Capital Budgeting
Process of Capital Budgeting:
• Huge cash outlay.
• Decision taken is irressable.
• Invest in lumsum the receipt is piecemeal
• Wrong decision will affect the very base of the company.
Capital Budgeting Rules:
• Ignore accounting profit and take only cash flows.
• Try only incremental basis ignore Average calculation.
• Consider all incidental effects.
• Ignore sunk cost (ie. Cost remain unaltered for various alternatives available is sunk cost)
• Consider opportunity cost (Opportunity Loss is Opportunity cost)
• Beware of allocated cost – Ignore them
• Depreciation is an important cash flow when taxation is considered. If no taxation, no depreciation.
• Interest should not be considered as part of the cost, in the arrival of cash inflow for investing decision problems. If deducted add back post tax interest.
• Separate investing decision and financing decision.
• Be consistent with inflation rates. All future cash flows is assumed as without inflation. Such cash flows are referred as real cash flows.
• Cash flows under the influence of inflation would be referred to as money cash flows. (Money cash flows (or) Nominal Cash Flows (or) Market cash flows)
• Unless otherwise stated cost of capital is considered after tax basis because cash flows will be considered only on after tax basis. (PV factor is the inverse of compounding factor)
• Equation to find out the PV of an amount if cost of capital and Inflation rate is given
(1 + Money Rate) = (1 + Real Discount rate) * (1 + Inflation Rate)
Method of evaluating Capital Budgeting:
1. Pay back method
2. Annual Rate of Return
3. Discounted cash flow
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI) (or) Benefit cost Ratio
• Equated Annuity Cost (EAC) (or)
Equated Annuity Benefit (EAB)
• Discounted Pay Back (or) Time adjusted BEP
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