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CAPITAL BUDGETING

INTRODUCTION:-

The capital budget may be defined as


“ the firm’s decision to invest its current funds most
efficiently in the long-term assets in anticipation if an
expected flow of benefits over a series of years. Therefore
it involves a current outlay or series of outlay of cash
resources in return for an anticipated flow of future
benefits. Capital budgeting is the process of identifying ,
analyzing and selecting investment projects whose returns
(cash flow) are expected to extend beyond one year.

Firm’s investment decisions would


generally include expansion, acquisition, modernization,
replacement of fixed assets.

TECHNIQUES OF CAPITAL BUDGETING


The investment
evaluation techniques play vital role in evaluating a
project. Profitability of a firm will increase if the proposal is
profitability. Selection of profitability project will help to
maximize value of the firm through the maximization of
profits. Therefore, capital budgeting decisions form the
framework for a firm’s future development.

A wide range of criteria has been


suggested to judge the worthwhileness of investment of
investment alternative. Evaluation techniques are divided
into two broad categories.
• Traditional techniques or non-discounted
techniques

• Modern techniques or discounted cash flow


techniques.

The traditional techniques are


further subdivided into two , such as

• Payback period (PBP).

• Accounting rate of return on Average


rate of return(ARR)

The discounted cash flow techniques are again subdivided


into three. Such as

• Net Present Value (NPV) technique.

• Internal rate of return (IRR) technique.

• Profitability Index (PV) technique.

TRADITIONAL TECHNIQUES:-
The traditional techniques are
further subdivided into two. Such as

• Pay Back Period (PBP).

• Accounting Rate of Return on Average Rate of Return


(ARR).

PAY BACK PERIOD


Payback period is one of the most popular and
widely recognized techniques of evaluating investment
proposals. Payback period may be defined as that period
required recovering the original cash outflow invested in a
project. In other words it is the minimum required number
of years to recover the original cash outlay invested in a
project. The cash flow after taxes are used to compute
payback period.

Payback period can be calculated in


two ways

• Using formula

• Using cumulative cash flow method.

The first method can be applied when the annual


cash flows stream of each year is equal i.e., uniform cash
flows for all the years. In the situation the following
formula is used to calculate payback period.

PAY BACK PERIOD=ORIGINAL


INVESTMENT/CONSTANT ANNUAL CASH F LOWS AFT
ER TAX.

The second method is applied when the annual


cash flows after taxes are unequal of not uniform over the
projects life period. In this situation, payback period is
calculated through the process of cumulative cash flows,
cumulative process goes up to the period where
cumulative cash flows equal to the actual cash outflows.

PBP=YEAR BEFORE FULL RECOVERY+


(UNRECOVERED AMOUNT OFINVESTMENT+
CASH FLOWS DURING YEAR)

DECISION RULES:-
Acceptance or reject of the project decides
based the comparison of calculated PBP with the
(maximum) standard payback period:

ACCEPT: Cal PBP < standard PBP

REJECT: Cal PBP > standard PBP

ADVANTAGES OF PAY BACK PERIOD:

The merits of payback period ate:

• It is very simple and easy to understand.

• Cost involvement in calculating PBP is very less with


the comparison of modern methods.

LIMITATIONS OF PAY BACK PERIOD:

Payback period method suffers from the following


limitations

• It ignores cash flows after payback period.

• It is not an appropriate method of measuring the


profitability of a project, as it does not consider
all cash inflow yielded the investment.

• It does not take into consideration time value of


money.
• There is no rational basis for setting a minimum
payback period.

• It is not consistent with the objective of


maximizing shareholders ‘wealth since share
value does not depend on pay back periods of
investment projects.

PROFORMA OF CASH INFLOWS AFTER TAXES (CFAT)

PARTICULARS AMOUNT(Rs.)
Sales Revenue *****
Less: Variable cost *****
Contribution *****
Less: Fixed cost *****
Earnings Before Depreciation Taxes(EBDT) *****
Less: Depreciation *****
Earnings Before Taxes (EBT) *****
Less: Taxes *****
Earnings After Taxes (EAT) *****
Add: Depreciation *****
Cash Flows After Tax ( CFAT) *****

CONCLUSION:-

“ PAY BACK PERIOD REQUIRED TO


RECOVER THE ORIGINAL CASH OUT FLOW OF
INVESTMENT.”
SAROJINI INSTITUTE OF
TECHNOLOGY

SUBJECT
INTRODUCTION TO TECHNOLOGY
MANAGEMENT

SUBMITED TO
M.SRINATH GARU(ASST. PROFESSIOR
MBA)
SUBMITED BY
RAJENDRA PRASAD.D
MBA
Reg NO:09MF1E0036

SAROJINI INSTITUTE OF
TECHNOLOGY

SUBJECT
INTRODUCTION TO TECHNOLOGY
MANAGEMENT

SUBMITED TO
M.SRINATH GARU(ASST. PROFESSIOR
MBA)
SUBMITED BY
KALESH.D
MBA
Reg NO:09MF1E0018