FINANCIAL MANAGEMENT

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 Firm

How to
utilize funds

Short term Long term

investment investment

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LONG TERM INVESTMENTS
Long term projects are always more important
than any short term projects because of following
two reasons
• Investment amount involves in such projects
are very big
• These decisions are irreversible

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Definitions
According to the definition of Charles T.
Hrongreen, “capital budgeting is a long-term
planning for making and financing proposed
capital out lays
According to the definition of Richard and
Green law, “capital budgeting is acquiring inputs
with long-term return”.

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According to the definition of G.C. Philippatos,
“capital budgeting is concerned with the allocation of the
firms source financial resources among 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 immediate and subsequent streams of
expenditure”.

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Need and Importance of Capital Budgeting
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.
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.

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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.
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

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It is concerned with long term decision making
Including huge and substantial investment. Right
decision is very important in case of capital
budgeting.
Before projects are undertaken, they should be assessed and
evaluated. As a general rule, projects should not be
undertaken unless:
 They are expected to provide a suitable financial return, a
 The investment risk is acceptable

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 The basis for making an
investment decision

accounting Internal Net

payback rate of present Discounte
rate of
period return value d cash
return
(IRR) (NPV) flow (DCF
(ARR)

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Definition of ARR
The accounting rate of return (ARR) of an
investment project is the accounting profit
(usually before interest and tax) expressed as a
percentage of the capital invested
ARR measures the financial return from specific
capital project.
The essential feature of ARR is that it is based on
accounting profits
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Unfortunately there is no standard definition of
accounting rate of return. There are two main
definitions:
 Average annual profit as a percentage of the
average investment in the project
 Average annual profit as a percentage of the
initial investment.

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Accounting Profit
Accounting Profit are the one calculated in the
normal manner.it is nothing but Earning after tax
(EAT) it is calculated as under
EBT = sales – Vc – Fc – Dep –Int
EAT = EBT – Tax
EAT = sales – Vc – Fc – Dep –Int - tax

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CASH PROFIT
It refers to the profit that are earned in cash i.e
Earning after tax but before depreciation. It is
obtained by adding depreciation to EAT. Thus
Cash profit = EAT + Dep
i.e
Cash Profit = sales – Vc – Fc –Int - tax

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Question
Sales for the three years are 200 L 400 and 500 L .
Vc cost is 40%. FC excluding depreciation is 50
L. Depreciation is 60 L. tax rate 40%. Find
1. Accounting profit
2. Cash profit

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Yr Sales Vc Fc Dep Ebt Tax Eat Cash
profit

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A question might specify which definition to apply. If in
doubt, assume that capital employed is the average amount
of capital employed over the project life
However, you might be expected to define capital employed
as the total initial investment (capital expenditure + working
capital investment).

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Profits will vary from one year to the next
over the life of an investment project. As indicated
earlier, profit is defined as the accounting profit, after
depreciation but before interest and taxation. Since
profits vary over the life of the project, it is normal to
use the average annual profit to calculate ARR.
Profit is calculated using normal accounting rules,
and is after deduction of depreciation on non-current
assets.
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Decision rule for the ARR method
Decisions using ARR are made with reference to a target
set by the company. In other words, a company decides
on what it considers to be an acceptable level of return
and assesses projects by comparing them to this level.
The decision rule for capital investment appraisal using
the ARR method is if the
• Accept a project when its ARR is higher than the target.
• Reject a project when its ARR is less than the target .

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