M.B.A PROGRAMME

M.B.A Programme

INTRODUCTION

Capital project planning is the process by which companies allocate funds to various investment projects designed to ensure profitability and growth.

Evaluation of such projects involves estimating their future benefits to the company and comparing these with their costs.

In a competitive economy, the economic viability and prosperity of a company depends upon the effectiveness and adequacy of capital expenditure evaluation and fixed assets management.

Capital budgeting refers to planning the deployment of available capital for the purpose of maximizing the long-term profitability of the firm. It is the firms decision to invest its current funds most efficiently in long-term activities in anticipation of future benefits over a series of year

In other words, capital budget may be defined as the firms decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. Therefore, it involves a current outlay or series of outlay of cash resources in return for an anticipated flow of future benefits. capital budgeting is the process to identify, analysis and select investment projects, whose returns (cash flows) are expected to extend beyond one year. Firms investment decisions would generally a include expansion, acquisition, modernization, replacement of fixed assets or long-term assets. From the above definition, we may identify the basic features of capital budgeting viz., potentially large anticipated benefits, relatively a high degree risk, and a relatively long-time period between the initial outlay and anticipated return.

DEFINITIONS OF CAPITAL BUDGETING:-

Capital budgeting is a long term planning for making and financing proposed capital outlays

-T.Horngreen

A budget is an estimate of future needs arranged according to at an orderly basis covering some or all the activities of an enterprise for a definite period of time

- George R. Terry

Budget as a financial and/ or quantitative statement prepared to a definite period of time, of the policy to be pursued during that period for the purpose of attaining a given objective

- ICMA, London

CAPITAL BUDGETING INVOLVES:

The search for new and more profitable investment proposals.

The making of an economic analysis to determine the profit potential of each investment proposal.

Committing significant resources

Planning for the long term 5 to 50 years

Decision making by senior management.

Forecasting long term cash flows.

Estimating long term discount rates & Analyzing risk

Capital budgeting may be defined as the firms formal process or the acquisition and investment of capital. It involves the firms decision to invest its current funds for addition, disposition, modification and replacement of fixed assets.

FEATURES OF CAPITAL BUDGETING PROCESS

Capital budgeting decisions have the following features:

It involves exchange of current funds for future a benefits.

They benefit future periods.

They have the effect of increasing the capacity, efficiency, spanof life regarding future benefits.

Funds are invested in long-term activities

Some of the examples of capital budgeting decision are:

Introduction of a new product.

Expansion of business by investing in plant and machinery.

Replacing and modernizing a process.

Mechanization of process.

Choice between alternative machines.

SIGNIFICANCE

Capital budgeting decisions are significant due to the following reasons

GROWTH:

The fixed assets are earning assets, since they have decisive influence on the rate of return and direction of firms growth. A wrong decision can effect the other projects, which are already running under profits. In other words unwanted or unprofitable investments will result in heavy operating costs.

MORE RISKY:

Investment in long-term assets increases average profit but it may lead to fluctuations in its earnings, then firm will become more risky. Hence, investment decision decides the future of the business concern

HUGE INVESTMENTS:

Long-term assets involve more initial cash outflows, which makes it imperative for the firm to plan its investment programmes very carefully and make an advance arrangement of funds either from internal sources or external sources or from both the sources.

IRREVERSABILITY:

Long-term asset investment decisions are not easily reversible and that too, with much financial loss to the firm; due to difficulties in finding out market for such capital items once they have been used. hence firm will incur more loss in that type of capital assets.

EFFECT ON OTHER PROJECTS:

Whenever long-term asset investment is a part of expansion programme, its cash flow effects the projects under consideration, if it is not economically independent. The effect may be increased in profits or decrease in profits. So, while taking investment in long-term assets, the decision maker has to check the impact of this project on other projects, if the effect is in terms of increase in profits then he/she has to accept the project and vice versa.

DIFFICULT DECISION:

Capital budgeting decision is very difficult due to

a. Decision involves future years cash inflows,

b. Uncertainty of future and more risk.

OBSTACLES FOR CAPITAL BUDGETING:

Capital budgeting decisions are very important, but they pose difficulties which shoot from three principle sources

MEASUREMENT PROBLEM:

Evaluation of project requires identifying and measuring its costs and benefits, which is difficult since they involve tedious calculations and lengthy process. Majority of replacement and expansion programmes have impact on some other activities of the company (introduction of new product may result in the decrease in sales of the other existing product) or have some intangible consequences (improving morale of the workers).

