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Unit 4 Capital Budgeting (Page no. 1-17) www.apnenotes.co
Downloaded from www.apnenotes.co 1 Capital Budgeting Introduction  Every organization, irrespective of its nature or size, in the course of its functioning, usually acquires, upgrades, replaces the assets such as land and buildings, plant and machinery and so on.  For each of these, there exist two or more alternatives, which need to be carefully evaluated on the basis of their costs and revenues. To improve the quality of decisions, an understanding of the principles and practices of capital budgeting is essential. Definition  Capital budgeting is the process which involves the planning of capital expenditures in various investment projects. Only those investment projects are included, which are expected to yield returns beyond one year. It is also called long-term investment analysis as it involves only long-term expenditure.  Capital expenditure is expenditure on the projects, which yield a return beyond one year, for example, expenditure on building, machinery and research and development.  Short-term capital expenditures, for example, expenditures on inventories, which can be adjusted in the short-run are not included. Significance of capital budgeting  Capital budgeting decisions assume special significance for the following reasons: 1. Substantial capital outlay: Capital budgeting decisions involve substantial capital outlay. 2. Long-term implications: Capital budgeting proposals are of longer duration and hence have long-term implications. For instance, the cash flows for next 5 to 15 years have to be forecasted. 3. Strategic in nature: Capital budgeting decision can affect the future of the company significantly as it constitutes the strategic determinant for the success of a company. A right investment decision is the secret of the success of many business enterprises. 4. Irreversible: Once funds are committed to a particular project, the decision cannot be taken back. If the decision is to be reversed, the firm may have to lose a significant portion of the funds already committed. It may involve loss of time and efforts. In other words, the capital budgeting decisions are irreversible or may not be easily reversible. Complications underlying capital budgeting decisions  Capital budgeting decisions are complex because of the following reasons:  Varying cash flows at different points of time: Cash flows occur at different points of time in future. The future cash flows, both inflows and outflows, are to be
Downloaded from www.apnenotes.co 2 estimated now to decide whether to commit substantial funds in a project under consideration or not. Since the future is uncertain, the process of estimating future cash flows needs to be a specialised task.  Time value factor: Cash inflows occurring at different points of time have to be compared with the corresponding cash outflows using the concept of time value of money. Why is capital budgeting necessary?  It is necessary to reduce costs or increase revenues to maximise profits. The company is said to be efficient in its operations when it can maximise profits. In other words, capital budgeting decisions are made to keep the business vibrant, competitive, profitable and thus efficient. Capital budgeting decisions can be classified into two types:  Projects that reduce costs • Projects that increase revenues Steps in capital budgeting  Capital budgeting can increase the value of a firm. The steps involved in capital budgeting are as follows: 1. Determination of the cost of the project under consideration. 2. Estimation of the cash flows from the project. 3. Measurement of the risk involved in cash flows. 4. Determination of appropriate discount rate - generally market rate of interest is used for the purposes of discounting. 5. Obtaining the present value of the future cash flow with the project’s cost.  If the present value of the future cash flow from the project is greater than the initial cost of the project, firm should undertake the project as it will increase the value of the firm.  If the present value of the future cash flow from the project is lesser than the initial cost of the project, the firm should not undertake the project. Methods of capital budgeting  Capital budgeting decisions are made on different criteria. How are these criteria determined?  These criteria differ in concepts. Some use thumb rule and some use logic and scientific approach. So, based on these criteria, the methods of capital budgeting can be classified as: A. Traditional methods (i) Payback period (ii) Accounting rate of return method B. Discounted cash flow methods (i) Internal rate of return (IRR) method (ii) Net present value (NPV) method
Downloaded from www.apnenotes.co 3 (iii) Profitability index (PI) method Payback period method  Under payback method, the decision to accept or reject a proposal is based on its payback period. Payback period refers to the period within which the original cost of the project is recovered. It is calculated by dividing the cost of the project by annual cash inflows.  Payback period = cost of the project/annual cash inflows  The shorter the length of the payback period, the better is the project in terms of paying back the original investment. Particularly where the future is uncertain, the companies favour this method.  The earlier the original investment is recovered, the better it is in terms of safety and liquidity. Where the cash inflows are uniform through out, they are said to be even. Where cash inflows are even  Example: 1. The cost of a project is Rs.50,000. The annual cash inflows for the next 4 years are Rs.25,000. What is the payback period for the project?  Solution:  Payback period=Cost of the project/Annual cash inflows  = 50,000/25,000  = 2years 2. A project which requires an initial investment of Rs.1,00,000 would give a return of Rs.20,000 each for the next 10 years. Find the payback period of the project?  Solution:  PB=cost of the project/annual cash inflows  =Cfo/Cfi  =1,00,000/20,000  =5 years  Which means the initial investment can be recovered in 5 years for this project. Where cash inflows are uneven  Where the cash flows are not uniform, they are said to be uneven. In such a case take the cumulative cash inflows and see how much time it takes to get back the original investment.  Example: The cost of a project is Rs.50,000 which has an expected life of 5 years. The cash inflows for the next 5 years are Rs.24,000, Rs.26,000, Rs. 20,000, Rs.17,000 and Rs.16,000 respectively. Determine the payback period.