Capital Budgeting

Capital Budgeting is the process of finding out the long term viability of the project. In simple terms, any business
procures fund and invests it in assets. These assets in turn are used to provide income to the organisation. Let us
relate it to a balance sheet.

Equities and Liabilities Amount

Shareholder’s Fund
Equity Capital
Preference Capital
Reserves and Surplus
Non-Current Liabilities
Debenture
Fixed Deposit
Deferred Tax Liabilities
Bank Loan
Current Liabilities
Trade Payable
Bank Overdraft
Outstanding Expenses
Provisions

Total
Assets
Non-Current Assets
Land
Building
Machinery
Equipment
Furniture
Computers
Goodwill
Trademark
Current Assets
Inventory
Trade Receivable
Short Term Securities
Cash and Bank Balance
Total

It is a skeletal form of a corporate balance sheet which does not cover all the items. We present it to explain the
concept of capital budgeting. What are the sources for procurement of fund? Recollect our discussion in the chapter
cost of capital. The green highlighted accounts are the sources. Now what are the assets relating to capital
budgeting? The light blue highlighted portions are the assets for relating to capital budgeting which will create
infrastructure for generating income. Observe, we have left aside the current assets and current liabilities from our
discussion as they are short term in nature. Capital budgeting is a planning process to determine whether it is worth
investing in those assets. As it involves planning, we call it a project. The meaning of ‘viability’ explains whether
income generated justifies the investment in the project.
Capital Budgeting decisions are
a) Long Term- extending to the life period of the asset
b) Irrevocable- Once funds are committed we cannot retrieve it back.
c) Huge investment- The Non-Current assets we have highlighted involves huge amount of money.
d) Complex- Different kinds of factors both inside and outside the company affects the decision on investment
e) Having alternatives- The business starts with capital budgeting so the promoter can think of different
opportunities available to him/her.
There are six tools in capital budgeting
a) Payback period- Number of years required to get back the investment
b) Average Rate of Return(ARR)- Average income of the company over the years
c) Net Present Value(NPV)- The difference between discounted cash inflow and outflow
d) Internal Rate of Return(IRR)- The rate which equates the discounted cash inflow with the discounted cash
outflow.
e) Profitability Index- The ratio of discounted cash inflow and discounted cash outflow

Before discussing the different methods, we need to understand difference between the income and the cash flow.

Example: Find out the net return and Cash flow of a business where Revenue(Sales) is Rs. 40 Crores, Raw Material
Consumed-Rs. 23 Crores, Employee Benefit Expenses- Rs 5 Crores, Interest Expenses- Rs 2 Crores, Depreciation and
Amortization – Rs 5 Crores and Tax rate 25%.

Particulars Net Revenue Cash Flow

Revenue 40 40
Less: Expenses
Raw Material Consumed 23 23
Employee Benefit Expenses 5 5
Interest Expenses 2 2
Depreciation and Amortization 5 5
Profit Before Tax 5 5
Tax 25% 1.25 1.25
Profit after Tax 3.75 3.75
Add Depreciation --- 5
Amortization
Net Revenue/Cash inflow 3.75 8.75

In cash flow calculation non-cash expenses are added back to the profit after tax. ARR considers net revenue as the
basis of viability whereas other tools use cash flow as the basis. The project gets cash inflow over the years of its
existence whereas the initial amount spent on the project is cash outflow.

Payback Period:

Example:

A project with a life period of 5 years has following expected cash inflow:

2021- Rs 30 Croes
2022- Rs 20 Croes
2023- Rs 15 Croes
2024- Rs 24 Crores
2025- Rs 18 Crores

The project requires an initial investment of Rs 75 Crores and the promoter is happy if it can be recovered in 4 years.
Whether the promoter should accept the project?

Answer:

We will have to see in how many years the money can be recovered. In three years the project recovers 30+20+15=
65 Crores.

For another 10 crores it needs 10/24*12= 5 months to recover.

So the payback period is 3 years 5 months which is less than the expected 4 years. Hence the Project should be
accepted.

