Presented by Abhijeet Birari

Assistant Professor
MGM Institute of Management
MBA(Finance), NET+JRF, Ph.D. (Pursuing)

CAPITAL BUDGETING
 CAPITAL BUDGETING
• It is not budgeting for raising capital.

• It is an investment decision.

• Capital Budgeting refers to the total process of generating,

evaluating, selecting and following up of capital expenditure
alternatives.
 FEATURE OF CAPITAL BUDGETING
• Long term effects
• High degree of risk
• Huge funds
• Irreversible decision
• Most difficult decisions
• Impact on firm’s competitive strength
• Impact on cost structure
 OBJECTIVES OF CAPITAL BUDGETING

• Wealth maximization of shareholders

• Evaluation of proposed capital expenditures
• Determination of priority
• Cost control
• Analysis of past decisions
• Valuation of fixed assets
• Capital structure planning
 FACTORS AFFECTING CAPITAL BUDGETING
DECISIONS
• Technology change
• Competitors strategy
• Demand forecast
• Type of management
• Fiscal policy
• Cash flow
• Return expected from investment
• Non-economic factors
 TYPES OF PROJECTS
• Profit Oriented:
– New project
– Expansion project
– Modernisation projects
– Replacement projects
– Diversification projects
 TYPES OF PROJECTS
• Service Oriented:
– Research and Development projects
– Welfare projects
– Educational projects
– Prestige projects
CAPITAL BUDGETING PROCESS

Project Generation

Project Evaluation

Project Screening and Selection

Project Execution

Follow Up
 KINDS OF CAPITAL BUDGETING DECISIONS

• Accept-reject decisions
• Mutually exclusive decisions
• Capital rationing decisions
 INFORMATION REQUIRED FOR CAPITAL
BUDGETING

Cost and Benefit Required Rate of Economic life of

of proposal Return project

Risk of Intangible
Available funds
obsolescence factors
TECHNIQUES OF CAPITAL BUDGETING
Techniques of CB
Traditional
Urgency Method

Pay-back period

Average Rate of Return

Discounted Cash Flow

Net Present Value

Internal Rate of Return

Profitability Index

Terminal Value
URGENCY METHOD
 URGENCY METHOD
• It is criteria used to justify the acceptance of capital projects on
the basis of emergency requirements

• Urgency or degree of necessity plays an important role

• Project can not be postponed

• Example: Breakdown of machinery

 MERITS AND DEMERITS

• Merits:
 Simplicity
 Can be taken for short term

• Demerits:
 Not based on scientific analysis
 Fails to measure effect on profitability
 Profitable projects may be postponed
PAY-BACK PERIOD METHOD
 PAY-BACK PERIOD METHOD

• Most popular and widely recognized method

• It recognizes recovery of original investment in shortest period

• Pay-back period is the length of time required to recover

the initial cost of the project

• It expresses how long it will take to recover initial investment

from cash flow returns
 PAY-BACK PERIOD METHOD

1. Pay-Back Period when cash flows are equal

• Pay-back period is computed by dividing the initial investment

by net annual cash flows.

• Formula: PBP  I
C

• I=Initial Investment
• C=Net annual cash flows
 PAY-BACK PERIOD METHOD

• Example:

• A company is considering to invest Rs. 15,000 for a new

machine on which it expects to receive annual net cash inflows
of Rs. 6,000 for 4 years. The pay-back period of this machine is
___?

• Answer: 2.5 years

 PAY-BACK PERIOD METHOD

2. Pay-Back Period when cash flows are unequal

• Pay-back period is computed by cumulating the cash flows till

the time cumulative cash inflows become equal to the initial
investment outlay.

• Formula:
 PAY-BACK PERIOD METHOD

• Example:

• An investment of Rs. 10,000 in a project generates cash inflows as

follows
• Year 1 : Rs. 2000
• Year 2 : Rs. 4000
• Year 3 : Rs. 12000

• What is the payback period for the project.

• Answer: 2 years 4 months

 PAY-BACK PERIOD METHOD

• Example:

• An investment of Rs. 1,00,000 in a project generates cash inflows as follows.

Find pay-back period.