UNCERTAINITY:

Selection or rejection of a capital expenditure project depends on expected costs and benefits in the future. Future is uncertain, if any body tries to predict the future, it will be childish or foolish. Hence, it is impossible to predict the future cash inflows.

TEMPORAL SPEED:

The costs and benefits, which are expected, are associated with a particular capital expenditure project spread out over a long period of time, which is 10-20 years for industrial projects and 20-50 years for infrastructure projects. The temporal spread creates some problems in estimating discount rates for conversation of future cash inflows in present values and establishing equivalences.

PRINCIPLES:

Capital budgeting decisions should be taken on the basis of the Following factors:

Creative search for profitable opportunities: Profitable investment opportunities should be sought to supplement existing proposals.

Long- range capital planning: It indicates sectoral demand for funds to stimulate alternative proposals before the aggregate demand for funds is finalized.

Measurement of project work: Here, the project is ranked with the other projects.

Screening and selection: The project is examined on the basis of Selection criteria, such as the supply cost of capital, expected returns alternative investment opportunities, etc.

Retirement and disposal : The expiry of the life cycle of a project is marked at this stage.

Forms and procedures : These involve the preparation of reports necessary for any capital expenditure programme.

COMPONENTS OF CAPITAL BUDGETING

Initial Investment Outlay:

It includes the cash required to acquire the new equipment or build the new plant less any net cash proceeds from the disposal of the replaced equipment. The initial outlay also includes any additional working capital related to the new equipment. Only changes that occur at the beginning of the project are included as part of the initial investment outlay. Any additional working capital needed or no longer needed in a future period is accounted for as a cash outflow or cash inflow during that period.

Net Cash benefits or savings from the operations:

This component is calculated as under:-

(The incremental change in operating revenues minus the incremental change in the operating cost = Incremental net revenue) minus (taxes) plus or minus (changes in the working capital and other adjustments).

Terminal Cash flows:

It includes the net cash generated from the sale of the assets, tax effects from the termination of the asset and the release of net working capital.

The Net Present Value technique:

Although there are several methods used in Capital Budgeting, the Net Present Value technique is more commonly used. Under this method a project with a positive NPV implies that it is worth investing in.

RANKING OF CAPITAL BUDGETING PROPOSALS

A firm should select its own projects after considering the advantages and disadvantages of each of them. For this purpose, it should rank the proposals. Proposals are ranked on the basis of the following considerations.

Mutually Exclusive Investment Proposals

This kind of proposal connote those proposals which represent alternative methods of doing the same job. In case one proposal is accepted, the need to accept the other is ruled out. For example, there are 5 pieces of equipment available in the market to carry out a job. if the management chooses one piece of the equipment, others will not be required because they are mutually exclusive projects.

Contingent Investment Proposals

There are certain projects utility which is contingent upon the acceptance of others. For e.g., management of an enterprise may be contemplating to construct, employees quarters and a co-operative shops. If it decides not to build quarters, the need for the shop does not arise. If the management decides to construct quarters but not shops, the employees will have no shop to make purchases. These are contingent projects.

Independent investment proposals

It includes all such investment proposals as are being considered by the management for performing different tasks with in the organization. Investment in machinery, automobiles, buildings, parking lot, recreation centre and so on are the examples of the independent investment proposals. Acceptance of each of these projects is done on its own merit with out depending on other projects.

Replacement

The investments, which are contemplated for replacing, old and antiquated equipment so that the job could be performed more efficiently, are termed as replacements.

NEED OF CAPITAL BUDGETING

The importance of capital budgeting can be well understood from the fact that unsound investment decision may prove to be fatal to the very existence of the concern. The need, significance or importance of capital budgeting arises mainly due to the following

Large investments

Long-term commitment of funds

Irreversible nature

Long-term effect on profitability

Difficulties of investment decisions

National importance.

OBJECTIVES FOR CAPITAL BUDGETING

It determines the capital projects on which work can be started during the budget period after taking into account their urgency and the expected rate of return on each project.

It estimates the expenditure that would have to be incurred on capital projects approved by the management together with the sources from which the required funds would be obtained.

