Capital Investment Decisionsppt
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Transcript of Capital Investment Decisionsppt
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Capital Investment Decisions
SY BBI
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Introduction-
The efficient allocation of capital is the most
important finance function in modern times
i.e. to commit the firms funds to the long termassets
Investment decision of a firm is generally
known as capital budgeting or capital
expenditure decision
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Definition-
A capital budgeting decision may be defined
as the firms decision to invest its current
efficiently in the long term assets in
anticipation of an expected flow of benefits
over a series of years
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Firms investment decisions generally include-
Expansion
Acquisition Modernization
Replacement of long term assets
Sale of a division or business
Change in sales distribution, aggressive
advertisement campaign, R& D programme etc.
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Features of Investment Decisions-
Exchange of current funds for future benefits
Funds are invested in long term assets
Future benefits will occur to the firm over a
series of years
Decisions by top management
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Importance of Investment decisions
They have long term implication for the firm &
can influence its risk complexion
Involve commitment of large amount of funds Irreversible decisions
Are amongst the most important decisions to
make
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Classification of investment decisions-
1. Mutually Exclusive Decisions
Ex. A company can use more labour intensive ,
semi automatic machine or employ more capital
intensive, highly automatic machine for
production
2. Independent investments- ex. A company may
increase its plant capacity to manufactureadditional units of product and may also
undertake the production of a new product.
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Contingent Investment-
Ex. A company decides to build a new plant in
remote area it may also have to invest inhouses, roads, hospitals, schools to attract the
work force.
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Investment Decision Rule
It should maximise the shareholders wealth.
It should consider all cash flows to determine the true profitability of the
project.
It should provide for an objective and unambiguous way of separating
good projects from bad projects.
It should help ranking of projects according to their true profitability.
It should recognise the fact that bigger cash flows are preferable to
smaller ones and early cash flows are preferable to later ones.
It should help to choose among mutually exclusive projects that project
which maximises the shareholders wealth.
It should be a criterion which is applicable to any conceivable investment
project independent of others.
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Capital Budgeting Process
Steps
1. Project Identification
2. Project Evaluation & Selection
3. Monitoring & Review
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Project Identification
This step is most critical & most difficult for
successful capital investment
Initial proposals can come from all levels ofmanagement
Well defined investment objective
Proper co-ordination of interrelated activities Definite duration
Projects are unique
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Monitoring & Review
After the approved project is implemented it
is monitored with the help of feedback report
Includes comparing the actual performancewith planned targets
Post completion audits
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Post Audit
An important aspect of the capital budgeting process-
(1) comparing actual results with those predicted bythe projects sponsors
(2) explaining why any differences occurred.For example, many firms require that the operating
divisions send a monthly report for the first six months
after a project goes into operation, and a quarterly report
thereafter, until the projects results are up to
expectations. From then on, reports on the operation are
reviewed on a regular basis like those of otheroperations.
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Post Audit Purpose
1. Improve forecasts.
2. Improve operations.
3. Identify termination opportunities.
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CAPITAL RATIONING
There is hardly ever enough cash to invest in allinvestment opportunities
Scarcity of resources makes one to use the
limited resources in an optimal way The act of placing restrictions on the amount of
new investments or projects undertaken by acompany. This is accomplished by imposing a
higher cost of capital for investmentconsideration or by setting a ceiling on thespecific sections of the budget.
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Example-
Suppose ABC Corp. has a cost of capital of 10%but that the company has undertaken too manyprojects, many of which are incomplete.This causes the company's actual returnon investment to drop well below the 10% level.As a result, management decides to place a capon the number of new projects by raising the costof capital for these new projects to 15%. Starting
fewer new projects would give the companymore time and resources to complete existingprojects.
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Sensitivity analysis
(SA) is the study of how the variation
(uncertainty) in the output of a mathematical
model can be apportioned, qualitatively or
quantitatively, to different sources of variation
in the input of the model . Put another way, it
is a technique for systematically changing
parameters in a model to determine theeffects of such changes.
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Evaluation Criteria
1. Discounted Cash Flow (DCF) Criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
2. Non-discounted Cash Flow Criteria
Payback Period (PB)
Discounted Payback Period (DPB) Accounting Rate of Return (ARR)
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Net Present Value Method
Net present value should be found out by
subtracting present value of cash outflows
from present value of cash inflows. The
formula for the net present value can be
written as follows:
31 20
2 3
0
1
NPV
(1 ) (1 ) (1 ) (1 )
NPV(1 )
n
n
n
t
t
t
C CC CC
k k k k
CC
k!
!
!
L
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Calculating Net Present Value
Assume that Project Xcosts Rs 2,500 nowand is expected to generate year-end cashinflows of Rs 900, Rs 800, Rs 700, Rs 600and Rs 500 in years 1 through 5. Theopportunity cost of the capital may beassumed to be 10 per cent.
2 3 4 5
1, 0.10 2, 0.10 3, 0.10
4, 0.10 5, 0.
Rs 900 Rs 800 Rs 700 Rs 600 Rs 500NPV Rs 2,500
(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)
NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )+ Rs 600(PVF ) + Rs 500(PVF
!
!10)] Rs 2,500
NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683
+ Rs 500 0.620] Rs 2,500
NPV Rs 2,725 Rs 2,500 = + Rs 225
! v v v v
v
!
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Acceptance Rule
Accept the project when NPV is positive
NPV > 0
Reject the project when NPV is negative
NPV < 0
May accept the project when NPV is zero
NPV = 0
The NPV method can be used to selectbetween mutually exclusive projects; the one
with the higher NPV should be selected.
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Advantages
Analysis is based on the entire economic life
of the project
Recognizes time value of money Applicable for uneven cash flows
Compared projects with same initial
investments
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Disadvantages
Difficult to determine discount rate
Limited use with projects with unequal
investments