•

Fi •

n
•
•

a •
•

n •
•
ci •
An Insight to •
al
Capital Budgeting •
•
•

M •
•

a •
•
n •
www.ipsacademy.or
•
 •
Fi
n
a
n
• • OVERVIEW
ci
al

M
•
§ Capital budgeting is a decision involving
a selection of capital expenditure proposals.
n www.ipsacademy.or
 •
Fi
n
a
n
ci •
al • IMPORTANCE

M
•
a
n www.ipsacademy.or
Fi •
n
a
n
•
ci • DIFFICULTIES
•
al
•
§ Uncertainties of Future.
M
a
n • www.ipsacademy.or
Fi • CAPITAL BUDGETING PROCESS
•
n PROPOS
ALS
•
•
a
N PLANNING PHASE
E I •
W MR PROPOS

R
EJE E
n
•

CT
IN OVE ALS

D
PP
O
EVALUATION PHASE

RT I
V ME •

NI

O
U
ES
T
E NT
ci
PROJE •
S IN

R
EJE E
CTS

CT
T PLA SELECTION PHASE •

D
RO A
P
OS
al
M NNI
P
LS
E NG ACCEPTED •

R
EJE E
CT
N AND PROJECTS •
D
IMPLEMENTATION
RO T
T EVA P
EC

PHASE •
J
S

O LUA
ONLINE
P TIO •
M
PROJECTS
P N CONTROL PHASE
O P •
R ROC PROJECT •
a T
U
EED
URE
TERMINATION
AUDITING PHASE •

n
NI •
www.ipsacademy.or•
 •
Fi • WHY CASH FLOW METHOD OF
n EVALUATION?
a •
§ Accrual basis of Accounting.
n
•
ci § Cash flow approach takes in to account ‘time
al value of money’.
•
M § In the absence of real performance
improvement accountants may accelerate
a revenues and defer costs.
n www.ipsacademy.or
•
Fi
•
•

n
•
EVALUATION CRITERIA
•

a •
•

n DISCOUNTING
• NON
DISCOUNTING
CRITERIA • CRITERIA
ci •
•
al INTERN
•
DISC. •
NET AL PR’AB
PAYBA
PRESE RATE LTY
CK •
NT OF INDEX
M PERIO•
VALUE RETUR (PI)
D •
N
ACC.
a •
•
RATE
PAYBA
CK
OF
n
PERIO
• RETUR
D
www.ipsacademy.or
N
•
Fi •
• PAYBACK PERIOD
n •

§ Defined as the numbers of years required to

a cover the original cost outlay.
n •
ci •
al •
INITIAL •
PAYBACK PERIOD INVESTMENT
ANNUAL CASH •
M FLOW
•
a
•
n www.ipsacademy.or •
Fi •
• ADVANTAGES AND DISADVANTAGES
n
• OF PAYBACK PERIOD
a •
•
n

DISADVANTAGE
•
§ Ignores cash after•
ADVANTAGES

§ Simple.
ci the payback period.•
al § Emphasizes on •

S
• § Fails to consider
earlier cash flows. • ips

‘time value of the

M § Rough and ready money’ •
a method or dealing
with risk. •
n www.ipsacademy.or•
 •
Fi • AVERAGE RATE OF RETURN
n •
§ Investment project is judged by looking at its
a rate of return on book value.
n § Evaluates return on accounting profits. i.e. on
ci accrual basis
al Annual returns are expressed in percentage of
§
net investment.
AVERAGE PROFIT AFTER •
AVERAGE RATE
M
TAX •
100
OF RETURN AVERAGE INVESTMENT
•

a •
•

n www.ipsacademy.or•
•
Fi •
• ADVANTAGES AND DISADVANTAGES OF
n ACCOUNTING RATE OF RETURN
a •
•
n

DISADVANTAGE
§ Ignores the life of•
ADVANTAGES

•
ci § Simple. the project. •

al • § Considers value
•

S
§ Fails to consider
of project to its ‘time value of the
• ips

economic life. money’.

M § Ignores the size of•
a investment required.•
n www.ipsacademy.or
•
Fi •
• ADVANTAGES AND DISADVANTAGES OF
n ACCOUNTING RATE OF RETURN
a •
n § Affected by
•

DISADVANTAGE
§ Based on •
ADVANTAGES

ci accounting profits; accounting •

no separate practices; changes•

al

S
•
calculation in method of •
• required. depreciation and
inventory costing
M
• ips

affects earnings and

a hence ARR •
n www.ipsacademy.or
•
 •
Fi • WHY ?... TIME VALUE OF MONEY
n
a § Opportunity cost of the money.
n
§ Inflationary pressures.
ci
al § Uncertainty of the future. i.e. preference of
current consumption than future consumption.
M •
•

a
• ips

•
n www.ipsacademy.or•
Fi •
•
n
• WHY ?... TIME VALUE OF MONEY
a
n •
ci § In 1624, the Red Indians sold Manhattan Island
al at the ridiculously low figure of $24.

