Capital Budgeting:

Capital Budgeting Capital budgeting is a long term planning for making and financing
proposed capital outlay Capital budgeting refers to firms formal process for the acquisition and
investment of capital. Capital budgeting refers to the total process of generating, evaluating,
selecting and following up on capital expenditure alternatives Thus capital budgeting is a
decision making process through which a business concern evaluates the purchase of various
fixed assets for expansion, replacement Capital budgeting is a planning of capital expenditure
which provide yields over a number of years.

Process of capital Budgeting:
Process of capital Budgeting The various steps involved in capital budgeting process depend on.
According to Quinin G. David the following five steps are involved in the process of capital
budgeting: (1) Project Generation (2) Project Evaluation (3) Project Selection (4) Project
Execution (5) Follow Up

Importance of Capital Budgeting:
Importance of Capital Budgeting (1) Substantial Expenditure (2) Long Time Period (3)
Irreversibility (4) complex Decision

Types of Capital Expenditure Decisions:
Types of Capital Expenditure Decisions On the basis of Firms Existence : (1)Replacement and
Modernization Decision (2)Expansion Decision (3)Diversifiction Decision On the Basis of
Decision Situation: (1)Mutually Exclusive Decisions (2)Accept Reject Decisions (3)Contingent
Decisions

Project Evaluation Techniques:
Project Evaluation Techniques Traditional Techniques: Pay Back Period Accounting or average
Rate of Return Payback Reciprocal Pay Back Period It is the period within which the entire
cost of a project will be completely recovered. It is the period within which the total cash inflows
from the project equals the cost of the project. Cash flow means profit after tax before
depreciation.

Slide 6:
Calculation of pay back period: (1)When cash flow accrues at even rate, where there is equal
cash inflows: Pay back period = total investment / cash inflow (2)When cash flow accrues at
uneven rate i.e. where there is unequal cash inflow B Pay back period = E + ------- C E = no of
years immediately preceding the year of recovery B= balance amount of investment to be
recovered C = saving (cash inflow) during the year of final recovery

Slide 7:
Merits: It is an important guide to investment policy It lays a great emphasis on liquidity It acts
as a yardstick in comparing the profitability of two projects. It weighs early returns heavily and
ignores distant returns It is simple to operate and easy to operate. Demerits: it ignores the time
value of money It does not consider the cost of capital It fails to consider that profits from
different projects may arrive at an uneven rate. It over emphasizes liquidity and ignores capital
wastage and the economic life of an asset

Average Rate of Return:
Average Rate of Return This method is also known as accounting rate of return, is used to
measure the rate of return on an investment in a project. Under this method average annual profit
(after tax) is expressed as percentage of investment. average annual profit after tax ARR = -------
---------------------------------- * 100 average investment Average annual profits = is determined by
adding the after tax expected profits for each year of the life of the project and dividing the same
by the no. of year Average Investment = original investment divided by 2. if there is scrap value,
then cost minus scrap value will be divided by 2 and to this scrap value should be added. If there
is additional working capital required by the project it should also be added.

Slide 9:
Advantage: It is simple to calculate and easy to understand. It considers savings over the entire
life of the project It recognizes the concept of the net earnings It facilitates the comparison of
new product project with that of cost reducing project or other projects of competitive nature
Disadvantage: It does not consider time value of money. It does not take into account life period
of the various investments. In the case of long term investment it may not reveal true and fair
view.

Pay Back Reciprocal:
Pay Back Reciprocal It is reciprocal of payback period. A major draw back of the payback
method is that it does not indicate any cut off period for the purpose of investment decision. The
payback reciprocal is a helpful tool for quickly estimating the rate of return of a project provided
its life is at least twice the payback period. The payback reciprocal can be calculated as follows:
Average annual cash flow Pay back reciprocal = ------------------------------------ Initial Investment

Net Present Value:
Net Present Value The best method for evaluation of an investment is NPV . This method takes
into account the time value of money. The net present value of an investment proposal may be
defined as the sum of present values of all the cash inflows less the sum of the present values of
all the cash outflows associated with the project. NPV =Discounted cash inflows Discount cash
outflow Cash inflow means profit after tax before depreciation Acceptance Rule : NPV > 0
Accept the project NPV = 0 Reject or may be accept NPV < 0 Reject the project

Slide 12:
Merits: It considers time value of money The whole stream of cash flows is considered The NPV
uses the discounted cash flows The net present value can be seen at the addition to the wealth of
shareholder. Demerits: It involves difficult calculations The ranking of the project depend on the
discount rate The application of this necessitates forecasting cash flows and discount rate. Thus
accuracy of NPV depends on accurate estimation of these two factor which may be quite difficult
in practice

Internal rate of return:
Internal rate of return It is a rate at which the present value of cash outflow is equal to the present
value of cash inflows. In other words we may say that IRR is that value at which NPV of the
project is zero. It is also as yield on investment ,marginal efficiency of capital, marginal
productivity of capital and rate of return. Accept-Reject Rule: If IRR > cost of capital Accept If
IRR= cost of capital Accept or reject If IRR < cost of capital Reject

Slide 14:
Merits: It considers the time value of money It considers all the cash flows generated during the
life of the project. It is easier to use. Demerits: It involves complex method of calculation. Under
the IRR method it is presumed that all the intermediate cash flows can also be reinvested at the
IRR In case of non conventional cash flows there may be in determinant or multiple IRR

