Capital Budgeting Decisions

Capital Budgeting Decisions
Module – 2 (Part-I)
PPTs by Dr. Kasamsetty Sailatha

Contents
• Introduction
• Meaning and definition of Capital Budgeting
• Need and Importance of Capital Budgeting
• Capital Budgeting Process
• Evaluation techniques
• NPV Vs IRR
• Multiple IRRs
• Capital Rationing
• Risk Analysis in Capital Budgeting
• Measurement of Risk
• Project variance
• Expected NPV
Dr. Kasamsetty Sailatha

Introduction
• The word Capital refers to be the total
investment of a company in tangible and
intangible assets.
• Whe eas udgeti g defi ed the Rowland
a d Willia it ay be said to be the art of
building budgets.
• Budgets are blue print of a plan and action
expressed in quantities and manners.

• Capital budgeting is a long term planning exercise
in selection of the projects which generates
returns over a number of years in future and the
heavy expenditure is to be incurred in the initial
years of the project to generate returns over the
life of the project. Therefore, this includes the
investment decision.
• Investment decision/ capital budgeting decision is
a decision concerned with allocation of funds to
get proper yield from project. So that it can
recover the cost associated with each source of
fund and earn required amount of profit to
compensate the risk involved in the business.

• The examples of capital expenditure:
1. Purchase of fixed assets such as land and
building, plant and machinery, good will, etc.
2. The expenditure relating to addition,
expansion, improvement and alteration to the
fixed assets.
3. The replacement of fixed assets.
4. Research and development project.

Meaning and Definition
• Capital Budgeting: It is process of planning for
capital expenditure which is to be made to
maximize the long-term profitability of the
organization.

Definition
• According to the Charles T. Hrongreen, apital udgeti g is a
long-term planning for making and financing proposed capital
out lays.
• According to G.C. Philippatos, apital udgeti g is o er ed
with the allo atio of the fi s fi a ial esou es a o g the
available opportunities. The consideration of investment
opportunities involves the comparison of the expected future
streams of earnings from a project with the immediate and
subsequent streams of earning from a project, with the
i ediate a d su se ue t st ea s of e pe ditu e .
• According to the Lyrich, apital udgeti g o sists i pla i g
of available capital for the purpose of maximizing the long-term
p ofita ilit of the o e .

Need and Importance of Capital Budgeting
1. Huge investments: Capital budgeting requires huge
investments of funds, but the available funds are
limited, therefore the firm before investing projects,
plan are control its capital expenditure.
2. Long-term: Capital expenditure is long-term in
nature or permanent in nature. Therefore financial
risks involved in the investment decision are more. If
higher risks are involved, it needs careful planning of
capital budgeting.
3. Irreversible: The capital investment decisions are
irreversible, are not changed back. Once the decision
is taken for purchasing a permanent asset, it is very
difficult to dispose off those assets without involving
huge losses. Dr. Kasamsetty Sailatha

4. Long-term effect: Capital budgeting not only
reduces the cost but also increases the
revenue in long-term and will bring significant
changes in the profit of the company by
avoiding over or more investment or under
investment. Over investments leads to be
unable to utilize assets or over utilization of
fixed assets. Therefore before making the
investment, it is required carefully planning
and analysis of the project thoroughly.

CAPITAL BUDGETING PROCESS
• Capital budgeting is a difficult process to the investment of
available funds. The benefit will attained only in the near future
but, the future is uncertain. However, the following steps followed
for capital budgeting, then the process may be easier are.
1. Identification of various investments proposals: The capital
budgeting may have various investment proposals. The proposal
for the investment opportunities may be defined from the top
management or may be even from the lower rank. The heads of
various department analyse the various investment decisions, and
will select proposals submitted to the planning committee of
competent authority.
2. Screening or matching the proposals: The planning committee
will analyse the various proposals and screenings. The selected
proposals are considered with the available resources of the
concern. Here resources referred as the financial part of the
proposal. This reduces the gap between the resources and the
investment cost. Dr. Kasamsetty Sailatha

3. Evaluation: After screening, the proposals are evaluated
with the help of various methods, such as pay back period
proposal, net discovered present value method, accounting
rate of return and risk analysis. The proposals are evaluated
by.
(a) Independent proposals
(b) Contingent of dependent proposals
(c) Mutually exclusive proposals.
• Independent proposals are not compared with another
proposals and the same may be accepted or rejected.
• Whereas higher proposals acceptance depends upon the
other one or more proposals. For example, the expansion
of plant machinery leads to constructing of new building,
additional manpower etc.
• Mutually exclusive projects are those which competed
with other proposals and to implement the proposals after
considering the risk and return, market demand etc.

