Capital Budgeting Decisions

2. Capital Budgeting Decisions • Capital Budgeting Decisions may be defined as the firms decisions to invest its current funds most efficiently in the long term assets in anticipation of benefits over a series of years. • Capital Budgeting Decision is the planning process used to determine weather a firm’s long term investments are worth pursuing.

3. The firm has limited budget. • So, management needs to use capital budgeting techniques to determine which projects will yield the highest return over an applicable period of time.

4. Firm’s Investment Decision generally include • Expansion • Acquisition • Modernization • Replacement of Long term assets. • Change of Advertisement • Change the method of R & D

5. Capital Allocation • Capital allocation or Capital Budgeting Techniques. • Following are the techniques for Capital budgeting: • Net Present Value (Present Worth) • Payback

6. Net Present Value (Present Worth) • Cash flows arising at different time periods differ in value and are comparable only when their Present Value are found out. • Present value should be calculated using the opportunity cost of capital as discount rate. • NPV should be found out by subtracting the PV of cash outflows from inflows. • The Project should be accepted if NPV >0

8. Opportunity Cost of Capital • Return or income forgone in investing in a particular project, instead of investing the same sum in some other project.

9. Payback • Payback is the number of years required to recover the Initial Investment. • Payback = Initial Investment /Annual Cash inflows

10. Capital Financing • Raising funds for business • The amount of the new funds needed from the investors and lenders as well as funds available from the internal sources to support new capital projects are determined in Capital Financing Function.

11. Capital • Wealth in the form of money or other assets owned by a person or organization or available for a purpose such as starting a company or investing.

12. Sources of Capital Funds • Equity Capital • Debt Capital

13. Equity Capital • The part of the capital of a company that comes from the issue of shares. • It includes Common stock • Preferred stock • Retained earnings

14. Debt Capital • When a business raises Capital (money) by taking Debt, its called Debt Financing. • The money can be raised by taking a loan from the bank • The money can be raised by issuance of Bonds or Debentures

15. Capital Asset Pricing Model (CAPM) • The capital asset pricing model (CAPM) describes the relationship between risk and expected return • The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk.

16. The commonly used formula to describe the CAPM relationship is as follows. • Expected Return = Risk Free Rate + (Market Return - Risk Free Rate)*Beta

17. For example, let's say that the current risk free-rate is 5%, and the expected market return is 12% next year. • You are interested in determining the return that Reliance Inc. will have next year. • You have been given that its beta value is 1.9. • The overall stock market has a beta of 1.0, so Reliance’s beta of 1.9 tells us that it carries more risk than the overall market; this extra risk means that we should expect a higher potential return than the 12% of the Market. 

18. Required (or expected) Return = • 5% + (12% - 5%)*1.9 = 18.3%. • What CAPM tells us is that Reliance has a required rate of return of 18.3%. So, if you invest in Reliance, you should be getting at least 18.3% return on your investment

19. Market portfolio • A market portfolio is a theoretical bundle of investments that includes every type of asset available in the world financial market, with each asset weighted in proportion to its total presence in the market. • The expected return of a market portfolio is identical to the expected return of the market as a whole.  • Market Return is the return on the Market Portfolio.

20. Sensitivity coefficient (Beta) • Sensitivity coefficient is a measure of sensitivity of a share price to movement in the market price. • It measures systematic risk. • The beta for market is 1. • If beta for some security >1, it means that it carries more risk than overall market. • If beta for some security <1, , it means that it carries less risk than overall market.

21. When beta value is less, the shares are not very sensitive to the market fluctuations. • (Called Defensive shares). • When beta value is more, the shares are sensitive to the market fluctuations. • (Called Aggressive shares). • A fully diversified market portfolio has a Beta = 1

22. Risk premium • Risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset in order to induce an individual to hold the risky asset rather than the risk-free asset.

23. Cost of Capital • What is 'Cost Of Capital' • The cost of funds used for financing a business. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC).

24. Firm’s Cost of capital is the overall required rate of return on the aggregate of investment Projects.

25. Leasing • A contract by which an owner (the lessor) of a specific asset (such as a piece of land, building, equipment, or machinery) grants a second party (the lessee) the right to its possession and use for a specific period and under specified conditions, in return for specified periodic rental or lease payments.