It restricts the capital expenditure on projects with in authorized limits.

TYPES OF CAPITAL BUDETING DECISIONS:-

Capital budgeting decisions are of paramount importance in financial decision making. In first place they affect the profitability of the firm. They also have a bearing on the competitive position of the firm because they relate to fixed assets. The fixed assets are true goods than can ultimately be sold for-profit. Generally the capital budgeting of investment decision includes addition, disposition, modification, and replacement of fixed assets.

C

C

o

inflows

cash

Annual

investment

Initial

EXPANSION OF EXISTING BUSINESS:-

A company may add capacity to its existing product lines to expand existing operations. For example Siva Shakthi Bio Planttec may increase its plant capacity to manufacture more detergents soaps & powder. It is an example of related expansion.

EXPANSION OF NEW BUSINESS:-

A Firm may expand its activities in a new business expansion of a new business requires investment and new kind of production activating with in the firm. If packing manufacturing company invests in a new plant and machinery to produce ball bearings, which the firm has not manufactured before, this represents expansion of new business or unrelated diversification. Sometimes accompany acquires existing firms to expand its business.

REPLACEMENT AND MODERANIZATION:-

The main objective of modernization and replacement is to improve operating efficiency reduce costs. Cost savings will reflect in the increased profits, but the firms revenue may remain unchanged. Assets become outdated and absolute with technological changes. The firm must decide to replace those with new assets that operate more economically. Replacement decisions help to introduce more efficient and economical assets and therefore, are also called cost-reduction investments.

However replacement decisions that involve substantial modernization and technological improvements expand revenues as well as reduce costs. Yet another useful way to classify investments is as follows:

Mutually exclusive investments

Independent investments

Contingent investments

FACTORS FOR CAPITAL BUDGETING

Cost of acquisition of permanent asset as land and building, plant and machinery, goodwill, etc.

Cost of addition, expansion, Improvement or alteration in the fixed assets.

Cost of replacement of permanent assets.

Research and development project cost, etc.

CAPITAL BUDGETING PROCESS

The preparation of the capital budget is a process that lasts many months and is intended to take into account neighborhood and bough needs as well as organization wide. The process begin in the fall, when each of the segment holds public hearings, each community board submits a statements of its capital priorities for the next fiscal year to the managing director and appropriate borough chairmen. The capital budgeting process involves 8 steps explained in theoretic as follows:

Identification of investment proposals

Screen proposals

Evolution of various proposals

Fixing priorities

Final approval

Implementing proposals

Performance review

Feed back

1) IDENTIFICATION OF INVESTMENT PROPOSALS

The capital budgeting process begins with the identification of investment proposals. The investment proposals may originated from the top management or from any officer of the organization. The department head analyses the various proposals in the light of the corporate strategies and submit the suitable proposal to the capital budgeting committee in case of large organizations concerned with process of long-term investment proposals.

Identification of investment ideas it is helpful to

Monitor external environment regularly to scout investment opportunities.

Formulate a well defined corporate strategy based on through analysis of strengths, weaknesses, opportunities, and threats.

Share corporate strategy and respective with persons.

Motivate employees to make suggestions.

2) SCREEN PROPOSALS

The expenditure planning committee screens the various proposals received from different departments in different angles to ensure that these are in selection criteria of the organization and also do not lead to department imbalances.

3) EVALUTION OF VARIOUS PROPOSALS

The next steps in capital budgeting process in to evaluate the probability of various probability the independent proposals are those which do not complete with one another and the same way be either accepted or rejected on the basic of a minimum return on investment required.

4) FIXING PRIORITIES

After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected straight away. But it may not be possible for the organization to invest immediately in all the acceptable proposals due to limitations of funds. Hence, it is very essential to rank the various proposals and to establish priorities after considering urgency, risk & profitability involved the criteria.

5) FINAL APPROVAL

Proposals meeting the evaluation and other criteria are finally approved to be included in the capital expenditure budget. However proposals involving smaller investment may be decided at the lower levels for expeditious action. The capital expenditure budget lay down the amount of estimated expenditure to be incurred on fixed assets during the budget period.

