CAPITAL BUDGETING & INVESTMENT
APPRAISAL METHODS
PRESENTATION
BY
PROF. V.RAMACHANDRAN
SIESCOMS, NERUL, NAVI MUMBAI
1
AGENDA
 Concept of Capital Budgeting
 Capital Expenditure Budget
 Importance of Capital Budgeting
 Rational of Capital Expenditure
 Kinds of Capital Investment Proposals
 Factors affecting Investment Decision
 Investment Appraisal Methods
 Capital Rationing
2
Concept of Capital Budgeting
 Finance Manager is concerned with Planning and
Financing investment decisions.
 Financing Decisions relate to determination of
amount of long term finance and decision on
sources for financing the same.
 Investment decisions also termed as “Capital
Budgeting Decisions” involve cost - benefit
analysis.
 Investment decisions are based on careful
consideration of factors like profitability, safety,
liquidity, solvency etc.
3
Why Capital Budgeting
 Capital investment means investments in projects which
by nature involve huge expenditure and results of the
same are known only after a long time.
Why Capital investment is necessary






For investments in New Projects
Replacement of worn out/ out dated assets.
Expansion of existing capacity – To meet high demand or
inadequate production capacity.
Diversification – to reduce risk
Research and Development – Ensuring updated
technology.
Miscellaneous – Installation of Pollution Control equipment,
4
other legal requirements.
Capital Budgeting
 The term Capital Budgeting refers to long term planning




for proposed capital outlays and their financing
It involves raising of long term funds and their
utilization.
In other words, It is the formal process for acquisition
and investment of capital.
Capital Budgeting is a many-sided activity.
It is a process of:
 searching for new and more profitable investment
options
 by taking into account the consequences of accepting
an investment proposal
 by making a detailed economic analysis of the profit
making potential of each investment proposal.
5
Capital Budgeting
 Essential features based on which decisions are
taken
 Profit
potential
 Degree of risk
 Gestation period i.e time lag from the
period of initial investment to anticipated
returns.
6
Capital Expenditure Budget
 It is the formal plan of Capital expenditure
on new projects/ purchase of fixed assets.
 Provides for the capital outlay available for
procurement of capital assets during the
Budget period.
 It is prepared by taking into consideration




Future demand projections/growth of industry
the available production capacities,
allocation of existing resources and
likely improvement in production
techniques.
7
Capital Expenditure Budget-objectives
 Determines the When the work on capital
projects can be commenced
 Estimates the expenditure that would be
incurred on the projects approved by the
management and the sources from which
finance will be obtained
 Restricts capital expenditure on projects
within the authorized limits
8
Importance of Capital Budgeting
 One of most crucial and critical business decisions
 Involvement of heavy funds- Improper and ill-advised




investment and incorrect decisions can jeopardize the
survival of even Biggest firm
Long – term implications- Impact of capital decisions are
known after a long period. A wrong decision can prove
disastrous for the long term survival of the firm
Irreversible decisions
Most difficult decisions to make – Capital Budgeting
decisions require assessment of future events which are
uncertain. Further assessing future costs and benefits
accurately in quantitative terms is not easy. E.g KCC and
Taloja
In view of the above the capital expenditure decisions
are best reserved for consideration of the highest 9
level of management
Kinds of Capital Investment Proposals
 Independent proposals-
Don’t compete with any other proposal. They are
cases of “accept or reject” proposals on the
minimum return on investment cut off criteria basis.
 Contingent or dependent Proposals :Proposals whose acceptance depends on the
acceptance one or more proposals.-Substantial
Expansion of plan, other capital requirement. Like
township etc
 Mutually exclusive proposals;e.g Temperature control Systems, Agitator, Valves
Etc
10
Factors affecting Capital investment
decisions
 The amount of investment


where no funds constraints are there
proposals giving higher rate of return than
the minimum cut off rate may be accepted
However where fund constraints are
there, then Capital Rationing has to be
resorted to.
Projects should be arranged in ascending
order of capital investment and giving due
consideration of priority
11
Investment Appraisal Methods
 In view of the importance of Capital Budgeting
decisions, it is essential that the Capital Investment
appraisal method adopted must be sound.
 A good appraisal method should have the
features.





