31306354 capital budgeting(3)

8/8/2019 31306354 Capital Budgeting(3)

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CAPITALAPITAL

BUDGETINGUDGETINGAniruddha GachakeAniruddha Gachake


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Introductionntroduction

Decisions involving huge capital and timeDecisions involving huge capital and timeat the same time gives rise to revenuesat the same time gives rise to revenues

over a number of years.over a number of years.

CAPITAL BUDGETING


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Meaning of Capitaleaning of Capital

BudgetingudgetingCapital budgeting is a required managerial tool.Capital budgeting is a required managerial tool.One duty of a financial manager is to chooseOne duty of a financial manager is to chooseinvestments with satisfactory cash flows andinvestments with satisfactory cash flows and

rates of return. Therefore a financial manager rates of return. Therefore a financial manager must be able to decide whether an investmentmust be able to decide whether an investmentis worth undertaking and be able to chooseis worth undertaking and be able to chooseintelligently between two or more alternatives.intelligently between two or more alternatives.To do this a sound system procedure toTo do this a sound system procedure toevaluate, compare and select projects isevaluate, compare and select projects isneeded. This procedure is called capitalneeded. This procedure is called capitalbudgeting.budgeting.


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Need For Capitaleed For Capital

BudgetingudgetingDebt Equity StudyDebt Equity StudyBetter capital managementBetter capital management

Planning implementation control


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Types of Capitalypes of Capital

Budgetingudgeting1. project size 1. project size * Small* Small* Large* Large2. type of benefit to the firm 2. type of benefit to the firm * an increase in cash flow* an increase in cash flow* a decrease in risk* a decrease in risk* an indirect benefit* an indirect benefit

3. degree of dependence 3. degree of dependence * mutually exclusive projects* mutually exclusive projects* complementary projects* complementary projects* substitute projects* substitute projects4. degree of statistical dependence 4. degree of statistical dependence * positive dependence* positive dependence

* negative dependence* negative dependence5. type of cash flow 5. type of cash flow * conventional cash flow only one change in the cash floe sign* conventional cash flow only one change in the cash floe sign* Non conventional cash flow more than one change in the cash flow sign* Non conventional cash flow more than one change in the cash flow sign


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Supply of capital upply of capital

Sources of capitalources of capitalA company may raise funds from the following sourcesA company may raise funds from the following sources

New issueNew issue

Right issueRight issue Loan stockLoan stock Retained earningsRetained earnings Bank borrowingsBank borrowings Government sourcesGovernment sources LeasingLeasing Hire purchaseHire purchase Venture capitalVenture capital


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Capital Rationingapital Rationing

Companies specify an overall limit on theCompanies specify an overall limit on thetotal budget for capital spending, thistotal budget for capital spending, this

process of deciding the limit of capitalprocess of deciding the limit of capitalspending is known as capital rationing.spending is known as capital rationing.


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Types of capitalypes of capital

rat ioningationingHard capital rationing This arises whenHard capital rationing This arises whenconstraints are externally determined.constraints are externally determined.

This will not occur under perfect market.This will not occur under perfect market.Soft capital rationing This arises withSoft capital rationing This arises withinternal management imposed limits oninternal management imposed limits on

investment expenditure.investment expenditure.


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Reasons for capitaleasons for capital

rat ioning -ationing -External reasons These arises when a firm is unable toExternal reasons These arises when a firm is unable toborrow from the outside. For example if the firm is under borrow from the outside. For example if the firm is under financial distress, tight credit conditions or the firm has afinancial distress, tight credit conditions or the firm has anew unproven product. Similarly borrowing limits imposednew unproven product. Similarly borrowing limits imposedby banks particularly in relation to smaller firms andby banks particularly in relation to smaller firms andindividuals.individuals.Internal reasons-Internal reasons-

Private owned companyPrivate owned company

Divisional constraintDivisional constraint Human resource limitationsHuman resource limitations Debt constraintsDebt constraints


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Cost of capital -ost of capital -

Cost incurred to procure the capitalBy weighted average


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Calculating cost ofalculating cost of

capitalapitalWe calculate a companys weightedWe calculate a companys weightedaverage cost of capital using a 3 stepaverage cost of capital using a 3 step

process process Cost of capital componentsCost of capital components Capital structureCapital structure

Weighting the componentsWeighting the components


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Project Feasibil i ty -roject Feasibil i ty -

The feasibility of the project can be judged byThe feasibility of the project can be judged by

Market analysisMarket analysis Technical analysisTechnical analysis Financial analysisFinancial analysis

Economic analysisEconomic analysis Environmental analysisEnvironmental analysis


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Market analysis -arket analysis -

Deals with two questions Deals with two questions Demand for the proposed productDemand for the proposed product Market share of the project under appraisal.Market share of the project under appraisal.To answer these questions the market analyst require followingTo answer these questions the market analyst require following

information information Consumption trendConsumption trend Supply positionSupply position Production possibilities and constraintsProduction possibilities and constraints Cost structureCost structure

Elasticity of demandElasticity of demand Consumer behaviour Consumer behaviour


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Technical analysis -echnical analysis -

Analysis of the technical and engineeringAnalysis of the technical and engineeringaspects of the project.aspects of the project.


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Financial analysis -inancial analysis -

To judge the financial viability of theTo judge the financial viability of theproject.project.

Tools Tools Break even pointBreak even point Cost of capitalCost of capital Budgeting techniques etc.Budgeting techniques etc.


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Economic analysis -conomic analysis -

Economic analysis also referred to asEconomic analysis also referred to associal cost benefit analysis, is concernedsocial cost benefit analysis, is concerned

with judging a project from the larger with judging a project from the larger social point of view.social point of view.


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Environmental analysisnvironmental analysis

-Evaluating the project considering theEvaluating the project considering theenvironmental issues.environmental issues.

M h d f j


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Methods of projecto s o pro ecevaluation- Methods ofvaluation- Methods ofranking investmentanking investmentproposalsroposals

Pay back method or payback period Pay back method or payback period The payback period is the number of yearsThe payback period is the number of years

required to return the original investmentrequired to return the original investmentfrom the net cash flow. ( net operatingfrom the net cash flow. ( net operatingincome after taxes plus depreciation ).income after taxes plus depreciation ).


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Mathematically -athematically -

Pay Back Period = cash outlay/ AnnualPay Back Period = cash outlay/ Annualcash inflowscash inflows


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Accounting rate ofccounting rate of

returnseturns

Accounting rate of return = Average netAccounting rate of return = Average netprofit / Average Annual investmentprofit / Average Annual investment


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Profitabili ty index -rofitabili ty index -

Profitability index = PV of future cashProfitability index = PV of future cashflows/ PV of initial investmentflows/ PV of initial investment


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Date 13/5/2010Date 13/5/2010

31306354 capital budgeting(3)

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