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Capital-Budgeting Process
• The process is designed to help policy makers:
– In the selection of a few capital projects from many
alternatives
• From an inventory of capital projects to a capital budget
– In the timing of the expenditure to be incurred by the
projects selected
– In fitting the selected capital projects into the overall
financial program of the government unit
• (1) Capital asset inventory (2) capital
improvement plan (3) long-term financial analysis
(4) capital budget
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(1) Capital Asset Inventory
• An inventory and assessment of the existing capital facilities
includes its:
– Age
– Condition
– Degree of use
– Capacity / LOS
– Replacement cost
• The inventory of capital facilities helps to determine whether
the existing facilities are to be:
– Renewed, replaced, expanded, or retired
• It also helps to determine repair and maintenance needs and
estimated costs
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1. ESTIMATION OF CASH FLOWS
Traditional or Time-adjusted or
Non-discounting Discounted cash flows
I . PAYBACK PERIOD:
# The payback period is defined as “the number of
years required for the proposal’s cumulative cash inflows to be
equal to its cash outflows.”
# The payback period is the length of time required
to recover the initial cost of the project.
# The payback period may be suitable if the firm
has limited funds available and has no ability or willingness to
raise additional funds.
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II . ACCOUNTING RATE OF RETURN (OR) AVERAGE
RATE OF RETURN
(ARR)
# The ARR may be defined as “the annualized net
income earned on the average funds invested in a project.”
# The annual returns of a project are expressed as a
percentage of the net investment in the project.
COMPUTATION OF ARR:
These are based upon the fact that the cash flows occurring at
different point of time are not having same economic worth.
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II. PROFITABILITY INDEX METHOD:
This technique is a variant of the NPV technique and is also
known as BENEFIT - COST RATIO or PRESENT VALUE INDEX.
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III. INTERNAL RATE OF RETURN (IRR) METHOD:
The IRR of a proposal is defined as the discount rate which
produces a zero NPV, i.e., the IRR is the discount rate which will
equate the present value of cash inflows with the present value of
cash outflows.