Capital

Budgeting

Neha
Bhawna
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The term 'Capital Budgeting' refers to long term
planning for proposed capital outlays & their
financing.
•It may be defined as “ the firm’s formal process for the
acquisition & investment of capital.”

• It is the decision making process by which the firm

evaluate the purchase of major fixed assets.

• The investment in current assets necessitated on

account of investment in a fixed assets, is also to be
taken as a capital budgeting decision.

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CASES OF CAPITAL BUDGETING DECISION

1. Replacements
2. Expansion
3. Diversification
4. R&D
5. Miscellaneous

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 Operating Budget &
Capital Budget
OB CB
It shows planned operations It deals exclusively with the
for the coming period. major investment proposal.

It includes sales, production, It assesses the economics

production cost & selling of capital expenditure &
& distribution overhead investment.
budgets.

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 CAPITAL EXPENDITURE
BUDGET
1. It is a type of functional budget.
2. It is the firm’s formal plan.
3. It provides a guidance as to the amount of
capital that may be required for procurement
of capital assets during the budget period.
4. It is prepared after taking into account the
available production capacities, probable
reallocation of existing resources & possible
improvements in production techniques.

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Objectives of a Capital Expenditure
Budget

1. It determines the capital projects on which work can

be started during the budget period.

2. It estimates the expenditure that would have to be

incurred on capital projects.

3. It restricts the capital expenditure on projects within

authorised limits.
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Types of Investment decisions

 Tactical Investment Decisions

 Strategic Investment Decisions

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 Importance of Capital
Budgeting

 Involvement of heavy funds

Long-term implications

 Irreversible decisions

 Most difficult to make

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 Rationale of Capital
Expenditure

 Expenditure increasing revenue

 Expenditure reducing costs

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Kinds of Capital Investment Proposals

 Independent proposals

 Contingent or dependent
proposals

 Mutually exclusive proposals

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Factors affecting Capital Investment Decisions :
1.The amount of investment

Computation of capital investment required:

(i)Cost of new project

(ii) Installation cost

(iii)Working capital: Investment in a new project may

also result in increase or decrease of net working capital
requirements.
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(iv)Proceeds from sale of asset

(v)Tax effects

(vi)Investment allowance: this is allowed to encourage

capital investment of the cost of new machined and
equipment for calculating income tax allowances thus
reduces the cost of the initial investment on the project.

2. Minimum rate of return on investment: It is

basically decided on the basis of the cost of capital.

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3. Return expected from the investment

There are two ways to calculate:

*Accounting profit
*Cash flows

 The cash flow approach for determination of benefit from a

capital investment project is better as compared to accounting
profit approach on account of following reasons:

o Determination of economic value

o Accounting ambiguities
o Time value of money
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4. Ranking of investment proposals: necessary in
the following 2 circumstances:-

a) Where capital is rationed

b) Where two or more investment opportunities are
mutually exclusive.

5. Risk and uncertainty

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 Capital Budgeting Appraisal
Methods
1. Pay back period method
2. Discounted cash flow method
I. The net present value method
II. Present value index method
III. Internal rate of return
3. Accounting rate of return method
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 Pay-back period:
The term pay-back refers to the period in
which the project will generate the
necessary cash to regroup the initial
investment

Or
In other words ,the payback period is the
length of time required to recover the initial
cost of the project.
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E.g. If a project requires Rs. 20,000 as initial
investment and it will generate an annual cash
inflows of Rs 5000 for 10yrs the pay-back will
be 4 years.

Payback period = initial investment

annual cash inflow

= 20000/5000 = 4
Unadjusted rate of return = annual return * 100
initial investment

= 5000 /20000 *100 = 25%

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 When the annual cash inflows
are un equal:
E.g. a proposal requires a cash outflow
of Rs. 20,000 and is expected to
generate cash inflow of Rs 8000,Rs
6000, Rs 4000, Rs 2,000 Rs 2,000 over
next 5 yrs
Sol:The payback period = 4
as the sum of cash inflow is 20,000
year Annual CF Cumulative c f
1 8,000 8,000
2 6,000 14,000
3 4,000 18,000
4 2,000 20,000
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 Que : A co. requires an initial investment of Rs
40,000 the estimated net cash flow are as follows

1 2 3 4 5 6 7 8 9 10
7,000 7,000 7,000 7,000 7,000 8,000 10,000 15,000 10,000 4,000

Calculate Pay back period

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Sol:

Pay back period Initial outlay Rs. 40,000

Cash outflows for 5 yrs

7000+7000+7000+7000+7000=35,000
Balance outlay=40,000-35,000=5000

Cash flow for 6 year=8,000

PBP = 5yrs+5,000/8,000=5.62 yrs

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Decision rule: If the payback period is more than
the target period , then the proposal should be
rejected.