6) IMPLEMENTING PROPOSALS:-

Preparation of a capital expenditure budgeting & incorporation of a particular proposals in the budget does not itself authorize to go ahead with implementation of the project. A request for authority to spend the amount should be made to be the capital expenditure committee which may like to review the profitability of the project in changed circumstances. In the implementation of the projects networks techniques such as PERT & CPM are applied for project management.

7) PERFORMANCE REVIEW

In this stage the process of capital budgeting is the evaluation of he performance of the project. The evaluation is made through post completion audit by way of comparison of actual expenditure on the project with the budgeted one, and also by comparing the actual return from the investment with the anticipated return. The unfavorable variances if any should be looked into and the causes the same is identified so that identified so that corrective action may be taken in future.

It throws light on how realistic were the assumptions underlying the project.

It provided a documented log of experience that is highly valuable for decision making.

GUIDELINE FOR CAPITAL BUDGETING

There are many guidelines for capital budgeting process either it is long-term or short- term plan.

The major points are:

Need and objectives of owner

Size of market in terms of existing & proposed product lines and anticipated growth of the market share

Size of existing plants & plans for new plant sites and plant

Economic conditions which may affect the firms operations and

Business and financial risk associated with the replacement & existing assets of the purchases of new assets.

CONTENTS OF THE PROJECT REPORT

Raw material

Market and marketing

Site of project

Project engineering dealing with technical aspects of the project

Location and layout of the project building

Building

Production capacity

Work schedule

CRITERIA FOR CAPITAL BUDGETING

Potentially, there is a wide array of criteria for selecting projects. Some shareholders may want the firm to select projects that will show immediate surges in cash flow, others may want to emphasize long-term growth with little importance on short-term performance viewed in this way; it would be quite difficult to satisfy the differing interests of all the shareholders. Fortunately, there is a solution.

METHODS FOR EVALUTION

In view of the significance of capital budgeting decisions, it is absolutely necessary that the method adopted for appraisal of capital investment proposals is a sound one. Any appraisal method should provide for the following.

a) A basis of distinguishing between acceptable and non acceptable projects.

b) Ranking of projects in order of their desirability.

c) Choosing among several alternatives

d) A criterion which is applicable to any conceivable project.

e) Recognizing the fact that bigger benefits are preferable to smaller ones and early benefits to later ones.

There are several methods for evaluating the investment proposals. In case of all these methods the main emphasis is on the return which will be derived on the capital invested in the project.

Non DCF Criteria

(a) Pay back period

The pay back period one of the most popular and widely recognized traditional methods of evaluation investment proposals. Pay back period is the number of years required to recover the original cash outlay invested in a project.

If the project generates constant annual cash flows, the pay back period can be computed by dividing cash outlay by the annual cash inflows.

Pay back period =

o

C

= Initial investment

C = Annual cash inflows

In the case of un equal cash inflows, the pay back period can be found out by adding up the cash inflow until the total is equal to the initial cash outlay.

Merits:

1) This method is simple to understand and easy to calculate.

2) Surplus arises only if the initial investment is fully recovered. Hence, there is no profit on any project unless the payback period is over.

3) When funds are limited, projects having shorter payback period should be selected, since they can be rotated more number of times.

4) This method is focuses on projects which generate cash inflows in earlier years.

5) As time period of cash flows increases, risk and uncertainty also increases.

Limitations:

1) It stresses on capital recovery rather than profitability.

2) It does not consider the return from the project after its payback period.

3) Administrative difficulties may be faced in determining the maximum acceptable payback period.

(b) Accounting Rate of Return (ARR)

The accounting rate of return (ARR) also known as the return on investment (ROI) uses accounting information, as revealed by financial statements, to measure to profitability of an investment. The accounting rate of return is the ratio of the average after fax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.

A R R =

100

investment

Average

Income

Average

Merits:

This method is simple to understand.

It is easy to operate and compute.

Income throughout the project life is considered.

It can be readily calculated using the accounting data.

Limitations

It does not consider cash in flows which is important in project evolution rather than PAT.

It takes the rough average of profits of future years. The pattern or fluctuations in profits are ignored.

It ignores time value of money, which is important in capital budgeting decisions.

DFC Criteria

(a) Net Present value (NPV)

The NPV present value (NPV) method is the classic method of evaluating the investment proposals. If is a DCF technique that explicitly recognizes the time value at different time periods differ in value and comparable only when their equipment present values are found out.

