CAPITAL

BUDGETING
Dr. Sadhna Bagchi
CAPITAL BUDGETING

■  Introduction ■  Process of capital budgeting

■  Definition ■  Techniques of capital budgeting
■  Cases of capital budgeting ■  Merits and demerits of capital
budgeting
■  Concept of capital budgeting
■  Accept and reject criteria
■  Importance of capital budgeting
 INTRODUCTION
The finance manager concerned with the investment decision ,
popularly known as capital budgeting decision, require comparison of
cost against benefits over the long period.
For Example :
 The deployment finances of additional plant and equipment cannot
be recovered in the short run. Such investment may affect revenues for
the period ranging from 2 to 20 years or more. Such investment
decision involve a careful consideration of various factors profitability,
safety, liquidity and solvency.
DEFINITION

Capital budgeting is the planning process used to determine whether an

organizations long term investments such as new machinery ,
replacement machinery ,new plants new products and research
development projects are worth the funding of cash through the firms
capitalization structure (debt ,equity or retained earnings)..
CAPITAL BUDGETING
■ NATURE ■ IMPORTANCE
■ CB Decisions have long-term ■ Huge amount of resources are
impact on the business stability, involved that has impact on
■ growth & success ■ business strategy, growth, and
survival.
■ CB Decisions involve huge
investment of funds ■ Difficult to “bail out”, once an
investment is made.
■ CB Decisions are more complicated
from concerns of future cash ■ The capital investments are
challenging and critical to the
■ flow estimates and their evaluation
at the time of making ■ success of the company. An
incorrect decision may end with
■ investment
the
■ CB Decisions are not easily ■ company’s closing-out from the
reversible mainly because of loss market.
CASES OF CAPITAL BUDGETING-
Replacement
Expansion
Diversification
Research and development
Miscellaneous
PROCESS OF CAPITAL
BUDGETING
Capital budgeting is a difficult process to the investment of
available funds. The benefit will attained only in the near
future but, the future is uncertain.
 Identification of various investments proposals
 Screening or matching the proposals
 Evaluation
 Fixing priority
 Final approval
 Implementing
 Performance review of feedback
RELEVANT CONCEPTS
Independent Projects - are projects where selection or rejection of one project
does not have any impact on the selection or rejection of the other project.
Management can select any number of projects from the given options.
Mutually Exclusive Projects- are projects that compete each other, acceptance
of one project becomes automatic rejection of the other or vice versa. The projects
compete with each other based on the superior financial
performance. There can be any number of projects for a subject and competing with
each other. Management has to decide about one project from all alternatives or
options.
Decision Rules: The decision rules for independent and
mutually exclusive projects slightly differ. The way of looking at investment
opportunities under both types varies.
EVALUATION TECHNIQUES

A: Traditional ■ 2. B: Discounted Cash Flow (DCF)/

Techniques Discounted
Time Adjusted (TA) Techniques
Payback
■ 1. Payback Period 1. Net Present Value (NPV)
period (PB) (DPB)
2. Internal Rate of Return (IRR
■ 3. .3. Modified Internal Rate of
Accounting Return (MIRR)
Rate of
Return 4. Terminal Value (TV)
(ARR) 5. Profitability Index (PI) or
Benefit/Cost
Ratio
DECISION RULES
FOR ALL CAPITAL BUDGETING
TECHNIQUES
Tech. Single or Independent Project(s) Mutually Exclusive Projects
1 PB Less than the Target Period Shortest Payback Period
.
2 DPB Less than the Target Period
3 ARR Above the Target Rate With the highest ARR
4 IRR A positive NPV NPV ith the highest positive
Higher than the Target Rate (Cost of NPV
Capital) With the highest IRR
5 MIRR Higher than Target Cost of Capital
(i.e. WACC) With higher MIRR
6 TV If PVTS>PVO Accept, And if PVTS<PVO
Reject With the highest PVTS>PVO
7 PI
PAY BACK PERIOD METHOD

The payback period is the length of time required to recover the

initial cost of the project. The payback period is the length of time
required to recover the initial cost of the project. The payback
period therefore can be looked upon as the length of time
required for a proposal to break even on its net investment.

■ CALCULATION OF PAYBACK PERIOD-

When Annual Inflow are Equal.

When the Annual Cash Inflow are Unequal

Merits & Demerits

Merits

Simple to calculate

Liquidity Indications

Break even of investment can be calculated.

Demerits

Ignores

the profitability factor.

Its is the method of recovery.

Ignores salvage Value.

Ignores the time value of money.

