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“Capital Budgeting is an Art of Funding Assets that are worth more than they cost to
achieve a predetermined Goal” i.e. Optimising the wealth of the Business Enterprise.
The Capital Budgeting involves a current outlay or series of outlays of cash resources in
return for an anticipated flow of future benefits. In other words, the system of Capital
Budgeting is employed to evaluate expenditure decisions which involves current outlays
but are likely to produce benefits over a period of longer than one year. These benefits
may be either in the form of increased revenues or reduction in cost.
FEATURES:
3. EXPANSION PROJECT
B) Do SWOT analysis
5. IMPLEMENTATION
6. FOLLOW-UP
METHODS OF EVALUATION
METHODS OF EVALUATION
TRADITIONALMODERN
Therefore,
Initial investment
Pay back period = ------------------------
Annual cash inflow
CONCLUSION:
In the above example project C has the shortest pay back and is more desirable.
ADVANTAGES
1. SIMPLE METHOD
This is the most simple method very easy and clear to understand. This does not
involve tedious mathematical calculation.
3. CONSERVATIVE PRINCIPLES
This method makes it clear that no profit arises till the pay back period is over.
This helps the new companies they should start paying dividends.
LIMITATIONS:
FOR EXAMPLE:-
In the above example project ‘A’ is having short pay back that must be accepted but is
does not give return afterwards but project ‘B’ gives constant returns even after its pay
back period. So on the whole project ‘B’ is profitable still ‘A’ is accepted under this
method.
Thus cash inflow after pay back period is ignore.
3. PROFITABILITY
The pay back period method does not take into account the measure of
profitability. It is only concerned with the projects capital recovery.
4. TIME VALUE OF MONEY
This method does not consider time value of money i.e. it ignores the interest
which is an important factor in making sound investment decisions. A rupee
borrowed tomorrow is worth less than a rupees today.
Ex. There are projects A & B the cost of the project is Rs.30000 in each case.
Year Cashinflow
Project ‘A’ Project ‘B’
1 Rs.10000 Rs.2000
2 Rs.10000 Rs.4000
3 Rs.10000 Rs.24000
In both the cases the pay back period is 3 years however project ‘A’ should be
preferred as compared to project ‘B’ because of speedy recovery of the initial
investment.
CONCLUSION:
NOTE: If the sum states that return is to be calculated on the original investment them
instead of Average Investment, cost itself is to be considered.
MERITS:
1) SIMPLE AND EASY TO CALCULATE
2) Consider income from the project throughout its life & not just the initial years
unlike payback period.
3) When a number of capital investments proposals are considered, a quick decision
can be taken by use of ranking the investment.
DEMERITS:
PRESENT VALUE :
If you invest Rs.1000/- for 3 years in a savings A/c. that pays 10% interest per
year. If you let your interest income be reinvested, your investment will grow as follows.
Rs.
First Year Principal at the beginning 1000
Interest for the year 100
(10/100*1000)
principal at the end 1100
The process of investing Money as well as reinvesting the interest earned thereon is
called compounding. The future value or compounded value of an investment after ‘n’
years when the interest rate is ‘r’ is
n
F.V. = P.V. (1 + r)
Ex. You deposit Rs.1000 today in a bank which pays 10% interest compounded
annually, how much will the deposit grow to after 8 years & 12 years?
Q. A firm can invest Rs.10,000 in a project with a life of 3 years. The projected cash
inflows are
Years Rs.
1 4000
2 5000
3 4000
Answer:-
The discount factor can be calculated based on Re. 1 received in with ‘r’ rate of
interest in 3 years.
1 .
(1 + r)n
The NPV is the DIFFERENCE BETWEEN the present values of cash inflows and
the present values of cash outflows.
NPV = Σ PV of inflow – Σ PV of outflow
DECISION RULE
ACCEPT : if NPV is positive i.e. NPV > 0
REJECT : if NPV is negative i.e. NPV < 0
DEFINITION:
The NPV of an investment proposal may be defined as “The sum of the Present
Values of all the cash inflows – The sum of the Present Values of all the cash
outflows”
MERITS:
1. Considers Time Value of Money.
2. Considers Total Cash Inflows. i.e. entire life.
3. Best Decision Criteria for Mutually Exclusive Project.
4. NPV technique is based on the cash flows rather than the Accounting profits and
thus helps in analyzing the effect of the proposal on the wealth of the
shareholders in a better way.
Thus, it satisfies one of the basic objective of Financial Management i.e. Wealth
Maximization
LIMITATIONS:
4. Calculation of the desired rate of return presents serious problems. Generally cost
of Capital is the basis of determining the desired rate. The calculation of cost of
Capital is itself complicated. Moreover desired rate of return will vary term year to
year.
ADVANTAGES:
1. THE NPV DO NOT GIVE TRUE PICTURE WHEN SELECTION AMONG THE PROJECTS
HAS TO BE MADE AND THE INVESTMENT SIZE IS DIFFERENT.
A PROJECT A & B HAVING COST RS.1,00,000 AND 80,000 RESPECTIVELY.
