Capital Budgeting

Decisions
Sessions 4 & 5
Revision
• Importance of CB
• Types of CB decisions
 Effect of
 Tax Effect
 Effect on Other Projects
 Effect of Indirect Expenses
 Effect of Depreciation
 Working Capital Effect
 Salvage Value
 EVALUATION TECHNIQUES
(1) Traditional Techniques
(i) Average rate of return method
(ii) Pay back period method
(2) Discounted Cashflow (DCF)/Time-Adjusted (TA) Techniques
(i) Net present value method
(ii) Profitability index
(iii) Internal rate of return method
 AVERAGE RATE OF RETURN METHOD
Also called accounting rate of return
Based on Accounting profits
Ambiguous, but most commonly accepted formula
ARR = Average annual profits after taxes / Avg investment over life of project X 100%

Where, Average investment = 1/2 (Initial cost of machine – Salvage value) + Salvage value + net
working capital
And Annual average profits after taxes = Total expected after tax profits/Number of years
 AVERAGE RATE OF RETURN METHOD: EXAMPLE 1

• Eg: Purchase price of machine = 11,000

• Salvage Value = 1,000
• Working capital required = 2,000
• Life of project = 5 years and
• SLM is followed

• Average investment =?
 EXAMPLE 1

• Purchase price of machine = 11,000

• Salvage Value = 1,000
• Working capital required = 2,000
• Life of project = 5 years and
• SLM is followed

• Average investment = 2,000 + 1000 + ½ (11,000-1000) = 8,000

Example 2
Determine the average rate of return from the following data of two machines, A
and B.
Particulars Machine A Machine B
Cost Rs 56,125 Rs 56,125
Annual estimated income after
depreciation and income tax:
Year 1 3,375 11,375
2 5,375 9,375
3 7,375 7,375
4 9,375 5,375
5 11,375 3,375
36,875 36,875
Estimated life (years) 5 5
Estimated salvage value 3,000 3,000
Depreciation has been charged on straight line basis.
Solution: ARR = (Average income/Average investment) × 100
Average income of Machines A and B =(Rs 36,875/5) = Rs 7,375.
Average investment = Salvage value + 1/2 (Cost of machine – Salvage value) = Rs 3,000 + 1/2
(Rs 56,125 – Rs 3,000) = Rs 29,562.50.
ARR (for machines A and B) = (Rs 7,375/Rs 29,562.50) × 100 = 24.9 per cent.
 AVERAGE RATE OF RETURN (ARR) METHOD

• How to take decisions?

• ARR > Pre-determined minimum rate of return

• Merits:
• Simple to use and easy to understand
• Accounting information available easily
 AVERAGE RATE OF RETURN (ARR) METHOD

• Limitations:
• The ARR is unsatisfactory method as it is based on accounting profits
• Ignores time value of money
• Does not consider incremental Cash Flows
• Does not differentiate between size of investment

Machines Average Annual Average ARR (%)

Earnings Investment
A Rs. 6,000 Rs. 30,000 20
B 2,000 10,000 20
C 4,000 20,000 20
 PAY BACK METHOD

• How many years will it take for the cash benefits to pay the original
cost of an investment?

• Cash benefits mean CFATs ignoring the interest

• The pay back method measures the number of years required for the
CFAT to pay back the initial capital investment outlay
• Original/initial Investment (outlay) is the relevant cash outflow for a
proposed project at time zero (t = 0).
 PAY BACK METHOD

It is determined as follows :
(i) In the case of annuity CFAT
• Annuity is a stream of equal cash inflows.
• Payback (in yrs) = Initial investment/Annual CFAT.
 PAY BACK METHOD

• Example:

• An investment of Rs 40,000 in a machine is expected to produce CFAT

of Rs 8,000 for 10 years,
• What is the payback period?
 PAY BACK METHOD

• Example contd:

• An investment of Rs 40,000 in a machine is expected to produce CFAT

of Rs 8,000 for 10 years,
• Payback period =5 yrs
 PAY BACK METHOD

• (ii) In the case of mixed CFAT:

