Published on April 21, 2009
Unit-2 : Unit-2 CAPITAL BUDEGTING EXPENDITURE : EXPENDITURE There are two types of expenditure- 1.Capital expenditure 2.Revenue expenditure CAPITAL BUDEGTING : CAPITAL BUDEGTING INTRODUCTION-capital budgeting deals with the selection of proposals/project for making long term investment decision and their implementation. The budget is a plan detailing projected inflows and out flows of cash during a specific future period. DEFINITION : DEFINITION “capital budgeting or capital management may be defined as the process of determining which investment or allocation of long-term funds are to be made by an enterprise. ” Capital budgeting process : Capital budgeting process 1.Project generation 2.Project evaluation 3.Project selection 4.Project execution 5.follow-up Investment evaluation criteria : Investment evaluation criteria After the cash flow is estimated in respect of a proposal /project, it is put to evaluation criteria in order to determine weather the proposal to accepted. There are two types of evaluation criteria- Where cash flow is discounted to the present value Where it is not discounted The commonly used discounting techniques : The commonly used discounting techniques 1.Net present value method (NPV) 2.Discounted benefit-cost ratio method 3.Internal rate of return (IRR) 4.Modified internal rate of return (MIRR) The commonly used non-discounted techniques : The commonly used non-discounted techniques 1. Pay-Back Period Method 2. Accounting Rate of Return Pay Back Period Method : Pay Back Period Method In this method , time period of recovery of cost of project by its own cash earning is calculated. In other words, this method indicates the length of time in years which is required to get back the cost of investment by its annual cash earnings. Calculation of cash earning : Calculation of cash earning Sales (Revenue) ----- less-operating exp including dep ----- Net Income ----- less-Income Tax ----- Net Income after Tax ----- Add- Depreciation ----- Net cash inflow ----- Types of cash flow : Types of cash flow 1. Even cash flow 2. Un-even cash flow In case of even cash flow : In case of even cash flow Pay Back Period- Original investment Annual cashinflow (aftertax ) In case of uneven cash inflows : In case of uneven cash inflows Pay Back Period- E+B C E-Stands for number of years immediately preceding the year of final recovery B- Stands for the balance amount still to be recovered C-Stands for cash inflow the year of final recovery Example : Example A project cost Rs 500000 and yield annually a profit of Rs 80000 after [email protected]% . but before tax of 50% . Calculate Pay back period. Example 2 : Example 2 outlay of a machine is Rs 10000, yield Rs 2000, Rs 3000, Rs 4000 , and 6000. Discounted pay back period : Discounted pay back period An important weakness of pay back period is that it ignore the time factor of cash inflows from investment .to overcome this weakness , discounted pay back period may be calculated. Example : Example Cost of investment Rs 1000000 Life 5 year Annual cash inflow Rs 400000 Cut off rate 10% Accounting Rate of return : Accounting Rate of return This method is also known as accounting rate of return or financial statement method because the main figures used in the calculation are derived from accounting statement under this method . Percentage rate of return of the annual net profit on investment is calculated. formula : formula Rate of return – Average annual net income ×100 Average investment Rate of return- Average annual cash inflow – dep ×100 Average investment Calculation of average investment : Calculation of average investment Average investment- initial investment + scrap 2 Net present value : Net present value This method is used when the management has prescribed minimum rate of return or cut of rate. PV = 1 (1+r)n PV- present factor R- rate of interest/cut off rate n- number of years Net present value : Net present value Example1 : Example1 Initial investment=Rs 5000000 Cash flow=Rs 3000000, Rs 3500000, Rs 2000000 Scrap at the end of III year = Rs 1000000 Rate=10% Example : Example Two machine X and Y are available each cost Rs 50000, Scrap is at Rs 3000, and Rs 2000 respectively earning after Tax expected- YEAR CASH FLOW X Y 1 Rs 15000 5000 2 20000 15000 3 25000 20000 4 15000 30000 5 10000 20000 Profitability index : Profitability index Internal rate of return : Internal rate of return IRR is that discount rate which brings down the value of net cash inflows during the life of the project so that it is equal to the value of initial investment . The project will be excepted if IRR is greater than the required rate of return.