Average Rate of Return:

Example:

A project has the following revenue and expenses over five years

Rs/Crs

Year Revenue Expenses

2021 60 40
2022 50 35
2023 56 41
2024 48 34
2025 62 54

Prevailing tax rate is 25%. The project has an investment of Rs 75 Crores. The average industry return is 12%.
Whether the project should be accepted?

Answer:

Net revenue

Year Revenue Expenses Profit Tax(25%) Profit after

before tax Tax
2021 60 40 20 5 15
2022 50 35 15 3.75 11.25
2023 56 41 15 3.75 11.25
2024 48 34 14 3.5 10.5
2025 62 54 8 2 6

Average profit = (15+11.25+11.25+10.5+6)/5= 10.8

Average Rate of Return= 10.8/75= .144 i.e. 14.4%

As the project gives higher return than the industry returns, we accept the project.

Net Present Value

Example

A project has the following revenue and expenses over five years

Rs/Crs

Year Revenue Expenses

2021 50 40
2022 60 35
2023 66 41
2024 58 34
2025 72 54

Prevailing tax rate is 25%. The project has an investment of Rs 75 Crores. Depreciation is charged 10% on asset value.
All the investment are non-current assets only. The expenses do not include depreciation. The expected return in the
industry return is 10%. The terminal value of the project is 15 crores. Calculate the NPV and comment on the
acceptability of the project.

Answer:

Calculation of Net Present Value

Rs/Crs
 Partculars 2021 2022 2023 2024 2025
Revenue 50 60 66 58 72

Expenses without depreciation 40 35 41 34 54

Depreciation 7.5 7.5 7.5 7.5 7.5
Total Expenses 47.5 42.5 48.5 41.5 61.5
Profit before tax 2.5 17.5 17.5 16.5 10.5
Tax 25% 0.625 4.375 4.375 4.125 2.625
Profit after tax 1.875 13.125 13.125 12.375 7.875

Add: Depreciation 7.5 7.5 7.5 7.5 7.5

Cash Inflow 9.375 20.625 20.625 19.875 15.375

          15
  9.375 20.625 20.625 19.875 30.375

Discounting factor(10%) 0.909 0.826 0.751 0.683 0.621

Discounted Cash Inflow 8.52 17.04 15.49 13.57 18.86

Total Discounted cash inflow

for five years 73.49        
Cash outflow 75        

NPV -1.52        

The net present value is negative. Hence the project should be rejected.

Internal Rate of Return

A project has the following revenue and expenses over five years

Rs/Crs

Year Revenue Expenses

2021 50 40
2022 60 35
2023 66 41
2024 58 34
2025 72 54

Prevailing tax rate is 25%. The project has an investment of Rs 75 Crores. Depreciation is charged 10% on asset value.
All the investment are non-current assets only. The expenses do not include depreciation. The expected return in the
industry return is 10%. Terminal value of the project is 15 crores. Calculate the IRR. Comment on the acceptability of
the project if the expected return of the project is 8%.

Answer

It is same as the example in NPV.

We will have to calculate the IRR through extrapolation as we have done in Cost of Debt.

At 10% discounting rate NPV is -10.83 as done in the above problem.

At 6% discounting rate we will calculate the NPV.

Consider the last six rows of the previous example

Cash Inflow 9.375 20.625 20.625 19.875 15.375

          15
  9.375 20.625 20.625 19.875 30.375
Discounting
factor(6%) 0.943 0.89 0.84 0.792 0.747
Discounted Cash
Inflow 8.84 18.36 17.33 15.74 22.69
Total Discounted cash
inflow for five years 82.95        
Cash outflow 75        
NPV 7.95        

Now the figure line appears as follows

6% 10%

----------------------------------------------------

7.95 -1.52

IRR= 6%+(7.95/(7.95+1.52))/(10%-6%)=9.35%

The project should be accepted as IRR is more than the expected rate of return i.e 8%.

Accept Reject Rule

As we observe from the above examples the project should be accepted if

Payback Period- Less than the expectation of the promoter.

ARR- More than the industry average

NPV- is positive

IRR- more than the expected return.

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I suggest you should understand the above examples to attempt the examination properly and learn the concepts for your future career.
You may work out the problems from your text books. I have written and framed the examples on my own. If there are any errors, point me
out . I will correct it.