I. M.

Pandey, Financial Management, 9th 1

ed., Vikas.
Business Bazigar
Capital Budgeting and
Financial Management
By-Rahul Jain
 Meaning
Financial management is a systematic
process that provides the necessary
financial information to help a
business produce and distribute
goods and services in a way that will
make the most profit. It also
provides feedback about how well
the organization is doing.

I. M. Pandey, Financial Management, 9th 4

ed., Vikas.
 Finance Functions
Investment or Long Term Asset
Mix Decision
Financing or Capital Mix Decision
Dividend or Profit Allocation
Decision
Liquidity or Short Term Asset Mix
Decision

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Financial accounting and Financial
Management
Financial accounting gives the
financial status of the company
to people outside the company.
It is recording and reporting the
activities and events that lead to
cash inflow and outflow.
Financial management means
efficiently managing the various
resources of the company.
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Financial accounting and Financial
Management
Certainty
Accounting is maintenance of financial
records. So, it deals with what has already
occurred. This makes it more certain.
A finance manager is concerned with what
is going to happen in the future. He takes
critical decisions that will affect the future
of the company. These are based on
various calculations and assessments. This
is not easy because there are many
uncertainties in financial management.
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 Time Value of Money
Time preference for money is
an individual’s preference for
possession of a given amount of
money now, rather than the same
amount at some future time.
Three reasons may be attributed
to the individual’s time preference
for money:
– risk
– preference for consumption
8 – investment opportunities
 Future Value
Compounding is the process of finding the
future values of cash flows by applying the
concept of compound interest.
Compound interest is the interest that is
received on the original amount (principal) as
well as on any interest earned but not
withdrawn during earlier periods.
Simple interest is the interest that is
calculated only on the original amount
(principal), and thus, no compounding of
interest takes place.

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 Example
If you deposited Rs 55,650 in a bank, which
was paying a 15 per cent rate of interest on a
ten-year time deposit, how much would the
deposit grow at the end of ten years?

Fn  P(1  i) n

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 Present Value
Present value of a future cash flow
(inflow or outflow) is the amount of
current cash that is of equivalent value
to the decision-maker.
Discounting is the process of
determining present value of a series of
future cash flows.
The interest rate used for discounting
cash flows is also called the discount
rate.

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 Present Value of a Single Cash
Flow
The following general formula can be
employed to calculate the present value of a
lump sum to be received after some future
periods: Fn
P  Fn  (1  i ) 
n

(1  i )
n

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 Exercises
What's the present value of:

A. $10000000 in 1 years at 16 percent?

B $9,000 in 2 years at 8 percent?

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 What is Capital Budgeting?

• Analysis of potential projects.

• Long-term decisions; involve
large expenditures.
• Very important to firm’s future.
 Nature of Capital Budgeting
Decisions
The investment decisions of a firm are
generally known as the capital budgeting, or
capital expenditure decisions.
The firm’s investment decisions would
generally include expansion, acquisition,
modernisation and replacement of the long-
term assets. Sale of a division or business
(divestment) is also as an investment
decision.
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.
 Steps in Capital Budgeting
• Estimate cash flows (inflows &
outflows).
• Determine r = WACC for project.
• Evaluate cash flows.
 Cash Flow Estimation Of Project

Initial Terminal
outlay Cash flow

0 0 11 22 33 4 55 66 .. .. .. nn

Annual Cash Flows

 Features of Investment
Decisions
The exchange of current funds for
future benefits.
The funds are invested in long-
term assets.
The future benefits will occur to
the firm over a series of years.
 Evaluation Criteria
1. Discounted Cash Flow (DCF)
Criteria
– Net Present Value (NPV)
2. Non-discounted Cash Flow
Criteria
– Payback Period (PB)
– Accounting Rate of Return (ARR)
 Payback
Payback is the number of years
required to recover the original cash
outlay invested in a project.
That is: Payback =
Initial Investment
=
C0
Annual Cash Inflow C
Assume that a project requires an
outlay of Rs 50,000 and yields
annual cash inflow of Rs 12,500 for
7 years. The payback period for the
Rs 50,000
project is: PB =
Rs 12,000
= 4 years
 Payback
Unequal cash flows In case of unequal cash
inflows, the payback period can be found out by
adding up the cash inflows until the total is equal
to the initial cash outlay.
Suppose that a project requires a cash outlay of
Rs 20,000, and generates cash inflows of Rs
8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during
the next 4 years. What is the project’s payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
 Payback for Franchise L
(Long: Most CFs in out years)
0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

Franchise S (Short: CFs come
quickly)

0 1 1.6 2 3

CFt -100 70 100 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

 Acceptance Rule
The project would be accepted if its
payback period is less than the
maximum or standard payback period
set by management.
As a ranking method, it gives highest
ranking to the project, which has the
shortest payback period and lowest
ranking to the project with highest
payback period.
 Evaluation of Payback
Certain virtues:
– Simplicity
– Cost effective
– Short-term effects
– Risk shield
– Liquidity
Serious limitations:
– Cash flows after payback
– Cash flows ignored
– Cash flow patterns
– Administrative difficulties
– Inconsistent with shareholder value
 Accounting Rate of Return
Method
The accounting rate of return is the ratio
of the average after-tax profit divided by
the average investment. The average
investment would be equal to half of the
original investment if it were depreciated
constantly.
Average income
ARR =
Average investment

A variation of the ARR method is to divide

average earnings after taxes by the original cost
of the project instead of the average cost.
 Acceptance Rule
This method will accept all those
projects whose ARR is higher than
the minimum rate established by
the management and reject those
projects which have ARR less than
the minimum rate.
This method would rank a project
as number one if it has highest ARR
and lowest rank would be assigned
to the project with lowest ARR.
Evaluation of ARR Method
The ARR method may claim some
merits
– Simplicity
– Accounting data
– Accounting profitability
Serious shortcoming
– Cash flows ignored
– Time value ignored
– Arbitrary cut-off