N.P.V =

0

n

n

3

3

2

2

1

k)

(1

C

.........

k)

(1

C

k)

(1

C

k)

(1

C

C

-

+

+

+

+

+

+

+

+

NPV =

=

-

+

n

i

o

C

k

C

0

1

1

)

1

(

Where

NPV = Net present value

fi

C

= Cash flows occurring at time

k = the discount rate

n = life of the project in years

0

C

= Cash outlay

Merits

1) NPV method takes account the time value of money.

2) All cash inflows are considered.

3) All cash inflows are converted into present value.

4) It satisfies value additively principle i.e., NPV of two or more projects can be added.

Limitations

1) It may not satisfactory answer when the projects being compared involved different amounts of investment.

2) It is difficult to use.

3) It may mislead when dealing with alternative projects or limited funds.

4) It involves difficult calculations.

5) It involves forecasting cash flows and applications of discount rate.

(b) Internal Rate of Return (IRR)

The internal rate of return (IRR) method is another discounted cash flow technique which takes account of the magnitude and thing of cash flows, other terms used to describe the IRR method are yield on an investment, marginal efficiency of capital, rate of return over cost, time adjusted rate of internal return and soon.

NPV =

=

+

+

+

+

n

0

i

n

1

fi

)

k

1

(

WC

SV

)

k

1

(

C

Where

fi

C

= Cash flows occurring at different point of time

k = the discount rate

n = life of the project in year

0

C

= Cash out lay

SV & WC = Salvage value and working capital at the end of the n years.

IRR = L +

)

L

H

(

)

b

a

(

A

-

-

Where

L = Lower discount rate at which NPV is positive

H = Higher discount rate at which NPV is negative

A = NPV at lower discount rate, L

B = NPV at higher discount rate, H

Merits:

1) This method considers the time value of money.

2) All cash flows are considered.

3) It has psychological appeal to the users.

4) The percentage figure calculated under this method is more meaningful and acceptable, because it satisfies them in terms of rate of return on capital.

Limitations:

1) It may not give unique answer in all situations.

2) It is difficult to understand and use in practices.

3) It implies that the intermediate cash inflows generated by the project.

(C) Profitability index (PI)

Yet another time adjusted method of evaluating the investment proposals is the benefit cost (B/C.) ratio or profitability index (PI) Profitability index is the ratio of the present valued of cash inflows, at the required rate of return, to the initial cash out of the investment.

PI =

outlay

Cash

Intial

inflow

Cash

of

PV

Where PV = Present Value

Merits:

1) This method considers the time value of money.

2) All cash inflows are considered.

3) It is a better evaluation technique than NPV.

Limitations:

It fails as a guide in resolving capital rationing when projects are indivisible.

Diagram 1.3

COMMITTEE IN CAPITAL BUDGETING

CAPITAL COMMITMENT PLAN

The progress of projects included in the capital budget, a capital commitment plan is issued three times a year. The commitment plan lays out the anticipated implementation schedule for there current fiscal and the next three years. The first commitment plan is published within 90days of the adoption of the capital budget. Updated commitment plans are issued in January & April along with the companys budget proposals.

The commitment plan translates the appropriations approved under the adopted capital budget into schedule for implementing individual projects. The fact that funds are appropriated for a project in the capital budget does not necessarily mean that work will start or be completed that fiscal year. He choice of priorities and timing of projects is decided by office management & budget in consultation with the agencies along with considerations of how much the managing director thinks the organization can afford to append on capital projects overall.

The capital commitment plan lays out the anticipated implemented schedule for capital projects and is one source of information on how far along projects are although not a consistent or always useful one. The adopted commitment plan is usually published in September, & then updated in January & April.

In the capital budgeting for every two adjacent years there will be gap. The gap between authorized commitments and the target is presented in capital commitment plan as diminishing over the course of the year plan, in practice many of the unattained commitments will be rolled over into the next years plan, so that the current year gap will remain large. The gap has grown in recent year exceeding in last two executive capital plans.

KINDS OF CAPITAL BUDGETING

Capital budgeting refers to the total process of generating, evaluating, selecting and following up a capital expenditure alternatives. The firm allocates or budgets financial recourses to new investment proposals. Basically, the firm may be confronted with three types of capital budgeting decisions:-

The accept or reject decision,

The mutually exclusive choice decisions, and

The capital rationing decision

The time period creates some problems in estimating discount rates & establishing equivalences.

