2Capital Budgeting Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures.Very important to firm’s future.
3Capital budgetingCapital budgeting (is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research and development projects are worth pursuing
4Investment Decisions Replacement Projects Expansion Projects Diversification ProjectsResearch and Development Projects
5Capital Budgeting Process Identification Of Investment ProposalsScreening The ProposalsEvaluation Of Various ProposalsEstablishing PrioritiesFinal ApprovalImplementing ProposalPerformance Review
6Pay backThe number of years required to recover a project’s cost, or “How long does it take to get our money back?”Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.
8Disadvantages· The payback period entirely ignores many of the cash inflows, which occur after the payback period.The payback period also ignores the salvage value and the total economic life of the project.. It ignores the timing of the occurrence of the cash flows. It considers the cash flows occurring at different point of time as equal in money worth and ignores the time value of money· Advantages of the payback method:· Payback can be important: long payback means capital tied up and high investment risk.The method also has the advantage that it involves a quick, simple calculation and an easily understood concept.
9ARRannualized net income earned on the average funds invested in a project.the annual returns of a project are expressed as a percentage of the net investment in the project.ARR= Average Annual Profits/Average Investment
10Net present value (NPVThis technique involves calculating the present value of all future cash inflows and cash outflows that will result from undertaking a projectThese positive and negative present values are then netted off against one another to determine the net present value of the project
11The net present value of a project is calculated where:Ft = cash flow generated by the project in year tr = the opportunity cost of capitalC0 = the cost of the project (initial cash flow,)n = the life of the project in years
12strengths It recognizes the time value of money. It helps in evaluation of proposals involving cash flows over a period of several years. The cash flows occurring at different point of time are not directly comparable, but they can be made comparable by the application of the discounting procedure.The NPV technique considers the entire cash flow stream and all the cash inflows and outflows, irrespective of the timing of their occurrence, are incorporated in the calculation of the NPV.The NPV technique is based on the cash flows rather than the accounting profit and thus helps in analysing the effect of the proposal on the wealth of the shareholders in a better way.
13Internal rate of return (IRR) The IRR technique is also based on a DCF model, but focuses on the rate of return in the DCF equation rather than the NPVThe IRR is defined as the discount rate that equates the present value of a project’s cash inflows with the present value of the its cash outflowsThis is the equivalent of saying that the IRR is the discount rate at which the NPV of the project is equal to 0
15Inflation and Capital Budgeting nominal values are the actual amount of money making up cash flowsreal values reflect the purchasing power of the cash flowsreal values are found by adjusting the nominal values For the rate of inflation
16Inflation and Capital Budgeting INFLATION EFFECTS TWO ASPECTS OF CAPITAL BUDGETINGPROJECTED CASH FLOWSDISCOUNT RATE
17Inflation and Capital Budgeting Nominal Discount rate= (1+Inflation rate)*(1+real rate of discount)-1Effect of capital Budgeting Can Be can be incorporated byDiscounting the money cash flows at nominal discount rateDiscounting real cash flows at the real discount rate
18Inflation and Capital Budgeting inflation has the following effects:a) Inflation will mean higher costs and higher selling prices. It is difficult to predict the effect of higher selling prices on demand. A company that raises its prices by 30%, because the general rate of inflation is 30%, might suffer a serious fall in demand.b) Inflation, as it affects financing needs, is also going to affect the cost of capital.c) Since fixed assets and stocks will increase in money value, the same quantities of assets must be financed by increasing amounts of capital. If the future rate of inflation can be predicted with some degree of accuracy, management can work out how much extra finance the company will need and take steps to obtain it, e.g. by increasing retention of earnings, or borrowing.