UNIT- 2

CAPITAL BUDGETING
Capital Budgeting – An Overview
An efficient allocation of capital (investment) is
the most important finance function in the
modern times.
It involves decisions to commit the business firm’s
funds to the long-term assets.
Such decisions are of considerable importance to
the firm since they tend to determine its
value,
size by influencing its growth, profitability and risk.
The investment decision of a firm on fixed
assets/long-term assets are generally known as the
capital budgeting or capital expenditure decisions.
As capital budgeting decision may be defined as
the firm’s decision to invest its current funds most
efficiently in the long-term assets in anticipation of
an expected flow of benefits over a serious of
years.
The main characteristic of a capital expenditure is
that
the expenditure is incurred at one point of time
whereas benefits of the expenditure are realized at
different points of time in future.
Techniques/methods of Capital Budgeting
At each point of time a business firm has a
number of proposals regarding various projects in
which it can invest funds.
But the funds available with the firm are always
limited and it is not possible to invest funds in all
the proposals at a time.
Hence, it is very essential to select from amongst
the various competing proposals, those which
give the highest benefits.
 There are several criteria that have been suggested
by economists, accountants, and others to judge the
worthwhileness of investment projects.
 The important investment criteria, classified into two
broad categories:
 Non-discounting criteria or traditional techniques:
Payback period
Accounting rate of return
 Discounting criteria or time adjusted techniques:
Net present value
Benefit cost ratio or profitability index method
Internal rate of return
Non-discounting criteria or traditional techniques:
Payback period:
The payback period is the length of time required
to recover the initial investment/cash outlay on
the project.
Decision rule:
Accept the project if the actual or computed
payback period is less than the maximum PB
period set by the firm, otherwise the project is
rejected.
In ranking two investment projects, the project
with shorter payback period should be chosen
because it pays for itself more quickly.
 A. Payback period with equal cash inflows:
 Profit before depreciation and after taxes are known as cash
inflows.
 When the project generates constant annual cash inflows, the
following one is the formula to calculate payback period.
 PBP = Net investment/Annual cash inflows
 For example, XYZ business firm is considering an investment
in project ‘A’. The maximum payback period set by the firm’s
management is 4 years.
Net investment = $12,000
Annual cash inflows = $4000
Estimated life = 5years
 Required:- Compute the payback period and give your
decision.
 The PBP = $12,000/$4,000 = 3 years
 Decision: XYZ business firm should accept the investment in
project ‘A’ because the computed PBP (3 years) is less than
the maximum allowable PBP (4 years).
B:Payback period with unequal cash inflows:
If the expected cash inflows are unequal, the PBP
is calculated by determining the length of requires
for cumulative cash inflows to equal the net
investment.
PBP = Year before recovery + Unrecovered cost at
start of year/Cash flow during the next year.
Case-1: There are two projects ‘x’ and ‘y’. Each
project requires an investment of $56,000. You
are required to rank these projects according to
the pay-back period method form the following
information.
Cash inflows
Year Project ‘X’ Project ‘Y’
1 $14,000 $22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
Limitations of payback period method:
Though payback period method is the simplest,
oldest and most frequently used method, it
suffers from the following limitations.
It does not take into account the cash inflows
earned after the payback period and hence the
true profitability of the projects cannot be
correctly assessed.
 For example, there are two projects ‘x’ and ‘y’. Each
project requires an investment of $25,000. The cash
inflows from the two projects are as follows:
Year Project ‘X’ Project ‘Y’

1 $5,000 $4,000
2 8,000 6,000
3 12,000 8,000
4 3,000 7,000
5 - 6,000
6 - 4,000
 According to the payback method, project ‘x’ is better
because of earlier payback period of 3 years as compared
to 4 years payback period in case of project ‘y’.
But it ignores the earnings after the payback
period.
Project ‘x’ gives only $3,000 of earnings after the
payback period while project ‘y’ gives more
earnings i.e. $10,000 after the payback period.
It may not be appropriate to ignore earnings after
the payback period especially when these are
substantial.
It is a measure of the project’s capital recovery,
not profitability.
Another limitation of this method is that it ignores
the time value of money and does not consider
the magnitude and timing of cash inflows.
It treats all cash flows as equal though they occur
in different periods.
It ignores the fact that cash received today is
more important than the same amount of cash
received after some years.
For example:
 Year Annual cash inflows
Project-1 Project-2
1 $10,000 $4,000
2 8,000 6,000
3 7,000 7,000
4 6,000 8,000
5 4,000 10,000
Total $35,000 $35,000
 According to the payback method both the projects may be treated
equal as both have the same cash inflows in 5 years.
 But in reality project no.1 gives more rapid returns in the initial
years and is better than project no.2.
 C. Discounted payback period:
 As we discussed above the serious limitation of the
payback period method is that it ignores the time value
of money.
 Hence, an improvement over this method can be made
by employing the discounted payback period method.
 Under this method, the present values of all cash
outflows and inflows are computed at an appropriate
discount rate,
 The present values of all inflows are cumulated in order
of time.
 The time period at which the cumulated present values
of cash inflows equals the present value of cash outflows
is known as discounted payback period.
 The project which gives a shorter discounted payback
period is accepted.
 Case-2: The following information regarding to project ‘A’ and ‘B’ of
XYZ corporation.
Cost of the projects = $56,000
Life of the projects = 5 years
Cost of capital (cut off rate) = 10%
Annual cash inflows of projects are as follows:
Cash inflows
Year Project ‘A’ Project ‘B’
1 $14,000 $22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
Total $93,000 $93,000