Profitability Index:
Profitability Index Under this method the ratio of present value of cash inflows to the present
value of outflow is calculated and the decision regarding acceptance or rejection depends on the
fact whether the ratio is greater than 1 or less than 1. PI is used when we have to compare a no of
projects each involving different amount of cash flows. PI = present value of cash inflow ---------
--------------------------------- present value of cash outflow

Slide 16:
Merits: It is simple to use and easy to understand. It takes the concept of time value of money. It
considers all the cash inflows generated during the life time of the project. Demerits: It involves
complex method of calculation. Under the IRR method it is presumed that all the intermediate
cash flows can also be reinvested at the IRR

Capital Rationing:
Capital Rationing Resource Constraints: Financial resources are scare Return Maximization:
Investment planning is called capital rationing. Classification of Investment Proposal: Nature of
project Indivisible Divisible Meaning Investment should be made in full. Partial or proportionate
investment is not possible Partial investment is possible. Proportionate NPV can be calculated
Steps in decision making Determine the combination of projects to utilise amount available
Compute NPV of each combination Select the combination with maximum NPV (1)Compute PI
of various projects and rank them. (2) Projects are selected based on maximum profitability
index.

EBIT & EPS Analysis :
EBIT & EPS Analysis Financial break even point: it denotes the level at which a firms EBIT is
just sufficient to cover interest and preference dividend. Interest + P.D. It is computed as EBIT =
----------------------- (1- tax rate) Point of indifference: it refers to that EBIT level at which EPS
remains the same irrespective of the debt equity mix. In other words at this point rate of return on
capital employed is equal to the rate of interest on debt. This is also known as break even of
EBIT for alternative financial plans.

Slide 19:
the point of indifference can be calculated with the help of the following formula: ( X-I 1 )(I-T)-
PD = ( X-I 2 )(I-T)-PD Indiff. Point = ---------------------- --------------------- S 1 S 2 X= point of
indifference or BEP EBIT level I=interest under alternative 1 I 2 =interest under alternative 2 T=
tax rate PD = preference dividend S 1 = no of equity shares in alternative 1 S 2 = = no of equity
shares in alternative 2

Interpretation of Indifference point:
Interpretation of Indifference point The calculation of indifference point helps in ascertaining the
level of operating profit beyond which the debt alternative is beneficial because of its favorable
effect on earning per share or uncommitted earnings per share. In other words it is profitable to
raise debt for strengthening EPS if there is likelihood that future operating profits are going to be
higher than level of EBIT as determined and vice versa.

Risk and Uncertainty in capital Budgeting :
Risk and Uncertainty in capital Budgeting There are different methods which are used to
incorporate risk in the capital budgeting decisions. Sensitivity Analysis approach: under the
sensitivity analysis approach the decision maker estimates the net present value of the project
under three conditions: Pessimistic, most likely, optimistic thus decision maker estimates the
NPV in all the three conditions and will help to decision maker to have better insight of the
expected NPV of the project

Slide 22:
The decision maker would be facilitated if somehow the probabilities can be assigned to
occurrence of pessimistic most likely and optimistic situations. The probabilities can be assigned
on the objective basis or subjective basis. Merits: it is simple and easy to understand This
approach helps in calculating the NPV of project in different conditions. Demerits: probabilities
can not be accurate The acceptance and rejection of the project is dependent on the nature of
decision maker.

Decision Tree Approach:
Decision Tree Approach This method is used when the cash flows related with the project are of
dependent nature i.e. cash flow of the year 1 has relation with the cash flow of the year 2. under
this method the occurrence of particular level of cash flows is also assigned probabilities and
generally each cash flow is succeeded by more than one cash flow as a result of which it has tree
like structure.

Risk adjusted discount rate approach:
Risk adjusted discount rate approach This approach involves incorporation of risk in the discount
rate of the proposal which is used to discount the expected cash inflows of the project. The
discount rate is increased on the basis of expected risk of the project. The risk adjusted discount
rate is a composite discount rate that takes into account both the time factor and risk factor. The
risk of the project can be measured using standard deviation or coefficient of variation. The
higher the value of the standard deviation or coefficient of variation the higher the value of the
risk and hence the discount rate should be accordingly increased.

Slide 25:
Merits: it is simple and easy to understand It helps in incorporating risk in project evaluation
very easily. Demerits: The adjustment in discount rate is based on the subjective approach of a
decision maker. Under this approach the risk is incorporated in the discount rate which is in fact
not the correct element It is general technique and does not make use of the statistical methods in
any way to incorporate risk.

Certainty equivalent approach:
Certainty equivalent approach Under this approach the risk is incorporated in the cash flows
related with the project by multiplying each of the cash flow with a factor called as coefficient of
certainty equivalent. The coefficient of certainty equivalent is given by the ratio of riskless cash
flow to the risky cash flow. Risk less cash flow CCE = ----------------------------- Risky cash flow
Risk less cash flows are those cash flows which a decision maker expects on its investment if the
risk involved in the investment is zero. These are generally the cash flows one can get by
investment in government securities.

Slide 27:
Under this approach the actual cash flows which are subject to risk first converted into risk less
cash flows and there after they are discounted using risk less interest rate. The coefficient of
certainty equivalent is a fractional amount and its value varies between 0 & 1. The coefficient
has got inverse relationship with the amount of risk. Higher the value of risk, lower would be the
value of the coefficient and vice versa.

Slide 28:
Merits: It is easy to calculate It incorporates risk at the right place i.e. in the cash inflows which
are subject to change. Demerits: It involves use of subjective approach while determining
expected risk less cash flows It is a general technique and does not make use of the statistical
methods in any way to incorporate ris