Module-2

Analysis and Techniques of

Capital Budgeting
Capital Budgeting
• Capital budgeting is the process of taking long term investment
decisions whose benefits are expected over series of years.

• Example:
(1) Setting up of factories.
(2) Installing a machinery.
(3) Increase in production capacity.
Why are CB decisions are important?
(1) Long term growth and effects
(2) Large amount of funds involved
(3) Risk involved
(4) Irreversible decisions.
Types of CB decisions
(I) On the basis of firm’s existence

A. Replacement decisions
 Replacing fixed assets due to expiry of its economic life.
B. Modernisation decisions
 Replacing fixed assets due to its technological obsolescence.
C. Expansion decisions
 Increasing existing production capacity.
D. Diversification decisions
 Commencing new product/service lines.
Types of CB decisions…….continued
(II) On the basis of decision situation

A. Mutually Exclusive Decisions

 Firm is considering the purchase of machine A or machine B.
B. Accept – Reject Decisions
Project A, B and C are generating returns of 20 %, 18 % and 14 %
respectively. If firm’s minimum rate of requirement is 15 %, then it will
select Project A and Project B.
C. Contingent decisions/Complimentary decisions
If a company accepts a proposal to set up a factory in remote area, then it
may have to invest in building other infrastructure like houses for
employees, roads etc.
Capital budgeting Process
1. Project Planning
2. Project Evaluation
3. Project Selection
4. Project Implementation
5. Project Control
6. Project Review
Techniques of Capital Budgeting
(I) Traditional Techniques
(A) Accounting Rate of Return
(B) Payback Period

(II) Discounted Cash Flow technique

(C) Net Present Value
(D) Profitability Index
(E) Discounted Payback period
(F) Internal rate of return
 Average rate of return
• Average rate of return means average annual yield on project.

• Average rate of return = Annual average earning after taxes *100

Average Investment

where,
Average Investment = ½ (Original cost – Salvage Value) + Salvage Value+ Working Capital

Rule:
Accept the project if ARR is greater than and equal to minimum acceptable rate of
return.
Q1. Calculate Average rate of return of project:
Annual Earning after tax
Year Annual EAT
1 35,000
2 40,000
3 30,000
4 35,000

Original cost = Rs. 1,00,000

Salvage Value= Rs. 40,000
Working Capital = Rs. 10,000
Note:
Average rate of return = Annual average earning after taxes *100
Average Investment
Average Investment = ½ (Original cost – Salvage Value) + Salvage Value+
Working Capital
Q2. Calculate Average rate of return of project:
Annual Earning after tax
Year Annual EAT
1 40,000
2 60,000
3 80,000
4 20,000
Original cost = Rs. 80,000
Installation Charges = 20,000
Salvage Value= Rs. 20,000
Working Capital = Rs. 20,000
Note:
Average rate of return = Annual average earning after taxes *100
Average Investment
Average Investment = ½ (Original cost – Salvage Value) + Salvage Value+
Working Capital
Q3. Calculate Average rate of return of project:
Annual Earning after tax
Year Annual EAT
1 50,000
2 75,000
3 25,000
4 50,000
5 50,000

Original cost = Rs. 1,00,000

Installation Charges = 20,000
Note:
Average rate of return = Annual average earning after taxes *100
Average Investment
Average Investment = ½ (Original cost – Salvage Value) + Salvage Value+
Working Capital
Q4. Calculate Average rate of return of project:
Annual Earning after tax
Year Annual EAT
1 50,000
2 75,000
3 25,000
4 50,000
5 50,000
Original cost = Rs. 1,00,000
Installation Charges = 20,000
Salvage Value = 10,000
Note:
Average rate of return = Annual average earning after taxes *100
Average Investment
Average Investment = ½ (Original cost – Salvage Value) + Salvage Value+
Working Capital
Q5. Calculate Average rate of return of project:
Annual Earning after tax
Year Annual EAT
1 50,000
2 75,000
3 25,000
4 50,000
5 50,000
Original cost = Rs. 1,00,000
Installation Charges = 20,000
Salvage Value = 10,000
Working Capital = 10,000
Note:
Average rate of return = Annual average earning after taxes *100
Average Investment
Average Investment = ½ (Original cost – Salvage Value) + Salvage Value+
Assessment
Q6. Calculate Average rate of return on Q7. Calculate Average rate of return on
machine: project:
Annual Earning after tax Annual Earning after tax
Year Annual EAT Year Annual EAT
1 50,000 1 1,25,000
2 75,000 2 1,50,000
3 25,000 3 1,45,000
4 50,000 4 1,55,000
5 50,000 5 1,75,000
6 75000
Cost of Machine = Rs. 5,00,000 Cost of Project = Rs. 10,00,000
Installation Charges = Rs 50,000 Cost of setting up project = Rs 1,00,000
Salvage Value = 20,000 Scrap Value = 15,000
Working Capital = 20,000 Working Capital = 35,000
Payback Period
• Payback period is the number of years required to recover the cost of
project.