• Year 1 : Rs. 45,000

• Year 2 : Rs. 45,000
• Year 3 : Rs. 40,000
• Year 4 : Rs. 40,000
• Year 5 : Rs. 30,000

• Answer: 2 years 3 months

• Example:

• India sweets is considering the purchase of a machine. Two

machines are available in the market, A and B, each costing Rs.
1,00,000. Earning after tax are expected to be as follows:
Year Cash Flow (Machine A) Cash Flow (Machine B)
1 25,000 12,500
2 37,000 37,500
3 50,000 50,000
4 25,000 37,500
5 12,500 25,000

• Answer: A – 2 year 9 months; B – 3 years

 PAY-BACK PERIOD METHOD

• Merits:
–Simple
–Low cost
–Risk of obsolescence
–Liquidity oriented
 PAY-BACK PERIOD METHOD

• Demerits:
–Ignores profitability
–Ignores post pay back cash flows
–Ignores timing of cash flows
–Ignores cost of capital
–Ignores present value of cash flows
AVERAGE RATE OF RETURN METHOD
 ARR METHOD

• Also known as ‘Accounting Rate of Return Method’

• It does not consider present value of cash inflows

• Used to measure profitability of investment proposal

• When original investment is considered : Return on Investment

• When average investment is considered : Average Rate of

Return
 ARR METHOD

• ARR is found by dividing average annual income after tax by

average investment.

ARR=PADT/Average investment

Where:
ARR=Annual Rate of Return
PADT=Profit after Depreciation and Tax
DISCOUNTED CASH FLOW TECHNIQUES
 DISCOUNTED CASH FLOW TECHNIQUES
• Traditional methods ignore present value of cash flows

• Ignorance may lead to false conclusions

• In DCF, future cash flows are adjusted with reference to certain

rate of interest
 DISCOUNTED CASH FLOW TECHNIQUES
• Concept of Present Value:

• The sum of money received in future is less valuable than it is

today.

• Example: What will be present value of Rs. 100 received next

year if inflation is 10%.
 DISCOUNTED CASH FLOW TECHNIQUES
• Example: What will be present value of Rs. 100 received next
year if inflation is 10%.

• Formula: PV  FV
(1  r )

• PV=Present Value
• FV=Future Value
• r=Discounting Rate
• Example: What will be the total present values (in 2017) of
following at 10% discount rate.

• 2018 : Rs. 110

• 2019 : Rs. 121

FV1 FV2 FV3 FVn

Formula: PV     ....... 
(1  r ) 1  r  1  r 
1 2 
1  r n

• Answer: Rs. 200

• Example: Calculate present values for following cash flows at
10% discount rate.

Year Cash Flow

1 20,000
2 30,000
3 40,000
4 50,000

• Answer: Rs. 1,07,150

NET PRESENT VALUE METHOD
 NET PRESENT VALUE METHOD
• Discounted cash flow technique

• Used only when the rate of return on investment is

predetermined by management

• NPV is the difference between present value of future cash

inflows and initial investment discounted at firm’s cost of
capital.
 NET PRESENT VALUE METHOD
• Procedure for calculating NPV:

1. Determination of minimum rate of return (Cost of Capital)

2. Computation of present value of cash inflows and outflows

3. Computation of Net Present Value (NPV)

 NET PRESENT VALUE METHOD
• Formula:
C1 C2 C3 Cn
NPV     .......  I
(1  r ) 1  r  1  r 
1 2 
1  r n

• Where:
– NPV=Net Present Value
– I-Initial Investment
– R=Discount Rate
– N=Number of years
Discounting Rate at 10%

• Year 1 : 0.909
• Year 2 : 0.826
• Year 3 : 0.751
• Year 4 : 0.683
• Year 5 : 0.621
• Example: Find out NPV for which a project requires
initial investment of Rs. 25,000 and involves a net cash
flow of Rs. 12,000 each for 3 years. The cost of funds is
8%. There is no scrap value.

• Answer ~ Rs. 5,920

• Example: Find out NPV for following project at 10%
discount rate. Salvage value at the end of 5ht year is Rs.
40,000. Year Cash Outflow Cash Inflow
0 150000 -
1 30000 20000
2 - 30000
3 - 60000
4 - 80000
5 - 30000

• Answer ~ Rs. 8,860

 NET PRESENT VALUE METHOD
Decision Criterion:

 Investment proposal is accepted if NPV is either positive or

zero

 Reject proposal if NPV is negative

 NET PRESENT VALUE METHOD
Advantages:

 Considers lifetime cash flows

 Considers time value of money
 Suitable in uneven cash flows
 Comparison of relative productivity
 NET PRESENT VALUE METHOD
Disadvantages:

 Complex to understand
 Difficult to determine cost of capital
 Unsuitable for projects having different costs
 Unsuitable for projects of different economic life
INTERNAL RATE OF RETURN METHOD
 IRR METHOD

• IRR is a rate which equates present value of expected cash inflows

with current investment.

