Capital Budgeting.pptx

a process that businesses use to evaluate potential major projects or investments
We shall learn about Capital Budgeting and all the details related to it in this article:

What is Capital Budgeting in detail
Features of capital budgeting
Understanding capital budgeting and how it works
Techniques/Methods of capital budgeting with Examples
Process of capital budgeting
Factors affecting capital budgeting
Objectives
Limitations of capital budgeting

1. Capital Budgeting

2. INTRODUCTION:- Capital project planning is the process by which companies allocate funds to various investment projects designed to ensure profitability and growth. Evaluations of such projects involve estimating their future benefits to the company and comparing these with their costs.

3. MEANING AND DEFINITION Capital budgeting refers to planning the deployment of available capital for the purpose of maximizing the long term profitability of the firm. It is the firm’s decision to invest its current funds most efficiently in long term activities in anticipation of flow of future benefits over a series of years. “capital budgeting is the process to identify, analysis and select investment projects, whose returns(cash flows) are expected to extend beyond one year. ”

4. “ Capital budgeting consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern” – Lynch

5. What are the Features of Capital Budgeting? Features/nature/ Characteristics of Capital Budgeting Huge Funds : Capital budgeting involves the investment of funds currently for getting benefits in the future. High Degree of Risk : To take decisions that involve a huge financial burden can be risky for the company. Affects Future Competitive Strengths : The future benefits are spread over several years. Sensible investing can improve its competitiveness, whereas a wrong investment may lead to business failure.

6. Difficult Decision : When the future is dependant on capital budgeting decisions, it becomes difficult for the management to grab the most appropriate investment opportunity. Estimation of Large Profits : Each project involves a huge amount of funds with the perspective of earning desirable profits in the long term. Long Term Effect : The effect of the decisions taken, will be visible in the future or the long term. Affects Cost Structure : For instance, it may increase the fixed cost such as insurance charges, interest, depreciation, rent, etc. Irreversible Decision : Capital expenditure decisions are irreversible since it involves a high-value asset which may not be sold at the same price once purchased.

7. Objectives of Capital Budgeting Control of Capital Expenditure : Estimating the cost of investment provides a base to the management for controlling and managing the required capital expenditure accordingly. Selection of Profitable Projects : The company has to select the most suitable project out of the multiple options available to it. For this, it has to keep in mind the various factors such as availability of funds, project’s profitability, the rate of return, etc. Identifying the Right Source of Funds : Locating and selecting the most appropriate source of funds required to make a long-term capital investment is the ultimate aim of capital budgeting. The management needs to consider and compare the cost of borrowing with the expected return on investment for this purpose.

8. Generation and Screening of a project idea Generation and Screening of a project idea begins when someone with specialized knowledge or expertise or some other competence feels that he can offer a product or service ♦ Which can cater to a presently unmet need and demand ♦ To serve a market where demand exceeds supply ♦ Which can effectively compete with similar products or services due to its better quality/price etc.

9. An organization has to identify investment opportunities which are feasible and promising before taking a full fledged project analysis to know which projects merit further examination and appraisal. Generation and Screening of a project idea involves the following tasks :-

10. Generation of ideas – A panel is formed for the purpose of identifying investment opportunities. It involves the following tasks which must be carried out in order to come up with a creative idea. (a) SWOT analysis – Identifying opportunities that can be profitably exploited (b) Determination of objectives – Setting up operational objectives like cost reduction, productivity improvement, increase in capacity utilization, improvement in contribution margin.

11. (c) Creating Good environment – A good organizational atmosphere motivates employees to be more creative and encourages techniques like brainstorming, group discussion etc. which results in development of creative and innovative ideas. (2) Monitoring the Environment – An Organization should systematically monitor the environment and assess its competitive abilities in order to profitably exploit opportunities present in the environment. The key sectors of the environment that are to be studied are :- (a) Economic Sector – It includes, State of economy, Overall rate of Growth, Growth of primary, secondary and tertiary sectors, Inflation rate, Linkage with world economy, BOP situation, Trade Surplus / Deficit. (b) Government Sector – It includes, Industrial policy, Government programmes and projects, Tax framework, Subsidies, incentives,concessions , Import and export policies,Financing norms.

