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Capital Budgeting

 The investment decision of a firm is generally


known as the capital budgeting or capital
expenditure decisions.

 A capital budgeting decision may be defined as the


firm’s decision to invest its current funds most
efficiently in the long – term assets in anticipation
of an expected flow of benefits.
The firm’s investment decision would generally
include:

• Expansion of existing business


• New business
• Acquisition
• Modernization
• Replacement of the long term assets
• Sale of division or business (disinvestment)
Importance of Capital Budgeting
• Capital budgeting decisions involve long-term
implication for the firm, and influence its risk
complexion.
• Capital budgeting involves commitment of large
amount of funds.
• Capital decisions are required to assessment of
future events which are uncertain.

• Capital budgeting decisions are irreversible.


• Capital budgeting ensures the selection of right
source of finance at the right time.
Objectives of Capital Budgeting

• To ensure the selection of the possible


profitable capital projects

• To ensure the effective control of capital


expenditure

• To ensure maximization of profit by allocating


the available funds
Principles of Capital Budgeting Decisions
A capital budgeting decision involves the following
principles or factors:

• Creative search for profitable opportunities

• Evaluation of various proposals in order of priority


having regard to the amount available for investment.

• A careful estimate of the amount to be invested

• A careful estimate of revenues to be earned and costs


to be incurred in future in respect of the project under
consideration.
• A listing and consideration of non-monetary factors
influencing the decisions.

• Evaluation of actual results achieved against those


budget.

• Care should be taken to consider working capital


requirements.

• It should recognize the fact that bigger benefits are


preferable to smaller ones and early benefits are
preferable to latter benefits.
Capital Budgeting Process
The following procedure may be considered in the process of capital
budgeting decisions:
• Identification of profitable investment proposals.

• Screening and selection of right proposals.

• Evaluation of measures of investment worth on the basis of


profitability and uncertainty or risk.

• Final approval and preparation of capital expenditure budget.

• Implementing proposal, i.e., project execution.

• Review the performance of projects.


Types of Capital Expenditure
(1) Capital expenditure increases revenue.
(2) Capital expenditure reduces costs.

Capital Expenditure Increases Revenue:


• It is the expenditure which brings more revenue to the
firm either by expanding the existing production
facilities or development of new production line.

Capital Expenditure Reduces Costs:


• Such a capital expenditure reduces the cost of present
product and thereby increases the profitability of
existing operations. It can be done by replacement of
old machine by a new one.
Types of Capital Budgeting Proposals

Capital expenditure proposals may be classified into:

(1) Independent Proposals

(2) Dependent Proposals or Contingent Proposals

(3) Mutually Exclusive Proposals


Independent Proposals
• An independent project is one where the decision to accept or
reject the project has no effect on any other projects being
considered by the company.

• The cash flows of an independent project have no effect on


the cash flows of other projects or divisions of the business.

• Independent proposals do not depend upon each other.


Independent investments serve different purposes and do not
compete with each other.

For example the decision to replace a company's computer


system would be considered independent of a decision to build
a new factory.
Dependent Proposals or Contingent
Proposals

Contingent investments are dependent projects; the


choice of one investment necessitates under taking
one or more other investment.

For example: Construction of new building on


account of installation of new plant and machinery.
Mutually Exclusive Investments

• Mutually exclusive investments serve the same purpose


and compete with each other.

• If one investment is undertaken, others will have to be


excluded.

• In mutually exclusive projects, the cash flows of one


project can have an impact on the cash flows of another.
Investment Evaluation Criteria
Three steps are involved in the evaluation of an
investment:

 Estimation of the cash flow

 Estimation of the required rate of return

 Application of a investment decision rule for


making the choice
Investment Decision Rule
The investment decision rules may be referred to as
capital budgeting techniques, or investment criteria.

• Appraisal technique should be sound.


• The essential property of a sound technique is that
it should maximise the shareholders’ wealth.
Other properties of the sound technique are:

 It should consider all cash flows to determine the true


profitability of the project

 It should provide for an objective way of separating good


projects from bad projects

 It should help ranking of projects according to their true


profitability

 It should recognize the fact that bigger cash flows are


preferable to smaller ones and early cash flows are
preferable to later ones.

 It should help to choose among mutually exclusive projects


that projects which maximise the shareholders’ wealth.
Methods of Evaluating Capital Investment Proposals
1. Traditional Methods
(1) Pay-back period method or Payout method.
(2) Improvement of Traditional Approach to Pay-back Period Method.
(a) Post Pay-back profitability Method.
(b) Discounted Pay-back Period Method.
(c) Reciprocal Pay-back Period Method..

(3) Rate of Return Method or Accounting Rate of Return Method [ARR]

Time Adjusted Method or Discounted Cash Flow Method


(1)Net Present Value Method [NPV]
(2)Internal Rate of Return Method [IRR]
(3)Profitability Index Method [PI]

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