Scribd Logo
Upload

Welcome to Scribd!

  • 16 views

    Bba FM Notes Unit Iii

    Uploaded by

    Sunita Sehgal
    The document discusses capital budgeting, which refers to the process of planning and evaluating long-term investments. It covers the meaning, process, objectives, methods, and types of capital budgeting decisions. The key methods discussed are payback period, net present value, internal rate of return, and profitability index.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd

    Bba FM Notes Unit Iii

    Uploaded by

    Sunita Sehgal
    16 views7 pages
    The document discusses capital budgeting, which refers to the process of planning and evaluating long-term investments. It covers the meaning, process, objectives, methods, and types of capital budgeting decisions. The key methods discussed are payback period, net present value, internal rate of return, and profitability index.

    Original Description:

    Study material of financial management for ip students

    Original Title

    BBA FM NOTES UNIT III

    Copyright

    © © All Rights Reserved

    Available Formats

    DOCX, PDF, TXT or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    The document discusses capital budgeting, which refers to the process of planning and evaluating long-term investments. It covers the meaning, process, objectives, methods, and types of capital budgeting decisions. The key methods discussed are payback period, net present value, internal rate of return, and profitability index.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    16 views7 pages

    Bba FM Notes Unit Iii

    Uploaded by

    Sunita Sehgal
    The document discusses capital budgeting, which refers to the process of planning and evaluating long-term investments. It covers the meaning, process, objectives, methods, and types of capital budgeting decisions. The key methods discussed are payback period, net present value, internal rate of return, and profitability index.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 7

    Dr.

    Akhilesh Das Gupta Institute of Technology & Management


    BBA Department

    Name of Faculty: Mr. Sachin Jindal

    Subject Code: BBA

    Subject Title: Financial Management

    Notes
    Unit-III
    Meaning of Capital Budgeting: Capital Budgeting refers to the planning
    process which is used for decision making of the long term investment. It helps
    in deciding whether the projects are fruitful for the business and will provide
    the required returns in the future years. It is important because capital
    expenditure requires a huge amount of funds. So before making such
    expenditures in the capital, the companies need to assure themselves that the
    spending will bring profits to the business. Investments in heavy machinery or
    big constructions are examples of capital budgeting.
    Capital budgeting process is a decision-making process where a company
    plans and determines any long-term Cap-ex whose returns in terms of cash
    flows are expected to be received beyond a year. Investment decisions may
    include any of the below:

     Expansion
     Acquisition
     Replacement
     New Product
     R&D
     Major Advertisement Campaign
     Welfare investment

    Features of Capital Budgeting

    Capital Budgeting is characterized by the following features:

     There is a long duration between the initial investments and the expected
    returns.
     The organizations usually estimate large profits.
     The process involves high risks.
     It is a fixed investment over the long run.
     Investments made in a project determine the future financial condition of an
    organization.
     All projects require significant amounts of funding.
     The amount of investment made in the project determines the profitability of
    a company.

    Objectives of Capital Budgeting

    The following points present the objectives of the capital budgeting:

     Capital Expenditure Control: Organizations need to estimate the cost of


    investment as it allows them to control and manage the required capital
    expenditures.
     Selecting Profitable Projects: The company will have to select the most
    appropriate project from the multiple possibilities in front of it.
     Identification of Source of funds: The businesses need to locate and
    select the most viable and apt source of funds for long-term capital
    investment. It needs to compare the various costs like the costs of
    borrowing and the cost of expected profits.

    Limitations of Capital Budgeting

    Although capital budgeting provides a lot of insight into the future prospects of a
    business, it cannot be termed a flawless method after all. In this section, we learn
    about some of the limitations of capital budgeting.

    Cash Flow

    It is a simple technique that determines if an enhanced value of a project justifies


    the required investment. The primary reason to implement capital budgeting is to
    achieve forecasting revenue a project may possibly generate. The problem could be
    the estimate itself. All the upfront costs or the future revenue are all only estimates
    at this point. An overestimation or an underestimation could ultimately be
    detrimental to the performance of the business.

    Time Horizon

    Usually, capital budgeting as a process works across for long spans of years. While
    the shorter duration forecasts may be estimated, the longer ones are bound to be
    miscalculated. Therefore, an expanded time horizon could be a potential problem
    while computing figures with capital budgeting.
    Besides, there could be additional factors such as competition or legal or
    technological innovations that could be problematic.

    Time Value

    The payback period method of capital budgeting holds a lot of relevance, especially
    for small businesses. It is a simple method that only requires the business to repay
    in the predecided timeframe. However, the problem it poses is that it does not count
    in the time value of money. This is to say that equal amounts (of money) have
    different values at different points in time.

    Discount Rates

    The accounting for the time value of money is done either by borrowing money,
    paying interest, or using one’s own money. The knowledge of discount rates is
    essential. The proper estimation and calculation of which could be a cumbersome
    task.

    Even if this is achieved, there are other fluctuations like the varying interest rates
    that could hamper future cash flows. Therefore, this is a factor that adds up to the
    list of limitations of capital budgeting.