PRESENT VALUE OF INFLOW OF THE PROJECT ARE RS.1,20,000 & RS.1,00,000
BOTH HAVE NPV OF RS.20,000 AND AS PER NPV THEY ALIKE.
HERE P/I TECHNIQUE SEEMS TO GIVE A BETTER RESULT.
1,20,000 1,00,000
P/I (A) = --------------- = 1.20 P/I (B) = ------------- = 1.25
1,00,000 80,000
CONCLUSION: IN TERMS OF NPV BOTH PROJECT ARE EQUAL BUT IN TERM OF P/I ACCEPT
PROJECT B.
2. IT CONSIDERS TIME VALUE OF MONEY.
3. IT CONSIDERS THE ENTIRE CASH INFLOW AND ALL CASH OUTFLOW IRRESPECTIVE
OF THE TIMING OF THE OCCURRENCE.
4. IT IS BASED ON CASH OUTFLOW RATHER THAN THE ACCOUNTING PROFIT AND
THUS HELPS IN ANALYZING THE EFFECT OF THE PROPOSAL ON THE WEALTH OF
THE SHAREHOLDER.
DISADVANTAGES:
1. IT INVOLVES DIFFICULT CALCULATION.
2. THIS BEING AN EXTENTION OF NPV WHERE THE PREDETERMINATION OF THE
REQUIRED RATE OF RETURN ‘K’ ITSELF IS A DIFFICULT JOB. IF THE VALUE OF
‘K’ IS NOT CORRECTLY TAKEN THEN WHOLE EXERCISE OF NPV MAY GO
WRONG.
PROJECT A PROJECT B
Initial cash outflow 1,50,000 1,10,000
P.V. of cash inflow 2,10,000 1,65,000
NPV 60,000 55,000
AS PER NPV ACCEPT PROJECT A
P/I 2,10,000 = 1.4:1 1,65,000 = 1.5:1
1,50,000 1,10,000
AS PER P/I ACCEPT PROJECT B
IN SUCH A CASE FOLLOW NPV UNLESS THERE IS CAPITAL RATIONING. THIS IS BECAUSE
IF THE FIRM HAS FUNDS OF RS.1,50,000 TO INVEST THEN AS PER NPV TECHNIQUE
PROJECT A IS TO BE ACCEPTED BECAUSE IT WILL RESULT IN INCREASE IN
SHAREHOLDERS WEALTH TO THE EXTENT OF RS.60,000 AGAINST PROJECT B WHICH
WILL INCREASE IN SHAREHOLDERS WEALTH ONLY BY RS.55,000.
THE BETTER PROJECT IS ONE, WHICH ADDS MORE TO THE WEALTH OF THE SHARE
HOLDER.
• The other variant of the NPV technique is known as terminal value technique.
• Here the future cash inflows are discounted to make them comparable.
• In terminal value technique the future cash flows are first compounded at the
expected rate of interest for the period from their occurrence till the end of the
economic life of the project.
• The compound values are then discounted at an appropriate discount rate to find
out the present value.
• Then the present value is compared with initial outflow to find out the suitability of
the project.
Steps:
1. Find the compounded value
Year Cash inflow Remaining year P.V. factor Compounded
value
1 3
2 2
3 1
4 0
Σ
2. The above compound value to be discounted at a discount factor and the P.V. is to
be found out.
3. The above (2) to be compared with initial investment to get NPV.
For Eg
IF a sum of Rs.800 is invested in a project and become Rs.1000 at the end of a year, the
rate of return come to 25% which is calculated as under:
I= C
(1 + r)
I = Initial investment
C = Cash inflow
R = I.R.R.
(1 = r)
800 (1 + r) = 1000
800 + 800r = 1000
800r = 200
This rate ‘K’ is also known as cut off rate or the hurdle rate. A particular proposal may be
accepted.
If its IRR ‘r’ is MORE THAN the MINIMUM REQUIRED RATE ‘K’ ACCEPT IT.
IF the IRR ‘r’ is just Equal To the Minimum Required Rate ‘K’ than the firm may be
INDIFFERENT.
If the IRR ‘r’ is LESS THAN the MINIMUM REQUIRED RATE ‘K’ the project is altogether
rejected.
In case of mutually exclusive project the project with highest IRR is given top
priority.
MERITS:
1. The method considers the entire economic life of the project.
2. It gives due weightage to time factor. I.e. It consider time value of money.
3. Like NPV technique, the IRR technique is also based on the consideration of all the
cashflows occurring at any time. The salvage value, the working capital used and
released etc. are also considered.
4. IRR is based on cashflows rather than accounting profit.
DEMERITS:
1. It involves complicated trial and error procedure.
2. It makes an implied assumption that the future cash inflows of a proposal are
reinvested at a rate equal to IRR for ex. In case of mutual exclusive proposal say A
& B, having IRR of 18% and 16% respectively, the IRR technique make an implied
assumption that the future cash inflows of project A will be reinvested at 18%
while the cash inflow of project B will reinvested at 16%.
3. It is imaginary to think that the same firm will have different reinvestment
opportunities depending upon the proposal accepted.