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Should We Pursue Building of This Plant?

This document discusses capital budgeting techniques used to analyze potential long-term investments. It describes capital budgeting as focused on different investment plans that are expected to generate cash flows over several years. The document then outlines traditional capital budgeting techniques like payback period, accounting rate of return, net present value, profitability index, and internal rate of return. For each technique, it provides an example calculation and decision rules for whether to accept or reject an investment project based on the results of the analysis.

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Dikshit Kothari
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57 views24 pages

Should We Pursue Building of This Plant?

This document discusses capital budgeting techniques used to analyze potential long-term investments. It describes capital budgeting as focused on different investment plans that are expected to generate cash flows over several years. The document then outlines traditional capital budgeting techniques like payback period, accounting rate of return, net present value, profitability index, and internal rate of return. For each technique, it provides an example calculation and decision rules for whether to accept or reject an investment project based on the results of the analysis.

Uploaded by

Dikshit Kothari
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Capital Budgeting

Should we
pursue building of
this
plant?

CAPITAL:- Fixed Assets Used in


Production
BUDGET:- Plan of Inflow &
Outflow of a case for a defined
period
CAPITAL BUDGET:- Focused on
the different investment plan
CAPITAL BUDGETING:

Potential Decision to LongTerm investments are expected


to generate cash flow over a
series of years.

Features & Problems


Features:

Long-Term Effects
Substantial Commitments
Irreversible Decisions
Affect the Capacity & Strength to compete

Problems: Future Uncertainty


Time Element
Measurement Problem

Types of Capital
Budgeting
Types

Firms Existence

New Firm

Existing Firm

Decision Situation

Mutually
Exclusive

Accept-Reject

Capital Budgeting
Techniques
Capital Budgeting
Techniques

Traditional
Pay Back
Period

Avg. Rate
of Return

Discounte
d
Net
Present
Value
Internal
Rate of
Return

Profitabilit
y Index

Pay Back Period


PAY BACK PERIOD METHOD

CASH OUT
FLOW

CASH INFLOW

The number of years required to recover a projects


cost
or

Annual Inflows are Equal

Suppose Initial Investment = Rs. 10,00,000


Annual Cash In-Flow = Rs. 2,50,000 per annum
Economic Life of Machine = 5yrs
PAYBACK PERIOD = Initial
Investment/Annual Cash In-flow
= (10,00,000/2,50,000)
Cash InYears flow(Rs.)
2,50,000 = 4 Years
1st
2nd
3rd
4th
5th

2,50,000
2,50,000
2,50,000
2,50,000

Annual Inflows are


Unequal
Suppose Initail Investment = Rs. 10,00,000
Economic Life of Machine = 5yrs
PAYBACK PERIOD = Years + (Required Amt /
Next Yr Cash Inflow)
Cash InYears flow(Rs.)
1st
2,50,000
2nd
3,00,000
3rd
3,50,000
4th
4,00,000
5th
4,50,000
6th
2,50,000

Cumulati
=
ve Cash
flow =
2,50,000
=
5,50,000
9,00,000
13,00,000
17,50,000
20,00,000

3 + [(10,00,000 9,00,000)]/ 4,00,000]


3 + (1,00,000/4,00,000)
3 + 0.25 = 3.25 Years

Decision Rule
Pay Back Period > Target Period Rejected
Pay Back Period <Target Period Accepted
PBP of Machine A < PBP of Machine B Accept
Machine A

Accounting Rate of Return


Annualized Net Income
Earned on Average
Funds Invested in a
project

Example

Solution
ARR = (Avg. Net Profit After Tax/ Avg.
Investment)*100
Avg. Net Profit After Tax = 3,50, 000/5 = Rs. 70,000
Avg. Investment = [(Initial Cost of Asset-Salvage
value)/2]+
Add. Net Working Capital + Salvage Value
Avg. Investment = [(5,20,000
20,000)/2]+0+20,000
= Rs. 2,70,000

Decision Rule
ARR> Specified Rate of Return Accepted
ARR< Specified Rate of Return Rejected
ARR of Machine A < ARR of Machine B Accept
Machine B

Net Present Value


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.
NPV compares the value of a
Rupees today to the value of
that same Rupees in the future,
inflation
and
into
NPV =taking
Present
Value
of returns
Cash InflowPresent
Value account.
of Cash
Outflow

Example

Initial Investment = Rs. 8,00,000


No. of Years = 5 yrs (N)
Rate of Interest = 10% p.a (R)
PVF = 1/(1+R)N
Present Value(PV) = (Cash inflow x PVF)

NPV = Present Value of Cash Inflow- Present Value of


Cash Outflow
NPV = 10,11,300 8,00,000
NPV = 2,11,300

Decision Rule
NPV > 0 Accepted
NPV < 0 Rejected
NPV of Project A < NPV of Project B Accept
Project B

Profitability Index
Profitability index
define as the benefits
per rupee invested in
the proposal
This technique is also
known as Benefit-Cost
Ratio
The profitability index
method compares the
present value of future
cash inflows with the
initial investment

Example
Initial Investment = Rs. 10,00,000
No. of Years = 5 yrs
Rate of Interest = 10% p.a
Hence, PI= (PV of Cash Inflow/PV of Cash Outflow)
= (10,11,300/10,00,000) = 1.01
PI>1, Accept the Proposal

Decision Rule
PI > 1 Accepted
PI < 1 Rejected
PI of Project A < PI of Project B Accept Project B

Internal Rate of Return


Also called the timeadjusted rate of return.
It is the minimum rate that
could be paid for the
money invested in a project
without losing money.
It is also described as the
discount rate that results in
a projects net present
value equaling zero.

Example

Decision Rule
IRR > Cost of Raising Capital Accepted
IRR < Cost of Raising Capital Rejected
IRR of Project A < IRR of Project B Accept Project
B

THANK YOU

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