capital budgeting ani

8/4/2019 Capital Budgeting Ani

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Capital Budgeting

By

Prof. AnirbanCCIM, Blore


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Prof. Anirban, CCIM, Blore, Capital Budgeting

t

The investment decisions of a firm isgenerally known as the capital budgetingdecisions and it consists of the Long Termplanning for the proposed capital outlays

and their financing.t C/B may be defined as the firms decision

to invest its current funds most effectiveand efficient way in the long term assetsin anticipation of an expected flow ofbenefits over a series of years.

Capital Budgeting. What's that????


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Capital Budgeting Within The Firm

The Position of Capital Budgeting

Capital Budgeting

Long Term Assets Short Term Assets

Investment Decison

Debt/Equity Mix

Financing Decision

Dividend Payout Ratio

Dividend Decision

Financial Goal of the Firm:

Wealth Maximisation


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Examples of Long Term Assets


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Capital Budgeting. Features

t It has potentiality to anticipate a huge profit.

t It involves high degree of risk.

t Involves relatively a long period of time

between the initial outlay and the anticipated

returns.

t Involves the exchange of current funds (which

are invested in long term assets) for the future

benefits.t Future benefits will occur to the firm over a

series of time.


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Importance of C/B Decisions

t Growtht Risk

t Funding

t Irreversibility

t Complexity


7/25Prof. Anirban, CCIM, Blore, Capital Budgeting

Capital Budgeting. Process..

t

Identification of the potential investment opportunities.t Assembling of the proposed investments.

t Decision making.

t Preparation of the capital Budget and appropriation.

t Implementation Adequate formulation of the project.

Use of the principle of responsibility

Use of network techniques

t Performance Review



Investment Evaluation Criteria

t Three steps are involved in theevaluation of an investment:

Estimation of cash flows

Estimation of the required rate of return(the opportunity cost of capital)

Application of a decision rule for making

the choice



Modern orDiscounted Cash flow

method

C/B

Techniques

Traditional orNon Discounted Cash

flow method

ARR

PB PI

IRR

NPV



Net Present Value

t

NPV is the classic economic and generallyconsidered to be the best method for

evaluating capital investment proposals.

t

This is one of the discounted cash flow (DCF)techniques which explicitly recognize Time

value of Money.



Steps in NPV calculation

t Cash flows of the investment project should be

forecasted based on realistic assumptions.t Appropriate discount rate should be identified to

discount the forecasted cash flows. The appropriatediscount rate is the projects opportunity cost of

capital.t Present value of cash flows should be calculated using

the opportunity cost of capital as the discount rate.

t The NPV is the difference between the Total present

value of the Future Cash in Flows and Future cashoutflows.

t The project should be accepted if NPV is positive(i.e., NPV > 0).



Equation of NPV

31 2

02 3

0

1

NPV (1 ) (1 ) (1 ) (1 )

NPV(1 )

n

n

n

t

t

t

C CC C

Ck k k k

C

Ck



Acceptance Rule

t Accept the project when NPV is positive NPV > 0

t Reject the project when NPV is negative NPV< 0

t May accept the project when NPV is zero NPV = 0

t The NPV method can be used to select between

mutually exclusive projects; the one with the higher

NPV should be selected.


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Profitability Index

t

Profitability index

is the ratio of thepresent value of cash inflows, at the

required rate of return, to the initial cash

outflow of the investment.

t Criterion :

PI > 0 Implies Accept the project

PI < 0 Implies Reject the project

PI = 0 Implies the decision is indifferent


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Internal Rate of Return Method

t The internal rate of return (IRR) is the rate that equates the

investment outlay with the present value of cash inflow receivedafter one period. This also implies that the rate of return is thediscount rate which makes NPV = 0.

t i.e. PVCIPVCO = 0, i.e. PVCI = PVCO

t So IRR will be rate of return where NPV =0

t This rate is also called as the rate at which the expected inflowsbreak even with the cash outflows of the project.

t Some time IRR lies between two trial rates called Higher orUpper trial rate and Lower Trial rate. To calculate exact IRR wecan use the following interpolation formula.

t NPV at LTRt Exact IRR = LTR + x Diff. of trial

NPV at LTRNPV at HTR rates


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Acceptance Rule

t Accept the project whenr >k.t Reject the project whenr


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Average Rate of Return/ROI

t

The accounting ratio and return also known asthe ROI uses accounting information as revealed

by financial statements to measure the

profitability of the investment.

t The accounting rate of return is the ratio of theaverage after-tax profit divided by the average

investment. The average investment would be

equal to half of the original investment if it were

depreciated constantly.


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Contd

t ARR = [Average Return (PAT) / Average Invt]

t Where, AR = [Total Return / Time]

t

AI = [{Cost - Scrap} / 2] or[{Cost - Scrap } / 2} + Net W/C + Scrap Value


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Payback Period

t Payback is the number of years required to

recover the original cash outlay invested in aproject.

t If the project generates constant annual cashinflows, the payback period can be computed by

dividing cash outlay by the annual cash inflow.t PBP = [Initial Investment / Annual Cash Flows]

t Assume that a project requires an outlay of Rs50,000 and yields annual cash inflow of Rs 12,500

for 7 years. The payback period for the projectis:

50000 / 12500 = 4 years


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Payback Period

t Unequal cash flows In case of unequal cash

inflows, the payback period can be found out

by adding up the cash inflows until the total is

equal to the initial cash outlay.

t Suppose that a project requires a cash outlayof Rs 20,000, and generates cash inflows of

Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000

during the next 4 years. What is the projectspayback?

3 years + 12 (1,000/3,000) months

3 years + 4 months


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Acceptance Rule

t The project would be accepted if its paybackperiod is less than the maximum or standardpaybackperiod set by management.

t As a ranking method, it gives highestranking to the project, which has theshortest payback period and lowest rankingto the project with highest payback period.


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Payback Reciprocal and Rate of Return

t The reciprocal of payback will be a close

approximation of the internal rate of

return if the following two conditions are

satisfied:

The life of the project is large or at least twice

the payback period.

The project generates equal annual cashinflows.


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Capital Rationing

t Capital Rationing is the financialsituation in which a firm has only fixed

amount of allocate among competing

capital expenditure.

t It means a situation in which a firm has

more acceptable investments than it can

finance.


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Risk & Sensitivity Analysis

t Sensitivity analysis is a behavioral

approach that uses a number of possible

values for a given variable to assess its

impact on a firms returns.

t It provides different cash flow estimates

under three assumptions:

The worst i.e. most pessimistic

The expected i.e. most likely The best i.e. the most optimistic


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Prof Anirban CCIM Blore Capital Budgeting

Any

Questions

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capital budgeting ani

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