Presentation on Capital Investment : Meaning and

Types and Capital Budgeting

Made by: SHUBHAM GOYALBBA(BE) 4561/10

BIRLA INSTITUTE OF TECHNOLOGY, NOIDA

Capital Investment : Definition

Funds invested in a firm or enterprise for the purposes of furthering its business objectives. Capital investment may also refer to a firm's acquisition of capital assets or fixed assets such as manufacturing plants and machinery that is expected to be productive over many years.

Capital Investment : Types Physical Assets : are tangible investments

like land, building, plant, machinery, vehicles, and computers.

Monetary Assets : are financial claims against some parties. Deposits, bonds, and equity shares are examples of such assets.

Intangible Assets : are not in the form of physical assets or financial claims. They represent outlays on research and development, training, market development, franchises, and so on and are expected to generate benefits over a period of time.

Capital Investment : Classification

Strategic Investment : is one that has a significant impact on the direction of the firm. Tata Motor’s decision to invest in a passenger car project may be regarded as a strategic investment.

Tactical Investment : is meant to implement a current strategy as efficiently or as profitably as possible. An investment by Tata Motors to replace an old machine to improve productivity represents a tactical investment.

Capital Budgeting : Budgeting

Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

Capital Budgeting : FunctionsGenerating investment project proposals

consistent with the firm’s strategic objectives

Estimating after tax-incremental operating cash flows for the investment projects

Evaluating project incremental cash flowsSelecting projects based on a value-

maximizing acceptance criterionContinually re-evaluating implemented

investment projects

Capital Budgeting : Phases

Review

Implementation

Financing

Selection

Analysis

Planning

Capital Budgeting : MethodsMany formal methods are used in capital budgeting, including the techniques such as :

o Accounting Rate of Returno Payback Periodo Net Present Valueo Profitability Indexo Internal Rate of Returno Modified Internal Rate of Returno Equivalent annuityo Real options valuation

Equivalent Annuity

The equivalent annual annuity (EAA) approach calculates the constant annual cash flow generated by a project over its lifespan if it was an annuity. The present value of the constant annual cash flows is exactly equal to the project's net present value (NPV). When used to compare projects with unequal lives, the one with the higher EAA should be selected.

Accounting Rate of Return : Definition

Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return.

Accounting Rate of Return : Formula

• ARR = Average profit / Average Investment

• where Average Investment = (Book value at beginning of year 1 + Book value at end of useful life) / 2

Payback Period : Definition and Formula

Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. Payback period is usually expressed in years.Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3 ... etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.

Payback Period : Definition and Formula

To calculate a more exact payback period : Payback Period = Amount to be Invested / Estimated Annual Net Cash Flow 1

It can also be calculated using the formula: Payback Period = (p - n)÷p + ny = 1 + ny - n÷p

Whereny= The number of years after the initial investment at which the last negative value of cumulative cash flow occurs.n= The value of cash flow at which the last negative value of cumulative cash flow occurs.p= The value of cash flow at which the first positive value of cumulative cash flow occurs.

Net Present ValueIt is the difference between the

present value of cash inflows and the present value of cash outflows.

NPV is used in capital budgeting to analyze the profitability of an investment or project.

Profitability Index

It is an index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:

Internal Rate of ReturnIRR can be used to rank several

prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first

IRR is sometimes referred to as "economic rate of return (ERR)

Modified Internal Rate of ReturnWhile the internal rate of return (IRR)

assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project.

The formula for MIRR is: