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CAPITAL BUDGETINGTHE INVESTMENT DECISION ANALYSIS

Presentator

M. Subramanian,

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NATURE OF INVESTMENT DECISIONSShri Shakti LPG Ltd, a Hyderabad based company, put

up facilities to import and market LPG, at an estimated

cost of Rs.103.50 crores.

Tata Metalinks has set up a new Mini Blast Furnacewith associated systems for manufacture of foundry

grade pig iron.

Lupin Chemicals Ltd has set up a project to

manufacture Rifampcin, an anti-TB drug, at anestimated cost of Rs.8250 lakhs.

Maruti Udyog Ltd has planned for plant expansion a

new plant plan was under consideration at Hubli,

Karnataka.1/10/2012 2Prof.MS

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NATURE OF INVESTMENT DECISIONS

The above items, which appeared in newspapers,

are typical examples of capital expenditure

decisions, also referred to as capital budgeting or

investment decisions.

Such a decision may be defined as the companys

decision to invest its current funds most efficiently

in long-term assets in anticipation of an expected

flow of benefits over a series of years.

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Capital expenditure decision occupies a very important

place in corporate finance for the following reasons:

(Characteristics of Capital Budgeting Decisions)

(a) Huge amount of money involved.

(b) Irreversible decision.

(c) Involves a longer period - long-term plan.

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FOLLOWING ARE THE TYPICAL EXAMPLES WHENHEAVY CAPITAL INVESTMENT MAY BE NECESSARY:

y Replacements

y Expansion

y Diversification

y Research & Development

y Miscellaneous

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WHILE CAPITAL EXPENDITURE DECISIONS ARE EXTREMELY

IMPORTANT, MANAGERS FIND IT EXTREMELY DIFFICULT TO ANALYZETHE PROS AND CONS AND ARRIVE AT A DECISION BECAUSE:

y Measuring cost and benefits of investment proposal

whether it be a mini-steel plant or a library is difficult

because all costs and benefits cannot be expressed intangible terms.

y The benefits of capital expenditure are expected to occur

for a number of years in the future, which is highly

uncertain.

y Because the costs and benefits occur at different points oftime, for a proper analysis of the viability of the

investment proposal, all these have to be brought to a

common time-frame. Hence time value of money becomes

very relevant here.

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FACTORS AFFECTING CAPITAL

INVESTMENT DECISIONS

y Amount of Investment

y Minimum Rate of Return on Investment

y Return Expected from the Investment

y Ranking of Investment Proposals

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KINDS OF CAPITAL INVESTMENT PROPOSALS

y Independent Proposal

y Mutually Exclusive Proposal

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CAPITAL INVESTMENT DECISION Step-by-Step Process

y Step-1 Identification of potential investment

opportunity

y Step-2 Preliminary screening

y Step-3 Feasibility study

y Step-4 Implementation of project proposal

y Step-5 Performance review

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CAPITAL BUDGETING APPRAISAL METHODS

y TRADITIONAL METHODS

y Pay Back Method

y Average Rate of Return Method

y MODERN METHODS

y Net Present Value Method

y Internal Rate of Return

y Profitability Index (or) Benefit Cost Ratio

Method

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