ACCEPT / REJECT CRIETERIA

If the actual pay-back period is less than the

predetermined pay-back period, the project would
be accepted. If not, it would be rejected.
Exercise :
Continued
 AVERAGE RATE OF RETURN
Average rate of return means the average rate of return or profit taken for
considering the project evaluation. This method is one of the traditional
methods for evaluating the project proposals
■ MERITS-
.It is easy to calculate and simple to understand.
It is based on the accounting information rather than cash inflow.
It is not based on the time value of money.
It considers the total benefits associated with the project.
■ DEMERITS-
It ignores the time value of money.
It ignores the reinvestment potential of a project.
Acceptance and Rejection criteria : If the actual accounting rate of return is more than
the predetermined required rate of return, the project would be accepted. If not it would be
rejected.
AVERAGE RATE OF RETURN
ARR = Net Annualised Income/Average amount of fund Invested X 100
Net Annualised Income= Amount of Income after tax
a)If income is equal every year
ARR= Net Annual Profit after tax / Average amount of fund Invested X 100
b) If income is unequal across the world
ARR= Average Annual Profit after tax / Average amount of fund Invested X 100
Average Annual Profit after tax= Aggregates of after tax profits during the life span of
projects/Life span of a capital budgeting projects
Average amount of fund Invested is computed as follows
b)
When straight line method is used: ½*(Initial outlay +Installation exp – salvage value)+Salvage
value
c)In case additional working capital requirement during the life of the projects, the average
amount of funds invested are duly increased by the amount of working capital requirments as
½*(Initial outlay +Installation exp – salvage value)+Salvage value + Working Capital
Exercises:

1. Machine costing Rs. 2,80,000 that has a salvage value Rs. 20,000. Economic life is 5
years. Expected yield after tax
1st year 30,000 2nd year 35,000 3rd 25,000 4th 25,000 5th 35,000. Applying ARR
method,
should the machine be purchased ? If the existing rate of return is 22%.
2. A new machinery that has depreciable base is 2,45,000 with a salvage value 30,000:
expected economic life is 5 years and is likely to result in additional earning of before
depreciation and taxes are:
1st year 1,04,000 2nd year 1,02,000 3rd 99,000 4th 1,03,000 5th 1,07,000. assuming that a
working capital requirement of Rs. Rs. 25,000, SLM method f depreciation and tax rate is
35%. . Applying ARR method,
should the machine be purchased ? If the existing rate of return is 25%.
3. Initial outlay Rs. 2,00,000 and expected cash flow of Rs. 70,000, Rs. 60,000, Rs, 60,000,
Rs, 40,000, Rs. 30,000. Find out payback period of investment .
Discounted cash flow Techniques
I) Net Present Value(NPV)
NPV=CF1 /(1+r)1 + CF2 /(1+r)2 +………+CFn /(1+r)n = (CFt /(1+r)t) – C0
NPV = Net Present Value
CFt = Cash in-flows for given periods
Co = Initial Investment
r = Discount Rate
The XYZ company’s interest rate is 10% p.a.
Discount Factors @ 10% p.a. for AED. 1 are as given below:
Year 1 = 0.909 Year 2 = 0.826 Year 3 = 0.751 Year 4 = 0.683
Formula to calculate Discount Factor @ 10% p.a. for AED. 1 is given as follows:
Discount Factor = 1/(1+10%)n
 Exercise:
Q. 6.6 A co is planning to buy a m/c at a cost of Rs. 1,40,000. Its economic life is 5
years during which it is expected to generate the following CFAT:
1. 40,000 2. 50,000 3. 60,000 4. 30,000 5. 20,000. Calculate the NPV of this
investment proposal using 8%, 10%, 12% , 14% , 16% and these discount rates.
 Profitability Index
■ PI= Total present value of Cash inflows/ Total present value of cash outflows
Decision criteria: If the value of PI is at least 1, The project is accepted, otherwise it is
rejected.
This is because PI≥ 1 implies that NPV≥ 0
Exercise : 6.8 A company has to make a choice between two projects X & Y.
The initial outlays of two projects are Rs. 3,10,000 and Rs. 5,90,000.
respectively for X and Y. The scrap value after 5 years Rs. 20,000 and Rs.
50,000 respectively. The opportunity cost of Capital of the company is 14%.
The annual cash flow are as under:
year I II III IV V
Project X 10,000 80,000 2,44,000 2,18,000 1,15,000
Project Y 1,20,000 2,68,000 2,92,000 2,74,000 2,10,000
You are required to suggest the acceptability of these mutually exclusive
projects on the basis of profitability index.
Internal Rate of Return
Internal rate of return is the rate of return promised by an investment projects
over its useful life.
C00 = CF1 /(1+r)1 + CF2 /(1+r)2 +………+CFn /(1+r)t + SV+WC/ /(1+r)n
IRR stand for determined when present value of cash inflows are equals the
present value of cash outflows i.e.
PV( cash inflows) = PV (cash out flow)
Calculation of IRR
a) When Net Annual Cash are equal
Calculate PVIFA value and serve as starting point
Find PVIFA value from PVIFA table closest to PVIFA value
PVIFAr(L)% >PB > PVIFAr(H)%
Determine the actual IRR by interpolations using the following formula :
IRR= r+[ PVIFAr,n – PB]/ PVIFA r(L) – PVIFA r(H) ] x delta r
 Exercise:
6.9 A project that entails an initials investment Rs. 50,000 is expected to provide an
annual cash flows of Rs. 12,0000 for a period of 6 years. Calculate its IRR
6.10 A project proposal that enitial investment Rs. 1,00,000 is expected to provide
annual cash flows of Rs. 50,000; 50,000,; 30,000 ; 5,000; 5,000 for a period of 5 years.
Calculate IRR.
6.11 A Co. is considering the projects, which cost is Rs. 10,000 and the annual cash
flows are 1st year- Rs.1,000 2nd year- Rs. 1,000 3rd year- 2,000 4th year 10,000 Compute
the IRR and comment on the project if the opportunity cost is 14%.
6.12 A co. is considering which of the two mutually exclusive projects it should be
under take. The finance director think that the project with higher NPV should be
chosen as both projects have the same initial outlay and length of life. The co
anticipated a cost of capital 10% and net after tax cash flows of the projects are as
follows:
Years: 0 1 2 3 4 5
X (200) 35 80 90 75 20
Y (200) 218 10 10 4 3
 IRR Method
When Net Annual Cash are not equal
a) Compute the average net annual cash inflows to determine surrogate payback
period = Initial Investment/ Average annual CFAT
b) Find the PVIFA value close to surrogate payback period such that one value is
below to surrogate and other is above.
c) Identify the discount rate corresponding to each of PVIFA and find the NPV at this
rates.
d) The NPV value computed just above zero and on computed by higher rate should
be just below zero.
IRR= r+ [ NPV/NPV r(L) – NPV r(H) ]X r
Where r=either of two discount rate r(L), r(H)
NPV r(L) = NPV by applying lower rate
NPV r(H) = NPV by applying higher rate
r = excess of r(H) over r(L)
 Modified Rate of Return
Assumption : projects cash flows are not reinvested
MIRR= n√ (Terminal value of Cash flow / Terminal value of Cash out flows ) –
1
PV = Terminal value of Cash flow /)1+r) n