M
• Was the amount really ridiculous?
a
n www.ipsacademy.or
•
 •
Fi •

n • WHY ?... TIME VALUE OF MONEY

•
a •
•
n
•
ci § If the Red Indians had merely taken the $24
al (Rs.1200) and reinvested it at 6 percent annual
interest up to 1992, they would have had $50
billion (Rs. 25 lakh crore ), an amount sufficient
M to repurchase most of New York City.
a •
•
n www.ipsacademy.or•
•
 •
Fi • DISCOUNTED PAYBACK METHOD
n •
a
n
ci •
al § Improvement over ‘payback period method’,
considers ‘time value of money’.
M
a
n www.ipsacademy.or
§ It surmounts the objection that equal weight is
Fi
•

• DISCOUNTED PAYBACK METHOD

n
a
n
•
ci
al

§ The discounted payback rule asks, “How many

M periods does the project have to last in order to
a make sense in terms of net present value?”
n www.ipsacademy.or
 •
Fi • NET PRESENT VALUE METHOD
n
a
§ Its the difference between the total discounted
n inflows and outflows.
ci § Depends solely on the forecasted cash flows and
al the opportunity cost of capital.
§ Opportunity cost of capital is the expected rate
of return on investment of equivalent risks.
M § Present value of cash flows is calculated using
a opportunity cost of capital at discount rate.
n www.ipsacademy.or •
 •
Fi • NET PRESENT VALUE METHOD
n •
a § Ideal for mutually exclusive projects.
n § Projects are ranked in the order of highest
‘Net Present Values'
ci •

al •
•
•
•
M •
•
a •

n •
www.ipsacademy.or
• ips

•
Fi •
• ADVANTAGES AND DISADVANTAGES OF
n
• NET PRESENT VALUE METHOD
a •
•
n § Considers‘time § Difficult to

DISADVANTAGE
•
ADVANTAGES

value of money’. ascertain future •

ci cash flows. •

al § Relies on
•

S
•
discount rate and § Biased towards • ips

estimated cash longer term

M flows. projects. •
a •
n www.ipsacademy.or•
 •
Fi • INTERNAL RATE OF RETURN METHOD
n •
a § Also known as the ‘Marginal Rate of Return’
or ‘Time Adjusted Rate of Return’.
n
§ It is the discount rate at which the present
ci value of cash flows equals the present value
al of cash outflows. i.e. NPV = 0
§ In other words, IRR is the rate of return the
project earns.
M § The rate of discount is determined by the
a ‘trial and error method’ .
n
• ips

www.ipsacademy.or•
 •
Fi •

NET PRESENT VALUES

n
•
•

a •
•

n •
•
ci •
•
al
DISC. RATE
•
•
•

M
a § The point of intersection represents the IRR;
where NPV is equal to zero.
n www.ipsacademy.or•
•
Fi •
• ADVANTAGES AND DISADVANTAGES OF
n INTERNAL RATE OF RETURN METHOD
a •
•
n §Considers Working § Lengthy, based on

DISADVANTAGE
•
ADVANTAGES

Capital and Scrape ‘trial and error •

ci method’. •
Value
al •
•

S
§ Considers cash §Assumes that future
• ips

flows during the cash flows are

M whole economic reinvested at a rate•
a life. equal to IRR. •
n www.ipsacademy.or
•
Fi •
• DIFFERENCE BETWEEN NPV METHOD AND
n
• IRR METHOD
a •
•
n
NET PRESENT VALUE

§ Assumes that cost § Assumes that NPV

•

INTERNAL RATE OF
ci
•
of capital is known. is zero. •

al •

RETURN
• §
§ Calculates NPV, Figures out
given the discount discount rate that
• ips

M rate. makes NPV zero.

•
a •
n www.ipsacademy.or•
 •
Fi • PROFITABILITY INDEX
n •
a § The profitability index (or the benefit cost ratio)
n is the present value of forecasted future cash
flows divided by the initial investment:
ci P/V OF CASH INFLOW

al
• PROFITABILITY
INDEX INITIAL CASH OUTFLOW

•
M •
a
•
n
• www.ipsacademy.or
 •
Fi •

n
•
•

a •
•

n •
•
ci
Thank You •
•
al •
•
•

M •
•

a •
•
n •
www.ipsacademy.or
•