12. (c) Technological Sector – It includes, State of technology, Emergence of new technology, Receptiveness of the industry, Access to technical know how. (d) Socio-demographic sector –It Includes, Population trends, Income distribution, Educational profile, Employment of women, Attitude towards consumption and investment. (e) Competition Sector –It includes, No. of firms and their market share, Degree of homogeneity and production differentiation, Entry barriers, Marketing policies and prices, Comparison with substitutes in terms of quality/price/appeal etc.

13. (f) Supplier Sector – Availability and cost of raw material, energy and money (3) Corporate Appraisal – It involves identification of corporate strengths and weaknesses. The important aspects that are to be considered are:- (a) Market and Distribution – i. Market Image ii. Market share iii. Marketing and Distribution cost iv. Product line v. Distribution Network vi. Customer loyalty (b) Production and Operations – i. Condition and capacity of plant and machinery ii. Availability of raw materials and power iii. Degree of vertical integration iv. Location advantage v. Cost structure – Fixed and Variable costs

14. (3) Corporate Appraisal – It involves identification of corporate strengths and weaknesses. The important aspects that are to be considered are:- (a) Market and Distribution – i. Market Image ii. Market share iii. Marketing and Distribution cost iv. Product line v. Distribution Network vi. Customer loyalty (b) Production and Operations – i. Condition and capacity of plant and machinery ii. Availability of raw materials and power iii. Degree of vertical integration iv. Location advantage v. Cost structure – Fixed and Variable costs

15. (c) Research and Development – i. Research capabilities of a firm ii. Track record of new product developments iii. Laboratories and testing facilities iv. Coordination between research and other of departments the organization (d) Corporate Resources and Personnel – i. Corporate Image ii. Clout with government and regulatory agencies iii. Dynamism of top management iv. Competence and commitment of employees v. State of industrial relations

16. (e) Finance and Accounting – i. Financial leverage and borrowing capacity ii. Cost of capital iii. Tax situation iv. Relations with shareholders and creditors v. Accounting and control system vi. Cash flows and liquidity

17. Tools for identifying investment opportunities (a) Porter 5 forces Model → It helps in analyzing profit potential of an industry depending upon strength of – i. Threat of new entrants ii. Rivalry amongst existing companies iii. Pressure from substitute products iv. Bargaining power of buyer v. Bargaining power of seller

18. (b) Life cycle Approach → There are four stages a product goes through during his life cycle each stage represents different investment and net profit value (a) Pioneering Stage – In this stage the technology and product is new, there is high competition and very few entrants survive this stage. (b) Rapid Growth Stage – This stage witnesses a significant expansion in sales and profit. (c) Maturity Stage – It marks developed industries with mature product and steady growth rate. (d) Decline Stage – Due to introduction of new products and changes in customer preference the industry incur a decline in market share and profits. (c) Experience Curve Experience curve analyzes how cost per unit changes with respect to accumulated volume of production. Investment must be such that reduces costs.

19. (4) Looking for Project Ideas – Various sources to look for good project ideas include:- i. Trade fairs and exhibitions ii. Studying Government plans and guidelines iii. Suggestion of financial institutions and development agencies iv. Investigating local materials and resources v. Analyzing performance of existing industries vi. Analyzing social and economic trends vii. Analyzing new technological developments viii. Studying the consumption pattern of people abroad ix. Stimulating creativity to produce new ideas x. Reducing exports and imports

20. (5) Preliminary Screening – It refers to elimination of project ideas which are not promising. The factors to be considered while screening for ideas are:- ♦ Compatibility with the promoter – The idea must be consistent with the interest,personality and resources of entrepreneur. ♦ Consistency with Government priorities – The idea must be feasible with national goals and government regulations. ♦ Availability of inputs – Availability of power, raw material, capital requirements,technology . ♦ Adequacy of Market – Growth in market, prospect of adequate sale, reasonable Return on Investment. ♦ Reasonableness of cost – The project must be able to make reasonable profits with respect to the costs involved.