• Mixed Stream is a series of cash inflows exhibiting any pattern other than that
of an annuity.
• It is obtained by cumulating CFAT till the cumulative CFAT equal the initial
investment.
Example 3 (from Example 2)
Year Annual CFAT Cumulative CFAT
A B A B
1 Rs 14,000 Rs 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000* 17,000*
* CFAT in the fifth year includes Rs.3,000 salvage value also.
Example 3 contd.
Year Annual CFAT Cumulative CFAT
A B A B
1 Rs 14,000 Rs 22,000 Rs 14,000 Rs 22,000
2 16,000 20,000 30,000 42,000
3 18,000 18,000 48,000 60,000
4 20,000 16,000 68,000 76,000
5 25,000* 17,000* 93,000 93,000
* CFAT in the fifth year includes Rs.3,000 salvage value also.
 PAY BACK METHOD

To evaluate a proposal, Payback period should be less than some pre-

determined period.

Merits:
- Easy to calculate and simple to understand
- Superior to the ARR method in that it is based on cash flows
 PAY BACK METHOD
Limitations:
- Ignores time value of money
- Ignores all CashFlows after the payback period which maybe misleading
- Payback cannot be regarded as a measure of profitability
Particulars Project X Project Y
Total cost of the project Rs. 15,000 Rs. 15,000
Cash Inflows (CFAT)
Year 1 5,000 4,000
2 6,000 5,000
3 4,000 6,000
4 0 6,000
5 0 3,000
6 0 3,000
Payback period (yrs) 3 3
 PAY BACK METHOD

Discounted Payback period

- Adjusts for Time Value of Money
- But even then, the cut-off period is arbitrarily set
- Sometimes, the shortest discounted Payback period project have not
have the maximum NPV
 PAY BACK METHOD

Applications:
- Where Long Term outlook is uncertain Eg: Politically unstable
economies
- Firms with liquidity crisis
- Firms that lay more emphasis on Short Term earnings than Long Term
growth
DISCOUNTED CASHFLOW (DCF)/TIME-ADJUSTED (TA) TECHNIQUES

 The DCF methods satisfy all the attributes of a good measure of appraisal
 They consider the total benefits (CFAT) as well as the timing of benefits

 The present value or the discounted cash flow procedure recognises that cash flow streams at
different time periods differ in value and can be compared only when they are expressed in terms of
a common denominator, that is, present values. It, thus, takes into account the time value of money.
In this method, all cash flows are expressed in terms of their present values.

 These methods require CashFlows to be discounted at a certain rate (Cost of capital, or k)

Example 5 (General procedure for DCFs)
The present value of the cash flows in Example 4 are illustrated here
Year Machine A Machine B
CFAT PV factor Present value CFAT PV factor Present
(0.10) (0.10) value

1 2 3 4 5 6 7
1 Rs 14,000 0.909 Rs 12,726 Rs 22,000 0.909 Rs 19,998
2 16,000 0.826 13,216 20,000 0.826 16,520
3 18,000 0.751 13,518 18,000 0.751 13,518
4 20,000 0.683 14,660 16,000 0.683 10,928
5 25,000* 0.621 15,525 17,000* 0.621 10,557
69,645 71,521
*includes salvage value.
 NET PRESENT VALUE (NPV) METHOD
 The NPV may be described as
 the summation of the present values of (i) operating CFAT (CF) in each year and (ii) salvages
value(S) and working capital(W) in the terminal year(n)
 minus
 The summation of present values of the cash outflows (CO) in each year.

 The present value is computed using cost of capital (k) as a discount rate.
 NET PRESENT VALUE (NPV) METHOD
 The decision rule for a project under NPV is to accept the project if the NPV is positive and reject if
it is negative. Symbolically,
(i) NPV > zero, accept, (ii) NPV < zero, reject
 Zero NPV implies that the firm is indifferent to accepting or rejecting the project.

