Capital Budgeting

Prepared by:-
Priyanka Gohil
Definition

Investment decision in long-lived assets is generally

referred to as capital budgeting or capital expenditure
decision.
or
Capital budgeting is the process of evaluating the
profitability of the projects under consideration and
deciding on the proposal to be included in the capital
budget for implementation.
 Capital budgeting is used interchangeably with capital
expenditure decision, capital expenditure management,
long-term investment decision, management of fixed assets
and so on.
• Capital expenditure management includes addition,
disposition, modification and replacement of fixed assets.
Importance of Capital Budgeting
Capital budgeting decisions are the most important decisions in
corporate financial management.
These decisions commit a firm to invest its funds in the operating
assets (long-term assets) with the hope of employing them most
efficiently to generate a series of cash flow in future.
1. Capital budgeting decisions affect the profitability of a firm.
2. A capital expenditure decision has its effect over a long time
span and inevitably affects the company’s future cost structure.
3.Capital investment decisions, once made, are not easily reversible
without much financial loss to the firm.
4. Capital investment involves costs and majority of the firms have
scarce capital resources. This, underlines the need for thoughtful,
wise and correct investment decisions.
Rationale of capital budgeting

The rationale underlying the capital budgeting decision is

efficiency.

Capital budgeting decision can be of two types:

(i) Those which expand revenue
(II) Those which reduce costs
EVALUATION TECHNIQUES

The important evaluation methods of appraising capital

expenditure proposals can be classifies into two broad
categories:

A. Traditional
B. Time adjusted or discounted cash flow
A. Traditional Techniques

1. Payback Method
2. Accounting rate of return
1. Payback Method

“Pay back period is defined as the length of time required to

recover the initial cash out lay.”

Pay back method is the simplest and perhaps the most

widely employed, quantitative method for appraising capital
expenditure decisions.
Acceptance rejection criteria:-

Accepted:- If project’s pay back period is less than

the maximum or standard pay back period set by
management.
Rejected:- If project’s pay back period is more than
the maximum or standard pay back period set by
management.
Rank

Highest Ranking to the project which has the

shortest pay back

Lowest Ranking to the project which has highest

pay back
They are two ways of calculating Pay back
period

(I) When cash flow stream is in the nature of annuity for

each year of the project’s life, that is. CFAT are uniform.

Pay back period= Initial Investment

Constant annual cash flow
EX. An investment of Rs. 40,000 in a machine is expected
to produce CFAT of Rs. 8,000 for 10 years
EX. An investment of Rs. 60,000 in a machine is
expected to produce CFAT of Rs. 6,000 for 15 years
(II) When project’s cash flows are not uniform but vary from year
to year.

Pay back period

Balance of initial out lay
= Year prior to full to be recovered
recovery of initial outlay + at the beginning
of the year in which full
Recovery takes place
Cash in flow of the year in
which full recovery take place
EX. The following details are available in respect of the cash flows of
two projects A& B. Calculate pay back period.

Year Cash Flow of A Cash Flow of B

0 1,00,000 1,00,000
1 50,000 20,000
2 30,000 20,000
3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 _ 60,000
The following details are available in respect of the cash flows of two
projects A& B.

The initial investment is of Rs. 56,125.CFAT in the fifth year

include Rs. 3,000 salvage value. Calculate pay back period.

Year Annual CFAT Annual CFAT

A B
1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000
EX. ABC Ltd. Is considering investing in a project that costs Rs.
5,00,000. The estimated salvage value is zero; tax rate is 35 percent.
The company uses straight line depreciation for tax purposes i.e
1,00,000 and proposed project has cash flows before tax (CFBT) as
follows: Calculate pay back period:

Year CFBT
1 1,00,000
2 1,00,000
3 1,50,000
4 1,50,000
5 2,50,000
Discounted Pay back Period

A major shortcoming of the pay back period

is that it does not take into account the time
value of money.
 To overcome this limitation the
discounted payback period has been
suggested.
XYZ Ltd. Whose discounting factor is 10 percent, is
considering project the details of which are:

Year Project A Cash flow

0 4,00,000
1 2,00,000
2 1,75,000
3 25,000
4 2,00,000
5 1,50,000
2. Average Rate of Return/Accounting
Rate of Return
The average rate of return (ARR) method is used for
evaluating proposed capital expenditure, also known as the
return on investment (ROI) uses accounting information as
revealed by financial statements, to measure the profitability
of an investment.