21. (7) Sources of the Net Present Value In order to select a profitable and feasible project, a project manager must carry out a fundamental analysis of the product and factor market to know about entry barriers which lead to positive net present value. There are six entry barriers which result in a positive NPV project. They are – i. Economies of scale ii. Product differentiation iii. Cost advantage iv. Marketing reach v. Technological edge vi. Government policy

22. Acceptability of risk level – The desirability of the project also depends upon risks involved in executing it. In order to access risk the following factors must be considered:- -Project`s vulnerability to business cycles -Change technology -Competition from substitutes -Government`s control over price and distribution -Competition from imports

23. (6) Project Rating Index → It is a tool used for evaluating large number of project ideas. It helps in streamlining the process of preliminary screening. Hence a preliminary evaluation may be converted in project rating index. Steps to calculate project rating index→ I. Identifying the factors relevant for project rating II. Assigning weights to these factors according to their relative importance(FW) III. Rate the project proposal on various factors using suitable rating scale (FR) (5 point scale or 7 point scale) IV. For each factor multiply the factor rating with factor weight to get factor scores (FR X FW = FS) V. All the factor scores are added to get the overall project rating index. Organization determines a cut off value and the project below this cut off value are rejected.

24. (8)Entrepreneurial skills → An individual must possess the following traits and qualities in order to be a successful entrepreneur – i. He must be Willing to make sacrifices ii. He must be a good Leader iii. He must be able to make quick and rational decisions iv. He must have confidence in the project v. He must able to exploit market opportunities vi. He must have strong ego in order to survive ups and downs of a business

25. Capital Budgeting technique CAPITAL BUDGETING Discount cash flow technique Traditional Technique Payback Period Method Accounting Rate of Return Net Present Value Internal Rate of Return Profitability Index

26. Traditional Method Pay back period Method: the pay back period is the length of time require to recover the initial cash outlay on the project. It can be calculated as follow: Payback period = Cash outlay Annual cash inflow The method can be understood as follow : If a project involves a cash outlay of Rs 6,00,000 and generates cash inflow of Rs. 1,00,000, Rs 1,50,000, Rs. 1,50,000 and Rs 2,00,000 in the first, second, third and fourth Year respectively

27. A project which has an annual cash outlay Rs 10,00,000 and a constant annual cash inflow of Rs 3,00,000 has a pay back period = 10,00,000/3,00,000 = 3(1/3) year Example :- Advantages : It is a ready method, both in concept and application. It does not use involved concepts and tedious calculations assumptions. and has few hidden Since it emphasizes earlier cash inflows, it may be sensible criterion when the firm is pressed with problems of liquidity . It is a rough and ready method for dealing with risk. It favors projects which generate substantial cash inflows in earlier years and discriminates against projects which bring substantial cash inflows in later years but not in earlier years.

28. Disadvantages: A company can have more favourable short-run earnings for share by selling up a shorter pay back period. It however, be remembered that this may not be a wise long term policy as the company may have to sacrifice its future growth for current earnings . The emphasis in pay back is on the early recovery of the investment. Thus, it give an insight to the liquidity of the project. The funds so released can be put to other uses . The riskiness of the project can be tackled by having a shorter pay back period as it may ensure guarantee against loss. Company has to invest in many such projects where the cash inflows and life expectancies are highly uncertain

29. Practical Problems 1. A Project cost Rs 100000 and yield an annual cash inflow of Rs 20,000 for eight years. Calculate the pay back period. 2. There are two project X and Y . Each project requires an investment of Rs 20,000. you are require to rank these projects according to the payback period method from the following information Years Net Profit before depreciation and after tax Project “x” Project “y” 1 st 1000 2000 2 nd 2000 4000 3 rd 4000 6000 4 th 5000 8000 5 th 8000 -----

30. Sollution Answer 1. Payback period = Initial outlay of the project Annual Cash flow = 1,00,000/20,000 = 5 years Answer : 2 The payback period for project X is 5 year (Rs 1000+2000+4000+5000+8000) = 20000 The payback period for project Y is 5 year (Rs 2000+4000+6000+8000) = 20000 Hence project y should be preferred or rank first.