CAPITAL COMMITMENT PLAN:-

The progress of projects included in the capital budget, a capital commitment plan is issued three times a year. The commitment plan lays out the anticipated implementation schedule for their current fiscal and the next three years. The first commitment plan is published within 90days of the adoption of the capital budget. Updated commitment plans are issued in January & April along with the companys budget proposals.

The commitment plan translates the appropriations approved under the adopted capital budget into schedule for implementing individual projects. The fact that funds are appropriated for a project in the capital budget does not necessarily mean that work will start or be completed that fiscal year. He choice of priorities and timing of projects is decided by office management & budget in consultation with the agencies along with considerations of how much the managing director thinks the organization can afford to append on capital projects overall. The capital commitment plan lays out the anticipated implemented schedule for capital projects and is one source of information on how far along projects are although not a consistent or always useful one. The adopted commitment plan is usually published in September, & then updated in January & April.

In the capital budgeting for every two adjacent years there will be gap. The gap between authorized commitments and the target is presented in capital commitment plan as diminishing over the course of the year plan, in practice many of the unattained commitments will be rolled over into the next years plan, so that the current year gap will remain large. The gap has grown in recent year exceeding in last two executive capital plans.

KINDS OF CAPITAL BUDGETING:-

Capital budgeting refers to the total process of generating, evaluating, selecting and following up an capital expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals. Basically, the firm may be confronted with three

Types of capital budgeting decisions:-

The accept or reject decision,

The mutually exclusive choice decisions, and

The capital rationing decision

DIFFICULTIES OF CAPITAL BUDGETING:-

While capital expenditure decisions are extremely important, they also pose difficulties which stem from three principal sources:

Identifying & measuring the costs & benefits of a capital expenditure proposal tends to be difficult

There is great deal of uncertainty for capital expenditure decision which involves cost & benefits that extend far into the future

It is impossible to product exactly what will happen in the future

The time period creates some problems in estimating discount rates & establishing equivalences.

LIMITATIONS OF CAPITAL BUDGETING:-

Capital budgeting techniques suffer from the following limitations:

All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular circumstances.

The techniques of capital budgeting require estimation of future cash inflows and outflows. The future is always uncertain and the data collected for future may not be exact. Obliviously the results based upon wrong data may not be good.

There are certain factors like morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.

Urgency is another limitation in the evaluation of capital investment decisions.

Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting.

COST EFFECTIVE ANALYSIS:-

In the cost effectiveness analysis the project selection or technological choice, only costs of two or more alternatives choices are considering treating the benefits as identical. This approach is used when the acquisition of how to minimize the costs for undertaking an activity at a given discount rates in case the benefits and operating costs are given, one can minimize the capital cost to obtain given discount.

PROJECT PLANNING:-

The planning of a project is a technically pre-determined set of inter related activities involving the effective use of given material, human, technological and financial resources over a given period of time. Which in association with other development projects result in the achievement of certain predetermined objectives such as the production of specified goods and services?

Project planning is spread over a period of time and is not a one shot activity. The important stages in the life of a project are:

Its identification

Its initial formulation

Its evaluation

Its final formulation

Its implementation

Its completion and operation

The time taken for the entire process is the gestation period of the project. The process of identification of a project begins when we are seriously trying to overcome certain problems. They may be non-utilization to overcome available funds. Plant capacity, expansion etc,

CRITERIAN TABLE:-

In the evaluation process or capital budgeting techniques there will be a criteria to accept or reject the project. The criteria will be expressed as:

Table

Criterian/Method

Accept

Reject

Indifferent

Pay Back Period (PBP)

Target Period

=Target period

Accounting Rate of Return (ARR)

> Target Rate

< Target Rate

=Target rate

Net Present Value (NPV)

> 0

< 0

= 0

Internal Rate of Return (IRR)

>Cost Of Capital

1

< 1

= 1

METHODS OR TECHNIQUES OF CAPITAL BUDGETING:

There are many methods for the evaluating the profitability of investment proposals the various commodity used methods are follow bellow diagram

a. Traditional methods:

Payback period method (P.B.P)

Accounting Rate of Return Method (A.R.R)

b. Discounted or Time adjusted technique:

(I) Net Present Value method (N.P.V)

(II) Internal Rate of Return method (I.R.R)

(III) Profitability Index method (P.I)

PAY BACK PERIOD METHOD:

The pay back come times called as payout or pay off period method represents the period in which total investment in permanent assets pay back itself. This method is based on the principle that every capital expenditure pays itself back within a certain period out of the additional earnings generated from the capital assets.

