Capital Budgeting

Meaning

long term planning for proposed

capital outlays and their financing

-  raising of long term funds as well as their utilization

-  “ the firm’s formal process for the acquisition and investment of capital”

- involves firm’s decision to invest its current funds for addition, disposition, modification and

replacement of long term or fixed assets

Importance:

• involvement of heavy funds

• long term implications ( purchase a new plant)

• Irreversible decisions- cannot be change– Most difficulty to make future estimate

Techniques 1. Payback Period Method

-the period in which the project will generate the necessary cash to recoup the initial investment

a)  When the cash inflows are uniform every year

Payback period = Initial investment / Annual cash inflow*

*  indicates before depreciation but after taxation.

    

b)    When the cash inflows are not equal every year

Cumulative years + remaining amount needed to reach the initial investment / that year cash inflows

2. Discounted Cash Flow Method or Time Adjusted Techniques:

A-Net Present Value Method – -  under this method cash inflow and outflows associated with the project are first worked out

-   then the cash inflows and outflows are then calculated at the rate of return acceptable to the

management

-   this rate of return is considered as the cut off rate and is generally determined on the basis

of cost of capital suitably adjusted to allow

for the risk element involved in the project.

a)      Internal Rate of Return-   is that rate at which the sum of discounted cash

inflows equals the sum of discounted cash outflows. In other words it is the rate which discounts the cash

flows to zero.

Cash Inflows/ Cash Outflows = 1

i-  When cash inflows are uniform

F = I / C

Where F= Factor to be located

I = Original investment

C= Cash inflow per year

ii-  when cash inflows are not uniformthen instead of cash inflow per year

average cash inflow will be considered.b)  Net Present Value method= present value of future cash inflows / present value of future cash outflows 100

  

 3. Accounting or Average Rate

of Return Method (ARR) The capital investment proposals are judged on the

basis of their relative profitability. For this purpose, capital employed and related income are

determined according to commonly accepted accounting principles and practices over the entire economic life of the project and then the average

yield is calculated.

i)                    ARR = Annual average net earnings */ Original Investment 100

ii)              ARR = Annual average net earnings / Average Investment 100

iii) ARR = Increase in expected future annual net earnings/ Initial increase in required

investment 100 * is the average of the earnings

( after depreciation and tax)