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Capital budgeting

It is the process of making investment decisions in capital


expenditures. A capital expenditure the benefits of which are
expected to be received over period of time exceeding one year.
The followings are some of the examples of capital expenditure

1. Cost of acquisition of permanent assests as land & building,


plant & machinery, goodwill etc.
2. Cost of addition , expansion , improvement or alteration in
fixed assets
3. Cost of replacement of permanent assests.
4. Research and development project cost or capital expenditure
involves non- flexible long – term commitment of funds . It
involves the planning & control of capital expenditure

Acc to Charles T.Horngreen:-


“ Capital Budgeting is long term planning for investing &
financing proposed capital outlays”

It means capital planning for assets


Need or importance
1. Involves the exchange of current funds benefits to be
achieved in future
2. The future benefits are expected to be listed over a series of
year
3. The funds are invested in non- flexible & term activities
4. It has significant effect on the profitability of the concern
5. In involves huge funds generally
6. They are irreversible decisions
7. They are strategic investment decisions

Process of C.B.

Identification of investment proposals

Evaluation of various proposals

Finding priorities & Ranks

Approval & preparation of capital exp. Budgets

Implementation proposal

Performance review
Methods of Capital Budgeting
A)Traditional Methods
1) Pay- back period method or payout or pay off
method
2) Improvement of Traditional Approach to pay
back period method.
3) Rate of Return Method or Accounting
method
B) Time – adjusted Method or discounted method
1) Net present value method
2) Internal rate of return method
3) Profitability Method
4) Terminal value method
Pay- Back period Method
It is also called as payout or pay off period method represents
period in which the total investment in permanent asset pay
back itself. Thus it measures the period of time for the
original cost of project to be recovered from additional
earning of project itself.

The pay- back period can be ascertained in following


manner:-
1) Calculate annual net profit before depreciation & after
taxes these are called annual cash inflows.
2) Divide initial outlay (cost) of project by the annual cash
inflows, where the project generates equal annual cash
inflows.
Pay back period = Cash outlay of the project
Annual cash inflows.
3) Where the annual cash inflows are unequal the pay back`
period can be found by adding up the cash inflows until
total is equal to initial cash outlay of project.
Advantages:
The main advantages of this method is that it is simple to
understand and easy to calculate. It saves in cost, it requires
lesser time and labour as compared to other methods of capital
budgeting.
Disadvantages of pay-back method:
It does not take into account cash inflows earned after the pay
back period and hence true profitability of project cannot be
correctly assessed.
Illustration 1. A project costs Rs. 1,00,000 and yields an annual
cash inflow of Rs. 20,000 for 8 years. Calculate its pay-back
period
Solution:
The pay –back period of the project is as follows
Pay back period =Initial outlay of the project
Annual Cash Inflow
= 1,00,000= 5 years.
20,000
Illustration 2.
Determine the pay back period for a project which requires a
cash outlay of Rs. 10,000 and generates cash inflows of Rs.
2,000, Rs. 4,000, Rs. 3,000 and Rs. 2,000 in the first, second,
third and fourth year respectively.

Solution :
Total cash outlay = Rs. 10,000
Total cash inflow for the first 3 years =Rs. 2,000+4,000+3,000= Rs.9,000
Upto the third year the total cost is not recovered but the total cash inflows for the four
years are Rs. 9,000+2,000= Rs. 11,000 i.e. Rs. 1,000 more than the cost of the project. So
the pay back period is somewhere between 3 and 4 years. Assuming that the cash inflows
occur evenly throughout the year, the time required to recover Rs. 10,000 will be
1,000/2,000)12=6 months
Hence pay back period is 3 years and 6 months.

(2) Improvements in Traditional approach:


(a) Post pay back profitability method:
Post pay back profits X 100
Investment
One of the serious limitation of pay-back period is that it does
not take into account the cash inflows earned after pay-back
period. So an investment over this method is made by taking
into account the post pay-back profits.

Illustration 3. A project cost Rs. 5,00,000 and yields annually a


profit of Rs. 80,000 after depreciation @ 12% p.a. but before tax of
50% . Calculate the pay back period

Solution:

Rs.
Profit before tax 80,000
Less tax @ 50% 40,000
Profit after tax 40,000
Add back depreciation @ 12% on Rs.5,00,000 60,000
1,00,00
Profit before depreciation but after tax or annual cash inflows
Pay back period = Cost of the Project
Annual Cash inflow
= 5,00,000 = 5 years
1,00,000

(b) Pay back reciprocal method:

=Annual cash inflow


Total investment

This method should be used only when following two


conditions are satisfied:-
1. equal cash inflows are generated every year.
2. The project under consideration has long life which must be
at least twice pay back period.
(c)Post pay back period method:-
Post pay back period method takes into account the period
beyond pay-back method. This method is also known as surplus
life over pay-back method. The project which gives greatest
post pay-back may be accepted.