Advantages
•It is simple and easy and adopted by a small firm
having limited manpower.
• It gives the indication of liquidity . In case a firm
is having liquidity problem , this method is good
to adopt as it emphasizes earlier cash inflows.
• It deals with risk too. The project with a shorter
payback period will be less risky as compared to
project with a longer payback period.
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Disadvantages :
• It ignores the time value of money.

e.g. There are 2 projects a and b , the cost of project

is 30,000 in each case. The cash inflows are as :

year Project A Project B

1 10,000 2,000
2 10,000 4,000
3 10,000 24,000

• It ignores the return generated by a project after its

payback period.

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Discounted Cash Flow Method Or
Time Adjusted Technique
A method of evaluating an investment by
estimating future cash flows and taking
into consideration the time value of money
also called capitalization of income.

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DCF method for evaluating capital
investment proposal are of three types

 The net present value method

 Excess present value index.
 Internal rate of return.

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1. Net present value :

The difference between the present

value of cash inflows and the present
value of cash outflows. NPV is used
in capital budgeting to analyze the
profitability of an investment or
project.
 

NPV analysis is sensitive to
the reliability of future cash inflows
that an investment or project will
yield.  
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• NPV= [R1/(I + k)+ R2/(1+k)2…………..+R n/(1+k)n]-I

where:

NPV=Net Present Value,

R= Cash Inflows At Different Time Periods,

K= Cost Of Capital 0r Cut Off Rate,

I= Cash Outflows At Different Time Period

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ACCEPT OR REJECT CRETERIA
NPV> ZERO ACCEPT THE PROPOSAL

NPV< ZERO REJECT THE PROPOSAL

OR WHERE

PV>C ACCEPT

PV<C REJECT

PV Stands For Present Value Of Cash Inflows

C Stands For Present Value Of Cash OutfLows

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Merit

It is based on the entire cash flow stream rather

than accounting profit and thus help in analyzing
the effect of the effect of the proposal on the
wealth of the shareholders in a better way.

Demerit

Involves difficult calculation.

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 1. A co. requires an initial investment of rs
40,000 the estimated net cash flow are as
follows:
1 2 3 4 5 6 7 8 9 10
7,000 7,000 7,000 7,000 7,000 8,000 10,000 15,000 10,000 4,000

Using 10% cost of capital (discount)determine

Net present value?

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 Year Cash flows Present value
1 7,000 6363
2 7,000 5782
3 7,000 5257
Sol: 4 7,000 4781
5 7,000 7347
6 8,000 4512
7 10,000 5130
8 15,000 7005
9 10,000 4240
10 4,000 1544
Total 48,961
Initial outlay(-) 40,000
Net present value 8,961

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 b. Excess present value
index

•This is refinement of NPV method.

•A present value index is found out

by comparing the total of present
value of future cash inflows and total
of present value of future outflows.
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 Excess present value index
formula

= present value of future cash in

flows X 100
present value of future
outflows
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Excess present value provides ready
comparison between investment
proposal of different magnitudes.

for example: project ‘A’ requiring

an investment of Rs.100000 shows
excess present value of
Rs.20000,while another project ‘B’
requiring an investment of
Rs.10000 shows a present value of
Rs.5000.If absolute figures of net
present value are compared,
Project ‘A’ seems to b profitable.
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From excess present value index method
view

Present value index for

‘A’=(120000/100000)*100=120%.
Present value index for
‘B’=(15000/10000)*100=150%.

Now ‘B’ is profitable

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(c) Internal rate of return method

IRR is that rate @ which the sum of

discounted cash inflows equals the
sum of discounted cash out flows.
In other words, it is the rate which
discounts the cash flows to zero.
It can b stated in the form of a
ratio:
(cash inflows/cash
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In this method the discount rate Is not
known but the cash out flow and cash
inflow are known.