In case of Equal Annual Cash Inflows

Payback period = Initial Cash Outflows

Annual Cash Inflow
Q1. Calculate payback period:
Initial investment of project is Rs.1,00,000 • Payback Period = Initial C/O
Annual cash inflow after tax is Rs. 25000
Annual C/I
Life of project is 5 years

Note:
In case of Equal Annual Cash Inflows

Payback period = Initial Cash Outflows

Annual Cash Inflow
Q2. Calculate payback period Particulars Project A Project B Project C
for projects:
Initial C/O 4,00,000 3,50,000 2,80,000

Note: Annual CFAT 1,00,000 70,000 1,40,000

In case of Equal Annual Cash Inflows
Life of Project 5 years 5 years 5 years
Payback period = Initial Cash Outflows
Annual Cash Inflow

Sol:
Q3. Calculate payback period:
Cost of project is Rs.1,00,000
Life of project is 5 years
Following are Cash flow after tax:
Year CFAT
1 20,000
2 30,000
3 35,000
4 15,000
5 20,000
Q4. Calculate payback period:
Cost of project is Rs.1,50,000
Life of project is 5 years
Following are Cash inflow after tax:
Year CFAT
1 30,000
2 40,000
3 35,000
4 35,000
5 40,000
Q5. Calculate payback period: Payback period = 3 years , (2,50,000-1,85,000) *12
Cost of project is Rs.2,50,000 1,00,000
Life of project is 5 years
Following are Cash flow after tax:
Year CFAT Cum CFAT
1 40,000 40,000
2 60,000 1,00,000
3 85,000 1,85,000
4 1,00,000 2,85,000
5 1,25,000 4,10,000
Q6. Calculate payback period:
Cost of project is Rs.5,00,000
Life of project is 5 years
Following are Cash flow after tax:
Year CFAT
1 1,00,000
2 1,20,000
3 1,40,000
4 2,00,000
5 1,50,000
 We have studied two non
discounting capital budgeting
techniques: ARR and Payback
Period.
Lets study discounting techniques. Present value
factor table will be used.
Discounted Payback Period
• It is the period within which the entire cost of the project is expected
to be completely recovered by way of discounted cash inflows.
Q1. Calculate discounted payback period:
Cost of project is Rs.50,000
Life of project is 5 years
Cost of capital is 10 %. (Discounting rate)
Following are Cash inflow after tax:
Year CFAT
1 20,000
2 25,000
3 30,000
4 35,000
5 50,000
Q2. Calculate discounted payback period:
Cost of project is Rs.1,00,000
Life of project is 5 years
Cost of capital is 10 %
Following are Cash inflow after tax:
Year CFAT
1 25,000
2 50,000
3 75,000
4 100,000
5 50,000
Q3. Calculate discounted payback
period:
Cost of project is Rs.5,00,000
Life of project is 5 years
Cost of capital is 10 %
Following are Cash inflow after tax:
Year CFAT
1 1,25,000
2 1,00,000
3 1,75,000
4 2,00,000
5 2,50,000
Net Present Value
• It is very important capital budgeting technique.
• It is defined as the difference between present value of cash inflow
and present value of cash outflow.
NPV = PVCI-PVCO
where, NPV is Net present value of project.
PVCI = Present value of Cash Inflow
PVCO= Present value of cash outflow.

Analysis: If NPV is +, we will accept the project.

