CAPITAL BUDGETING

IMPORATNCE OF CAPITAL BUDGETING

 IT DETERMINES THE FUTURE DESTINY OF THE
COMPANY.
– GOOD DECISION  COMPANY WILL PROSPER
– BAD DECISION  COMPANY WILL SUFFER

 IT HAS EFFECTS ON LONG TIME SPAN

ESPECIALLY ON THE COST STRUCTURE.
 CAPITAL INVESTMENT DECISIONS ONCE MADE
ARE NOT EASILY REVERSIBLE.
 IT REQUIRES LARGE INVESTMENT AND
USUALLY WE HAVE LIMITED FINANCE.
 KINDS OF DECISONS
1. ACCEPT / REJECT DECISIONS
1. If project meets minimum criteria it will be accepted
else rejected.
2. More then one project can be accepted.
3. All will be independent.
2. MUTUALLY EXCLUSIVE PROJECTS DECISIONS
Mutually exclusive projects compete with each other
and acceptance of one will exclude the acceptance of
other projects.
3. CAPITAL RATIONING DECISIONS.
1. Where firms have unlimited funds
2. More than one projects if accepted than the firm use
rationing.
 EVALUATION TECHNIQUES

1. AVERAGE RATE OF RETURN METHOD

2. PAY BACK PERIOD METHOD

3. NET PRESENT VALUE METHOD

 1. AVERAGE RATE OF RETURN (ARR)

 ARR =
AV. ANNUAL PROFIT AFTER TAX * 100
AV. INVESTMENT OVER THE LIFE OF PROJECT

AVERAGE INVESTMENT =
SALVAGE VALUE+(1/2)(COST-SALVAGE VALUE)
 EXAMPLE DATA
MACHINE A MACHINE B MACHINE C
COST 56,125 56,125 61,150
ESTIMATED PROFIT AFTER TAX
YEAR 1 3,375 11,375 4,500
YEAR 2 5,375 9,375 5,500
YEAR 3 7,375 7,375 9,000
YEAR 4 9,375 5,375 10,000
YEAR 5 11,375 3,375 11,000

TOTAL INCOME 36,875 36,875 40,000

ESTIMATED LIFE 5 Years 5 Years 5 Years
ESTIMATED SALVAGE VALUE 3,000 3,000 3,000
AVERAGE INCOME TAX RATE 55% 55% 55%

DEPRECIATION METHOD STGT. LINE STGT. LINE STGT. LINE

 CALCULATION

Av. Income = 36,875 / 5 = 7,375

Av. Investment = 3,000 + (½)(56,125 – 3,000) = 29,562.50

ARR = 7,375 / 29,562.5 = 24.9%.

If predefined criteria of 20% ARR is set then both projects

qualify to be accepted.
CRITICISM:
1. It does not consider timing of cash inflow
2. Does not differentiate between the size of the investments
 2. PAY BACK PERIOD

PB = Investment / Constant annual cash flow after tax

Example:
Investment = Rs. 40,000/=
Annual cash flow after tax = Rs. 8,000 per year.

PB = 40,000 / 8,000 = 5 Years.

If the result is less than any predefined number of years then
the project can be accepted.

CRITICISM:
 It ignores cash flow after pay back period.
 If cash flow is not even:

YEARS PROJECT CUMMULATIVE PROJECT CUMMULATIVE

A B
1 14,000 14,000 22,000 22,000
2 16,000 30,000 20,000 42,000
3 18,000 48,000 18,000 60,000
4 20,000 68,000 16,000 76,000
5 25,000 93,000 17,000 93,000

In this case the initial investment on Project A (Rs. 56,125)

can be recovered between years 3 and 4.

While Project B, the initial investment can be recovered

between years 2 and 3.
 EXERCISE
DATA:
Project cost: Rs. 50,000
Life: 5 Years
Salvage Value: 0
Tax Rate: 55%
Depreciation: Straight Line.
Estimated Cash Flow before tax is:-
Years CFBT
1 10,000
2 11,000 COMPUTE:
3 14,000
1. PAY BACK PERIOD.
4 15,000 2. ARR
5 25,000
 3. PV, NPV

If I invest Rs. 1,000 in my bank account with an

interest rate of 5%, then after 3 years:

Year 1 Year 2 Year 3

Beginning Amount 1,000 1,050 1,102.5
Int. Rate 5% 5% 5%
Int. Amount 50 52.50 55.125
Ending Amount 1,050 1,102.5 1157.62
 Calculate NPV of both assets and decide which asset shall
be purchased. Develop loan repayment schedule for the
selected asset.
Asset A Asset B
Cost 500,000 700,000
Asset Life – years 5 5
Salvage Value 10,000 20,000
Yearly Return from Asset 175,000 250,000
Loan Yearly Installment 152,704.69 208820.89
Amount
Interest Rate 16% 15%
Loan Life – years 5 5