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CAPITAL BUDGETING

CAPITAL BUDGETING. BY PROF. P. M. POPHALE. NATURE OF DECISION. 1. LONG TERM INVESTMENT .Investments are for a very long period of time 2. LARGE OUTLAY . Involves large amount of funds 3. RETURNS OVER A PERIOD . Returns are received over a period of time. NATURE contd….

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CAPITAL BUDGETING

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  1. CAPITAL BUDGETING BY PROF. P. M. POPHALE

  2. NATURE OF DECISION 1. LONG TERM INVESTMENT .Investments are for a very long period of time 2. LARGE OUTLAY . Involves large amount of funds 3. RETURNS OVER A PERIOD . Returns are received over a period of time

  3. NATURE contd…. 4. IRREVERSIBLE DECISION . Decisions once taken are difficult to reverse 5. CURRENT OUTFLOW OR A SERIES OF OUTFLOW .Outflow at current period 6. ANTICIPATED FUTURE FLOWS . Future flows are anticipated

  4. NATURE contd. … 7. TECHNICAL ANALYSIS . The technical viability of project is established 8. BENEFIT OF INCREASED REVENUES 9. ADDITION, DISPOSITION, MODIFICATION, REPLACEMENT OF FIXED ASSETS . Decisions increasing revenues or reducing costs

  5. NATURE contd. … 10. HIGH DEGREE OF RISK e.g.pager .Dealing with uncertain future consisting of large no. of factors affecting 11.AFFECTING EVALUATION BY ANALYSTS . Analysts may affect the evaluation

  6. NATURE contd. … 12. REVENUE FORECASTS . Revenue forecasts is a pre-requisite 13. DIFFICULT TO CALCULATE ALL BENEFITS IN MONETARY TERMS . Non monetary impact is not counted

  7. DATA REQUIRED • CASH FLOWS – INCREMENTAL & EFFECT ON EXISTING INFLOWS • TAX STRUTURE • DEPRECIATION • INCREMENTAL OUTFLOWS – INITIAL & ADDITIONAL

  8. CALCULATION OF CASH FLOWS • SALES • EXPENSES EXCLUDING INT & DEP • PBIDT • PBDT • PBT • PAT • CASHFLOWS

  9. METHODS OF EVALUATION • PAY BACK PERIOD METHOD . Period of repayment of initial investment • AVERAGE RATE OF RETURN . Average profits/Investments 3. DISCOUNTED CASH FLOW METHODS

  10. METHODS OF EVALUATION CONCEPT OF TIME VALUE OF MONEY . Computing and discounting THE IMPORTANCE OF CHOOSING DISCOUNTING FACTOR . The relevance and subjectivity of discounting factor

  11. DISCOUNTED CASH FLOW METHODS • NET PRESENT VALUE METHOD • RELATIVE NPV/ PROFITABILITY INDEX METHOD • INTERNAL RATE OF RETURN • TERMINAL VALUE METHOD

  12. NET PRESENT VALUE METHOD • SALES FORECAST . Based on market research and analysis • EXPENSES FORECAST . Based on past experience • COMPUTATION OF ACCOUNTING PROFIT . Calculated as per accounting principles

  13. NPV contd. … • CALCULATION OF CASH FLOWS . Cash flows = PAT + Non cash charges • APPLICATION OF DISCOUNTING FACTORS & PRESENT VALUES . Cash inflows x Discounting factor • TOTAL PV OF FUTURE INFLOWS

  14. NPV contd. … • TOTAL CASH OUTFLOW .Initial investment in FA & WC • NET PV .Total PV – Total cash outflow • DECISION MAKING – ACCEPT / REJECT DECISION . Accept if NPV is positive

  15. RELATIVE NPV NPV • RELATIVE NPV = -------------------- X 100 INVESTMENT • DECISION MAKING

  16. INTERNAL RATE OF RETURN • CALCULATE RATE OF RETURN WITH POSITIVE NPV • CALCULATE RATE OF RETURN WITH NEGATIVE NPV RATE WITH +VE NPV DIFF. BET. IRR = +VE NPV + -------------------------------------- X TWO RATES +VE NPV – NEGATIVE NPV OF RETURN

  17. LIMITATIONS OF DCF • DIFFICULT TO UNDERSTAND .Requires understanding of accounting concepts • SUBJECTIVE CHOICE OF DISCOUNTING FACTOR . Choice depends upon the person, discounting factor directly affects the decision

  18. LIMITATIONS OF DCF • PROPER CALCULATION OF CASH FLOWS . Sales forecast, profit anticipations may not be scientifically arrived at • UNCERTAIN FUTURE . All forecasts are subject to uncertainty

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