Illustration 4. There are two projects X and Y. Each Project


requires an investment of Rs. 20,000. You are require to rank
these projects according to the pay back method from the
following information:

Illustration 5. For each of the following


profitability and (iii) post-back profitability index:
(a) Initial Outlay Rs. 50,000
Annual cash inflow (after tax but before depreciation) Rs.
10,000
Estimated Life 8 years.

(b) Initial Outlay


Annual cash inflow (after tax but before depreciation):
First three years Rs. 15,000
Next Five years Rs. 5,000
Estimate life 8 years
Salvage Rs. 8,000
Solution
(a) (i) Pay back period = Investment
Annual Cash inflow
= 50,000 = 5 years
10,000
(ii) Post pay back profitability= Annual cash inflow
(estimated life-pay back period)
= 10,000(8-5)= Rs. 30,000

(iii) Post back Profitability Index =30,000 X 100 = 60%


50,000
(b) (i) As the cash inflows are not equal during the life of the
investment, the pay back period can be calculated as
1st year’s cash inflow Rs. 15,000
2nd year cash inflow Rs. 15,000
3rd year’s cash inflow Rs. 15,000
4th year’s cash inflow Rs. 5,000
Rs. 50,000
Hence the pay back period is 4 years:
(ii) Post pay back profitability = Annual cash inflowxRemaining
Life after pay back period= Rs. 5,000x 4 = Rs. 20,000
(iii) Post pay-back profitability Index = 20,000x1000= 40%
50,000

(d) Discounted pay back method:-


Under this method the present values of all cash outflows &
inflows are computed at an appropriate discount rate. The time
period at which the cumulated present value of cash inflows
equal the present value of outflow is known as discounted pay
back period.
Illustration 6: Calculate discounted pay-back period from the
information given below :
Cost of Project Rs. 6,00,000
Life of the project 5 years
Annual Cash Inflow
Cut off rate 10%
Solution:-
Calculation of Present Values of Cash inflows

Years Inflows P.V. at 10 Present Communlative


Rs. discount Value Present Value
factor Rs.
1. 2,00,000 .909 1,81,800 1,81,800
2. 2,00,000 .826 1,65,200 3,47,000

3. 2,00,000 .751 1,50,200 4,97,200


4. 2,00,000 .683 1,36,600 6,33,800
5. 2,00,000 .621 1,24,200 7,58,000

Cummulative present value of cash inflows at the end of the third


year is Rs. 4,97,200 and it is Rs. 6,33,800 at the end of fourth year.
Hence discounted pay-back period falls in between 3 and 4 years.
To be exact.

Discounted pay-back period =3 years + 1,02,800


1,36,600
(e)Accounting Rate of Return Method:-
This method take into account the earnings expected from the
investment over their whole life. It is known as accounting rate
of return method. Under this method the accounting concept of
profit (net profit after tax & depreciation) is used rather than
cash inflows. The project of higher rate of return is selected. It
can be used in several ways:-
(1) Average rate of return method:
It establishes the relationship between average annual profit to
total investment
Average annual profit X 100
Net investment in profit
(2) Return per unit of investment method:
Total profit X 100
Net investment
(3) Return on average investment method:-
Total profit X 100 or T.P.
Average investment Total investment
2

(4) Average return on Average Investment Method:-


This is the most appropriate method
Average annual profit X 100
Average investment
(2) Divide the initial outlay (cost Outlay of the project by
the annual cash inflow, where the project generates constant
cash inflows.
Thus, where the project generates constant cash inflows
Pay-back period = Cash outlay of the project or Original cost of
the asset
Annual Cash Inflows

(3) Where the annual cash inflows (Profit before


depreciation and after taxes) are unequal, the pay-back period
can be found by adding up the cash inflows until the total is
equal to the initial cash outlay of project or original cost of the
asset.
3. RATE OF RETURN METHOD
This method takes into account the earnings expected from
the investment over their whole life. It is known as Accounting
Rate of Return method for the reason that under this method, the
Accounting concept of profit (net profit after tax and depreciation)
is used rather than cash inflows. According to this method, various
projects are ranked in order of the rate of earnings or rate of return.
The project with the higher rate of return is selected as compared
to the one with lower rate of return. This method can also be used
to make decision as to accepting or rejecting a proposal. The
expected return is determined and the projet which has a higher
rate of return than the minimum rate specified by the firm called
the cut off rate, is accepted and the one which gives a lower
expected rate of return than the minimum rate is rejected.
The return on invetment method can be used in several ways as
follow:
(a) Average Rate of Return Method. Under this method average
profit after tax and depreciation is calculated and then it is divided
by the total capital outlay or total investment in the project. In
other words, it establishes the relationship beteen average annual
profit to total investments.
Thus,