For example , if a sum of Rs.800

invested in project becomes Rs.1000
at the end of a year, the rate of return
comes 25%, calculated as follows
I= R/(I + r),
Where,
I=cash out flow i.e., initial investment.
R=cash inflows.
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R= rate of return yielding by the
ACCEPT/REJECT CRITERION
•Since IRR is the maximum rate of
interest which an organization can
afford to pay on capital
investment in a project, thus

•A project would qualify to be

accepted if IRR exceeds the cut-off
rate.

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 When cash flows are uniform.
In case the two projects show uniform cash
inflows, the internal rate of return can be
calculated by locating the factor in annuity table
II.
The factor is calculated as follows:
F=I/C,
Where,
F = factor to be located
I= original investment
C= cash flow per year
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When cash inflows are not uniform
•The IRR is calculated by making trial calculations
in an attempt to compute the correct interest
rate which equates the present value of the cash
inflows with present value of cash outflows.

•In the process the cash inflows are to be

discounted by a number of trial rates.

•The first trial rate can b calculated by the same

formula which is used for determining the
internal rate if return when cash inflows are
uniform. 39
Comparison of the rate of return
approach and present value
approach

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 The chief point of difference b/w the two are
as follows
•The NPV method takes the interest rate as a
known factor while IRR method take it as
unknown factor.

•The NPV seeks to find out the amount that can

be invested in a given project so that its
anticipated earnings will exactly suffice to repay
this amount with interest at the market rate.
while the IRR method seeks to find the maximum
rate of interest at which the funds invested in a
project could be repaid out the cash inflows
arising out of that project.

•Both the NPV and IRR method proceed on the

presumption that the cash inflows can be41
Similarities in the result under NPV and IRR

Both NPV & IRR will give same result regarding

an investment proposal in the following cases:

(I) project involving conventional cash

inflows, i.e., when an initial outflow is followed
by a series of inflows.

(II) Independent investment proposals ,i.e.,

proposals the acceptance of which does not
preclude the acceptance of others

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 Conflict in results under NPV & IRR

NPV & IRR give conflicting results in

case of mutually exclusive
projects, where acceptance of
one project result in non-
acceptance of the other project.

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Conflicting results may be due to any
one or more of the following reasons:

•The projects require different

cash outlays .

•The projects have unequal lives.

•The projects have different

patterns of cash flows.
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 Accounting or average rate of return
(ARR) method.

This method judge the investment

proposal on the basis of their
relative profitability.
Capital employed and relative
income are determined according
to commonly accepted accounting
principals and practices aver the
entire economic life of the project
and then the average yield is45
 Calculation of ARR

1. (Annual avg net earnings/original

investment) * 100.
2. (annual avg net earnings/avg
investments)*100.( avg of
earnings after dep and tax).
3. (Increase in expected future
annual net earnings/initial
increase in required
investments)*100 46
 The amount of average investment can be
calculated according to any of the following
methods

4. (a) original investment/2

(b) (original investment-scrap value
of asset)/2.
(c) (original investment + scrap
value of asset)/2.
(d) (original investment-scrap value
of asset)/2+addl.networking cap+
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 Accept or reject criterion

The different projects may be

ranked in the ascending or
descending order of their rate of
return.
Projects below the minimum rate
will be rejected.
Projects giving rates of return
higher than the minimum rate are
preferred. 48
Replacement of existing asset
An asset or equipment may have
eto be replaced before its useful
life because a more economic
alternative is available in view of
constant technological
development.
This help in reducing the costs and
increasing the operational
efficiency.
In this case it is necessary to49
 CAPITAL RATIONING
Capital rationing is a situation where a firm
has more investment proposals than it can
finance.

It can be defined as a situation where a

constraints is placed on the total size of
capital investment during a particular period.

In such an event the firm has to select

combination of investment proposals that
provide the highest NPV subject to the
budget constraints for the period.
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Selecting of projects require the taking of
the following steps

•Ranking of the projects according

to profitability index or internal
rate of return.

•Selecting projects in descending

order of profitability until the
budget figures are exhausted
keeping in view the objective of
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maximizing the value of the firm.