What are the different methods of capital budgeting?
The different method capital budgeting are:
A. Net Present value
B. Internal Rate of return
C. Profitability Index
D. Payback period
E. Accounting rate of return.
Capital Budgeting Techniques, Importance and Example.
Capital Budgeting Techniques are:
A. Traditional Approach or Non Discounting
a) Pay Back Period Method: Pay Back Period of an investment is the duration or the time required when Net Cash Inflow becomes equal to initial Capital Outlay.
Payback Period=Total Initial Capital Outlay/ Annual expected cash flow after deducting tax.
Payback reciprocal: It is the reciprocal of payback period.
Payback reciprocal=Average annual cash inflow / Initial capital outlay.
Importance:
i. It provides the organization an estimation of the time requiredto gets back the cash invested.
ii. The duration of the project delivers an estimate for the risk associated with the project as the duration is directly related with the risk.
Example: If a project costs 20, 00,000 for the initial investment and net cash inflow after tax is 400,000. Payback period will be=20, 00,000/4, 00,000=5 year.
b) Accounting Rate of Return: The accounting rate of return represent the average annual net income as a percentage of the total investment.
Accounting rate of return=Average annual net income/Investment.
Importance:
i. This method does not involve special practice to generate data as it uses regularly generated data.
ii. This techniquestudies all incomes over the whole life of the project andhelps to measure the investment profitability.
Example: Suppose a project require initial investment =10, 00,000 and total profit of 5 year is 400,000.ARR=400,000/5/10,00,000=8%
B.Time Adjusted or Discounted Cash Flow Technique
a) Net Present value Method: The net present value is discounted cash flow method. It considers the time value of money in assessingprincipal investment. The Net Present Value (NPV) method uses a specified discount rate. This discount rate conveys all successive net cash inflows to their present value.
Net Present Value=Present value of net cash inflow-Total net initial outlay
Importance:
i. Net present Valueconsiders Time value of Money.
ii. NPV uses discounted technique as a result it express cash flow in current rupees.
b) Internal Rate of return Method: Internal rate of return for an investment is the discount rate at which the present value of the expected net cash flows and initial cash outflow become equal.
This rate is to be found by trial and error method. In this method discount rate is not known but all cash outflow and inflow are present.
While evaluating a proposal the IRR rate is compared with the cut off rate (cut off rate is the minimum rate which management wishes to have from any project and this is based upon cost of capital).
If IRR Rate>Cut off rate=Project accepted
If IRRRate<Cut off rate=Project rejected.
Importance:
i. This method takes into account time value of money.
ii. This technique is easy to use.
c) Profitability Index: Profitability index is also known as the desirability factor. This technique is used while comparing a number of proposals involving different amount of cash inflow. In general a project is acceptable if the profitability index value is greater than 1.
Profitability Index=Sum of discounted cash inflow/Initial cash outlay or total discounted cash outflow.
Importance:
i. This method uses the concept of time value of money.
ii. It is animprovedproject valuation technique then NPV.
d) Modified Internal Rate of Return: The modified internal rate addresses some of the limitations which are found in internal rate of return. In this method all cash flow are taken to the terminal value using an appropriate discount rate excluding preliminary investment. This results in a single stream of cash inflow in the terminal year.
Importance:
i. It eliminates multiple IRR rate.
ii. It addresses the reinvestment rate issue
e) Discounted Pay Back Period Method: Payback period is time taken to recover the original investment from the project cash flow. This is also known as break even period. Discounted payback period considers present value of cash flows, discounted at companies cost of capital to estimate breakeven point and it is that period in which future discounted cash flow equals the initial outflow. The shorter the period the better it is.
Why capital budgeting is significant for a firm?
Capital Budgeting is significant for a firm. Some of the significances are as follows:
A. Develop Long Term strategic goals: The capability of developing long term strategic goal is essential for the growth of the business of the firm. Capital Budgeting helps in developing such long term strategic goals.
B. Long Time Period Decision: The Capital budgeting decision has a great impact for the future. This decision not only affects the future benefits and expenditures but also impact the rate and direction of growth of the firm. It also helps to determine if such a project should be accepted or not.
C. Extensive Expenditure: Capital budgeting decision encompasses the investment of extensive amount of fund. It is therefore necessary for a firm to make such decision after a deep consideration so as it results in the profitable use of its scare resources. This is an important function for all firms as they seek to compete and profit in the industry. Any incorrect decision will not only result in huge losses but it can also be responsible for the failure of the firm.
D. Monitor and Control expenditure: Capital Budgeting helps to monitor expenditure and it also helps in controlling such expenditure.
E.Helps to take decision: It also helps to take decision whether a project is acceptable or unacceptable thereby helps in saving of money and time. But it involves an assessment of future benefit which is difficult to predict.
F. Facilitate the transfer of information: Capital Budgeting process helps to transfer the information to the correct decision maker in a firm.
G. Comparative study of alternative project: Capital Budgeting also helps to compare between alternative project and the significance of the project over the firm.
What is the definition of capital planning?
Capital Planning is also known as Capital Budgeting. It is a Process of evaluating and selecting long term investments such as new machinery, replacement of machinery,new plant, investment and expenditure which are in line with the goal of investor's wealth maximization.The Capital budgeting decisions are important and crucial as it involved extensive expenditure. It is a budget for major capital, investment and expenditure. When a business makes a capital investment, it incurs a cash outlay in expectation of future benefit. The expected benefit generally extends beyond one or two year in future.One of the most important task in capital budgeting is estimating future cash flow for a project.
What do you mean by capital rationing?
Capital rationing is a situation where the requirements of funds are greater than the availability of funds.In simple words; it refers to the selection of the investment proposals in a situation where availability of funds constraint, to maximize the wealth by maximizing the NPV of its projects selected for implementation. In cases where there are budget limitations, the use of Net present value technique is recommended as the highest total net present value of the group of projectwill provides the greatest increase in shareholder value.
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