Average Rate of Return


= Total Profits (after dep. & taxes) X 100
Net Investment in the project X No. of years of profit
Or Average annual profits X 100
Net investment in the Project.

Illustration. A project requires an investment of Rs. 5,00,000 and


has a scrap value of Rs. 20,000 after five years. It is expected to
yield profits after depreciation and taxes during the five eyars
amounting to Rs. 40,000. Rs. 60,000, Rs. 70,000, Rs. 50,000 and
Rs. 20,000. Calculate the average rate of return on the investment.
Solution:
Total profit= Rs. 40,000+60,000+70,000+50,000+20,000= Rs. 2,40,000
Average profit= Rs. 2,40,000 = Rs. 48,000
5
Net Investment in the project = Rs. 5,00,000-20,000 (Scrap value)= Rs. 4,80,000
Average Rate of Return =Average Annual profit X 1000
Net Investment in the Project.
= 48,000 X100 =10%
4,80,000

(b) Return per unit of Investment Method: This method is small


variation of the average rate of return. In this method the total
profit after tax and depreciation is divided by the total investment
i.e.

Return per unit of Investment= Total profit (after depreciation & taxes) X 100
Net Investment in the Project.

Illustration 8. Continuing illustration 7, the return per unit of


investment shall be:
2,40,000x100= 50%
4,80,000
(c) Return on Average Investment Method. In this method the
return on average investment is calculated. Using of average
investment for the purpose of return on investment is preferred
because the original investment is recovered over the lisfe of the
asset on account of depreciation charges. For example:
A machine costs Rs. 1,00,000 and has no scrap value after five
years. It is depreciated on straight line method.
The outstanding investment in the project is calculated as follows:
(1) Beginning of the first year Rs.
1,00,000
(2) At the end of the first year Rs.
80,000
(3) At the end of the second year
Rs. 60,000
(4) At the end of the third year Rs.
40,000
(5) At the end of the fourth year
Rs. 20,000
(6) At the end of the fifth year
Rs. 3,00,000
Average investment = 3,00,000 = Rs. 50,000
6
Or, Say, average Investment= Total Investment
2
= 1,00,000 = Rs. 50,000
2
Return on Average Investment:
Total Profit after depreciation and taxes X 100
Total Net Investment
2
Illustration 9. Taking the same figures as given in illustration 7, the
return on average investment
= 2,40,000 X 100 =100%
4,80,000
2
(d) Average Return on Average Investment Method. This is
the most appropriate method of rate of return on invetment. Under
this method, average profit after depreciation and taxes is divided
by the average amount of invetment; thus:
Average Return on Average Investment
=Average Annual Profit after dep and taxes X100
Average Investment
=Average Annual Profit X100
Net Investment
2
Illustration 10. Taking the same figures as given in illustration 7,
the average return on average investments:

=48,000 X 100 = 48,000 X 100


4,80,000 2,40,000
2

= 20%
Advantages of R.R.M.
1) It uses all earnings of a project.
2) It is based upon accounting concept of profit.
Disadvantages:
1) As like the pay-back record it also ignores the time
value of money.
2) It doesn’t take into consideration
B. Time Adjusted or Discounted cash flow method:-
There are three following methods
1. Net present value method
Following steps are taken into account in the processing of N.P.v.
(a) First of all determine an appropriate rate of interest that
should be selected as the min. required rate of return called
cut-off rate or discount rates.
(b) Compute present value of total investment outlay. If the
total investment is the to be made in initial year the
present value shall be same as cost of investment.
(c) Compete present value of total cash inflows (profit before
dep. & after tax) at above determined discount rate.
(d) Calculate net present value of each project by subtracting
the present value of cash outflows from the present value
of cash outflows for each project.
(e) When present value of cash inflows either exceeds or is
equal to the present value of cash outflows may be
accepted otherwise should be rejected.
Present value of Rupee = 1
(1+r)n
r=rate of interest /disc. Rate.
n=number of years.
Advantages: it recognizes the time value of money and takes
into account earnings over entire life of project so proposal can
be evaluated easily.
Disadvantages: It is difficult to operate and understand. It may
not give good result while comparing projects with unequal
investment of funds. It is not easy to determine appropriate
discount rate.
(2) Internal rate of return method
In this method cash flows of project are discounted at suitable
rate by hit and trial method, which equates the net present value.
So calculated to the amount of the investment. The internal rate
can be defined as that rate of discount at which present value of
cash inflows is equal to present value of cash outflows

The following steps are required to practice the IRR method.