ARR= Average annual profits after taxes/ Average income*100

Average investment over the life of the project

Average investment= Salvage value+ ½ (Cost of machine-

Salvage value)
Acceptance rejection criteria:-

Accept:- All those projects whose ARR is

higher than the minimum rate established by
mgmt.
Reject:- All those projects whose ARR is
Lower than the minimum rate established by
mgmt.
Rank

• This method would rank a project as

number one if it has highest ARR.
• Lowest rank would be assigned to the
project with lowest ARR.
EX. Determine the average rate of return from the following data of two
machines, A and B.

Machine A Machine B
Cost Rs. 56,125 Rs. 56,125
Annual estimated Income
After depreciation
and income tax:
Year 1 3,375 11,375
2 5,375 9,375
3 7,375 7,375
4 9,375 5,375
5 11,375 3,375
36,875 36,875
Estimated life (Years) 5 5
Estimated salvage Value 3,000 3,000
Ex. The following particular refer to two projects:-
X Y
Cost 40,000 60,000
Estimated life 5 year 5 year
Salvage Value Rs. 3,000 Rs. 3,000
Income after tax (Rs.)
1 3,000 10,000
2 4,000 8,000
3 7,000 2,000
4 6,000 6,000
5 8,000 5,000
Total 28,000 31,000
Calculate ARR
B. Time adjusted or discounted cash flow

1. Net present Value method

2. Internal rate of return method
3. Modified internal rate of return
4. Profitability index
1. Net present Value method

• Net present value takes into account the time

value of money. In this method, all cash
flows are expressed in terms of their present
values.
• The present value so determined is compared
with the present value of cash outflows.
Acceptance rejection criteria:-

Accept:- If NPV is positive

Reject:- If NPV is negative
Rank

Project with highest NPV would be assigned

the first rank, followed by others in the
descending order.
 Machine A Machine B
Year CFAT Year CFAT

1 14,000 1 22,000
2 16,000 2 20,000
3 18,000 3 18,000
4 20,000 4 16,000
5 25,000 5 17,000

The cost of capital is 10%, Calculate NPV, If Initial outflow is 56,125 .

 Machine X Machine Y
Year CFAT Year CFAT

1 10,000 1 50,000
2 20,000 2 40,000
3 30,000 3 20,000
4 45,000 4 10,000
5 60,000 5 10,000
2. Internal Rate of Return (IRR)

Internal rate of return is usually the rate of

return that a project earns.
IRR depends entirely on the initial outlay
and the cash proceeds of the project which is
being evaluated for acceptance or rejection.
It is, therefore, appropriately referred to as
internal rate of return.
Acceptance rejection criteria:-

The project would qualify to be accepted if

the IRR exceeds the cut-off rate.
The procedure for calculating IRR will
depend on whether the cash flows are
annuity or mixed stream.
IRR= r- ( PB-DFr)
DFrL- DFrH
Where,
PB= Pay back period
DFr= Discount factor for interest rate r
DFrL= Discount factor for discount rate

DFrH= Discount factor for higher interest rate

r= Interest rates used in the formula
Annuity

A project costs Rs. 36,000 and is expected to

generate cash inflows of Rs. 11,200 annually
for 5 years. Calculate the IRR of the project.
Mixed stream cash flow
A project requires an initial outlay of Rs. 1,00,000.
It is expected to generate the following cash
inflows:
Year Cash Inflows
1 50,000
2 50,000
3 30,000
4 40,000
What is the IRR of the project?
3. Modified Internal Rate of Return

 MIRR is a distinct improvement over the IRR.

 MIRR assumes that cash flows from the project are
reinvested at the cost of capital.
 Reinvestment at the cost of capital is considered
realistic and correct, the MIRR measures the
project’s true profitability.
PV of costs = PV of terminal value
PVC = TV
(1+MIRR)n
EX.

Year 0 1 2 3 4 5 6

Cash flows (Rs (100) (100) 30 60 90 120 130

in million)

Cost of capital is 12%.Find MIRR.

 EX. The cash flow stream of Nanotech Ltd. Is as
follows.
Years 0 1 2 3 4 5 6

Cash flows (in -120 -100 40 60 80 100 130

million)

The cost of capital is 13%. Find MIRR.

4.Profitability Index

The profitability index approach measures

the present value of returns per rupee
invested.

Profitability Index= PV of cash inflows

PV of Cash outflows
Acceptance rejection criteria:-

Accept:- Project will qualify for acceptance

if its PI exceeds one.
Reject:- Project will be rejected if its PI is
less than one.
Rank

The highest rank will be given to the project

with the highest PI, followed by others in the
same order.
Project Initial Cash Cash Cash
outlay flow flow flow
Year 1 Year 2 Year 3

A 1,00,000 60,000 50,000 40,000

B 50,000 20,000 40,000 20,000

C 50,000 20,000 30,000 30,000

Cost of capital is 15%