31. Accounting Rate of Return Technique (ARR) Accounting Rate of Return Technique (ARR): Also called as average rate of return is primarily based on accounting approach rather than cash flow approach. The accounting rate of return is found out by dividing the average income after taxes by average investment . ARR = Average Income after taxes Average Investment or Average income after taxes Original investment + salvage value 2

32. Question : A project require an investment of Rs 500000 and has a scrap of Rs 20000 after 5 years. It is expected to yield profit after depreciation and taxes during the five years accounting to Rs 40,000, Rs 60000, Rs 70000, Rs. 50000 and Rs 20000. calculate the average rate of return on the investment . Solutaion Totalprofit =40,000+60,000+70,000+50,000+20,000 =2,40,000 Average profit = 240000/5 =48,000 Net investment project =5,00,000-20,000 =4,80,000 Average rate of return = (Average annual profit/ Net investment in project )*100 = (48,000/480000)*100 = 10%

33. Merits: 1. Net earnings after depreciation are considered under this method and this of vital importance in the appraisal of investment proposals . 2 . It is an easy method to adopt and simple to understand. 3 . It considers the earnings over the life span of the project and as such superior to pay back method. Dem erits : 1. This method like the pay back method does not consider the time value of money . 2 . It does not differentiate between the size of investment required for investment proposals. Investment proposals may have the same ARR but may require different average investment. In such a situation the method is of no use for the firm can not precisely decide on the implementation of any specific proposal.

34. Modern Method Net Present Value (NPV )Method: This method is one of the discounted cash flow technique that takes into consideration the time value of money. It recognizes that cash flow streams at different time periods differ in value and can be compared only when they are expressed in terms of a common denominator i.e. present values. Discounted cash flow technique Net Present Value Internal Rate of Return Profitability Index

35. Procedure for calculating NPV: The process of calculating NPV is as follows: The annual net cash flow expected from a project is calculated by estimating all cash receipts and deducting from them all expenditure arising out of the project. The net cash flow is then discounted to give its present value. The rate used to discount the cash flow is required rate of return i.e. the minimum rate of return expected to be earned from the investment projects. The NPV of an investment proposal is then computed. It is equal to the sum of the present value of its annual net cash flows after tax less the investment's initial outlay.

36. NPV = Rt (1+i) t NPV = net present value Rt = net cash flow at time t i = Discount rate t = Time of the cash flow Thus , the NPV method is the process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the opportunity cost of capital as the appropriate discounting rate, and finding out the net present value by subtracting out the present value of cash outflows from the present value of cash inflows.

37. Features of NPV Method: 1. The NPV of simple project monotonically decreases as the discount rate increases. The decrease in the NPV, however, is at a decreasing rate . 2 . The NPV method is based on the assumption that the intermediate cash inflows of the project are re-invested at a rate of return equal to the firm's cost of capital. Merits 1. It considers the cash flow stream in its entirety . 2 . The net present value of various projects measured as they are in today's rupees can be added. For example, the net present value of a package consisting of two projects, A and B will simply be the sum of the net present value. 3 . It takes into account the time value of money . 4 . It squares neatly with the financial objective of maximization of the wealth of stockholders. The net present value represents the contribution to the wealth of stockholders.

38. Internal Rate of Return (IRR) Method It is another DCF technique which takes into account the time value of money. This technique is also known as yield on investment, marginal productivity of capital, time adjusted rate of return, marginal efficiency of capital, rate of return etc .