1) Determine future net cash flow before depreciation but after
taxes.
2) Determine rate of discount at which value of cash inflows.
3) Accept proposal of IRR is higher than or equal to minimum
required rate of return………
(3) Profitability Index Method or Benefit Cost Ratio:
It describes the relationship between present value of cash
inflows and present value of cash outflows. Thus:
P.I. =Present value of cash inflows
Initial cash outlays
Net P.I. = N.P.U.
Initial cash outlay
N.P.I. can also be found as P.I-1. The proposal is accepted if the
profitability index is more than on and is rejected in case of
profitability index is less than one.
Advantages & Disadvantages of profitability:
It is slight modification of Net Present Value method. In the case
of different project this method is mot suitable method. The other
advantages and disadvantages of themethod are same as those of
net present value method.
Difference between NPV & IRR.
(1) Discount rate : Under NPV method discount rate or cut off
rate is pre-determined. But under IRR it is calculated by hit & trial
method.
(2) Market Rate: The NPV method consider interest rate or cost
of capital. On other hand under IRR does not consider market
interest rate & it seeks to determine the minimum rate of interest at
which funds invested in project could be repaid by its earnings.
(3) Reinvested rate: Under NPV the cash flows reinvested at cut-
off rate in IRR cash flows are reinvested at IRR.
(4) NPV method is more reliable than IRR due to pre-determined
cut –off rate.

Present Value Table


(Present value of Re 1 payable or receivable annually for N years)
Year 8% 10% 12% 14% 15% 20%
01 0.92593 0.90909 0.89286 0.87719 0.86957 0.83333
02 .85734 .82654 .79719 .76947 .75614 .69444
03 .79383 .75131 .71178 .67497 .65752 .57870
04 .73507 .68301 .63552 .59208 .57175 .48225
05 .68058 .62092 .56743 .51937 .49718 .40188
06 .63017 .56447 .50363 .45559 ..43233 .33490
07 .58349 .51361 ..45305 .39964 .37594 .27908
08 .54027 .46651 .40388 .35056 .32690 .23257
09 .50025 .42410 .36061 .30874 .28426 .19381
10 .46319 .38554 .32197 .26974 .24718 .16151
* For a more complete set of Present Value Tables see Appendix A
at the end of the book.
Illustration 13. From the following information calculate the net
present value of the two projects and suggest which of the two
projects should be accepted assuming a discount rate of 10%.
Project X Project Y
Initial investment Rs. 20,000 Rs.
30,000
Estimated Life 5 years
5 years
Scrap value Rs. 1,000 Rs.
2,000
The profits before depreciation and after taxes (cash flows) are as
follows:-
Year 1 Year 2 Year 3 Year
4 Year 5
Rs. Rs. Rs. Rs. Rs.
Project X 5,000 10,000 10,000
3,000 2,000
Project Y 20,000 10,000 5,000
3,000 2,000

Solution:
Calculations for Net present value.
Project X
Year Cash flows Present value Present Value
Rs. of Re.1 @ 10% of Net Cash
(discount flows
factor) Using Rs.
present value
tables
Rs.
1. 5,000 .909 4,545
2. 10,000 .826 8,260
3. 10,000 .751 7,510
4. 3,000 .683 2,049
5.(Scrap value) 1,000 .621 621
Present Value of all cash inflows Rs. 24,227
Less present value of initial investment Rs. 20,000
(because all the investment is to be made in the
first year only, the present value is the same as
the cost of the initial investment) Rs. 4,227
Net present value.

PROJECT Y
Year Cash flows Present Value Present Value
Rs. of Re.1 @ 10% of Net Cash
(discount flows
factor) Using Rs.
present value
tables
Rs.
1. 20,000 .909 18,180
2. 10,000 .826 8,260
3. 5,000 .751 3,755
4. 3,000 .683 2,049
5. 2,000 .621 1,242
6. 2,000 .621 1,242
(Scrap Value) 34,728

Total Present Value of Cash Inflows Rs. 34,728


Less Present Value of initial investment Rs. 30,000
Net Present Value Rs. 4,728