MGT: Capital Decisions 

CAPITAL BUDGETING DECISIONS

  • An investment decision of a firm is generally know as capital budgeting or capital expenditure decision.

  • Capital budgeting is a firm`s decision to invest its current funds most efficiently in long term assets in anticipation of flow of benefits over a period of time.

     

    Examples of investing decision

  1. Purchase of new assets

  2. Acquisition of another firm

  3. Asset replacement &modernization

  4. Research & development programmes.

     

        Importance of investments decision

  1. Investment decision affects the value of a firm profitable ventures Inc`s. the value of a firm & vise-vasa.

  2. Decision exposes company finances to risk & if it’s not well made can lead to liquidation of company.

  3. Investment decision involves commitment of large amount of finances & if it is not well managed can lead to huge losses.

                        Classification of investment

  1. Mutually exclusive investment

  2. Independent investment.

  3.  Configent investment

 

  Mutually exclusive investment

-These are alternative options that serve the purpose and compete with each other. If a firm is for        instant considering 3 mutually exclusive invest. & one is taken; the other 2 will be left out.

 Independent investment

These investment do not serve the same purpose, they serve different purposes and therefore do not compete with each other. If a firm is for instant considering 10 independent projects, all of them can be undertaken at same time subject

Contingent investment

These are dependent projects. The choice of one investment necessitates that one or move other inv. should be undertaken e.g. If a company decides to build a factory in a remote location, it may have to invest in houses, roads, hostel. Schools, recreation facilities e.g. for employees so as to attract the work force.

Qualities of a sound investment evaluation criterion

Methods employed: – Accounting rate of return, payback period, internal rate, of return, net present value, and profitability index, discounted

  1. The technique should maximize on shareholder`s wealth

  2. Technique should consider cash flows over the entire life of the project in determining the true profitability of an investment.

  3. It should help ran king of projects based on their true profitability.

  4. Should recognize the fact that early cash flows are recognizable (preferable) to later ones and larger cash flows are preferable smaller ones.

  5. Should applicable to any conceivable investment project independent of others.

  6. The criteria should provide for an objectives and un ambiguous way of separating good projects from bad ones

       

    CAPITAL BUBGETING TECHNIQUES

  • The can be grouped into to categories

  1. Non –discounted cash flow techniques.

  2. Discounted cash flow techniques

     

  1. Non-discounted cash flow techniques

    -Uses cash flow as it is. It does not discounted cash flow to its equipment amount at the present. These techniques are as follows

  1. Accounting / Average Rate of Return

    Uses accounting information as revealed by the financial statements (Balance sheet & profit loss acc) to measure the profitability of an investment.

    EXAMPLE

Project KQ4 is expected to cost 80,000,000/= & have a useful life of 5yrs. Earnings before depreciation and tax for the 5yrs   are expected to be 20000000, 24000000, 28000000, 40000000 respectively.

Corporate tax is 40% and depreciation is on straight line basis

Required. Complete the projects accounting rate of return.

ARR=Average income/Average invest × 100%                   Income statement

                                                                                                  Annual dep = cost – sulvage value/useful life

                                                                                                                         =80,000-0/5

                                                                                                                      =16,000,000

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