4. Fixing property: After the evolution, the planning
committee will predict which proposals will give more
profit or economic consideration. If the projects or
p oposals a e ot suita le fo the o e s fi a ial
condition, the projects are rejected without
considering other nature of the proposals.
5. Final approval: The planning committee approves the
final proposals, with the help of the following:
(a) Profitability
(b) Economic constituents
(c) Financial violability
(d) Market conditions.
• The planning committee prepares the cost estimation
and submits to the management.Dr. Kasamsetty Sailatha

6. Implementing: The competent authority spends
the money and implements the proposals. While
implementing the proposals, assign
responsibilities to the proposals, assign
responsibilities for completing it, within the time
allotted and reduce the cost for this purpose. The
network techniques used such as PERT and CPM.
It helps the management for monitoring and
containing the implementation of the proposal.
7. Performance review of feedback: The final stage
of capital budgeting is actual results compared
with the standard results. The adverse or
unfavourable results identified and removing the
various difficulties of the project. This is helpful
for the future of the proposals.

Evaluation techniques
• By matching the available resources and projects it can
be invested. The funds available are always living
funds. There are many considerations taken for
investment decision process such as environment and
economic conditions. The methods of evaluations are
classified as follows:
(A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(iii) Accounts Rate of Return
(B) Modern methods (or Discount methods)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method

Pay-back Period
• It is one of the non-discounted cash flow
methods of capital budgeting. Pay-back
period is the time required to recover the
initial investment in a project.
• Formula to calculate PBP for even cashflows:
Initial investment
Pay-back period =
Annual cash inflows

(c)10 K 22 K 37 K 47K 54 K
Payback Solution for uneven
cashinflows
PBP = a + ( b - c ) / d
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K
Cumulative
Inflows
(a)
(-b) (d)

• Thumb Rule for PBP:
– If the calculated PBP is less than the standard PBP
Accept.
– If the calculated PBP is higher than the standard
PBP Reject.
• Thumb Rule for Ranking PBP:
– Shorter the PBP – Higher Ranking
– Longer the PBP – Lower Ranking

• Merits of Pay-back method: The following are
the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement
over the accounting rate return.
3. Pay-back method reduces the possibility of loss
on account of obsolescence.
• Demerits
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back
period.
3. It is one of the misleading evaluations of capital
budgeting.

PBP Strengths and
Weaknesses
Strengths:
– Easy to use and
understand
– Can be used as a
measure of
liquidity
– Easier to forecast ST
than LT flows
Weaknesses:
– Does not account
for TVM
– Does not consider
cash flows beyond
the PBP
– Cutoff period is
subjective

Accounting Rate of Return
• It is also k o as A e age ate of etu , ‘ate of
return, return on investment or return on capital
e plo ed.
• It is based on the accounting information rather
than the cashinflows.
• The ARR may be defined as “the annualized net
income earned on the average funds invested in a
project.” The annual returns of a project are
expressed as a percentage of the net investment in
the project.

• We determine the average profits by adding
up the after-tax profits expected for the each
year of the profits life and dividing the result
by the number of years.

• The average investment is determined by
dividing the net investment by 2.
Or
Or
Or

• The following formula is generally used to determine
the ARR.
or
• The ARR is determined based on the Total Income
method as:

• On the basis of Original Investment Method:
• On the basis of Average Investment Method:

• Thumb Rule For ARR:
– Accept the project if the ARR is more than the
minimum rate of return or the rate of return
predetermined by the financial manger.
– Reject the project if the ARR is less than the
minimum rate of return or the rate of return
predetermined by the financial manager.
• Thumb Rule for Ranking the ARR:
– Higher the ARR – Higher the Rank
– Lower the ARR – Lower the Rank

Particulars Rs.
Sales Xxx
Less: Operating Cost Xxx
Earnings before depreciation, interest and tax Xxx
Less: Depreciation xxx
EBIT xxx
Less: Interest xxx
EBT xxx
Less: Tax xxx
EAT xxx
Add: Depreciation xxx
Net Cashflows (CFAT) xxx
Proforma to Find the Net Cashinflows

• Advantages of ARR:
1. It is easy to calculate because it makes use of
readily available accounting information;
2. It is not concerned with cashflows rather based
upon profits which are reported in annual
accounts and sent to shareholders.
3. Unlike payback period method, this method
does take into consideration all the years
involved in the life of the project.
4. It high profits are required, this is certainly a way
of achieving them.

• Disadvantages of ARR:
1. It does not take into account the time value of
money;
2. It uses straight line method of depreciation, once a
change in method of depreciation takes place, the
method will not be easy to be used wand will not
work properly;
3. This method fails to distinguish the xize of
investment required for individual projects;
4. It is biased against short-term projects;
5. Several concepts of investment are used for working
out accounting rate of return. Thus, different
managers have different meaning when they refere
to ARR; and
6. ARR does not indicate whether an investment
should be accepted or rejected, unless the rate of
return is compared with arbitrary management
targets.

Capital Budgeting Decisions

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