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Capital Budgeting

1) Capital budgeting is the process of evaluating and selecting long-term investment projects. It involves identifying potential investment opportunities, assembling investment proposals, making decisions, preparing budgets, implementing projects, and reviewing performance. 2) Projects are classified as mandatory, replacement, expansion, diversification, research and development, or miscellaneous. Investment criteria include net present value, internal rate of return, benefit-cost ratio, payback period, and accounting rate of return. 3) The internal rate of return is the discount rate that makes the net present value of a project equal to zero. It is considered the most popular method for evaluating projects in practice, though multiple methods are typically used

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66 views17 pages

Capital Budgeting

1) Capital budgeting is the process of evaluating and selecting long-term investment projects. It involves identifying potential investment opportunities, assembling investment proposals, making decisions, preparing budgets, implementing projects, and reviewing performance. 2) Projects are classified as mandatory, replacement, expansion, diversification, research and development, or miscellaneous. Investment criteria include net present value, internal rate of return, benefit-cost ratio, payback period, and accounting rate of return. 3) The internal rate of return is the discount rate that makes the net present value of a project equal to zero. It is considered the most popular method for evaluating projects in practice, though multiple methods are typically used

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nikhil6710349
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CAPITAL BUDGETING

By-
Nikhil Pandey(45)
Pradeep Singh(52)
Saurabh Garjola(69)
Shamina Easmin(72)
Surjeet Kumar(77)
Tarun Ahlawat(78)
Vikram Pratap Singh(83)
CAPITAL BUDETING

Capital budgeting means maximum utilization of


fund.

Through capital we learn different technique that helps to


invest capital in particular field.
CAPITAL BUDGETING PROCESS

• Identification of Potential Investment Opportunities

• Assembling of Investment Proposals

• Decision Making

• Preparation of Capital Budget and Appropriations

• Implementation

• Performance Review
PROJECT CLASSIFICATION

• Mandatory Investments

• Replacement Projects

• Expansion Projects

• Diversification Projects

• Research and Development Projects

• Miscellaneous Projects
INVESTMENT CRITERIA

INVESTMENT
CRITERIA

DISCOUNTING NON-DISCOUNTING
CRITERIA CRITERIA

NET BENEFIT INTERNAL ACCOUNTING


PAYBACK
PRESENT COST RATE OF RATE OF
PERIOD
VALUE RATIO RETURN RETURN
NET PRESENT VALUE

n Ct
NPV =  – Initial investment
t=1 (1 + rt )t
NET PRESENT VALUE
The net present value of a project is the sum of the present value of all the cash
flows associated with it. The cash flows are discounted at an appropriate discount
rate (cost of capital)
Naveen Enterprise’s Capital Project ( Cost of Capital=15%)
Year Cash flow Discount factor Present
value 
0 -100.00 1.000 -100.00
1 34.00 0.870 29.58
2 32.50 0.756 24.57
3 31.37 0.658 20.64
4 30.53 0.572 17.46
5 79.90 0.497 39.71
Sum = 31.96
  Pros Cons
• Reflects the time value of money • Is an absolute measure and not a relative
• Considers the cash flow in its entirety measure
• Squares with the objective of wealth maximisation
PROPERTIES OF THE NPV RULE

• NPVs ARE ADDITIVE

• INTERMEDIATE CASH FLOWS ARE INVESTED AT

COST OF CAPITAL

• NPV CALCULATION PERMITS TIME-VARYING


DISCOUNT RATES

• NPV OF A SIMPLE PROJECT AS THE DISCOUNT


RATE
BENEFIT COST RATIO
PVB
Benefit-cost Ratio : BCR =
I
PVB = present value of benefits
I = initial investment
To illustrate the calculation of these measures, let us consider a project which is being evaluated
by a firm that has a cost of capital of 12 percent.
Initial investment : Rs 100,000
Benefits: Year 1 25,000
Year 2 40,000
Year 3 40,000
Year 4 50,000
The benefit cost ratio measures for this project are:
25,000 40,000 40,000 50,000
(1.12)
+ (1.12)2
+ (1.12)3
+ (1.12)4
BCR = = 1.145 NBCR = BCR – 1= 0.145
100,000
Pros Cons
Measures bang per buck Provides no means for aggregation
INTERNAL RATE OF RETURN
Net Present Value

Discount rate

The internal rate of return (IRR) of a project is the discount rate that
makes its NPV equal to zero. It is represented by the point of intersection
in the above diagram
CALCULATION OF IRR
Year Cash Discounting Discounting Discounting
flow rate : 20% rate : 24% rate : 28%
Discount Present Discount Present Discount Present
factor Value factor Value factor Value

0 -100 1.000 -100.00 1.000 -100.00 1.000 -100.00


1 34.00 0.833 28.32 0.806 27.40 0.781 26.55
2 32.50 0.694 22.56 0.650 21.13 0.610 19.83
3 31.37 0.579 18.16 0.524 16.44 0.477 14.96
4 30.53 0.482 14.72 0.423 12.91 0.373 11.39
5 79.90 0.402 32.12 0.341 27.25 0.291 23.25

NPV = 15.88 NPV = 5.13 NPV = - 4.02


CALCULATION OF IRR

NPV at the lower rate


lower + X difference in rate
rate lower rate NPV-higher rate NPV

5.13
24% + 28% - 24% = 26.24%
5.13 + 4.02
PROBLEMS WITH IRR

• NON-CONVENTIONAL CASH FLOWS

• MUTUALLY EXCLUSIVE PROJECTS

• LENDING VS. BORROWING

• DIFFERENCES BETWEEN SHORT-TERM AND

LONG-TERM INTEREST RATES


PAYBACK PERIOD
Payback period is the length of time required to recover the initial
outlay on the project
Naveen Enterprise’s Capital Project
Year Cash flow Cumulative cash flow
0 -100 -100
1 34 - 66
2 32.5 -33.5
3 31.37 - 2.13
4 30.53 28.40
Pros Cons
• Simple • Fails to consider the time value
of money
• Rough and ready method • Ignores cash flows beyond the
for dealing with risk payback period
• Emphasises earlier cash inflows
AVERAGE RATE OF RETURN
Average PAT X 100
Average Investment

Naveen Enterprise’s Capital Project


Year Book Value of PAT
Investment(Beg)

1 100 14
2 80 17.5
3 65 20.12
4 53.75 22.09
5 45.31 23.57

1/5 (14+17.5 +20.12+22.09+23.57)


ARR = 1/5(100+80+65+53.75+45.31) = 28.31%
INVESTMENT APPRAISAL
IN PRACTICE

• Over time, discounted cash flow methods have gained in


importance and internal rate of return is the most
popular evaluation method.

• Firms typically use multiple evaluation methods.

• Accounting rate of return and payback period are


widely employed as supplementary evaluation methods.

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