CAPITAL BUDGETING INVESTMENT APPRAISAL METHODS

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 Concept of Capital Budgeting

 Capital Expenditure Budget

 Importance of Capital Budgeting

 Rational of Capital Expenditure

 Kinds of Capital Investment Proposals

 Factors affecting Investment Decision

 Investment Appraisal Methods

 Capital Rationing

Concept of Capital Budgeting

 Finance Manager is concerned with Planning and

Financing investment decisions.

 Financing Decisions relate to determination of

amount of long term finance and decision on

sources for financing the same.

 Investment decisions also termed as “Capital

Budgeting Decisions” involve cost - benefit

analysis.

 Investment decisions are based on careful

consideration of factors like profitability, safety,

liquidity, solvency etc

Why Capital Budgeting

 Capital investment means investments in projects which

by nature involve huge expenditure and results of the same are known only after a long time.

Why Capital investment is necessary

 For investments in New Projects

 Replacement of worn out/ out dated assets.

 Expansion of existing capacity – To meet high demand or

inadequate production capacity.

 Diversification – to reduce risk

 Research and Development – Ensuring updated

technology.

 In other words, It is the formal process for acquisition

and investment of capital.

 Capital Budgeting is a many-sided activity.

 Gestation period i.e time lag from the

period of initial investment to anticipated returns.

Capital Expenditure Budget

on new projects/ purchase of fixed assets.

procurement of capital assets during the

Budget period.

 It is prepared by taking into consideration

 Future demand projections/growth of industry

 the available production capacities,

 allocation of existing resources and

 likely improvement in production

techniques

Capital Expenditure Budget-objectives

 Determines the When the work on capital

projects can be commenced

 Estimates the expenditure that would be

incurred on the projects approved by the

management and the sources from which

finance will be obtained

 Restricts capital expenditure on projects

within the authorized limits

Importance of Capital Budgeting

 One of most crucial and critical business decisions

 Involvement of heavy funds- Improper and ill-advised

investment and incorrect decisions can jeopardize the

survival of even Biggest firm

 Long – term implications- Impact of capital decisions are

known after a long period A wrong decision can prove

disastrous for the long term survival of the firm

 Irreversible decisions

 Most difficult decisions to make – Capital Budgeting

decisions require assessment of future events which are uncertain Further assessing future costs and benefits

accurately in quantitative terms is not easy E.g KCC and Taloja

 In view of the above the capital expenditure decisions are best reserved for consideration of the highest

level of management

Kinds of Capital Investment Proposals

 Independent proposals-

Don’t compete with any other proposal They are

cases of “accept or reject” proposals on the

minimum return on investment cut off criteria basis.

 Contingent or dependent Proposals

Proposals whose acceptance depends on the

acceptance one or more proposals.-Substantial

Expansion of plan, other capital requirement Like

township etc

 Mutually exclusive proposals;-

e.g Temperature control Systems, Agitator, Valves

Factors affecting Capital investment

decisions

investment- where no funds constraints are there

proposals giving higher rate of return than the minimum cut off rate may be accepted

 However where fund constraints are

there, then Capital Rationing has to be resorted to.

 Projects should be arranged in ascending order of capital investment and giving due consideration of priority

Investment Appraisal Methods

 In view of the importance of Capital Budgeting

decisions, it is essential that the Capital Investment

appraisal method adopted must be sound.

 A good appraisal method should have the

features.

 Clear Basis for distinguishing between acceptable and non acceptable projects

 Ranking the projects on the basis of desirability

 Choosing among several alternatives

 A criterion applicable to any conceivable project

 Recognizing bigger benefit projects are preferable

to smaller ones and early benefit projects are

preferable to later ones

Investment Appraisal Methods

 In all the appraisal methods emphasis is on the

return

 The basic approach to compare the investment in

the project with benefits derived there from.

 Following are the main methods generally

used;-1 Pay –back period method

2 Discounted Cash flow method

a) The Net present value method

b) Present value index method

c) IRR Method

3 Accounting Rate of return Method

Pay –back period method

 The term Pay –back Period refers to the period in which the project will generate the necessary cash to recoup

the initial investment

 For e.g- if a project requires Rs.20000 as initial

investment and it will generate an annual cash flow of

Rs.5000 for ten years, the pay-back period will be 4

years, calculated as follows

 Pay –back period =

 The Annual cash flow is calculated on the basis of Net

Initial investment Annual cash Flow

Pay –back period method

Unadjusted rate of return

= x100 =25%

Uneven cash flow:- If a project requires an initial

investment of Rs.20000 and annual cash inflows for 5 years are Rs.6000,Rs.8000,Rs.5000,Rs.4000 and

Rs.4000 respectively ,the pay –back period will be

Pay –back period method

Pay –back period method

 Criterion of accept or reject:

 Reciprocal of cost of capital (COC).

for e.g If COC is 20% the maximum acceptable

Pay-back period would be 5 years

(i.e.100/20)which can also be termed as cut off

point

 May be a predetermined Criteria by management

i.e.say Reciprocal of COC -Safety Margin.

5 years -1= 4

 Refer to illustration 5.4 and 5.5

Pay –back period method

Merits

 Useful for evaluation of projects with high

uncertainty, political instability, obsolescence of Technology etc

 Method based on the assumption that no profit arises till initial capital is recovered Suitable of new companies

 Simple to understand and to workout

 Reduces the possibility of loss due to

obsolescence as the investment is made only on

 Projects with long gestation period will

never be taken up though they yield better

returns

 The method ignores the time value of money

Pay –back period method

Suitability

Political or other conditions are hazy this

method is suitable

 Firms suffering from liquidity crises

 Firms dependent on short term performances

Discounted Cash Flow (DCF)

 DCF Technique is an improvement on payback

period method.

 It takes into account Time Value of money i.e interest factor as well as the returns after the payback

period.

The method involves 3 stages

 Calculation of cash flows (both inflow and

outflow preferably after tax for full life of the

project).

 Discounting cash flows by applying a discount

factor.

 Aggregation of discounted cash flows and

ascertainment of net cash flow.

NPV Method

 The cash inflows and cash outflows

associated with the project are worked out

 The present value of these cash flows is

calculated at a rate of return acceptable to

the management ( Cost of capital suitably

adjusted for risk element)

 The net present value (NPV) i.e difference between total present value of cash inflow

and total present value of cash outflow is

ascertained

NPV Method

 Accept or reject criterion

 Where NPV > Zero Accept the proposal

 Where NPV < Zero Reject the proposal

 Refer illustration 5.6 , 5.7 and 5.8

Excess present value index

 This is a refinement of NPV method

 Instead of working out the NPV a present

value index is worked out by comparing total present value of future cash inflows and total present value of future cash outflows

 Refer illustration 5.10

Internal rate of return (IRR)

 IRR is that rate of return at which the sum of discounted cash inflows equals the sum of

Internal rate of return (IRR)

 Accept / Reject Criterion:

 IRR is the maximum rate of interest which

an organization can afford to pay on capital

invested in a project.

 A Project would qualify only if IRR exceeds

the cut-off rate.

 A project giving higher IRR than cut-off rate would be preferred

 Refer e.g 5.12 & 5.13

Accounting Rate of return (ARR)

 Under this method proposals are judged on the basis of relative profitability

 It is calculated on the following basis

 (Annual Average net earnings / original

investments)*100

 Annual Average net earnings is the average net earnings after depreciations and tax for the entire life of the project

 Refer illustration 5.16

CAPITAL BUDGETING & INVESTMENT APPRAISAL METHODS