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• AGENDA : 1) Capital Budgeting 2)Capital Budgeting process 3) Techniques of capital Budgeting 4) The cost of capital 5) Capital Budgeting extensions
Capital budgeting is the process of evaluating and selecting long term investments that are consistent with the goal of shareholders (owners ) wealth maximisation . Capital budgeting is the planning process used to determine a firms long term investments . Such as new machinery , replacement machinery, new products , R&D projects . Capital expenditure is an outlay of funds that is expected to produce benefits over a period of time exceeding one year These benefits may be either in the form of increased revenues or reduced costs . The term capital budgeting is otherwise called as investment appraisal .
• Sources of financing capital Budgeting Decision / Project finance : Capital budgeting decisions are financed using long term sources . The various types of long term sources are :• Equity capital ( Equity shares or ordinary shares )• Hybrid capital ( preference shares )• Debit capital ( Debentures / Bonds and Term loans )
• Stages of Capital Budgeting process : Planning Analysis : 1) Market analysis 2) Technical analysis 3) Financial analysis 4) Economic analysis 5) Ecological analysis Selection Implementation Review
Capital Budgeting Evaluation Techniques Non –discounting techniques Discounting techniques Ignores the time value of money Considers the time value of money3) Average Rate Return /Accounting 3) Net present value (NPV) rate of return (ARR) 2) Internal Rate of Return (IRR) 2) Pay back period (PBP) 3) Profit index or Benefit –cost Ratio (BCR)
Pay Back period : PBP is used as a first screening method , it gives an indication of rough measure of liquidity . Under this method accumulation of cash flows is made year after year until it meets the initial capital outlay ,to identify the recovery time of the capital amount invested. PBP = Initial investment Annual cash in flow1) If PBP > Target period – Accept the proposal2) If PBP < Target period – Reject the proposal3) If PBP = Target period -- Further analysis is required * Target period is the minimum period targeted by management to cover initial investment .
• ARR : Average Rate of Return : Average rate of return also known as accounting rate of return is defined as average cash inflows (Benefits) against unit investment ARR = Average cash inflows (Benefits ) * 100 Initial investment 1) If ARR > Target rate – Accept the proposal 2) If ARR < Target rate – Reject the proposal 3) If ARR = Target rate – Further analysis is required * Target rate is the minimum rate of return targeted by management ARR is otherwise called as return on capital employed method .
Discounting techniques : Under discounted cash flow techniques, the future net cash flows generated by a capital project are discounted to ascertain their present values . NPV: Net present value :Under NPV method future cash flows are discounted at minimum required rate of return of the project and then deduct it from initial out lay to arrive at the NPV of the project . NPV = PV (Benefits) – Initial investment 1) Accept if NPV > 0 2) Reject if NPV < 0 3) May accept or Reject if NPV = 0 n Ct Net Present Value = ∑ ---------t - C0 t=1 (1+k)
• IRR : Internal rate of return : IRR is a percentage discount rate used in capital investment appraisals which equates the present value of anticipated cash inflows with initial capital outlay . It is that discount rate at which NPV = 0 . Discount rate is ascertained by trail and error method . C 0 = C 1 + C 2 + C 3 + ….. C n (1+r) (1+r) 2 (1+r) 3 (1+r) n 1) Accept IRR > K 2) Reject IRR < K 3) May accept or Reject if IRR = K
Profitability index : The profitability index is the present value of an anticipated cash in flows divided by the initial investment . It is a method of assessing capital expenditure opportunities in the profitability index . Profitability index (pi) = Present value of cash inflows Present value of cash out flows This method is also called cost benefit ratio or desirability ratio