1

By
Prof. Anirban
CCIM, B’lore

Capital Budgeting
 Capital Budgeting…. What's that????
 The investment decisions of a firm is
generally known as the capital budgeting
decisions and it consists of the Long Term
planning for the proposed capital outlays
and their financing.
 C/B may be defined as the firm’s decision
to invest its current funds most effective
and efficient way in the long term assets
in anticipation of an expected flow of
benefits over a series of years.

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Capital Budgeting Within The Firm

T h e P o s i t i o n o f C a p i t a l B u d g e t in g

F in a n c ia l G o a l o f t h e F ir m :
W e a lt h M a x im is a t io n

I n v e s t m e n t D e c is o n F in a n c in g D e c is io n D iv id e n d D e c is io n

L o n g T e rm A s s e ts S h o r t T e r m A s s e ts D e b t / E q u it y M ix D iv id e n d P a y o u t R a t io

C a p ita l B u d g e tin g
Prof. Anirban, CCIM, B’lore, Capital
Budgeting
Examples of ‘Long Term Assets’

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Capital Budgeting…. Features
 It has potentiality to anticipate a huge profit.
 It involves high degree of risk.
 Involves relatively a long period of time
between the initial outlay and the anticipated
returns.
 Involves the exchange of current funds (which
are invested in long term assets) for the future
benefits.
 Future benefits will occur to the firm over a
series of time.

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Importance of C/B Decisions
 Growth  

 Risk 

 Funding  

 Irreversibility

 Complexity  

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Capital Budgeting…. Process..
 Identification of the potential investment opportunities.
 Assembling of the proposed investments.
 Decision making.
 Preparation of the capital Budget and appropriation.
 Implementation
– Adequate formulation of the project.
– Use of the principle of responsibility
– Use of network techniques
 Performance Review

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Investment Evaluation Criteria
 Three steps are involved in the
evaluation of an investment:
– Estimation of cash flows
– Estimation of the required rate of return
(the opportunity cost of capital)
– Application of a decision rule for making
the choice

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Traditional or Modern or
Non Discounted Cash Discounted Cash flow
flow method method

NPV

ARR

C/B IRR
Techniques

PB PI
Prof. Anirban, CCIM, B’lore, Capital
Budgeting
 Net Present Value
 NPV is the classic economic and generally
considered to be the best method for
evaluating capital investment proposals.
 This is one of the discounted cash flow (DCF)

techniques which explicitly recognize Time

value of Money.

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Steps in NPV calculation
 Cash flows of the investment project should be
forecasted based on realistic assumptions.
 Appropriate discount rate should be identified to
discount the forecasted cash flows. The appropriate
discount rate is the project’s opportunity cost of
capital.
 Present value of cash flows should be calculated using
the opportunity cost of capital as the discount rate.
 The NPV is the difference between the Total present
value of the Future Cash in Flows and Future cash
outflows.
 The project should be accepted if NPV is positive (i.e.,
NPV > 0).
Prof. Anirban, CCIM, B’lore, Capital
Budgeting
 Equation of NPV

 C1 C2 C3 Cn 
NPV      
3  n
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2

n
Ct
NPV    C 0
t 1 (1  k )
t

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Acceptance Rule
 Accept the project when NPV is positive NPV > 0
 Reject the project when NPV is negative NPV < 0
  May accept the project when NPV is zero NPV = 0
 The NPV method can be used to select between
mutually exclusive projects; the one with the higher
NPV should be selected.

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Profitability Index
 Profitability index is the ratio of the
present value of cash inflows, at the
required rate of return, to the initial cash
outflow of the investment.
 Criterion :

– PI > 0 Implies Accept the project

– PI < 0 Implies Reject the project
– PI = 0 Implies the decision is indifferent

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Internal Rate of Return Method
 The internal rate of return (IRR) is the rate that equates the
investment outlay with the present value of cash inflow received
after one period. This also implies that the rate of return is the
discount rate which makes NPV = 0.
 i.e. PVCI – PVCO = 0, i.e. PVCI = PVCO
 So IRR will be rate of return where NPV =0
 This rate is also called as the rate at which the expected inflows
break even with the cash outflows of the project.
 Some time IRR lies between two trial rates called Higher or Upper
trial rate and Lower Trial rate. To calculate exact IRR we can use
the following interpolation formula.
 NPV at HTR
 Exact IRR = LTR + x Diff. of trial

NPV at HTR – NPV at LTR rates

Prof. Anirban, CCIM, B’lore, Capital
Budgeting
 Acceptance Rule
 Accept the project when r > k.
 Reject the project when r < k.

 May accept the project when r = k.

 In case of independent projects, IRR and

NPV rules will give the same results if the

firm has no shortage of funds.

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Average Rate of Return
 The accounting ratio and return also known as
the ROI uses accounting information as revealed
by financial statements to measure the
profitability of the investment.
 The accounting rate of return is the ratio of the
average after-tax profit divided by the average
investment. The average investment would be
equal to half of the original investment if it were
depreciated constantly.

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Contd…

 ARR = [Average Return (PAT) / Average Invt]

 Where, AR = [Total Return / Time]
 AI = [{Cost - Scrap} / 2] or
[{Cost - Scrap } / 2} + Net W/C + Scrap Value

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Payback Period
 Payback is the number of years required to
recover the original cash outlay invested in a
project.
 If the project generates constant annual cash
inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow.
 PBP = [Initial Investment / Annual Cash Flows]
 Assume that a project requires an outlay of Rs
50,000 and yields annual cash inflow of Rs 12,500
for 7 years. The payback period for the project
is:
50000 / 12500 = 4 years
Prof. Anirban, CCIM, B’lore, Capital
Budgeting
 Payback Period
 Unequal cash flows In case of unequal cash
inflows, the payback period can be found out
by adding up the cash inflows until the total is
equal to the initial cash outlay.
 Suppose that a project requires a cash outlay

of Rs 20,000, and generates cash inflows of

Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000
during the next 4 years. What is the project’s
payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
Prof. Anirban, CCIM, B’lore, Capital
Budgeting
 Acceptance Rule
 The project would be accepted if its payback
period is less than the maximum or
standard payback period set by
management.
 As a ranking method, it gives highest
ranking to the project, which has the
shortest payback period and lowest ranking
to the project with highest payback period.

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
Payback Reciprocal and Rate of Return
 The reciprocal of payback will be a close
approximation of the internal rate of
return if the following two conditions are
satisfied:
– The life of the project is large or at least twice
the payback period.
– The project generates equal annual cash
inflows.

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Capital Rationing
 Capital Rationing is the financial
situation in which a firm has only fixed
amount of allocate among competing
capital expenditure.
 It means a situation in which a firm has

more acceptable investments than it

can finance.

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Risk & Sensitivity Analysis
 Sensitivity analysis is a behavioral
approach that uses a number of possible
values for a given variable to assess its
impact on a firm’s returns.
 It provides different cash flow estimates

under three assumptions:

• The worst i.e. most pessimistic
• The expected i.e. most likely
• The best i.e. the most optimistic

Prof. Anirban, CCIM, B’lore, Capital

Budgeting
 Any
Questions
????
Prof. Anirban, CCIM, B’lore, Capital
Budgeting