3 Capital Budgeting and Financial Management By-Rahul Jain
4 I. M. Pandey, Financial Management, 9th ed., Vikas. MeaningFinancial management is a systematic process that provides the necessary financial information to help a business produce and distribute goods and services in a way that will make the most profit. It also provides feedback about how well the organization is doing.I. M. Pandey, Financial Management, 9th ed., Vikas.
5 Finance Functions Investment or Long Term Asset Mix Decision Financing or Capital Mix DecisionDividend or Profit Allocation DecisionLiquidity or Short Term Asset Mix Decision
6 Financial accounting and Financial Management Financial accounting gives the financial status of the company to people outside the company. It is recording and reporting the activities and events that lead to cash inflow and outflow.Financial management means efficiently managing the various resources of the company.
7 Financial accounting and Financial Management CertaintyAccounting is maintenance of financial records. So, it deals with what has already occurred. This makes it more certain.A finance manager is concerned with what is going to happen in the future. He takes critical decisions that will affect the future of the company. These are based on various calculations and assessments. This is not easy because there are many uncertainties in financial management.
8 Time Value of MoneyTime preference for money is an individual’s preference for possession of a given amount of money now, rather than the same amount at some future time.Three reasons may be attributed to the individual’s time preference for money: risk preference for consumption investment opportunities
9 Future ValueCompounding is the process of finding the future values of cash flows by applying the concept of compound interest.Compound interest is the interest that is received on the original amount (principal) as well as on any interest earned but not withdrawn during earlier periods.Simple interest is the interest that is calculated only on the original amount (principal), and thus, no compounding of interest takes place.
10 ExampleIf you deposited Rs 55,650 in a bank, which was paying a 15 per cent rate of interest on a ten-year time deposit, how much would the deposit grow at the end of ten years?
11 Present ValuePresent value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent value to the decision-maker.Discounting is the process of determining present value of a series of future cash flows.The interest rate used for discounting cash flows is also called the discount rate.
12 Present Value of a Single Cash Flow The following general formula can be employed to calculate the present value of a lump sum to be received after some future periods:
13 Exercises What's the present value of: A. $ in 1 years at 16 percent?B $9,000 in 2 years at 8 percent?
14 What is Capital Budgeting? Analysis of potential projects.Long-term decisions; involve large expenditures.Very important to firm’s future.
15 Nature of Capital Budgeting Decisions The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.The firm’s investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firm’s expenditures and benefits, and therefore, they should also be evaluated as investment decisions.
16 Steps in Capital Budgeting Estimate cash flows (inflows & outflows).Determine r = WACC for project.Evaluate cash flows.
18 Features of Investment Decisions The exchange of current funds for future benefits.The funds are invested in long-term assets.The future benefits will occur to the firm over a series of years.
19 Evaluation Criteria 1. Discounted Cash Flow (DCF) Criteria Net Present Value (NPV)2. Non-discounted Cash Flow Criteria Payback Period (PB) Accounting Rate of Return (ARR)
20 PaybackPayback is the number of years required to recover the original cash outlay invested in a project.That is:Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is:
21 PaybackUnequal cash flows In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay.Suppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the project’s payback?3 years + 12 × (1,000/3,000) months3 years + 4 months
22 Payback for Franchise L (Long: Most CFs in out years) 122.43CFt-100106010080Cumulative-100-90-3050PaybackL=2 + 30/ = years
23 Franchise S (Short: CFs come quickly) 11.623CFt-100701005020Cumulative-100-302040PaybackS=/50 = years
24 Acceptance RuleThe project would be accepted if its payback period is less than the maximum or standard payback period set by management.As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period.
25 Evaluation of Payback Certain virtues: Serious limitations: Simplicity Cost effectiveShort-term effectsRisk shieldLiquiditySerious limitations:Cash flows after paybackCash flows ignoredCash flow patternsAdministrative difficultiesInconsistent with shareholder value
26 Accounting Rate of Return Method The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.A variation of the ARR method is to divide average earnings after taxes by the original cost of the project instead of the average cost.
27 Acceptance RuleThis method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate.This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.
28 Evaluation of ARR Method The ARR method may claim some meritsSimplicityAccounting dataAccounting profitabilitySerious shortcomingCash flows ignoredTime value ignoredArbitrary cut-off