Net Present n CFt Sn + Wn n COt

= ∑ + - ∑
Value t=1 (1+k)t (1+k)n t=1 (1+k)t
Table A-1 : The Present Value of One Rupee
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.789 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
 NET PRESENT VALUE (NPV) METHOD

• Merits
• Explicitly recognizes Time Value of Money (next slide example)
• Considers benefits over the entire life of the proposal
• A changing discount rate can be built into the NPV calculation
• Important for selecting between Mutually exclusive projects
• Achieves the objective of shareholders’ wealth maximization
Example 5 contd.
The present value of the cash flows in Example 4 are illustrated here
Year Machine A Machine B
CFAT PV factor Present value CFAT PV factor Present
(0.10) (0.10) value

1 2 3 4 5 6 7
1 Rs 14,000 0.909 Rs 12,726 Rs 22,000 0.909 Rs 19,998
2 16,000 0.826 13,216 20,000 0.826 16,520
3 18,000 0.751 13,518 18,000 0.751 13,518
4 20,000 0.683 14,660 16,000 0.683 10,928
5 25,000* 0.621 15,525 17,000* 0.621 10,557
69,645 71,521
*includes salvage value.

We would accept the proposals of purchasing machines A and B as their net present values are positive.
The positive NPV of machine A is Rs 13,520 (Rs 69,645 – Rs 56,125) and that of B is Rs 15,396 (Rs 71,521
– Rs 56,125).
 NET PRESENT VALUE (NPV) METHOD
• Demerits
• Difficult to understand and calculate (relative to Avg Rate of Return and
Payback method)
• Required rate of return calculation is difficult
Discount rate (%) NPV
Zero Rs. 5,000
4 3,465
8 2,179.50
10 1,614
12 1,093.50
16 168
20 (626.5)

• It is an absolute measure
• Two projects with different effective life
Example 5 contd.
In Example 5, if we incorporate cash outflows of Rs 25,000 at the end of the third year in respect of
overhauling of the machine, we shall find the proposals to purchase either of the machines are
unacceptable as their net present values are negative.
The negative NPV of machine A is Rs 6,255 (Rs 68,645 – Rs 74,900) and of machine B is Rs 3,379 (Rs
71,521 – Rs 74,900).
 Profitability Index (PI) or Benefit-Cost
Ratio (B/C Ratio)
The profitability index/present value index measures the present value of
returns per rupee invested. It is obtained dividing the present value of
future cash inflows (both operating CFAT and terminal) by the present
value of capital cash outflows.

Present value cash inflows

Profitability Index =
Present value of cash outflows

The proposal will be worth accepting if the PI exceeds one.

PV Index
When PI is greater than, equal to or less than 1, the net present value is greater
than, equal to or less than zero respectively.
In other words, the NPV will be positive when the PI is greater than 1; will be
negative when the PI is less than one. Thus, the NPV and PI approaches give the
same results regarding the investment proposals.
Example 6
In Example 3 (Table 3) of machine A and B, the PI would be 1.22 for
machine A and 1.27 for machine B:
Rs 69,645
PI (Machine A) = = 1.24
Rs 56,125
Rs 71,521
PI (Machine B) = = 1.27
Rs 56,125
Since the PI for both the machines is greater than 1, both the machines
are acceptable.
Profitability Index (PI)
• Merits
• Considers Time Value of Money
• Considers total benefits
• Sound conceptually
• Better than NPV (although some cases NPV may be superior)
Particulars A B
NPV (same) 10,000 10,000
Initial investment 50,000 25,000
NPV method Indifferent Indifferent
PI Yes
Comprehensive Examples
Example 7 (Q1 material)
Example 8 (Book)
• A company is considering an investment proposal to install new milling controls at a cost
of Rs. 50,000. The facility has a life expectancy of 5 years and has no salvage value. The
tax rate is 35%. Assume the firm uses SLM of depreciation and the same is allowed for
tax purposes. The estimated cash flows before depreciation and taxes (CFBT) from the
investment proposal is as follows:

• Compute the (i) Payback period (ii) Avg rate of return (iii) NPV @ 10% discount rate (iv)
Profitability index @ 10% discount rate
(i) Payback period

• The recovery of investment falls between the fourth and the fifth years.
• The Payback period is 4 years + a fraction of the fifth year
• = 4+ Rs 5,500 / Rs. 16,750 = 4.328 years
(ii) ARR
(iii) NPV
(iv) Profitability Index