BBN 111: Financial
Management
Lecture prepared by : Anup Kumar Srivastava (Asst. Professor)
Sharda University
Unit 2:
Lecture 1_2:Capital
LearningBudgeting
Outcome
Nature and Scope of Financial Management
➢Meaning and concepts of capital budgeting
➢Need of capital budgeting,
➢Practical Problems on Non Discounted Cash Flow Techniques:
➢Payback period and ARR
➢Practical Problems on Discounted Cash Flow Techniques:
➢Discounting Payback period, NPV, PI, IRR
Learning Objectives
❖ Understand the nature and importance of investment decisions
❖ Explain the methods of calculating net present value (NPV) and
internal rate of return (IRR)
❖ Show the implications of net present value (NPV) and internal rate
of return (IRR)
❖ Describe the non-DCF evaluation criteria: payback and accounting
rate of return
❖ Illustrate the computation of the discounted payback
❖ Compare and contrast NPV and IRR and emphasize the superiority
of NPV rule
Nature of Investment Decisions
1. The investment decisions of a firm are generally
known as the capital budgeting, or capital
expenditure decisions.
2. The firm’s investment decisions would generally
include expansion, acquisition, modernization
and replacement of the long-term assets. Sale of a
division or business (divestment) is also as an
investment decision.
Nature of Investment Decisions
Decisions like the change in the methods of sales
distribution, or an advertisement campaign or a
research and development programme have long-
term implications for the firm’s expenditures and
benefits, and therefore, they should also be evaluated
as investment decisions.
Meaning and concepts of capital budgeting
❖ The word Capital refers to be the total investment of a company of
firm in money, tangible and intangible assets.
❖ Whereas budgeting defined by the “Rowland and William” it may
be said to be the art of building budgets.
❖ Budgets are a blue print of a plan and action expressed in quantities
and manners.
The examples of capital expenditure:
1. Purchase of fixed assets such as land and building, plant and
machinery, good will, etc.
2. The expenditure relating to addition, expansion, improvement
and alteration to the fixed assets.
3. The replacement of fixed assets.
4. Research and development project.
Meaning and concepts of capital budgeting
❖ According to the definition of Charles T. Hrongreen, “capital
budgeting is a long-term planning for making and financing
proposed capital out lays.
❖ According to the definition of Richard and Green law, “capital
budgeting is acquiring inputs with long-term return”.
❖ According to the definition of Lyrich, “capital budgeting consists in
planning development of available capital for the purpose of
maximizing the long-term profitability of the concern”
Capital Budgeting
➢ Capital budgeting decisions relate to acquisition of
assets that generally have long-term strategic
implications for the firm.
➢ Capital budgeting decisions become fairly intricate
as it impacts other areas of corporate finance like
capital structure, dividends and cost of capital.
Features Of Capital Budgeting Decision
Capital budgeting decisions are characterized by:
➢ Non-reversible,
➢ Large initial outflow followed by small periodic
inflows,
➢ Information gap and inexperience,
➢ Strategic and risky in nature,
➢ No scope of learning and correcting from past
experience,
➢ Little flexibility.
Need and Importance of Capital Budgeting
1. Huge investments: Capital budgeting requires huge investments of
funds, but the available funds are limited, therefore the firm before
investing projects, plan are control its capital expenditure.
2. Long-term: Capital expenditure is long-term in nature or
permanent in nature. Therefore financial risks involved in the
investment decision are more. If higher risks are involved, it needs
careful planning of capital budgeting.
3. Irreversible: The capital investment decisions are irreversible, are
not changed back. Once the decision is taken for purchasing a
permanent asset, it is very difficult to dispose off those assets
without involving huge losses.
Need and Importance of Capital Budgeting
Long-term effect: Capital budgeting not only reduces the cost but also
increases the revenue in long-term and will bring significant changes in
the profit of the company by avoiding over or more investment or under
investment.
Over investments leads to be unable to utilize assets or over utilization
of fixed assets.
Therefore before making the investment, it is required carefully
planning and analysis of the project thoroughly.
Kinds of capital budgeting decisions
➢ The overall objective of capital budgeting is to maximize the
profitability.
➢ If a firm concentrates return on investment, this objective can be
achieved either by increasing the revenues or reducing the costs.
➢ The increasing revenues can be achieved by expansion or the size of
operations by adding a new product line.
➢ Reducing costs mean representing obsolete return on assets.
Capital budgeting process
1. Identification of investment proposals - where
2. Screening and evaluation of the proposals
3. Fixing priorities
4. Final approval and preparation of capital expenditure
budget
5. Implementing proposals
6. Performance review
Investment Evaluation Criteria
Three steps are involved in the evaluation of an investment:
1. Estimation of cash flows
2. Estimation of the required rate of return (the opportunity
cost of capital)
3. Application of a decision rule for making the choice
Methods of capital budgeting of evaluation
By matching the available resources and projects it can be invested. The
funds available are always living funds. There are many considerations
taken for investment decision process such as environment and
economic conditions.
The methods of evaluations are classified as follows:
(A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(ii) Accounts Rate of Return
(B) Modern methods (or Discount methods)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method
(iv) Discounting Payback period
Methods of capital budgeting of evaluation
