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Capital Budgeting

Capital Budgeting

Capital budgeting is the process of making investment decisions in capital expenditures. Capital expenditure is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in future. Thus capital budgeting refers to long term investment decisions.

Importance of capital budgeting

1. Large investment of funds:- capital budgeting involves large amounts of funds and the funds available with the firm are always limited. So it is important that the judicious use of available funds.

2. Long term commitment of funds:- capital budgeting involves large amounts of funds for long term or permanent basis. Long term commitment involves risk.

3. Irreversible nature:- Once decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without incurring heavy loss.

4. Long term effect on profitability:- long term investment decisions affect the future growth and profitability of the enterprise.

5. Risk of obsolescence:- there is risk of fixed assets becoming obsolete before the expiry of normal life of the asset.

6. Impact on cost structure:- It will change the fixed and variable cost proportion in total cost. Purchase of a new plant may reduce the salary of physical staff.

7. National importance:- Investment decisions though taken by individual concern is of national importance because it determines employment and economic growth of the nation.

Capital budgeting process

1. Conception of idea

2. Preliminary project proposal

3. Feasibility reports

4. Evaluation and ranking

5. Acceptance or rejection

6. Follow up.

Methods of capital budgeting or evaluation of investment proposals.

a. Traditional methods

i. Payback period method

ii. Average rate of return method (ARR)

b. Discounted cash flow methods

i. Net present value method (NPV)

ii. Internal rate of return method (IRR)

iii. Profitability Index method (PI)

Traditional methods

Payback period method:- Payback period is the period within which the initial investment is completely recovered. This method is also known is payout of pay off period.

a. Where annual cash inflow is uniform

PBP = original cost or the project

Net annual cash inflow

(ie profit before depreciation and after tax)

b. Where annual cash inflow is not uniform

Here the net annual cash inflows year after year are cumulated and the payback period is reached when the cumulative total is equal to the initial payment.

The project having lowest PBP will be selected

Accounting Rate of Return

ARR = Average annual profit X 100

Average investment Project project having highest ARR will be selected.

Discounted cash flow methods

1. Present Value

The concept that Rs1 received in the future is not equal to Rs1 received today is known as the ‘time value of money’. The process of converting cash to be received in the future into value at the present time by the use of an interest rate is called ‘discounting’.

Net Present Value (NPV) = PV of Cash Flows - Cash Outlay

The project having highest NPV will be selected.

  1. Internal rate of return:- IRR is the discount rate which equates the present value of cash inflows with present value of cash outflows. That means a rate of discount at which the NPV becomes zero. IRR= LR+ P1 - C X d

P1-P2

Project having highest IRR will be selected

3. Profitability Index:- Profitability Index is tha ratio of present value of cash inflows to present value of cash outflows

PI = present value of cash inflows

Initial investment

The project having highest PI will be selected

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