Definition of Capital Budgeting
Capital Budgeting involves decisions regarding long term investment proposal. Long term Investment means the proposal having longer life say 3 years or more. For the purpose of evaluation of a Capital Budgeting problem. Capital Budgeting Assignment Help is required by Students studying Finance and willing to make their career in Financial Management. Courseworktutors has made following points worth noting:
- As the investment are long term, Concept of present value would be applied. For the purpose of evaluation, Present value concept can only be applied on Cash flows and never on profit. So, we can conclude that evaluation of Capital Budgeting would always be done on Cash Flows and never on profit.
- The definition of Profit is not clear. Economist think that Profit means Earnings before Interest and Tax (EBIT). Taxation department consider profit means Earning before Tax(EBT) and Preference Shareholders think profit means Earning after Tax(EAT) and Equity Shareholders think profit means Earning available to Equity Shareholders ( ES to ESH). As the definition of profit is not clear, the decision based on Profit cannot be a good decision. But the meaning of cash is similar to everyone. For this purpose, decision of Capital Budgeting is based on Cash flow and not on profit.
Determination of Cash Flows
The Cash flows may be of two types. One is Cash Inflow and other is Cash outflow. Such cash flows can be determined under two methods:
Under this method, we calculate profit after tax in the usual manner and thereafter such Profit after tax is adjusted for non-cash items as follows:
|Add: Non Cash Income||XXX|
|Less: Cash Expense||XXX|
|Less: Non-Cash Expense||XXX|
|Profit before Tax||XXX|
|Profit after Tax||XXX|
|Add: Non-Cash Expense||XXX|
|Less: Non Cash Income||XXX|
|Net Cash Flow after Tax||XXX|
In this method, we consider each type of item individually. For this purpose, Profit and Loss items are classified as follows
- Cash Income : For Cash Income , Cash inflow would be the Cash income and outflow would be tax that needs to be paid in Cash income .So , Net Cash Inflow from cash Income would be ( Cash Income ( c ) – Tax (C * T) )
- Cash Expense: For Cash expense, cash outflow would be the cash expense and there would also be Tax Shied in the form of savings of Tax that would have been in case there was no cash expense. Net Cash outflow would be ( Cash expense ( c) – Tax Shield ( C*T) )
- Non Cash Income: In case of non cash income there would be no Cash Inflow but there would be Cash outflow as tax is paid on profit. Net Cash outflow would be (Non Cash Income * Tax Rate)
- Non Cash Expense: In case of non cash expense there would be no Cash outflow but there would be Cash inflow as profit would be less and there would be savings of Tax in form of Tax Shield . Net Cash Inflow would be (Non Cash Expense * Tax Rate)
Methods of Evaluation of Capital Budgeting
There are 5 Methods for evaluation of Capital Budgeting problem.
- Payback Period Method: It is defined as the time period when the Future Cash Inflow would be equal to Initial Investment. This method does not cover the concept of time value of money. It does not even consider cash flow after the Pay Back period.
Net Initial Investment is $400000 and cash inflow for year 1-4 is $93000, $93000, $125500, $125500. So, Payback period would be:
|Cash Inflow||Cumulative Cash Inflow|
Payback period would be = 3 + 400000-311500/125500 = 3.71 Years
- Discounted Cash Flow Method: It is defined as the time period with respect to which Present Value of future Cash inflow would be equal to initial investment. This method consider the concept of time value of money.
Net Initial Investment is $800000 and cash inflow for year 1-5 is $186000, $186000, $251000, $251000, $445000 and discounting rate is 10%. So, Payback period would be:
|Cash Inflow||Discounting Rate@10%||Discounted Cash Inflow||Cumulative Cash Inflow|
Discounted Pay Back Period = 4 + (800000-682644/276345) = 4.42 Years
- Net Present Value Method: This is the most important method of evaluating Capital Budgeting problem. All universities, Colleges gives student work in this method to solve their homework problem. This method consist of the following steps :
Step 1: Determine Initial Investment i.e. Cash outflow at Year)
Step 2: Determine Future Cash Inflow from Year 1 to Year N, here N is the life of the Proposal,
Step 3: Determine Present value of Future Cash Inflow
Step 4: Determine Net Present Value (PV of Cash Inflow – Net Present value)
How to make decision in Net Present value method?
When we calculate NPV, there could be 3 possible Outcomes:
- NPV > 0 ( Accept the Proposal as it indicates Cash profit)
- NPV < 0 ( Reject the proposal as it indicates Cash loss)
- NPV = 0 ( Indifferent as there would be no loss , no profit)
- Profitability Index Method: This method is an extension of NPV method. NPV method tells us Net Return from total Investment. Profitability Index method tell us Gross Amount of Return from Investment of $1.
How to make decision in Profitability Index method?
Profitability Index > 1 (Accept the Proposal as it indicates Cash profit)
Profitability Index < 1 (Reject the proposal as it indicates Cash loss)
Profitability Index = 1 (Indifferent as there would be no loss, no profit)
- Internal Rate of Return: Internal Rate of return is the required rate of return of an organization from the investment. When required rate of return is more than internal rate of return, the proposal should be rejected and when required rate of return is more than internal rate of return from investment, the proposal should be accepted. Most Students asking for Capital Budgeting Assignment Help ask questions either in this method or in Net Present Value method.
Capital Budgeting Assignment Help and Capital Budgeting Homework Help
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