Capital Budgeting
Introduction
Capital Budgeting is a long term
planning for making and financing
proposed capital outlays.
Capital Budgeting is in essence,
an application of the classic
proposition from the economic
theory of the firm, namely, a firm
should operate at a point where
marginal revenue is just equal to
its marginal cost.
Capital Budgeting
Introduction
When this rule is applied to
the capital budgeting decision
marginal rate is taken to be
the percentage rate of return
on investments and marginal
cost is the firm’s percentage
cost of capital.
Capital Budgeting
Introduction
The nature of capital budgeting
revolves around
Demand for capital – how much required to
undertake various projects?
Supply of capital – how much is available
and what cost?
Rationing of funds – how much to be spent
and where?
These questions are answered thru study of
demand for capital, supply of capital & cost
of capital.
Capital Budgeting
Demand for Capital
►
►
The demand schedule for capital
refers to the arrangement of the
various proposed projects in
descending order according to their
estimated rates of return together
with required amounts of capital
needed by the respective projects.
Any investment decision is profitable
if it adds more to revenue than to
cost or if it reduces cost more than
the revenue.
Capital Budgeting
Demand for Capital
Investment Worth or Profitability of
a Project
One of the most significant aspects of
capital budgeting is the measurement of
investment worth.
Criteria for appraisal –
1] Payback Period.
2] Discounted Present value
3] Internal Rate of Return
Capital Budgeting
Demand for Capital
Investment Worth or profitability of
a Project
1] Payback Period
Initial Investment Outlay
A Payback Period =
Annual Cash Flow
Thus a project with initial outlay of
Rs. 100,000 providing annual cash
flow of Rs. 25,000 will have a
payback period of four years.
Capital Budgeting
Demand for Capital
Investment Worth or profitability of
a Project
1] Payback Period
Merits :
Simple & easy to calculate.
Liquidity requirements considered.
Favours less risky projects.
Demerits :
Profitability ignored.
Assumes constant cash flow over a long
period.
Disregards time value of money.
Cash flow after the payback is ignored.
Capital Budgeting
Demand for Capital
Investment Worth or profitability of a
Project
2] Discounted Present Value (PDV)
R1
R2
Rn
DPV =
+
. . . +
1+ i (1+i)2
(1+i)n
R1 - Cash flow in year 1; R2 in year 2 etc.
i - rate of interest
Investment is worthwhile if DPV > project cost.
Capital Budgeting
Demand for Capital
Investment Worth or profitability of a
Project
3] Internal Rate of Return
R1
C =
R2
Rn
+
. . . +
1 + e
(1+e)2
(1+e)n
C = project cost.
R1 , R2 – expected return each year.
e - marginal efficiency of capital
Obtain value of e.
If e > i the market rate of interest, the project
is worthwhile.
Capital Budgeting
Supply of Capital and Cost of Capital
There are two sources for Supply of
capital.
Internal :Consists of accumulated non
cash expenditure of
depreciation; and retained
earnings or profits ploughed
back into business.
External: Issue of Shares & Debentures.
Inter-firm & other long term
borrowings.
Capital Budgeting
Supply of Capital and Cost of Capital
►
►
►
The cost of capital is the rate which
must be paid to obtain funds for
operating the enterprise.
Different costs exist for capital
from equity , preference shares,
retained earnings, depreciation etc.
Government decisions on interest
structure, reserve requirements for
banks, as well as investor psychology
have their influence on cost of
capital.
Capital Budgeting
Post Audit
Post Audit is essential function capital
budgeting.
It involves –
Comparison of actual results with those
predicted for investment decision.
Analysis and explanation of differences.
Analysis helps identifying deficiencies in
decision making process that can be corrected
for future proposals.
It also identifies differences that arise due
to factors beyond control of the firm.
Capital Budgeting
Project Planning
Capital Budgeting presupposes
Project Planning.
A project refers to a scheme of
investing resources.
Project planning is essentially a
long term planning of proposed
capital outlays.
Capital Budgeting
Project Planning
Features of Project PlanningDetermining the financial outlays.
Finalize time, technical and financial
dimensions.
It is a long term phenomenon.
It is non-repetitive one time exercise.
It envisages a flow yield in future.
Capital Budgeting
Project Planning
Stages of Project PlanningIdentify investment opportunities.
Assemble resources.
Optimize the use of resources
Estimate the yield.
Select the project on the basis of
investment worth .
Decide on the project.
Implement.
Appraise.
Conduct Performance Review.