Categories: Finance

Capital Budgeting

The above-mentioned two types of decisions are fundamentally different as for as the level of uncertainty is concerned. Cost reduction decisions are less uncertain as compared to the revenue enhancing decisions because in cost reduction decisions a quite reliable past data is available to compare with the future benefits. On the other hand in revenue enhancing decisions future revenues are compared with future costs that increase the level of uncertainty to a great extent.

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Relevant Cash Flows

It has already been mentioned that capital budgeting decisions depend upon future cash flows rather future profits that include non-cash expenditures and incomes. To determine the relevant cash flows high level of professional skills are mandatory required to judge the relevant or irrelevant cash or non-cash expenditures. Relevant cash flows are of two types i.e. cash outflows and cash inflows.[linkunit] Cash outflows are relatively easy to determine because it include initial capital outlay plus any installation cost of plant and machinery. Moreover it may include working capital investment initially recoverable after the completion of the project. Cash inflows are more technical in nature and are determined by adding depreciation to the earnings after tax for each year. In addition salvage value of any asset and recovery of working capital are also added at the end of the project.

Evaluation Techniques

There are two broad categories of techniques in capital budgeting i.e. traditional and time-adjusted. The later are more popular and are commonly known as discounted cash flow techniques. The first category include average rate of return method and pay back period. The second category include the following:

• Net Present Value

• Internal Rate of Return

• Profitability Index

Average Rate of Return

It is based on accounting information rather than cash flows. The formula is :

ARR = (Ave. annual profit after tax / avg. investment over the life of project) x 100

Payback

It is most widely use technique, which evaluates the capital investment project over the period or number of years required for cash benefits to recover the initial capital investment. Pay back period is calculated from following formula:

PBP = Investment / Constant annual cash flow

Net Present Value

The most reliable and comprehensive tool for the capital investment appraisals. It discounts the annual net relevant annual cash flows to the present value and compared to the initial investment outlay.

Internal Rate of Return

Another important and extensively used technique for capital investment decisions in capital budgeting is Internal rate of return. IRR is the discount rate that equates the present value of the expected cash inflows to the present value of expected cash outflows. If IRR is above the required rate of return the project is accepted otherwise it is rejected.

Profitability Index

The profitability index measure the benefit of the return per dollar invested. This method is also called benefit and cost ration analysis. Symbolically,