• It is the rate where NPV is zero.

P1  I
IRR  LDR   ( HDR  LDR )
• Formula: P1  P2

• LDR=Lower Discount Rate

• HDR=Higher Discount Rate
• P1=Present Value ate LDR
• P2=Present Value at HDR
• I-Initial Investment
• Example: A project with an initial investment of Rs. 10,000 generates cash
inflow of Rs. 5000; Rs. 4000 and Rs. 3,000 with life of 3 years. What will
be IRR.

• Solution:

Find out P.V. Factor = Initial Investment/Average Annual Cash Inflows

P.V. Factor=10000/4000=2.5
• Example: A project with an initial investment of Rs. 10,000
generates cash inflow of Rs. 5000; Rs. 4000 and Rs. 3,000 with
life of 3 years. What will be IRR.

• Verification of First Trial Rate (at 10%)

Year Cash Inflow P.V. Factor at 10% Present Value (Rs.)
0 5000 0.909 4,545
1 4000 0.826 3,304
2 3000 0.751 2,253
10,102
• Example: A project with an initial investment of Rs. 10,000
generates cash inflow of Rs. 5000; Rs. 4000 and Rs. 3,000 with
life of 3 years. What will be IRR.

• Verification of First Trial Rate (at 12%)

Year Cash Inflow P.V. Factor at 10% Present Value (Rs.)
0 5000 0.893 4,465
1 4000 0.797 3,188
2 3000 0.712 2,136
9,789
• Example: A project with an initial investment of Rs. 10,000
generates cash inflow of Rs. 5000; Rs. 4000 and Rs. 3,000 with
life of 3 years. What will be IRR.
P1  I
IRR  LDR   ( HDR  LDR)
P1  P2

10,102  10000
IRR  10   (12  10)
10,102  9,789

IRR  10.65%
At this rate NPV is zero.
 IRR METHOD
Decision Rule:

• Accept Investment if IRR>Cost of Capital otherwise reject

• While ranking, project with highest IRR is given top priority
 IRR METHOD
Decision Rule:

• Accept Investment if IRR>Cost of Capital otherwise reject

• While ranking, project with highest IRR is given top priority
PROFITABILITY INDEX
 PROFITABILITY INDEX
• PI is the ratio between present value of future cash inflows with
present value of future cash outflows.

• It is also termed as Benefit-Cost Ratio

• PI=Total Present Value of Cash Inflows/Total Present Value of Cash

Outflows

• Accept investment if PI is above 1 and reject if below 1.

• Example: The initial cash outlay of a project is Rs. 50,000 and
it generates cash inflows of Rs. 20,000, Rs. 15,000 , Rs. 25,000
and Rs. 10,000 in first four years. Using Profitability Index,
appraise profitability of the investment assuming 10% rate of
discount.

• Solution:
Year Cash Inflow P.V. Factor at 10% Present Value (Rs.)
1 20,000 0.909 18,180
2 15,000 0.826 12,390
3 25,000 0.751 18,775
4 10,000 0.683 6,830
Total 56,175
TERMINAL VALUE METHOD
 PROFITABILITY INDEX

• It is assumed that cashflows are reinvested elsewhere

immediately at a predetermined rate of interest.

• If the present value of the sum total of the compounded reinvested

cash flows is greater than the present value of the cash flows, the
project is accepted.
• Example:
• Gems private Ltd. Has the following details in respect of a project
under consideration:
• Initial outlay : Rs. 2,00,000
• Life of project : 5 yrs
• Cash inflows : Rs. 1,50,000 for 5 years
• Cost of capital : 12% p.a.
• Expected interest rate at which cash inflows can be reinvested
• Year 1 2 3 4
• Int. %) 7 7 8 9
• Solution: P.V.=Compounded Value/(1+r)^n

Rate of Years of Compounding Compounded

Year Cash Inflows
Interest investment Factor Value