Capital Investment And Budgeting

Presentation on
Capital Investment : Meaning
and Types and Capital
Budgeting

Made by: SHUBHAM GOYAL
BBA(BE) 4561/10
BIRLA INSTITUTE OF TECHNOLOGY, NOIDA

Capital Investment : Definition
Funds invested in a firm or enterprise
for the purposes of furthering its
business objectives. Capital investment
may also refer to a firm's acquisition of
capital assets or fixed assets such as
manufacturing plants and machinery
that is expected to be productive over
many years.

Capital Investment : Types
 Physical Assets : are tangible
investments like
land, building, plant, machinery, vehicles,
and computers.
 Monetary Assets : are financial claims
against some parties.
Deposits, bonds, and equity shares are
examples of such assets.
 Intangible Assets : are not in the form of
physical assets or financial claims. They
represent outlays on research and
development, training, market
development, franchises, and so on and
are expected to generate benefits over a

Capital Investment :
Classification
 Strategic Investment : is one that has a
significant impact on the direction of the
firm. Tata Motor’s decision to invest in a
passenger car project may be regarded
as a strategic investment.
 Tactical Investment : is meant to
implement a current strategy as
efficiently or as profitably as possible. An
investment by Tata Motors to replace an
old machine to improve productivity
represents a tactical investment.

Capital Budgeting : Budgeting
Capital budgeting (or investment
appraisal) is the planning process used
to determine whether an organization's
long term investments such as new
machinery, replacement machinery, new
plants, new products, and research
development projects are worth
pursuing. It is budget for
major capital, or
investment, expenditures.

Capital Budgeting : Functions
 Generating investment project
proposals consistent with the firm’s
strategic objectives
 Estimating after tax-incremental
operating cash flows for the
investment projects
 Evaluating project incremental cash
flows
 Selecting projects based on a value-
maximizing acceptance criterion
 Continually re-evaluating implemented

Capital Budgeting : Phases
Planning

Analysis

Selection

Financing

Implementation

Review

Capital Budgeting : Methods
Many formal methods are used in capital
budgeting, including the techniques such
as :

o Accounting Rate of Return
o Payback Period
o Net Present Value
o Profitability Index
o Internal Rate of Return
o Modified Internal Rate of Return
o Equivalent annuity
o Real options valuation

Equivalent Annuity
The equivalent annual annuity (EAA)
approach calculates the constant
annual cash flow generated by a project
over its lifespan if it was an annuity. The
present value of the constant annual
cash flows is exactly equal to the
project's net present value (NPV). When
used to compare projects with unequal
lives, the one with the higher EAA
should be selected.

Accounting Rate of Return :
Definition
Accounting rate of return, also known
as the Average rate of return, or ARR is
a financial ratio used in capital
budgeting. The ratio does not take into
account the concept of time value of
money. ARR calculates the
return, generated from net income of
the proposed capital investment. The
ARR is a percentage return.

Accounting Rate of Return :
Formula
• ARR = Average profit / Average
Investment
• where Average Investment =
(Book value at beginning of year 1 +
Book value at end of useful life) / 2

Payback Period : Definition and
Formula
Payback period in capital budgeting refers to
the period of time required for the return on an
investment to "repay" the sum of the original
investment. Payback period is usually
expressed in years.
Start by calculating Net Cash Flow for each
year: Net Cash Flow Year 1 = Cash Inflow Year
1 - Cash Outflow Year 1. Then Cumulative
Cash Flow = (Net Cash Flow Year 1 + Net
Cash Flow Year 2 + Net Cash Flow Year 3 ...
etc.)
Accumulate by year until Cumulative Cash
Flow is a positive number: that year is the
payback year.

Payback Period : Definition and
Formula
 To calculate a more exact payback period :
Payback Period = Amount to be Invested /
Estimated Annual Net Cash Flow 1
 It can also be calculated using the formula:
Payback Period = (p - n)÷p + ny = 1 + ny - n÷p
Where
ny= The number of years after the initial
investment at which the last negative value of
cumulative cash flow occurs.
n= The value of cash flow at which the last
negative value of cumulative cash flow occurs.
p= The value of cash flow at which the first
positive value of cumulative cash flow occurs.

Net Present Value
 It is the difference between the
present value of cash inflows and the
present value of cash outflows.
 NPV is used in capital budgeting to
analyze the profitability of an
investment or project.

Profitability Index
It is an index that attempts to identify
the relationship between the costs and
benefits of a proposed project through
the use of a ratio calculated as:

Internal Rate of Return
 IRR can be used to rank several
prospective projects a firm is
considering. Assuming all other factors
are equal among the various
projects, the project with the highest
IRR would probably be considered the
best and undertaken first
 IRR is sometimes referred to as
"economic rate of return (ERR)

Modified Internal Rate of
Return
 While the internal rate of return (IRR) assumes
the cash flows from a project are reinvested at
the IRR, the modified IRR assumes that
positive cash flows are reinvested at the firm's
cost of capital, and the initial outlays are
financed at the firm's financing cost.
Therefore, MIRR more accurately reflects the
cost and profitability of a project.
 The formula for MIRR is:

Capital Investment And Budgeting

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Capital Investment And Budgeting