If NPV is -, we will reject the project.
If NPV = 0, we may accept or reject the project.
Q1. Calculate the Net present value of
project if
Cost of project is Rs.75,000
Life of project is 5 years
Cost of capital is 10 %. (Discounting rate)
Following are Cash flow after tax:
Year CFAT
1 25,000
2 28,000
3 32,000
4 38,000
5 50,000
Q2. Calculate the Net present
value of project if
Cost of project is Rs.10,00,000
Life of project is 5 years
Cost of capital is 10 %.
(Discounting rate)
Following are Cash flow after tax:
Year CFAT
1 2,00,000
2 3,00,000
3 2,00,000
4 1,50,000
5 2,00,000
Q3. You are appointed as a consultant. You have to advise
company about the selection of project using Net Present Value.
Cost of capital is 10 %. (Discounting rate)
Following are Cash flow after tax:
Project A
Cost of project = 9,50,000
Year CFAT
1 2,50,000
2 3,00,000
3 2,00,000
4 2,50,000
5 3,00,000

Project B
Cost of project = 8,50,000
Year CFAT
1 1,50,000
2 2,50,000
3 2,20,000
4 1,75,000
5 2,80,000
Profitability Index
• It is defined as the ratio of present value of cash inflow and present
value of cash outflow.
PI = PVCI
PVCO
where, PI is Profitability Index.
PVCI = Present value of Cash Inflow
PVCO= Present value of cash outflow.

Analysis: If PI > 1, we will accept the project.

If PI < 1, we will reject the project.
If PI = 1, we may accept or reject the project.
Q1. Calculate Profitability Index of a
project:
Cost of project is Rs.75,000
Life of project is 5 years
Cost of capital is 10 %. (Discounting rate)
Following are Cash inflow after tax:
Year CFAT
1 30,000
2 25,000
3 30,000
4 25,000
5 30,000
Q2. Calculate NPV and profitability index
of a project:
Cost of project is Rs.2,00,000
Life of project is 5 years
Cost of capital is 10 %
Following are Cash flow after tax:
Year CFAT
1 55,000
2 50,000
3 75,000
4 80,000
5 50,000
Q3. You are appointed as a consultant. You have to advise
company about the selection of project using Profitability
Index.
Cost of capital is 10 %. (Discounting rate)
Following are Cash flow after tax:
Project A Project B
Cost of project = 9,50,000 Cost of Project = 8,50,000
Year CFAT Year CFAT
1 2,50,000 1 1,50,000
2 3,00,000 2 2,50,000
3 2,00,000 3 2,20,000
4 2,50,000 4 1,75,000
5 3,00,000 5 2,80,000
Q1. Given : Cost of project is Rs.1,00,000
Life of project is 5 years
Cost of capital is 10 %
Following are Cash inflow after tax:
Year CFAT
1 55,000
2 40,000
3 55,000
4 50,000
5 60,000
Calculate :
(1) Payback period
(2) NPV
(3) PI
(4) Discounted Payback Period.
Internal Rate of Return
• Internal rate of return is the rate which equates present value of cash inflow
with present value of cash outflow associated with the project.

• Internal rate of return is the rate at which NPV is zero.

• Internal rate of return is the rate of return earned on the initial investments
made in the project.

• Accept the project. If IRR > Cost of capital.

• IRR = L + NPV L * (H-L)

NPVL-NPVH
• IRR = L + NPV L * (H-L)
NPVL-NPVH

Where,
L = Lower Discounting rate
H= Higher discounting rate
NPVL = Net present value at lower discounting rate
NPVH = Net present value at higher discounting rate
IRR = Internal rate of return

Higher the discounting rate, Lower will be the NPV.

Q1. Calculate Internal rate
of return.
Year Cash Flow
0 (384000)
1 1,50,000
2 1,25,000
3 1,00,000
4 75,000
5 50,000

PVIFA (9%, 5 years) = 3.890

PVIFA (10%, 5 years) = 3.791
Year Cash PVF PVCF PVF PVCF PVF PVCF
Inflow @ @ @
9% 10% 12%
Q2. Calculate Internal rate of
return.
Year Cash Flow
0 (9,00,000)
1 3,80,000
2 3,10,000
3 2,40,000
4 1,70,000
5 4,44,000

PVIFA (21%, 5 years) = 2.926

PVIFA (22%, 5 years) = 2.864
Year Cash PVF PVCF PVF PVCF PVF PVCF
Inflow @ @ @
21 % 22 % %
Q3. Calculate Internal rate of (I) Calculation of Average Annual Cash Inflow
return.
Year Cash Flow
0 (40,000)
1 13,000 (II) Calculation of approx or Fake Payback Period
2 8,000
3 14,000
4 12,000
5 11,000
6 15,000 (III) Refer PVIFA table, locate the value in 6 years. We will
found the value lies in between and
PVIFA (20%, 6 years) = 3.326
PVIFA (21%, 6 years) = 3.245
Year Cash PVF PVCF PVF PVCF PVF PVCF
Inflow @ @ @
20 % 21 % % 19
IRR = L + NPV L * (H-L)
(NPVL-NPVH)