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Notes Financial Management

This document discusses capital budgeting, which refers to long-term planning for projects with benefits spread over several periods. It describes the importance of careful capital budgeting decisions due to their substantial costs, long-term effects, irreversibility, and complexity. The capital budgeting process involves planning, evaluation, selection, implementation, control, and review of potential investment projects. The document also outlines several techniques used for capital budgeting analysis, including payback period, accounting rate of return, net present value, profitability index, internal rate of return, and discounted payback period.

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Ashutosh Shukla 12th B/6089
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35 views

Notes Financial Management

This document discusses capital budgeting, which refers to long-term planning for projects with benefits spread over several periods. It describes the importance of careful capital budgeting decisions due to their substantial costs, long-term effects, irreversibility, and complexity. The capital budgeting process involves planning, evaluation, selection, implementation, control, and review of potential investment projects. The document also outlines several techniques used for capital budgeting analysis, including payback period, accounting rate of return, net present value, profitability index, internal rate of return, and discounted payback period.

Uploaded by

Ashutosh Shukla 12th B/6089
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Financial management
Unit 2 : Capital Budgeting Decisions

Capital budgeting refers to long term planning of expenditure


whose return stretch over period .

It is process of deciding whether or not commit resource to


project whose benefit would be spread over several time period

It includes both raising of long term funds and their utilization.

It is a managerial decision since it involve more extended


estimations and prediction of things to come requiring high
level of intellectual ability.

Importance of capital budgeting decision :-


1. Cost  initial investment is substantial . Hnce
commitment of project should made properly.
2. Time  The effect of decision is known only in near future
and not immediately.
3. Irreversibility  Decisions are irreversible and
commitment should made on proper evaluation.
4. Complexity  Decision are based on forecasting of future
event and inflows. Quantification of future involve
application of statistical and probabilistic.
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Capital Budgeting Process :-


1. Planning : It Begins with identification of potential
investment opportunities. The opportunity then enter the
planning phase when the potential effect on firm’s fortune
is assessed and the ability of management of firm to
exploit the opportunity is determined.
2. Evaluation : This involve the determination of proposal
and its investment inflows and outflows. Various
techniques are used to appraise the proposal.
3. Selection : Considering risk and return associated with
individual project as well as cost of capital to organization,
the organization will choose among the project which
maximize shareholder’s wealth.
4. Implementation : when final selection is made the firm
must acquire the necessary funds, purchase asset and
begin implementation of project.
5. Control : The progress of project is monitored with aid or
feedback reports. These reports will include capital
expenditure progress report, performance report
6. Review : when a project terminates, the organization
should review the entire project to explain its success or
failure. This phase may have implication for firm’s planning
and evaluation procedures
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Cash Flow Estimations :


Before analyze how we calculate cash flow in capital budgeting ,
following items need consideration :

 Depreciation : Depreciation is a non cash item and


itself does not affect cash inflow. We must consider tax
shield or benefit from depreciation in our analysis. It is
consider as inflows.

 Opportunity Cost : It is forgoing of benefit due to


choosing an alternative course of action. This can occur at
any time either at initial outlay or during tenure of project.

 Sunk Cost : It is an outlay of cash that already been


incurred in past and cannot reversed in future. These cost
does not have any impact on decision making hence could
excluded from capital budgeting analysis

 Working Capital : While evaluating project initial


working capital requirement should treated as cash
outflow and at end of project it release should treated as
cash inflow. Further there may also possibility of additional
working capital during life of project this is treated as cash
outflow.

 Allocated Overhead : Since expenditure already


incurred allocated to new proposal they should not
consider as cash flows.
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 Additional Capital Investments : It shall treated as


cash outflows.
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Techniques of Capital Budgeting :-

1. Payback Period : Refers to period in which project


will generate necessary cash to recoup initial investment.

Actual payback period more than estimated payback


period  Reject

2. Accounting Rate Of Return : As per this method


capital investment proposals are judge on basis of their
profitability. For this capital employed and expected
income are determined according to commonly accepted
accounting principles and practice over the entire
economic life of project and then average yield is
calculated
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Return less than minimum desired rate of return  Rejected

3. Net Present Value : Net Present Value is Difference


between present value of benefit and cost. If NPV is
Positive  Accept Project.
If NPV is negative  Reject Project

4. Profitability Index : If present value method is


used, the present value of earning of one project cannot
come directly with present value of earning unless another
investment are of same size. In order to compare proposal
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of different size, the flow to investment must be related.


This can be done divide present value of earning by amount
of investments to give ratio called profitability index.

PI > 1  Accept

PI = 1  Accept

PI < 1  Reject

5. Internal rate of return : In Net present value


method the required rate of earning rate is selected in
advance. There is an alternative method which finding
earning rate at which present value of earning equals the
amount of investment. Thus IRR is the rate of return at
which the sum of discounted cash inflows equal the sum of
discounted cash outflows.
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IRR >= Cut off rate  accept

IRR< Cut off rate  Reject


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6. Discounted Payback Period : When pay back


period is computed after discounting the cash flows by pre
determined rate called discounted payback period.
Formula Remain same as for payback period.

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