 Required:- Compute discounted payback period and give your

decision?
Accounting rate of return
 This method takes into account the earnings
expected from the investment over their whole life.
 It is called as ARR method for the reason that under
this method, the accounting concept of profit (net
profit after tax and depreciation) is used rather than
cash inflows.
 Decision rule:
 Accept the project if the computed ARR is greater
than the maximum target ARR set by the firm,
otherwise the project is rejected.
 In ranking projects having the same target ARR, the
project with the highest ARR should be selected
because it is more profitable.
 Total profits (after dep. & taxes)
 Therefore, ARR = × 100
Net investment × No. of years of profits

(or)

Average annual profits

ARR = × 100
Net investment
Case-3: A project requires an investment of
$500,000 and has a scrap value of $20,000 after
five years. It is expected to yield profits after
depreciation and taxes during the five years
amounting to $40,000, $60,000, $70,000, $50,000
and $20,000. Assume maximum target ARR set by
the firm is 9%.
Required:- Calculate ARR on the investment and
give your decision.
 Discounting criteria or time adjusted techniques:
 The traditional methods of project investment appraisal
i.e., payback method as well as ARR method, suffer from
the serious limitations that give equal weight to present
and future flow of incomes.
 These methods do not take into consideration the time
value of money, the fact that a Birr earned to has more
value than a Birr earned after five years.
 The time adjusted or discounted criteria methods take into
account the profitability and also the time value of money.
 Net present value
 The NPV method is a modern method of evaluating
investment project proposals.
 This method takes into consideration the time value of
money and attempts to calculate the return on investments
by introducing the factor of time element.
 It recognizes the fact that a Birr earned today is worth more
than the same Birr earned tomorrow.
 The net present values of all inflows and outflows of cash
occurring during the entire life of the project is determined
separately for each year by discounting these flows by the
firm’s cost of capital or a pre-determined rate.
 Therefore, NPV = PV of cash inflows – PV of cash outflows
 Symbolically,
𝐶1 𝐶2 𝐶3 𝐶𝑛
NPV = + + +⋯ − 𝐶0
1+𝑟 1+𝑟 2 1+𝑟 3 1+𝑟 𝑛
(or)
 NPV = PV of cash inflows – PV of cash outflows
 Decision Rule:
Accept if NPV > 0
Reject if NPV < 0
if NPV = 0 (Indifference) may accept
 Case study-4: From the following information, calculate
the NPV of the two projects and suggest which of the
two projects should be accepted assuming a discount
rate of 10%.
Project ‘X’ Project ‘Y’
Initial Investment $20,000 $30,000
Estimated Life 5 years 5 years
Scrap value $1,000 $2,000

 The cash inflows are as follow:

Year 1 ($) Year 2 ($) Year 3 ($) Year 4 ($) Year 5 ($)
Project ‘X’ 5,000 10,000 10,000 3,000 2,000
Project ‘Y’ 20,000 10,000 5,000 3,000 2,000
 Benefit cost ratio or profitability index method
 BCR is the relationship between present value of cash inflows and
the present value of cash outflows.
 BCR is a slight modification of the NPV method.
 The NPV method has one major drawback that is not easy to rank
projects on the basis of this method particularly when the costs
(cash outflows) of the projects differ significantly.
 To evaluate such projects BCR is most suitable.
 BCR = PV of cash inflows/PV of cash outflows (or)
 Symbolically,
𝐶1 𝐶2 𝐶3 𝐶𝑛
+ + +⋯
1+𝑟 1+𝑟 2 1+𝑟 3 1+𝑟 𝑛
BCR =
C0
Decision Rule:
Accept if BCR > 1
Reject if BCR < 1
if BCR = 1 (Indifference) may accept
Case-5: Refer to the above case (Case study-4)
and calculate benefit cost ratio and also give your
decision.
Internal rate of return
 In the NPV method the net present value is determined
by discounting the future cash flows of a project at a
predetermined or specified rate called the cut-off rate.
 Under this method, since the discount rate is determined
internally, this method is called as the IRR method.
 The IRR can be defined as that rate of discount at which the
present value of cash inflows is equal to the present value
of cash outflows.
 Decision Criterion:
 If IRR is greater than the cost of capital, accept the
project.
 If IRR is less than the cost of capital, reject the project.
Therefore, Symbolically, IRR =
𝐶1 𝐶2 𝐶3 𝐶𝑛
𝐶0 = + + +⋯
1+𝑟 1+𝑟 2 1+𝑟 3 1+𝑟 𝑛
Case-6: Consider the cash flows of project being
considered by ABC business firm. Assume that
cost of capital is 13%.
Year Cash flow ($)
0 -100,000
1 30,000
2 30,000
3 40,000
4 45,000
Required:- Calculate internal rate of return and
give your suggestion whether the ABC business
firm should accept or reject the investment in
project?