Using log and anti log find out value of r

Decision criteria : Project accepted if MIRR>Cost of investment
In case of mutually exclusive projects the projects with higher MIRR should
be preferred.
Q. Initial Cost is Rs. 1,50,000 with an expected economic life of 5 years. The
cash flows after tax as under: Rs. 36,000; Rs. 37,000 ; Rs. 42,000; Rs.
48,000; Rs. 51,000. Assuming cost of capital is 12% to be reinvested of
interim cash flows. Find out the modified rate of return of project.
DISCOUNTED PAY BACK PERIOD
Discounted pay back period = A+ B/C
A= no of years immediately preceding the year of final recovery
B= Balance amount of recovery in the year of final recovery
C= Cash inflows in the final year of recovery
Exp: Initial outlay is Rs. 40,000

Year Cash flow DF @10% PV of cash Commulative

flow PV of Cash
flow
1 17,500 0.909 15,908 15,908
2 17,500 0.826 14,455 30,363

3 17,500 0.751 13,143 45,506

 TERMINAL VALUE METHOD
This is combination of NPV and MIRR. The difference between MIRR and TV method is
that in MIRR, the positive cash flows are reinvested at the cost of capital of the firm
Decision criteria: Project proposal is accepted if the PV of terminal value > =
Initial out flows
6.16 Initial Cost Rs. 4,00,000. Cash flows after tax is expected to be Rs.
1,20,000 for next 5 years, the cos tof capital is 12%, but the firm is
opportunity cost to reinvest the immediate cash flows at the rat eof 10% p.a.
Examine the acceptability of the projects on the basis of Terminal value and
NPV.
SPECIAL CAPITA BUDGETING DECISION
SITUATIONS
a) Replacement Decision
b) Projects with unequal cash flow
c) Capital Rationing