Download - capita budgeting-18-1-2011
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- Long term planning for proposed capital
outlays and their financing.
CAPITAL BUDGETING
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DEFINITION:
Capital Budgeting decision may be defined as
the firms decision to invest its current fund
more efficiently in long-term activities in
anticipation of an expected flow of future
benefit over a series of years.
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Capital Budgeting is a complex process which may
be divided into the following phases :-
y Identification of potential investment opportunities.
y Assembling of proposed investments.
y Decision Making
y Preparation of Capital Budget and appropriations
y Implementation
y Performance Review.
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BASIC FEATURES OF CAPITAL BUDGETING
DECISIONS :-
y Current funds are exchanged for future benefits;
y Investment in long-term activities; and
yFuture benefits will occur to the firm over series
of years.
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Whatarethe factorsthat giveriseto
the need forcapital investments ?
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y Wear and tear of old equipments.
y Obsolescence.
y Variation in product demand necessitating change in
volume of production.
y Product improvement requiring capital additions.
y Learning-curve effect.
y Expansion
y Change of plant site.
y Diversification.
y Productivity improvement.
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IMPORTANCE OF CAPITAL BUDGETING :-
y Long-term implications;
y Involvement of large amount of funds;
y Irreversible decisions;
y Risk and uncertainty;
y Difficult and Complicated exercise.
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INVESTMENT DECISION MAKING
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FACTORS INFLENCING INVESTMENT DECISION:-
y Management outlook;
y Competitors Strategy;
y Opportunities created by technological change;
y Market forecast;
y Fiscal incentives;
y Cash flow budget;
y
Non-Economic factors.
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Rationaleof Capital Budgeting Decisions:-
The main rationale is EFFICIENCY.
The main objective of the firm is to maximize profit
either by way of increased revenue or by cost
reduction.
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KINDS OF
CAPITAL BUDGETING DECISIONS
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Business firmsare generallyconfronted with
these 3 typesof Capital Budgeting Decisions:
y Accept Reject decisions
y Mutually exclusive decisions
y Capital Rationing decisions
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ACCEPT-REJECT DECISIONS :
If the proposal is accepted, the firm incurs the
investment and not otherwise.
Broadly, all those investment proposals which yield a
rate of return greater than cost of capital are accepted
and the others are rejected.
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MUTUALLY EXCLUSIVE DECISIONS :
It includesallthoseprojects whichcompete with
eachother in a way,thatacceptanceof one
precludestheacceptanceof otherorothers.
Thus,sometechniquehasto be used forselecting the
bestamong allandeliminatesotheralternatives.
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CAPITAL RATIONING DECISIONS :
Referstothesituations wherethe firmhavemore
acceptable investmentsrequiring greateramountof
financethan isavailable withthe firm.
It isconcerned withtheselection of a groupof
investmentsoutof many investmentproposals
ranked in thedescending orderof therateof return.
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In evaluating acapitalexpenditureproposal, 2
broadphasesare involved:-
yDefining the stream of costs and benefits
associated with the investment, and
yAppraising the stream of costs and benefits to
determine the worthwhileness of the investment.
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In defining the costs and benefits of a capital
expenditure proposal, the following principles must be
borne in mind:-
y Cash Flow Principle
y post-tax Principle
y incremental Principle
y long-term funds Principle
y interest exclusion Principle.
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To evaluate the stream of costs and benefits, several
appraisal criteria have been suggested. The important
ones are as follows:-
y Payback Period
y Average Rate of Return
y Net Present Value
y Benefit Cost Ratio
y Internet Rate of Return.
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The NET PRESENT VALUE of a project is equal to the
sum of the present values of all the cash flows(outflows
and inflows) associated with the project.
A Project is acceptable if its net present value exceeds
zero.
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The BENEFIT COST RATIO,also referred to as
Profitability Index, is defined as :
Present Value of BenefitsPresent Value of costs
A project is acceptable if its Benefits Cost Ratio > 1.
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The INTERNAL RATE OF RETURN ,of a project is the
discount rate which makes its net present value = 0.
A project is acceptable if its IRR > the cost of capital.
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The PAYBACK PERIOD ,is the length of time required
to recover the initial cash outlay on the project.
According to this criterion, a project is acceptable if its
payback period is less than a certain specified
Payback Period.
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The AVERAGE RATE OF RETURN ,also called the
Accounting Rate of Return, may be defined as :-
Profit after taxes
Book Value of the investment
Project is acceptable if its ARR exceeds certain cut-off
rate of return.
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CHOICE OF METHODS
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Business enterprise is confronted with large number of
investment criteria for selection of investment
proposals. It should like to choose the best among all.
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If a choice is to be made, the NET PRESENT
VALUE method generally is considered to be
superior theoretically because :-
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y It is simple to operate as compared to InternalRate of Return method ;
y It does not suffer from the limitations of multiplerates;
y The reinvestment assumption of the Net PresentValue Method is more realistic than internal
Rate of Return Method.
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On the other hand, some scholars have
advocated for Internal Rate of Return method on
the following grounds :
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y It is easier to visualize and to interpret as
compared to Net Present Value method;
y It suggests the max. rate of return and even in
the absence of cost of capital, it gives goodidea of the projects profitability.
y The IRR method is preferable over NPV methodin the evaluation of risky projects.
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A wide variety of measures are used in practice for
appraising investments. These include measures
suggested by capital budgeting literature and several
non-standard measures.
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The most commonly used method for evaluating small-
size investments is the payback method.
For larger investments, the Average Rateof Return
and, in more recent years, discounted cash flow
methods are commonly employed.
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ANY QUESTIONS?ANY QUESTIONS?
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