CAPITAL BUDGETING

Meaning of Capital Expenditure

It is the process of making investment decisions in capital expenditures. A capital exp.- May be defined as an expenditure the benefits of which are expected to be received over a period of time exceeding one year.

It may be in the form of following: Cost of acquisition of permanent assets as land and building, plant & machinery, goodwill etc.

Cost of addition, expansion, improvement or alteration in the fixed assets. Cost of replacement of permanent assets.

IMPORTANCE OF CAPITAL BUDGETING

IMPORTANCE
Difficulties of Investment Decisions Large Investments

Long term Effect on Profitability Irreversible nature

Long-term commitment of funds

CAPITAL BUDGETING PROCESS

IDENTIFY REVIEW INVESTMENT PERFORMANCE PROPOSAL REVIEW PERFORMENCE SCREEN PROPOSAL

PROCESS
IMPLEMENT THE PROPOSAL
FINAL APPROVAL FIX PRIORITIES EVALUATE VARIOUS PROPOSALS

KINDS OF CAPITAL BUDGETING OR EVALUATION OF INVT PROPOSALS

ACCEPT REJECT DECISIONS

CAPITAL RATIONING DECISION

MUTUALLY EXCLUSIVE PROJECT DECISIONS

CAPITAL BUDGETING TECHNIQUES

TRADITIONAL METHODS
PAY- BACK PERIOD METHOD: The Pay-Back period method is that method in which the total investment in permanent assets pays back itself. the pay-back period can be ascertained in the following manner: 1) Calculate annul of the net earning (profit) before depreciation and after taxes these a called annual cash inflows. 2) Divide the initial outlay (cost) of the project by the cash inflow, where the project generates constant annual cash inflows. Pay Back Period = Cash outlay of the project or the original cost / Annual cash inflows
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ADVANTAGES

Simple And Easy To Understand Saves in cost, requires lesser time Shorter pay back is preferred to the longer pay back period and it reduces the lost. Suitable for the shorter firm

DISADVANTAGES

Does not take into account the after pay back period inflows. Ignores the time value of money. Does not consider the cost of capital A subjectible decision Treats each asset individually. Does not measure the actual profitability.

Pay- Back Reciprocal Method

It is employed to estimate the Internal rate of return: Pay back reciprocal = Annual Cash Inflow Total Invt. Applied only when: Equal cash inflows are there The project has a long life.

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Post pay Back Period Method

Under this method the post pay back period is considered. Due to the limitation of Pay back period method the project having the greater post pay back period is to be considered

Discounted Pay back Method

Under this method the present value of cash inflows and outflows is calculated at an appropriate discounted rate. the time period in which the present value of inflows equates the present value of outflows is the discounted pay back period.

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RATE OF RETURN METHOD

AVERAGE RATE OF RETURN ARR = Average annual profits Net Invt in the project

Average annual profits= Total profits (after dep and taxes) No of years RETURN PER UNIT OF INVT.

Return per unit of invt.= TOTAL PROFITS (after dep. and taxes) * 100 Net Invt in the project

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? To solve.

A project requires an invt of Rs 5,00,000 and has a scrap value of Rs 20000 after 5 yrs. It is expected to yield a profit after dep. And taxes during 5 yrs amounting to Rs 40000, 60000, 50000 and 20000. Calculate the average rate of return.

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RETURN ON AVERAGE INVT METHOD:

Here we use the average invt for the purpose of return on invt is preferred RETURN ON AV INVT METHOD.= Total profits (after dep and taxes) Average Invt.

Average Return On Average Invt Method: ARAI = Average annual Profit (after dep and Taxes) Average Investment ( Net Invt/ 2)

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Eg:
A machine costs 100000 Rs and has no scrap value after 5 years. It is depreciated on straight line method: Beginning of the first year: 100000 At the end of 2nd year: 80000 At the end of 3rd year: 60000 At the end of 4th year: 40000 At the end of 5th year: 20000 At the end of 6th year: -

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ACCEPT REJECT CRITERIA in ARR

As an accept/ reject rule the ARR would be compared with the predetermined or a minimum required rate of return or cut off rate A project will be qualify if actual ARR is higher than the minimum desired ARR Otherwise rejected. Or ranking method can be followed.

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EVALUATION OF ARR METHOD

Easy Calculation Simple to understand and easy to use Total benefits associated with the project are taken into account.

But a coin has always two sides, so here ARR has some deficiencies also, as

it uses accounting income rather then cash inflows. it ignores time value of money. it does not differentiate between size of investment.

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ANNUITY TABLE
Year 1 2 3 4 5%
0.952 1.859 2.723 3.546

6%
0.943 1.833 2.676 3.465

8%
0.926 1.783 2.577 3.312

10%
0.909 1.736 2.487 3.17

12%
0.893 1.69 2.402 3.037

14%
0.877 1.647 2.322 2.914

5
6 7 8

4.33
5.076 5.786 6.463

4.212
4.917 5.582 6.21

3.993
4.623 5.206 5.747

3.791
4.335 4.868 5.335

3.605
4.111 4.564 4.968

3.433
3.889 4.288 4.639

9
10

7.109
7.722

6.802
7.36

6.247
6.71

5.759
6.145

5.328
5.65

4.946
4.216

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