Capital Budgeting

Capital expenditure intended to benefit future periods in contrast to revenue expenditure which benefits a current period in addition to a capital asset. - Kohler Capital budgeting is essentially a process of conceiving, analyzing, evaluating and selecting the most profitable project for investment.

Significance of Capital Budgeting

1. 2. 3. 4. Long-Term Implication Involvement of Large Amount of Fund Irreversible Decisions Risk and Uncertainty

Steps involved in Project Evaluation

1. Identification of Potential Opportunities 2. Assembling of Investment Proposals Replacement investment Expansion investment New product investment Obligatory or welfare investment 3. Decision Making 4.Preparation of Capital Budget and Appropriations 5.Implementations: Translation of investment proposals into concrete projects 6.Performance Review or Post-Completion Audit

Time Value of Money Based on the idea that the money received today is more than money receivable tomorrow. Cash in hand is valued more because it gives
Liquidity Opportunity to invest it and earn return on it.

This is called time value of money. This concept is applied to investment decisions.

 There is a time lag between investment and its returns. When an investment is made today, it begins to yield returns at some future data. The time gap between the investment and the first return from the investment is called time-lag. During this time lag, investor loses interest on the expected incomes. This implies that a rupee received today is worth more than a rupee receivable at some future date. In this context, the present value of a future income is lower than the value of the same amount received today.

Formula for computing Present Value

A= P(1+r)n PV of Amount(A)= A/(1+r)n

Methods of Investment Appraisal Net Present Value Internal Rate of Return Discounted Cash Flow

Net Present Value

NPV= TPV- TPC NPV= Net Present Value TPC= Total cost of investment without any recurring expenditures. TPV=Total Present value of annual stream If NPV> 0, the project is acceptable. If NPV=0, the project is accepted or rejected on noneconomic considerations; If NPV< 0, the project is rejected.

Internal Rate of Return(IRR)

Also called Marginal Efficiency of Investment(MEI), Internal Rate of Project (IRP) and Break Even Rate (BER). For example, if a one year project costing Rs. 100 million yields Rs. 120 million at the end of the year,

120 million Rs. 100 million (1 r)

(1 r)100 120 r 0.20

 The IRR or MEI is defined as the rate of interest or return which renders the discounted present value of its expected future marginal yields exactly equal to the investment cost of project. IRR is the rate of return at which the discounted present value of receipts and expenditures are equal. IRR is the rate of return NPV is equal to zero. IRR criterion is basically the same as Keyness Marginal Efficiency of Investment(MEI). The IRR criterion says that so long as internal rate of return is greater than the market rate of interest, it is always profitable to borrow and invest.