Decision rule:

A project is accepted if its payback period is less than period specific decision rule.

A project is accepted if its payback period is less than the period specified by the management and vice-versa.

Initial Cash Outflow

Pay Back Period = ----------------------------

Annual Cash Inflows

ADVANTAGES:

Simple to understand and easy to calculate.

It saves in cost; it requires lesser time and labour as compared to other methods of capital budgeting.

In this method, as a project with a shorter payback period is preferred to the one having a longer pay back period, it reduces the loss through obsolescence.

Due to its short- time approach, this method is particularly suited to a firm which has shortage of cash or whose liquidity position is not good.

DISADVANTAGES:

It does not take into account the cash inflows earned after the payback period and hence the true profitability of the project cannot be correctly assessed.

This method ignores the time value of the money and does not consider the magnitude and timing of cash inflows.

It does not take into account the cost of capital, which is very important in making sound investment decision.

It is difficult to determine the minimum acceptable payback period, which is subjective decision.

It treats each assets individual in isolation with other assets, which is not feasible in real practice.

ACCOUNTING RATE OF RETURN METHOD:

This method takes into account the earnings from the investment over the whole life. It is known as average rate of return method because under this method the concept of accounting profit (NP after tax and depreciation) is used rather than cash inflows. According to this method, various projects are ranked in order of the rate of earnings or rate of return.

Decision rule:

The project with higher rate of return is selected and vice-versa.

The return on investment method can be in several ways, as

Under this method average profit after tax and depreciation is calculated and then it is divided by the total capital out lay.

Average Annual profits

(after dep. & tax)

Average rate of return = ------------------------- ---- x100

Average Investment

ADVANTAGES:

It is very simple to understand and easy to calculate.

It uses the entire earnings of a project in calculating rate of return and hence gives a true view of profitability.

As this method is based upon accounting profit, it can be readily calculated from the financial data.

DISADVANTAGES:

It ignores the time value of money.

It does not take in to account the cash flows, which are more important than the accounting profits.

It ignores the period in which the profit are earned as a 20% rate of return in 2 years is considered to be better than 18%rate of return in 12 years.

This method cannot be applied to a situation where investment in project is to be made in parts.

NET PRESENT VALUE METHOD:

The NPV method is a modern method of evaluating investment proposals. This method takes in to consideration the time value of money and attempts to calculate the return on investments by introducing time element. The net present values of all inflows and outflows of cash during the entire life of the project is determined separately for each year by discounting these flows with firms cost of capital or predetermined rate.

The steps in this method are

1. Determine an appropriate rate of interest known as cut off rate.

2. Compute the present value of cash inflows at the above determined discount rate.

3. Compute the present value of cash inflows at the predetermined rate.

4. Calculate the NPV of the project by subtracting the present value of cash outflows.

Decision rule

Accept the project if the NPV of the projects 0 or positive that is present value of cash inflows should be equal to or greater than the present value of cash outflows.

NPV = PV of cash inflow initial cash outlay

ADVANTAGES:

It recognizes the time value of money and is suitable to apply in a situation with uniform cash outflows and uneven cash inflows.

It takes in to account the earnings over the entire life of the project and gives the true view if the profitability of the investment

Takes in to consideration the objective of maximum profitability.

DISADVANTAGES:

More difficult to understand and operate.

It may not give good results while comparing projects with unequal investment of funds.

It is not easy to determine an appropriate discount rate.

INTERNAL RATE OF RETURN METHOD:

The internal rate of return method is also a modern technique of capital budgeting that takes in to account the time value of money. It is also known as time- adjusted rate of return or trial and error yield method. Under this method the cash flows of a project are discounted at a suitable rate by hit and trial method, which equates the net present value so calculated to the amount of the investment. The internal rate of return can be defined as that rate of discount at which the present value of cash inflows is equal to the present value of cash outflow.

Decision Rule:

Accept the proposal having the higher rate of return and vice versa.

If IRR>K, accept project.

If IRR