Subject: Financial Management
Chapter no. 11: Capital Budgeting
Chapter No. 11 – Capital Budgeting
Contents ♦ Capital budgets as opposed to revenue budgets ♦ Different kinds of capital budgets – non-productive assets, improving operating efficiency and capital projects ♦ Choosing capital projects – Conventional and Discounted Cash Flow techniques ♦ Payback period, Discounted payback period, Net Present Value, Internal Rate of Return, Profitability Index methods ♦ Assumptions underlying different methods ♦ Introduction to IRR vs. NPV ♦ Incremental cash flow principle for evaluation of replacement decisions ♦ Numerical exercises on incremental cash flows, NPV, IRR, Discounted payback period and Profitability Index
At the end of the chapter the student will be able to: ♦ Apply incremental cash flow principle to a replacement decision ♦ Apply conventional as well as DCF techniques to capital investment decisions ♦ Determine NPV for a given project and fix the range of rates between which IRR for a given set of projections would lie ♦ Understand how IRR readily offers itself for fixing Equated installments on a loan at a given rate of interest, duration and periodicity like monthly or quarterly
Capital budgets as opposed to revenue budgets
The assumption here is that the students understand the significance of the term “budgets”. To recap, “budgets” are essentially meant for: ♦ ♦ Allocation of scarce resources and Control and monitoring of expenses
The budgets are of various kinds, depending upon the objectives in the organisation. The two major finance budgets that a business enterprise usually prepare are: ♦ Revenue budget – prepared on an annual basis with monthly break-up. Purpose is to control revenue expenses related to different activities in an organisation. There is a review process. The frequency of break-up could be less say a quarter. The frequency of review process and the period for which break-up is given like month or
Punjab Technical University, Online Virtual Campus
Subject: Financial Management
Chapter no. 11: Capital Budgeting quarter synchronise with each other. If there is a monthly break-up of expenses, the review is also done on a monthly basis. ♦ Capital budget – prepared on an annual basis with once in a year review process. This budget is more meant for capital expenses for which the enterprise will be required to manage within its internal accruals and not depend upon external finance. External finance and shareholders’ capital are warranted only for major capital expenditure like expansion, diversification, modernisation etc. The students will appreciate that there is a difference between capital expenditure on routine items like say copier machine, furniture and fixtures, EPABX (telephone exchange) etc. which do not give any return unlike industrial projects. Industrial projects require a lot of funds and in turn, give positive cash flows (net cash flows being positive – difference between cash outflows and cash inflows)
In this chapter we are going to learn about capital budgeting, a process of selection of projects and decision on alternative investment opportunities available to a business enterprise.
Different kinds of capital budgets – non-productive assets, improving operating efficiency and capital projects Just to link this point with what we have seen in the previous paragraph, we may state that there could be different kinds of capital budgets in an organisation like: 1. 2. Budgets for projects that involve huge capital outlays (cash outflows) but also bring in substantial net cash inflows Budgets for replacement of assets that bring in improved operating efficiency resulting in cost reduction that is indirectly cash inflow – this is different from the first one in requirement of funds also. Further this is done on an on going basis unlike industrial projects that happen once in a while Budgets for routine items that are fairly regular (examples given...
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