Clear Basis for distinguishing between acceptable
and non acceptable projects
Ranking the projects on the basis of desirability
Choosing among several alternatives
A criterion applicable to any conceivable project
Recognizing bigger benefit projects are preferable
to smaller ones and early benefit projects are
preferable to later ones
12
Investment Appraisal Methods



1.
2.
In all the appraisal methods emphasis is on the
return.
The basic approach to compare the investment in
the project with benefits derived there from.
Following are the main methods generally used;Pay –back period method
Discounted Cash flow method
a)
b)
c)
3.
The Net present value method
Present value index method
IRR Method
Accounting Rate of return Method
13
Pay –back period method
 The term Pay –back Period refers to the period in which
the project will generate the necessary cash to recoup
the initial investment
 For e.g- if a project requires Rs.20000 as initial
investment and it will generate an annual cash flow of
Rs.5000 for ten years, the pay-back period will be 4
years, calculated as follows
 Pay –back period =
Initial investment
Annual cash Flow
 The Annual cash flow is calculated on the basis of Net
income before depreciation but after considering the
tax. (PAT+Depreciation)
14
Pay –back period method
 The income expressed as %of initial investment is termed as
Unadjusted rate of return
Unadjusted Return =
=
Annual return
x100
Initial Investment
5000 x100 =25%
20000
Uneven cash flow:- If a project requires an initial
investment of Rs.20000 and annual cash inflows for 5
years are Rs.6000,Rs.8000,Rs.5000,Rs.4000 and
Rs.4000 respectively ,the pay –back period will be
calculated as follows
15
Pay –back period method
Year
1
2
Cash
Cumulative
Inflows cash inflows
6000
6000
8000
14000
3
4
5000
4000
19000
23000
5
4000
27000
Rs.19000 is recovered in 3years and Rs.1000 is left out of initial
investment. The cash inflow in 4th year is Rs.4000 which
indicates that pay-back period is in between 3rd and 4th
year.i.e.3+(1000/4000) = 3.25 years
16
Pay –back period method
 Criterion of accept or reject:
 Reciprocal of cost of capital (COC).
for e.g If COC is 20% the maximum acceptable
Pay-back period would be 5 years
(i.e.100/20)which can also be termed as cut off
point.
 May be a predetermined Criteria by management
i.e.say Reciprocal of COC -Safety Margin.
5 years -1= 4
 Refer to illustration 5.4 and 5.5
17
Pay –back period method
Merits
 Useful for evaluation of projects with high
uncertainty, political instability, obsolescence of
Technology etc
 Method based on the assumption that no profit
arises till initial capital is recovered. Suitable of
new companies
 Simple to understand and to workout
 Reduces the possibility of loss due to
obsolescence as the investment is made only on
short term projects
18
Pay –back period method
Demerits
 Ignores the returns after its pay –back
period
 Projects with long gestation period will
never be taken up though they yield better
returns
 The method ignores the time value of money
19
Pay –back period method
Suitability
 Hazy long term outlookPolitical or other conditions are hazy this
method is suitable
 Firms suffering from liquidity crises
 Firms dependent on short term performances
20
Discounted Cash Flow (DCF)
 DCF Technique is an improvement on payback
period method.
 It takes into account Time Value of money i.e interest
factor as well as the returns after the payback
period.
The method involves 3 stages
 Calculation of cash flows (both inflow and
outflow preferably after tax for full life of the
project).
 Discounting cash flows by applying a discount
factor.
 Aggregation of discounted cash flows and
ascertainment of net cash flow.
21
NPV Method
 The cash inflows and cash outflows
associated with the project are worked out.
 The present value of these cash flows is
calculated at a rate of return acceptable to
the management ( Cost of capital suitably
adjusted for risk element)
 The net present value (NPV) i.e. difference
between total present value of cash inflow
and total present value of cash outflow is
ascertained.
22
NPV Method
 Accept or reject criterion
 Where NPV > Zero Accept the proposal.
 Where NPV < Zero Reject the proposal.
 Refer illustration 5.6 , 5.7 and 5.8.
23
Excess present value index
 This is a refinement of NPV method.
 Instead of working out the NPV a present
value index is worked out by comparing total
present value of future cash inflows and total
present value of future cash outflows.
 Refer illustration 5.10.
24
Internal rate of return (IRR)
 IRR is that rate of return at which the sum of
discounted cash inflows equals the sum of
cash outflows.
 In other words it is the rate which discounts
the cash flows to zero.
 It can be stated in the form of formula as
under.
 Cash inflows =1
Cash outflows
25
Internal rate of return (IRR)
 Accept / Reject Criterion:
 IRR is the maximum rate of interest which
an organization can afford to pay on capital
invested in a project.
 A Project would qualify only if IRR exceeds
the cut-off rate.
 A project giving higher IRR than cut-off rate
would be preferred.
 Refer e.g. 5.12 & 5.13.
26
Accounting Rate of return (ARR)
 Under this method proposals are judged on
the basis of relative profitability.
 It is calculated on the following basis.
 (Annual Average net earnings / original
investments)*100
 Annual Average net earnings is the average
net earnings after depreciations and tax for
the entire life of the project.
 Refer illustration 5.16.
27
CAPITAL BUDGETING & INVESTMENT
APPRAISAL METHODS
28