c h d i ff e r e n t p r o j ec ts are evaluated is known as capital budgeting C ap i t a l b udge t i n g i s de f i n e d “ a s t h e f i r m ’s formal process for the c a p i t a l . It a cqu isi t i o n involves an d f i r m ’s in ves t m e nt decisions of t o in ves t addition, disposition, modification i t s c u rr e n t f u nd s f o r an d replacement of fixed assets”. “Capital budgeting is long term planning for making and financing proposed capital outlays”- Charles T Horngreen.

6. Significance of capital budgeting The success and failure of business mainly depends on how the available resources are being utilised. They influence the firm growth in long run These types of decisions are exposed to risk and uncertainty. They involve commitment of larger amount of funds They are irreversible, or reversible at substantial loss C a p i tal r at i on i ng g i ves s uff i c i ent s cope f o r t h e financial manager to evaluate different proposals and only viable project must be taken up for investments. It helps the management to avoid over investment and under investments

7. Methods of capital budgeting Traditional methods Payback period Accounting rate of return method Discounted cash flow methods Net present value method Profitability index method Internal rate of return

8. Payback period method It is one of the most popular and widely recognized traditional methods of evaluating investment proposals Payback is the number of years required to recover the original cash outlay invested in a project Payback Period = I nitial investment ------------------------- Annual cash inflow They compare the project’s payback with a predetermined standard payback The project would be accepted if its payback period is less than the maximum or standard payback period set by management.

9. Evaluation of payback Merits: Simplicity Cost effective Short-term effect: be setting up a shorter standard payback Risk shield Demerits: Cash flows ignored Timing of cash flows Inconsistent with shareholder value

10. Accounting rate of return The accounting rate of return is also known as return on investment (ROI) It uses accounting information as revealed by financial statement to measure the profitability of an investment The accounting rate of return is the ratio of the average after tax profit divided by the average investment ARR = Average Income ( earnings after taxes ) -------------------------------------------------- Average Investment ( book value of investment in the beginning & book value of investment at the end of n number of years)

11. Evaluation of ARR method Merits: Simplicity Accounting data Accounting profitability Demerits Cash flows ignored Time value ignored In this method ranks a Project as number one, if it has highest ARR, and lowest rank is assigned to the project with the lowest ARR.

12. Net present value method It is considered as the best Discounted cash flow method of evaluating the capital investment proposal. It recognises the impact of time value of money It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalents- present value are found out.

13. Steps involved in the calculation of NPV Cash flows of the investment project should be forecasted based on realistic assumption Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is project’s opportunity cost of capital Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate Net present value should be found out by subtracting present value of cash inflows from present value of cash outflow The project should be accepted if NPV is positive ( i.e , NPV > 0)

14. Acceptance rule Accept the investment project if its NPV is positive (NPV>0) Reject the project when NPV is negative (NPV<0) May accept the project when NPV is zero (NPV=0) The positive NPV will result only if the project generates cash inflows at a higher than the opportunity cost of capital A zero NPV implies that project generates cash flows at a rate just equal to opportunity cost of capital

15. Evaluation of NPV method Merits: Time value Measures of true profitability Shareholder value Demerits: Cash flow estimation Discount rate Mutually exclusive projects

16. Internal rate of return method It is another discounted cash flow technique which takes into account of the magnitude and timing of cash flows It is that rate at which the sum of discounted cash inflows equals the sum of discounted cash outflows It is the rate at which present value of the investment is zero It is called internal rate because it depends mainly on the outlay and proceeds associated with the projects and not any rate determined outside the investment

17. Calculating IRR Select any discount rate to compute the present value of cash inflows If the calculated present value of expected cash inflow is lower than the present value of cash outflows a lower rate should be tried On the other hand higher value should be tried if the present value of inflows is higher than the present value of outflows This process will be repeated unless the net present value becomes zero.

18. Acceptance rule Accept the project if its internal rate of return is higher than the opportunity cost of capital (r> k) Reject the project when (r< K) May accept the project when (r=k)

19. Profitability index Another time adjusted method of evaluating the investment proposals is the benefit-cost ratio or profitability index It is the ratio of the present value of cash inflows at the required rate of return to the initial outlay of the investment PI = PV of cash inflows -------------------------- Initial cash outlay Acceptance Rule: Accept the project PI is greater than one (PI>1) Reject the project when PI is less than one (PI<1) May accept the project when PI is equal to 1 (PI=1 )