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Capital Budgeting

Started by TechShristi, December 05, 2013, 12:13:18 am

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TechShristi

December 05, 2013, 12:13:18 am Last Edit: December 07, 2013, 09:09:20 pm by TechShristi
DEFINITION OF CAPITAL BUDGETING:

The process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing.In other word, capital budgeting refer to decision making process to decide whether to invest in a particular opportunities or not???

STEPS IN CAPITAL BUDGETING:


TYPES OF PROJECTS:


       
  • Setting up new project

  •    
  • Expansion Project

  •    
  • Diversification Project

  •    
  • Replacement and Modernization Project

  •    
  • R & D Project

DECISION RELATED TO ABOVE PROJECTS:


       
  • Mutually Exclusive Project Decision: Acceptance of one project lead to rejection of another project. For example; Selection of one machinery out of three available machinery.

  •    
  • Independent Project Decision:  Acceptance of one project donot lead rejection of other that is all the project are independent of one another.

  •    
  • Contingent Project Decision: Acceptance of one project is based on acceptance of another project that if one project is accepted than another project is to be accepted along with the original project.

CAPITAL BUDGETING TECHNIQUES: The capital budgeting techniques can be categorized in to two category as follows:

      1.  Traditional Techniques: Non- Time adjusted Method

             >> Accounting Rate of Return
             >> Pay back Techniques
        2.  Modern Techniques: Time adjusted Method
          >> Present Value Method
          >> Internal Rate of Return
          >> Profitability Index

1) Accounting Rate of Return:

ARR = Average PAT/Average Investment * 100
PAT = PBDT - Depreciation - Taxes
Average Investment = 1/2 (Original Cost of Machinery - Salvaged Value) + Salvaged Value + Net Working capital
Deprecation: Cost of Machinery - Salvaged Value/ Life
Average Investment: (Opening Balance + Closing balance/2) + Working Capital

2)  Pay back period:

Initial Cash outflow/Annual Cash Inflow
OR

Year reported as a full recovery +  unrecorded amount/Cash flow during the year


3) Net Present Value Method:


Where;
Ct= Cash Inflow
Co= Cash Out Flow
r = Discounting value and Discounting rate is equal to Cost of capital 

IN SIMPLE:

Present value of Cash outflow - Present Value of Cash Inflow
         

For Example:


4) Internal Rate of Return:

Lower rate + (NPV at lower rate/NPV at lower rate - NPV at higher rate) * (Difference in Higher rate and Lower rate)


5) Profitability Index:

Cash Inflow/Cash outflow




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TechShristi

December 05, 2013, 12:13:18 am Last Edit: December 07, 2013, 09:09:20 pm by TechShristi

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