Capital Budgeting--- B.Com/ BBA Semester 2/3, DU, BHU, DUSOL
Capital Budgeting
Overview:
- Capital Budgeting Decision techniques
- Discounted and non-discounted techniques
- Payback period
- NPV Method
- Profitability Index
- IRR Method
Definition--
Capital Budgeting is the process of planning and evaluating long-term investment decisions involving large expenditures. It helps a business decide whether to invest in a new project, equipment, expansion, or asset by estimating the future cash flows and comparing them with the initial cost.
✔ Time Value of Money
- This concept states that a sum of money is worth more now than future due to its earnings potential in the interim. This financial principle is based on the idea that money can earn interest or returns over time, so delaying its use results in an opportunity cost.
1. Compound Value Concept-- The Future Value (FV) is the value of current money after earning interest over a period of time i,e the current value of money in the future.
FV = PV × (1 + r) ^n
were,
PV = Present Value (initial investment)
r = rate of interest
n = time period
2. Present Value Concept-- The Present Value (PV) is the current value of future money, discounted at a specific interest rate.
PV = FV / (1 + r) ^n
were,
PV = Present Value (initial investment)
r = rate of interest
n = time period
Budgeting Techniques
✔Discounted Cash Flow-- Discounted Cash Flow (DCF) methods are capital budgeting techniques that consider the time value of money by discounting future cash flows to their present value. Discounted rate is the expected rate of return. It includes--
1. Net Present Value Method--
Net Present Value (NPV) is a capital budgeting method used to evaluate the profitability of an investment or project. It is the difference between the present value of cash inflows and the total net initial investment.
NPV= PV of Net cash inflow - Total Net initial investment
if NPV is (-) reject
if NPV is (+) accept
2. Internal Rate of Return--
It is a discount rate where NPV is 0 i,e. break even, it is not the actual value of the project.
It is also known as Yield on investment method or rate of return over cost method.
For uneven cash flow the calculation is done through interpolation.
LIR+ PV of LIR- Initial Investment/ PV of LIR- PV of HIR * (HIR-LIR)
where,
LIR= Lower Interest Rate (Assume it)
HIR = Higher Interest Rate (Assume it)
3. Profitability Index--
It measures the PV of returns per rupee invested, while NPV is based on the difference between the PV of future cash inflow and the PV of the cash outlays. It is also known as Benefit-Cost Ratio method.
PI= Sum of discounted cash inflow/ Initial Investment
if PI >1 Accept
if PI < 1 Reject
☝The PI method is superior to NPV method as the former evaluates the worth of project in terms of their relative than absolute magnitude
✔Non- Discounted Cash Flow
Non-DCF methods are traditional capital budgeting techniques that do not consider the time value of money. They focus on how quickly or how much return a project generates.
1. Accounting Rate of Return (ARR)
The Average Rate of Return (ARR) method evaluates the profitability of an investment by comparing the average annual accounting profit to the initial or average investment. It is based on accounting profit, not cash flows.
📌 ARR Based on Initial Investment = (Average Annual Profit / Initial Investment) × 100
📌 ARR Based on Average Investment = (Average Annual Profit / Average Investment) × 100
2. Payback Period
Payback period measures the number of years required for Cashflow after tax to payback initial outlay in an investment. It is a measure of liquidity of investment rather than profitability.
The reciprocal of payback period is a good approximation of IRR which otherwise requires a trial-and-error approach
Comments