    Methods of Capital Budgeting

    There are five major techniques used for capital budgeting decision analysis
    to select the viable investment are as below:
    #1 – Payback Period

    Payback Period is the number of years it takes to recover the investment’s


    initial cost – the cash outflow –. The shorter the payback period, the better it is.
    Features:

     Provides a crude measure of liquidity


     Provides some information on the risk of the investment
     Simple to calculate

    #2-Discounted Payback Period

    Features:

     It considers the time value of money


     Considers the risk involved in the project cash flows by using the cost of
    capital
    #3-Net Present Value Method

    NPV is the sum of the present values of all the expected cash flows in case a
    project is undertaken.
    NPV = Total Present Value- CF0
    where,

     CF0 = Initial Investment


     PV = Annual Cash Inflow * PV of Rs 1
     K = Required Rate of Return

     This method of capital budgeting analysis considers the time value of money
     Considers all the cash flows of the project
     Considers the risk involved in the project cash flows by using the cost of capital
     Indicates whether the investment will increase the project’s or the company’s
    value

    #4- Internal Rate of Return (IRR)

    IRR is the discount rate when the present value of the expected incremental
    cash inflows equals the project’s initial cost.
    i.e. when PV(Inflows) = PV(Outflows)

    Features:

     It considers the time value of money


     Considers all the cash flows of the project
     Considers the risk involved in the project cash flows by using the cost of capital
     Indicates whether the investment will increase the project’s or the company’s
    value

    #5- Profitability Index

    Profitability Index is the Present Value of a Project’s future cash flows divided
    by the initial cash outlay.
    PI = PV of Future Cash Flow / CF0
    Where,

    CF0 is the initial investment

    This ratio is also known as Profit Investment Ratio (PIR) or Value Investment
    Ratio (VIR).
    Features:

     It considers the time value of money


     Considers all the cash flows of the project
     Considers the risk involved in the project cash flows by using the cost of capital
     Indicates whether the investment will increase the project’s or the company’s
    value
     Useful in ranking and selecting projects when capital is rationed

    Types of Capital Budgeting Decisions

     Accept-Reject Decision. .
     Mutually Exclusive Project Decision. .
     Capital Rationing Decision.

    1. Accept-Reject Decision: This is a fundamental decision in capital budgeting.


    If the project is accepted, the firm would invest in it; if the proposal is rejected,
    the firm does not invest in it. In general, all those proposals which yield a rate of
    return greater than a certain required rate of return or cost of capital are
    accepted and the rest are rejected. By applying this criterion, all independent
    projects are accepted. Independent projects are the projects that do not compete
    with one another in such a way that the acceptance of one precludes the
    possibility of acceptance of another. Under the accept-reject decision, all
    independent projects that satisfy the minimum investment criterion should be
    implemented.

    2. Mutually Exclusive Project Decision: Mutually Exclusive Projects are those


    which compete with other projects in such a way that the acceptance of one will
    exclude the acceptance of the other projects. The alternatives are mutually
    exclusive and only one may be chosen. Suppose a company is intending to buy
    a new folding machine. There are three competing brands, each with a different
    initial investment and operating costs. The three machines represent mutually
    exclusive alternatives, as only one of these can be selected. Moreover, the
    mutually exclusive project decisions are not independent of the accept-reject
    decisions. The project should also be acceptable under the latter decision. Thus,
    mutually exclusive projects acquire significance when more than one proposal
    is acceptable under the accept-reject decision.

    3. Capital Rationing Decision: In a situation where the firm has unlimited


    funds, all independent investment proposals yielding returns greater than some
    pre-determined level are accepted. However, this situation does not prevail in
    most of the business forms in actual practice. They have a fixed capital budget.
    A large number of investment proposals compete for these limited funds. The
    firm must, therefore, ration them. The firm allocates funds to projects in a
    manner that it maximises long-run returns. Thus, capital rationing refers to a
    situation in which a firm has more acceptable investments than it can finance. It
    is concerned with the selection of a group of Investment proposals out of many
    investment proposals acceptable under the accept-reject decision. Capital
    rationing employs ranking of acceptable Investment projects. These projects can
    be ranked on the basis of a pre-determined criterion such as the rate of return.
    The projects are ranked in descending order of the rate of return.

    Process of Capital Budgeting

    The process of Capital Budgeting involves the following points:

    1. Identifying and generating projects

    Investment proposals are the first step in capital budgeting. Taking up


    investments in a business can be motivated by a number of reasons. There could
    be the addition or expansion of a product line. An increase in production or a
    decrease in production costs could also be suggested.

    2. Evaluating the project

    It mainly consists of selecting all criteria necessary for judging the need for a
    proposal. In order to maximize market value, it has to match the company's
    mission. It is crucial to consider the time value of money here.

    In addition to estimating the benefits and costs, you should weigh the pros and
    cons associated with the process. There could be a lot of risks involved with the
    total cash inflows and outflows. This needs to be scrutinized thoroughly before
    moving ahead.

    3. Selecting a Project

    Since there is no ‘one-size-fits-all’ factor, there is no defined technique for


    selecting a project. Every business has diverse requirements and therefore, the
    approval over a project comes based on the objectives of the organization.

    After the project has been finalized, the other components need to be attended
    to. These include the acquisition of funds which can be explored by the finance
    department of the company. The companies need to explore all the options
    before concluding and approving the project. Besides, the factors like viability,
    profitability, and market conditions also play a vital role in the selection of the
    project.
    4. Implementation

    Once the project is implemented, now come the other critical elements such as
    completing it in the stipulated time frame or reduction of costs. Hereafter, the
    management takes charge of monitoring the impact of implementing the project.

    5. Performance Review

    This involves the process of analyzing and assessing the actual results over the
    estimated outcomes. This step helps the management identify the flaws and
    eliminate them for future proposals.

    You might also like