# Capital Budgeting

**Topics:**Net present value, Internal rate of return, Investment

**Pages:**68 (22639 words)

**Published:**March 21, 2011

This Section includes :

Capital Budgeting Process Time Value of Money —Future Value —Present Value Investment Appraisal Techniques —Payback Period —Accounting Rate of Return —Earnings Per Share —Net Present Value —Internal Rate of Return —Net Terminal Value —Profitability Index —Discounted Payback Period Capital Rationing INTRODUCTION : Capital Budgeting is the art of finding assets that are worth more than they cost to achieve a predetermind goal i.e., ‘optimising the wealth of a business enterprise’. Capital investment involves a cash outflow in the immediate future in anticipation of returns at a future date. A capital investment decidion involves a largely irreversible commitment of resources that is generally subject to significant degree of risk. Such decisions have for reading efforts on an enterprise’s profitability and flexibility over the long-term. Acceptance of non-viable proposals acts as a drag on the resources of an enterprise and may eventually lead to bankrupcy. For making a rational decision regarding the capital investment proposals, the decision maker needs some techniques to convert the cash outflows and cash inflows of a project into meaningful yardsticks which can measure the economic worthiness of projects. CAPITAL BUDGETING PROCESS : A Capital Budgeting decision involves the following process : (1) Investment screening and selection (2) The Capital Budget proposal

Fianancial Management & international finance

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Financial Management Decisions COST-VOLUME-PROFIT ANALYSIS

(3) Budgeting Approval and Authorization (4) Project Tracking (5) Post-completion Auditor TIME VALUE OF MONEY : Concept We know that Rs. 100 in hand today is more valuable than Rs. 100 receivable after a year. We will not part with Rs. 100 now if the same sum is repaid after a year. But we might part with Rs. 100 now if we are assured that Rs. 110 will be paid at the end of the first year. This “additional Compensation” required for parting Rs. 100 today, is called “interest” or “the time value of money”. It is expressed in terms of percentage per annum. Why should money have time value? Money should have time value for the following reasons : (a) Money can be employed productively to generate real returns; (b) In an inflationary period, a rupee today has higher purchasing power than a rupee in the future; (c) Due to uncertainties in the future, current consumption is preferred to future consumption. (d) The three determinants combined together can be expressed to determine the rate of interest as follows : Nominal or market interest rate = Real rate of interest or return (+) Expected rate of inflation (+) Risk premiums to compensate for uncertainty. Methods of Time Value of Money (1) Compounding : We find the Future Values (FV) of all the cash flows at the end of the time period at a given rate of interest. (ii) Discounting : We determine the Time Value of Money at Time “O” y comparing the initial outflow with the sum of the Present Values (PV) of the future inflows at a given rate of interest. Time Value of Money Compounding (Future Value) (a) Single Flow (b) Multiple Flows (c) Annuity Discounting (Present Value) (a) Single Flow (b) Uneven Multiple Flows (c) Annuity (d) Perpetuity 108

Fianancial Management & international finance

Future Value of a Single Flow It is the process to determine the future value of a lump sum amount invested at one point of time. FVn = PV (1+i)n Where, FVn = Future value of initial cash outflow after n years PV = Initial cash outflow i = Rate of Interest p.a. n = Life of the Investment and (1+i)n = Future Value of Interest Factor (FVIF) Illustration : The fixed deposit scheme of Punjab National Bank offers the following interest rates : Period of Deposit 46 days to 179 days 180 days < 1 year 1 year and above FVn = PV (1+i)n = PV × FVIF (6,3) = PV × (1.06) 3 = 15,000 (1.191) = Rs. 17,865 Doubling Period “How long will it take for the amount invested to be...

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